January 22, 2016
Thank you so much, Ken, for that warm introduction – and happy new year.
I’m very pleased to be joining you for this important annual event – particularly as I was unable to attend last year. I was disappointed to miss last year’s meeting, but unfortunately the timing coincided with a trip to Asia I had previously planned.
But this year, even though the timing has allowed me to get here, it may keep me here a bit longer than planned. As you may know, Washington and much of the east coast is expected to be hit by a mega snow storm. So those of us who live in the northeast may not get home for a couple of days. That means many of us may just have to accept being stranded in Florida over being back home and shoveling.
Regardless of all the snow shoveling in DC, there is still a significant amount of work getting done in Washington. Today, I’d like to talk briefly about a number of our recent accomplishments, and highlight some areas where the Commission will focus in the first part of 2016.
One important achievement is taking place just this snowy morning. Today, we are announcing the permanent registrations for 18 swap execution facilities (SEFs). I’m very pleased that we are able to take this important step. These registrations represent continued progress toward the implementation of a new framework for trading on regulated platforms, as called for by Dodd-Frank and the G-20 leaders. It is bringing greater transparency, better price information and greater integrity to the process.
And it is worth pointing out important research that demonstrates the reforms we put in place are working. A recent report by the staff at the Bank of England noted that SEF trading has brought improved trading conditions—significantly lower transaction costs and better liquidity. And notwithstanding the industry complaints about geographical fragmentation, they reported that this did not compromise liquidity. I quote, “the improvements in transparency brought about by the Dodd-Frank trading mandate have substantially improved interest rate swap market liquidity.”1
There are five other SEFs that remain temporarily registered, and CFTC staff is continuing with their registration reviews. Pending their reviews, those facilities continue to operate under temporary registration status. I will return to the issue of SEF trading later.
Let me turn to some other important actions we took at the end of 2015 and then discuss some priorities for 2016.
Margin for Uncleared Swaps
The Commission adopted a strong final rule setting margin requirements for uncleared swaps.
Our margin rule is one of the most important elements of swaps market regulation set forth in the Dodd-Frank Act. There will always be a large part of the market that is not cleared – many swaps are not suitable for central clearing and our clearinghouses will be stronger if we exercise care in what is required to be cleared. However, we must take steps to protect against uncleared swaps posing excessive risk to the system. That is why margin requirements for uncleared swaps are so important.
I believe the rule we have adopted is strong and sensible. It is designed to reduce the risk that a default of a large financial entity would lead to further defaults by its counterparties, given the interconnectedness of our financial system. We became all too familiar with this risk in 2008.
The rule requires swap dealers and major swap participants to post and collect margin with financial entities with whom they have significant exposures. It requires initial margin, which is designed to protect against potential future loss on a default, as well as variation margin, which serves as mark-to-market protection. It allows for the use of a broad range of types of collateral, but only with appropriate haircuts. It requires a greater level of margin than for cleared swaps, given that uncleared swaps are likely to be less liquid.
The swap activities of commercial end-users were not a source of significant risk in the financial crisis, and in this rule we made sure that they can continue using the derivatives markets effectively and efficiently. That’s why an important feature of our rule is that these margin requirements do not apply to swaps with commercial end-users.
Our rule is practically the same as the rules adopted by the prudential regulators, and very similar to the international standards as well as the rules that we expect Europe and Japan to adopt very soon. Shortly after I took office, I committed to doing all we could to achieve such harmonization with this rule—there were many differences 18 months ago. I am pleased to say we have succeeded.
The issue of how our rule should apply to inter-affiliate transactions has received a lot of attention. The international standards do not require margin for inter-affiliate transactions – and we understand that Europe and Japan will not require it in their rules. I looked at this issue in terms of the goals of the rule, which are first and foremost to avoid the potential for the buildup of excessive risk from bilateral transactions between unaffiliated parties. Inter-affiliate transactions are not outward-facing and thus do not increase the overall risk exposure of the consolidated enterprise to third parties. Imposing the same third-party transaction standards on these internal activities of consolidated entities is likely to significantly increase costs to end-users without any commensurate benefit.
But the standards are still relevant to the safety and soundness of swap dealers and we must design appropriate protections. Therefore, we took the following actions: First, we have required that full variation margin be exchanged for all inter-affiliate swaps. This provides mark-to-market protection to either side, and prevents the potential buildup of a liability owed by one affiliate to another. Second, we have required initial margin in certain cases—specifically, in order to prevent evasion of the requirement to collect margin from third parties. We also require that initial margin be posted to a bank that is registered as a swap dealer, which is consistent with the prudential regulators’ rule. And third, we have required that inter-affiliate swaps be subject to a centralized risk management program that is reasonably designed to monitor and to manage the risks associated with such transactions.
This past year, the Commission unanimously took action to enhance cybersecurity protection in our markets. We proposed rules designed to make sure that the private companies, which run the core infrastructure under our jurisdiction—exchanges, clearinghouses, swap execution facilities and swap data repositories – are doing adequate evaluation of cybersecurity risks and testing of their own cybersecurity and operational risk protections. The proposals address information security, physical security, as well as business continuity and disaster recovery. The proposals set principles-based testing standards, which are deeply rooted in industry best practices.
The proposals identify five types of testing as critical to a sound system safeguards program: vulnerability testing, penetration testing, controls testing, security incident response plan testing, and enterprise-wide assessment of technology risk. Such efforts are vital to mitigate risk and preserve the ability to detect, contain, respond to, and recover from a cyberattack or other type of operational problem.
Before taking final action on these proposals, we will carefully consider any feedback we may receive. We hope to finalize these important rules before the end of this year.
Proposed Rule on Automated Trading
Let me turn to another area where we are responding to technological change. Last November, the Commission unanimously proposed a rule to address the increased use of automated trading. Today, almost all trading in our markets is electronic, and approximately 70 percent of trading in the futures market is automated.
Automated trading has brought many benefits to market participants – such as more efficient execution, lower spreads and greater transparency. But its extensive use also raises important policy and supervisory questions and concerns.
Our recent proposal focuses on minimizing the potential for disruptions or other operational problems that can be caused by automated trading. These could occur from fat fingers, untested algorithms or in other ways. Our proposal builds upon the steps we and the exchanges have already taken on this front. It relies on a principles-based approach that codifies many industry best practices.
Our proposal requires pre-trade risk controls such as message throttles and maximum order size limits, and other measures such as “kill switches,” which facilitate emergency intervention in the case of malfunctioning algorithms. But it does not prescribe the parameters or limits of such controls, because we believe market participants are the ones who should determine those specifics.
Our proposal sets general requirements pertaining to the design, testing and supervision of automated trading systems, but again it leaves the details of those to market participants. We have proposed requirements at the exchange level as well as at the clearing member and trading firm levels. This, too, is a best practice suggested by many firms. We have proposed requiring proprietary traders who access the market directly and who are using automated trading – to register with the CFTC. And we have included measures to limit the practice of self-trading.
We hope to finalize this rule in 2016 as well.
Improving Data Reporting
The CFTC is also taking important steps to ensure that the swap data we receive is accurate, consistent and timely.
Reporting of swaps transaction data was a key goal of the reforms agreed to by the leaders of the G-20 nations, and one of the most important components of the Dodd-Frank Act. We have come a long way since the fall of 2008, when a lack of reporting meant neither regulators nor market participants could assess the exposures or interconnectedness of major institutions. The reforms we have implemented have given regulators better information and market participants greater transparency.
But building an efficient system to collect and analyze data from this market is an enormous undertaking, and there is more work to do. Currently, for example, there is considerable variation in how different participants report the same fields to SDRs, and in how the SDRs themselves transmit information to the CFTC.
When the rules were first written, we purposely didn’t prescribe exactly how each field should be reported – for a number of reasons. First, when the agency issued the reporting rules, we didn’t yet have any data to inform our views. And second, we expected the industry to develop standardized terms. That, unfortunately, did not happen.
So in December, CFTC staff proposed technical specifications for the reporting of 120 priority data elements. We are requesting public input on this, which culminated months of work to identify priority areas where standardization or clarification is needed.
This is just one of the many actions the CFTC is taking to ensure accurate and efficient data reporting. We have already proposed actions to clarify reporting obligations with respect to cleared swaps and eliminate unnecessary reporting. I hope we can finalize these rule changes soon. We are also leading international efforts on data harmonization. And finally, we will continue to take enforcement actions so that participants comply with reporting obligations.
De Minimis Threshold
While there is still progress to be made on data reporting, it’s important to acknowledge how far we’ve already come. An important example of this is the preliminary report CFTC staff recently released on what is known as the “de minimis threshold” for swap dealing and major swap participants.
The de minimis limit was set by the CFTC and the Securities and Exchange Commission’s joint rule defining swap dealers. As you may know, if an entity engaged in swap dealing exceeds that threshold –which is currently $8 billion dollars in notional amount of swaps over the year – it must register as a swap dealer, which triggers oversight by the CFTC as well as disclosure, recordkeeping and documentation requirements.The rule also provides that about two years from now, that level will fall to $3 billion, unless the Commission takes action.
When our two agencies wrote the “de minimis exception” we originally did it without the benefit of much data.
But we now have substantial information that we can use to have a discussion about what is the appropriate level at which to set the de minimis threshold. And our staff report aims to start that conversation, by taking a fresh look at the issue. The staff’s preliminary report does not make a recommendation as to what the level should be. It instead explores the issues, and invites public comment on the data, the methodology and the issues discussed.
In fact, the comment period on this study recently closed. We will now begin the process of carefully studying the feedback we’ve received, producing a final report, and making a decision on what, if any, action to take.
Focus in Early 2016
Moving forward on the various proposals I have noted—such as on cybersecurity and automated trading—will be an important part of our agenda this year.
Let me say a little bit about some of our other priorities for the early part of 2016.
We remain keenly focused on preventing excessive risk and promoting stability in the financial system. A primary emphasis here will be clearinghouse strength and resiliency generally. There are considerable efforts going on domestically and internationally to look at a range of issues to make sure clearinghouses are strong and safe. This includes, determining whether we can develop standards for stress testing of CCPs. This would help us evaluate clearinghouse risk across borders.
And it also includes recovery planning. What happens if there is a problem at a CCP—one or more clearing members default? What happens if the so-called “waterfall” of resources available for a default are insufficient – that is, the initial margin of the defaulting members, the clearinghouse’s capital, the other clearing members’ prefunded contributions to the default fund, and potential assessments on clearing members.
We are working on these issues domestically, as well as internationally with our fellow regulators.
For example, we are co-chairing a CPMI-IOSCO group that is looking at stress testing, margin methodologies, capital and recovery plans. The work also includes reaching consensus with European regulators over their recognition of U.S. clearinghouses, or the issue of “equivalence.”
I have always believed there is an ample basis for the European Commission to declare us equivalent.
We’ve also been willing to work with the European Commission to make sure we are enhancing CCP resilience and minimizing differences that might lead to regulatory arbitrage. Now, there have been recent reports in the press that the Commission will act soon on this, and I welcome such news. I certainly am as keen as Commissioner Jonathan Hill to bring this to a conclusion, and hope that we can do so soon.
Let me turn to some other priorities.
Soon, I will ask the Commission to finalize our proposed rule on the cross-border application of our recently adopted rules on margin for uncleared swaps. In June of last year, the Commission unanimously approved a proposed cross-border approach, which is an important component of our rule on margin for uncleared swaps because it addresses risk that could be created outside our borders, but still jeopardize our financial stability and our economy.
I believe our final rule will draw a reasonable line that makes clear when we should take offshore risk into account. As with our broader margin rule, I expect it will recognize the importance of harmonizing rules with other jurisdictions.
In addition, the staff is working on reproposing rules related to capital requirements for swap dealers and major swap participants. As with the margin rules, we’re working with our fellow regulators—in this case the prudential regulators as well as the SEC—to harmonize these standards as much as possible.
And let me return to the subject I mentioned at the outset, which is trading of swaps on SEFs.
This spring, I will ask the Commission to consider a number of changes to enhance SEF trading and participation. Over the past 18 months, the Commission staff took several actions to do so, such as expanding modes of execution, simplifying the confirmation process, streamlining the process for correcting error trades, and providing relief on package trades, among others.
Now that we can free up some staff from the registration process, we can continue with further actions in that regard. So it is my intention to formalize a number of these “no action” letters and guidance through rulemaking proposals. We will also consider some additional issues, such as whether the Commission should play a greater role in the “made available to trade” determination process.
And now that ESMA has published the MiFiD II technical standards, we are also working to understand differences in our respective rules – in order to make progress toward harmonization.
These are just a few highlights for the beginning of 2016. There is a significant amount of work going on in other areas, including position limits, enforcement and a host of other activities.
But in the interest of having time for your questions, let me stop here, and close by noting that, given this workload, I was disappointed that, as a part of last year’s federal spending bill, the CFTC received no budgetary increase. As you know, our responsibilities were greatly expanded after the crisis, and our markets have grown enormously in size, importance and technological complexity.
But the CFTC’s appropriation simply doesn’t match our responsibilities. The markets we oversee are critical to commercial businesses, and profoundly affect the prices all Americans pay for many goods and services in our daily lives. Sensible regulation requires adequate resources, and is a good investment for our economy.
So again, thank you and I’d be pleased to take your questions.
1 Benos, Payne and Vasios , “Centralized trading, transparency and interest rate swap market liquidity: evidence from the implementation of the Dodd-Frank Act.” Bank of England, January 2016. Available at http://www.bankofengland.co.uk/research/Documents/workingpapers/2016/swp580.pdf
Last Updated: January 22, 2016