January 25, 2016
Thank you so much Jeffrey for that kind introduction. And thank you Lord Woolf. It’s really a pleasure to be here with you today. It’s an honor to speak in this distinguished venue.
I’m happy to see so many old friends – and meet some new ones as well. Some of you I’ve known for decades – since the beginnings of the global derivatives markets. We’re all a little older and greyer than we used to be. And I’ve noticed that many of you have lost a lot of hair.
It’s particularly a pleasure to meet some of you whom I have heard about over the years, but never had a chance to meet. In just a few short years, PRIME has emerged as a first-class convener of some of the brightest legal minds to help resolve complex financial disputes.
So I’m very happy to be here with you today – and not just because if I weren’t here, I’d be back home shoveling snow.
Today I thought I would discuss how we, as the primary U.S. agency responsible for the derivatives markets, look at what is happening in the derivatives world. The issues we are considering may impact dispute resolution, and the issues that you consider in disputes —valuation issues, contract interpretation issues—often are related to policy issues that we are thinking about. So I’d like to discuss a number of the issues currently high on our agenda – issues where your expertise may be very relevant. I will of course be expressing my own views, not necessarily the views of my fellow commissioners.
Let me start by giving you a brief overview of where we are in the implementation of the basic reforms of the over-the-counter swap market that were agreed to by the leaders of the G-20 and codified in our Dodd-Frank legislation. As many of you know, there were four key components. They were: central clearing of standardized swaps, oversight of the largest market participants, transparent trading on regulated platforms, and regular reporting.
Today, this framework is largely in place in the United States. Clearing is now required for most interest rate and credit default swaps. Today, approximately 75 percent of swap transactions in our markets are being cleared, as compared to only about 15 percent in 2007.
We have implemented a program for the oversight of major market participants. We just recently finalized our rules on margin for uncleared swaps, which is a key part of this effort.
Trading on regulated platforms is a reality, and is bringing increased transparency and integrity to the process. Our trading rules have been in place for a few years now, and we have almost two dozen swap execution facilities (SEFs).
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 that includes better liquidity in both the U.S. and European markets, despite some fragmentation.
And finally, transaction data is being reported and is publicly available. This gives regulators better information and has enhanced price discovery and competition for market participants.
Of course, there is more work to be done in all of these areas. So let me turn to a few issues that may be of particular interest to you.
Central Clearing Issues
First is the subject of central clearing and CCPs. I know some of you have raised the issue of dispute resolution regarding cleared swaps. Just because swaps are cleared doesn’t mean there won’t be disputes. So how will clearinghouses resolve these disputes? Are their rule books designed for that? Swaps, after all, are different than futures. The contracts are not products of the CCP or its affiliated exchange. Moreover, there is far more variation in terms, which may give rise to disputes.
Our rules provide that swap dealers must give notice of any dispute over $20 million dollars. We have recently delegated the authority to receive and review those notices to the National Futures Association, or NFA, which is our primary self-regulatory organization. But thus far, this has not been an area of much activity for us. So perhaps you have suggestions for things we should be thinking about. Certainly, as the industry gains more experience with clearing swaps, there may be policy issues regarding dispute resolution where your expertise may be helpful.
So I appreciate your interest in this area – and we are certainly open to hearing your thoughts as the process develops.
CCP Resiliency Generally
I want to turn to some larger policy issues concerning CCPs, which may interest you.
First, we have been working to reach consensus with the European Commission on the issue of “equivalence” so that European firms can continue to do business with our clearinghouses without incurring higher capital charges. I have always believed there is an ample basis for the European Commission to declare us equivalent, and that this should have happened some time ago. But in any event, we are getting closer. I have great respect for Commissioner Jonathan Hill, and he and I have developed a good relationship. He has indicated they will act soon, and we are working with the EC to do all we can to facilitate that.
It’s particularly important that they act soon because the European clearing mandate will take effect in a few months, assuming it is not delayed. And so equivalence and recognition of our CCPs is necessary to avoid any market disruption. I know Commissioner Hill wants to avoid any disruption to the market and avoid imposing any additional burden on European firms in particular. Needless to say, we support that goal. There are still some issues we are discussing, but I see no reason why this couldn’t happen very soon. But if it doesn’t, perhaps I will be in the market for some expert advice on dispute resolution.
Because we have made CCPs even more important in the global financial system, we are very focused on making sure they are strong and resilient. Over the last few years, the CFTC has done a major overhaul of our clearinghouse oversight. We have substantially strengthened risk management and increased transparency. We have incorporated international standards that we helped develop into our regulations, strengthened customer protection measures, and enhanced our examination, compliance, and risk surveillance programs.
And we’re also working with our colleagues in other countries in a number of ways on CCP resilience, as well as recovery and resolution planning. Let me mention a few particular issues in this area.
Stress Testing. First, there is considerable work going on to see whether we can develop standards for stress testing of CCPs. This would help us evaluate clearinghouse risk across borders. CCPs are different, of course, so there is no one size fits all. Some of you may have expertise that can be useful as we think about what those standards should be.
Recovery planning. Second is the subject of recovery planning. What happens if there is a problem at a CCP—one or more clearing members default? In particular, what happens if the so-called “waterfall” of resources available for a default are insufficient – that is, the initial margin of the defaulting members and their guarantee fund contributions, the clearinghouse’s capital, the other clearing members’ prefunded contributions to the guarantee fund, and potential assessments on clearing members.
Now of course, we think this scenario is highly unlikely, but we must plan for it. And we must be able to solve the problem without taxpayer money. The potential tools available to a clearinghouse in this situation will raise issues of how to distribute losses fairly among participants. For example, a clearinghouse has a matched book. If a clearing member defaults, there are those with gains that offset losses on other contracts. So we are exploring whether, under what circumstances, and to what extent, gains-based haircutting is an appropriate tool to allocate losses. Another tool is partial tear-ups, in order to re-establish a matched book. We are also considering the governance mechanisms over the use of recovery tools – and the transparency regarding the potential use of those tools. What should be agreed in advance regarding the use of such tools, and by whom? Questions as to the fairest ways to do this are important ones for the CCPs, market participants and us to consider.
The recovery planning issues remind us that if CCPs are to be successful, a robust clearing member industry is critically important. Those of you who have been involved with the Lehman bankruptcy – or with other defaulting counterparties – know from firsthand experience that the vital issue is to be able to transfer the positions of a defaulting institution quickly. And looking at how auctions can work effectively in scenarios involving significant stress on the system is another part of the recovery planning.
Supplementary Leverage Ratio. A related subject that may affect having a robust clearing industry and clearinghouse resiliency arises in the interaction of two regulatory goals coming out of the crisis—strengthening bank capital on the one hand, and promoting greater use of central clearing on the other. This pertains to the supplementary leverage ratio, or “SLR.”
Bank regulators around the world have done a great job working together to establish stronger capital requirements for banks, and in particular the largest institutions. One element of those measures is leverage ratios—limits on liabilities or exposures relative to assets. I support having strong capital requirements on banks, including leverage ratios. I support having those leverage ratios apply to derivatives. I am concerned, however, about how the SLR impacts clearing, and I know some of you share that concern.
The issue here is how a clearing member’s potential future exposure arising from cleared derivatives should be measured. The SLR does so through a schedule-based approach that many feel is flawed. Among other things, it doesn’t take collateral held by the clearinghouse into account. The concern is that the way the SLR measures potential future exposure could have a significant, detrimental effect on clearing, and in turn, on clearinghouse resiliency. A large banking institution will look at the costs of regulation on each aspect of its business. And if some clearing members choose to limit customers, or get out of the clearing business altogether, that may make it harder to deal with the next time a clearing member defaults.
I know some of you have given this issue some thought, and I would be interested in your ideas.
Improving Data Reporting
Let me turn to a different area, which is data reporting. The CFTC is taking many steps to ensure that the swap data we receive is accurate, consistent and timely.
I know you understand the importance of this. The lack of data in the fall of 2008 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 there is more to do. Creating a system to collect and effectively use data is a significant project. Currently, for example, there is considerable variation in how different participants report the same fields to swap data repositories (SDRs), and in how the SDRs themselves transmit information to the CFTC.
Therefore, CFTC staff has recently proposed technical specifications for the reporting of 120 priority data elements. We are requesting public input on this, and so we invite your thoughts.
And let me just say that this is just one of the many actions the CFTC is taking to ensure accurate and efficient data reporting. We hope to soon finalize some changes to our rules to improve the reporting of cleared swaps and eliminate unnecessary reporting. We are also leading international efforts on data harmonization.
De Minimis Threshold
We are also using the very valuable data we have today to take a fresh look at the issue of who should be considered a swap dealer. This relates to the “de minimis threshold” for defining swap dealers, as some of you know. What is the level of dealing activity that should trigger registration and oversight? Should that be measured solely by notional amount, or in other ways? We recently released a report on this and will be studying it further in the coming months, and we invite the public’s input on this as well.
Enhancing the Safety and Stability of our Markets
Thus far, all the issues I have talked about involve the regulatory response to the global financial crisis. That’s appropriate, given the devastation of the crisis. And regulators must often look back, and try to fix the problems of the past. But we must also be looking toward the future, and thinking about how the markets are evolving -- and the potential new risks. So let me briefly note two areas where the Commission recently unanimously approved proposals that aim to do just that. The first would enhance cybersecurity protections. This is a top priority. The risk of cyberattacks is perhaps the greatest single threat to the orderly functioning of our markets. Our proposal seeks to make sure that the critical market infrastructure that we oversee--the exchanges, swap execution facilities, clearinghouses and swap data repositories—engage in adequate testing of their own protections against cyberattacks and similar technological risks.
The second is a proposal to address the increased use of automated trading in our markets, which has dramatically expanded in recent years. Today, almost all trading in our markets is electronic. And automated trading represents about 70 percent of futures trading. Our proposal seeks to minimize the risk that automated trading will result in disruptions in the markets. Our proposal seeks to do that by requiring adequate risk controls, testing and monitoring of algorithms, and other measures. We hope to finalize these rules, which are still open for comment, later this year
Finally, let me turn to the area of enforcement.
Proving manipulation and attempted manipulation always raises interesting issues. New forms of bad behavior, such as spoofing, are complicated and constantly evolving. As I noted, trading in our markets today is mostly automated. As a result, analyzing trading patterns involves looking at massive quantities of data, which requires sophisticated IT capabilities. In the case of spoofing and manipulation, however, it also involves a concept that is very familiar to lawyers, from the days of our first year law courses. And that is the question of intent, one of the oldest concepts in criminal law.
We will continue to actively monitor and deter this type of behavior. In a recent case, a defendant entered over 460,000 orders, but consummated only 371 trades. As I said recently, if your trading firm is entering a lot of orders without the intention to consummate, you should probably go talk to your lawyers.
One enforcement area where we have been quite active, and I know many of you have an interest, is benchmarks. We brought the first LIBOR case, and have brought several cases since on LIBOR, FX and ISDA Fix. Our orders have required remedial actions that served as precedents for subsequent reform efforts. We will continue to be active in this area.
And I support reforms that seek to make sure benchmarks are transparent and administered with integrity. However, I also wish to note that it is important to make sure that statutory or regulatory requirements on benchmark administrators are properly designed and calibrated. We do not want to impose so many requirements on benchmark administrators that we stifle innovation in the development of new benchmarks, or make it impractical to secure sufficient participation in the rate setting process.
These are only a handful of the issues on our plate. The regulation of derivatives is a complex area, and so the involvement of people with experience and knowledge of the field – and how it has evolved –is always welcome. I believe it is especially important that we keep in mind the role that these markets play in enabling businesses to hedge routine commercial risk, and so it is important to make sure these markets function efficiently and effectively for them. Thank you again for inviting me here today.
I’m sorry I can’t stay for the whole day, but I’d be pleased to take a few questions.
Last Updated: January 25, 2016