December 12, 2011
I would like to begin by thanking the Edison Electric Institute for inviting me to speak today.
The Commission plays a critical role in energy markets. As the Commission tackles the many mandates under Dodd-Frank, the Commission must proceed cautiously and thoughtfully. If our new regulations are overly burdensome and proscriptive, they will force American businesses to make hard choices between allocating capital between fruitful activities that will spur market innovation, create much needed jobs, and grow our economy; or towards paying for needlessly expensive hedging of risk, high capital and margin costs, and other trading costs. Our challenge is to balance the new rules so it won't bust your budgets.
I noticed that one of the topics on the agenda for tomorrow, December 13th, is next steps for EEI. I believe that the most pressing issues facing the electricity business will be the swap dealer definition, clearing rules, capital and margin requirements and trading rules. I’ll provide my views on these issues and I will also touch on position limits and technology, and close with some brief thoughts on MF Global.
It is that time of year again when I start to fill out my Christmas list. I would like to share two items on my Christmas list with you. I bet many of you are wishing for these too.
At the top of my wish list, is for the Commission to issue a schedule outlining the order of rules to be considered and an implementation timeline for all of the rules under consideration. A more comprehensive and definitive schedule must be produced. Our rules have not been released in any particular order which contributes to regulatory uncertainty. Every market participant and foreign regulator I have spoken with asks about our schedule. I am certain that more transparency into scheduling and implementation will accelerate compliance. Our current opacity contributes to confusion and delay.
Thankfully, Congress took notice and retained language in the Commission’s annual 2012 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 If we ignore Congress, I fear we risk getting a large lump of coal in our stocking.
My second Christmas wish is that the Commission provide market participants an opportunity, via roundtables, to fully vet their concerns on our rulemakings. The Commission should host additional roundtables on: 1) client clearing documentation; 2) the mandatory clearing determination; and 3) the mandatory trading requirement. I sent a letter on July 18, 2011 asking for input on how the Commission should define what is clearable, because the rulemaking refused to address the issue. We received over a dozen responses from energy and agriculture groups. Thank you all for your input. On December 5, 2011, the Chairman agreed to roundtables on what is clearable and what is “tradeable.”
Hopefully, the Commission will host the third roundtable on client clearing documentation. Maybe this Christmas wish will come true!
There has been a lot of discussion about end-users and the burdens these entities will be faced with under Dodd-Frank. The end-user category is broad and very diverse. It includes Fortune 100 companies, power providers, farmers, municipalities, energy companies, agricultural processors, technology companies, manufacturing companies and host of other entities. While that list may seem complete, it’s not. The dealer definition should not extend to pension funds, endowments, and ERISA plans.
As the Commission continues to finalize rulemakings, we must pay close attention to Congressional direction that determined that for the most part commercial, corporate, municipal, and retirement end-users, for the most part, are not systemically risky and their commercial hedging activities are exempt from the clearing mandate and therefore the dealer definition.
These end-users rely on their credit quality and generally don’t post margin to their dealers. They also do not have large back-office operations dedicated to reconciling trade disputes, reporting trades, or engaging in the daily cash management of collateral. Under Dodd-Frank and our rule proposals, these end-users could be subject to all of these functions, each of which is completely new for them.
Swap Dealer Definition
I believe the entity definition rule is one of the most important rules facing market participants. If we get the definition wrong, there will be significant consequences for commercial firms. I believe the dealer definition is too broad and exemptions too narrow. As Congress intended, the Commission should adopt a risk-based approach to the entity definition rule that focuses on systematically-risky firms, and not cast the regulatory net as far and as wide as it can. Our proposed dealer definition captures end-users who neither pose systemic risk nor played any role in the 2008 financial crisis.
Being tagged as a swap dealer will subject firms to margin, collateral, and clearing requirements that could devour firms’ balance sheets. This will force commercial firms to make difficult decisions between making new investments and hedging commercial risk. As hedging opportunities become more cumbersome and expensive, commercials may face greater exposure to risk as they are forced to settle for dirty hedges, or not hedge at all.
In developing the rules governing cleared and uncleared swaps, it is important to keep in mind the specific Congressional direction in Section 2(a)(7) of the Dodd-Frank Act, which exempts end-users from clearing. The Dodd-Lincoln letter is also explicitly worded: “Congress clearly stated in this bill that the margin and capital requirements are not to be imposed on end-users...”.2 Congress preserved the ability for corporate, municipal, and commercial end-users to enter into uncleared swaps. It also instructed the regulators to only impose margin on an uncleared swap if appropriate to manage the risk of that swap. The final Commission regulations and prudential regulator rules should do the same.
In contrast to the overly broad entity definition, the de minimis proposal is too narrow and also fails to adopt a risk-based approach. The current proposal uses a threshold of $100 million in gross notional swap transactions. This number is way too low and fails to account for the significant differences in notional values among asset classes. I have argued vigorously for a higher de minimis threshold because the Commission failed to provide a bona fide hedging exemption or exempt swap transactions ancillary to one’s business. As such, right now, all swap transactions count towards the de minimis calculation. The Commission must either significantly increase the gross notional amount or employ a risk-based standard—such as counting only uncollateralized or non-centrally cleared exposure—in order to prevent commercial end-users from being swept up in the swap dealer definition. The Commission also needs to take steps to ensure that the de minimis standard, once established, employs a metric to ensure that the threshold does not become stale as markets grow, prices fluctuate, and notional values increase.
The entity definition proposal even missed an uncontroversial opportunity to clearly exempt certain agricultural cooperatives3, farm credit system financial entities, energy cooperatives, Section 201(f) cooperatives, and insured depository institutions dealings with its lending customers from the swap dealer definition. These entities are not the type of entities Congress had in mind when it was thinking of what a swap dealer would look like. These cooperatives are Main Street not Wall Street. The Commission should expressly exempt these entities from the swap dealer definition. I imagine the Commission will consider this rule in January.
Capital and Margin
As I mentioned above, the swap dealer definition has implications for the Commission’s proposed capital and margin rules as well as similar rulemakings from the prudential regulators. For EEI members that still qualify as non-financial end-users, our capital and margin rulemakings and those of the prudential regulators would influence the pricing for bilateral swap contracts, and therefore whether such contracts would remain commercially-viable hedging tools. EEI members should focus on the differences between our rulemakings and those of the prudential regulators, specifically regarding: (1) if margin is required to support uncleared swaps, (2) the instruments that would be deemed acceptable for margin, and (3) the interconnections between margin and capital. For example, if the swap dealer definition captures commercial end-users then they will be required to take a direct capital charge for each and every swap.
With regard to the margining of end-users, I believe the Commission’s draft rules are more consistent with Congressional direction to protect non-dealers and end-users because it allows margining in a manner agreed to by the parties in a credit support arrangement. Prudential regulators have put forward draft rules that prohibit bank swap dealers from posting margin to their counterparties and provide no capital threshold exemptions for end-users. The apparent differences in the rules are significant and the differences must be reconciled.
Designated Contract Market
You should also focus on the impact of our designated contract market (“DCM”) rulemaking on futures contracts. On December 1, 2010, the Commission approved a proposal that would require a DCM to delist futures contracts – including contracts currently listed on CME ClearPort -- unless trading in those contracts on the centralized market exceeds certain volume thresholds. To give you some perspective on the impact of this proposal – if the Commission adopts the proposal without significant modification, then CME would need to delist over 600 contracts.
A DCM, such as CME, may convert delisted futures contracts into swaps contracts and list them on a swap execution facility (“SEF”). Requiring such conversion appears needlessly disruptive, especially since the Commission has not finalized the SEF rulemaking and has not provided for provisional SEF registration. Additionally, conversion may decrease opportunities for portfolio margining, since the collateral supporting futures contracts and the collateral supporting swaps contracts are supposed to be kept separate. Moreover, depending on whether the futures contract subject to conversion references physical or financial commodities, the converted contract may be margined using a five-day liquidation period rather than a one-day liquidation period.
In sum, requiring the delisting of futures contracts and their conversion to swaps contracts appears to impose costs on market participants with no offsetting benefits. Specifically, market participants may face uncertain liquidity in the market, as the DCM determines whether a contract would need to be delisted and converted. After delisting and conversion, market participants may face increasing margin and a loss of portfolio margining. Given my energy background, I have a deep appreciation for the benefits that ClearPort affords to energy market participants. After the Enron insolvency, ClearPort was the primary mechanism for ameliorating counterparty credit fears and restoring liquidity to the energy markets. I find it ironic and unfortunate that the Commission is placing ClearPort in jeopardy for no reason. I hope that the Commission would reconsider in finalizing the DCM rulemaking.
We have massive new responsibilities under the Dodd-Frank Act that will require a heightened focus on technology investments, data management and analysis. Data is the foundation of the Commission’s surveillance programs and the new swap data repositories (“SDRs”) are where all of the data will come together. Under Dodd-Frank, the Commission is charged with collecting, aggregating, monitoring, screening, and analyzing data across swaps and futures markets for many purposes including enhanced surveillance capabilities aimed at identifying potential market disruptions and violations of the Commodity Exchange Act. Our current information systems are largely dependent upon the analytical capabilities and advanced computer –driven surveillance technology currently provided by the exchanges and self-regulatory organizations. This is unacceptable. We must develop our own analytical capabilities and ensure that the data that comes into to the Commission is of the highest quality. This is especially critical as this data may ultimately be disseminated to the public. We cannot continue to use yesterday’s solutions for today’s problems.
Mandatory Trade Data Reporting
On December 20, 2011, the Commission will consider two rulemakings under the Dodd-Frank Act that will establish swap data reporting requirements for swap counterparties and regulated entities, including SEFs, DCMs, DCOs, SDRs, SDs, MSPs, and counterparties who are neither SDs nor MSPs. The reporting requirements will provide transaction information to market participants in real-time and comprehensive information to the Commission, the Securities and Exchange Commission, and the prudential regulators. The fundamental goal of mandatory trade reporting is twofold. First, important swap transaction-level data will be made available to market participants to improve transparency, price discovery, and market integrity. Second, regulatory reporting will ensure that complete data concerning all swaps subject to the Commission’s jurisdiction is maintained in SDRs, where it would be available to the Commission and other financial regulators to fulfill their regulatory mandates, including systemic risk mitigation, market monitoring, and market abuse prevention.
The Commission must balance the important goal of ensuring that markets and regulators get the information that they need, while avoiding requiring market participants to transmit non-pertinent data. I recognize that these rules will require market participants to build out complex and costly technology systems. Thus, the rules must be structured in such a way as to ensure the burdens they impose are minimized and redundant reporting is avoided.
As you may know, various industry trade groups have challenged the Commission’s positions limits rule in Federal Court. Although I can’t comment on the litigation, I wanted to share a few of my serious concerns with the final position limits rule. My principal disagreement is with the Commission’s restrictive interpretation of the statutory mandate to establish position limits without making a determination that such limits are necessary and effective in relation to the identifiable burdens of excessive speculation on interstate commerce. I remain convinced that position limits, whether enforced at the exchange level or by the Commission, are effective only to the extent that they mitigate potential congestion during delivery periods and trigger reporting obligations that provide regulators with the complete picture of an entity’s trading. I believe that accountability levels and visibility levels provide more refined regulatory tools to identify, deter, and respond in advance to threats of manipulation and other non-legitimate price movements and distortions. My most serious concerns, apart from the setting of limits in general without the benefit of empirical data, are that: (1) bona fide hedging is defined too narrowly; (2) the aggregation rules are too complex, over-expansive and, in its application of exemptions, arbitrarily discriminatory against certain ownership structures; and (3) there is a serious risk of regulatory arbitrage.
Finally, a word on MF Global. It has been over a month since MF Global was placed into insolvency. The Commission is in the process of investigating the events leading up to the insolvency, including the whereabouts of 20 percent of segregated customer funds. In the meantime, the Commission is working with the trustee appointed by the Securities Investor Protection Corporation to ensure that any transfer or disbursement of remaining segregated customer funds occurs as soon as possible. Our staff is working very hard to identify and recover customer funds. As of last week, which is 5 weeks after MF Global was put into insolvency, 72% of customer funds are being returned. Within the first week, most futures customers were able to have their positions moved to another futures commission merchant.
Many have said that the failure of MF Global was not systemic and that we are lucky. I don’t view it in the same light. I am certain that the thousands of individuals who have lost money or can’t get access to their rightful property don’t share that sentiment either. The Commission must use MF Global as its own teachable moment and reconsider its final and proposed rulemakings under the Dodd-Frank Act.
In a statement last month, I urged the Commission to take immediate action to restore public confidence in our segregation regime, including (i) instituting random spot checks for segregation and (ii) providing additional transparency to customers regarding the risk profiles of intermediaries.4 Without a doubt improving the Commission’s capacity to monitor for FCM and clearinghouse risk is a priority.
Going forward we must revisit some key topics including whether the Commission should request legislative change to establish a bankruptcy trustee that would protect futures and swaps customer interests. We should also revisit penalties assessments as a means of a stronger deterrent. Further, we must evaluate our swaps segregation rulemaking in light of the MF Global collapse. We must ask, what are our options? Also, what is the range of costs?
On December 5th, the Commission voted to limit intermediary and DCO investments of customer funds to a subset of instruments that currently have limited risk. I supported these limitations as a first step towards enhancing customer protection. I also supported developing a proposal to provide more transparency into intermediary and DCO risks for customers and the public. However, promulgating new regulations may not be sufficient to increase public confidence in our customer protection regime. Rather, the Commission needs to devote at least equal attention to ensuring that market participants comply with our current regulations.
I support the Commission’s efforts to find the money and bring to justice anyone who violated the law.
It’s easy to focus on how much is changing with Dodd-Frank. The CFTC and the other federal financial regulators are writing rules at a frenetic pace and the market is already positioning itself to deal with the changes to come. Even though there is a lot of good that will come of this, there is no doubt that the cost for end-users in all categories to hedge their risk will increase. I continue to believe our rules must embody a risk-based approach to regulation. I will continue to endeavor to ensure that the Commission moves forward in a constructive manner that takes into account the views of market participants.
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 Letter from Chairman Christopher Dodd, Committee on Banking, Housing, and Urban Affairs, U.S. Senate, and Chairman Blanche Lincoln, Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, to Chairman Barney Frank, Financial Services Committee, United States House of Representatives, and Chairman Collin Peterson, Committee on Agriculture, United States House of Representatives (June 30, 2010); see also 156 Cong. Rec. S5904 (daily ed. July 15, 2010) (statement of Sen. Lincoln).
3 See “cooperative association of producers” as defined in CEA § 1a(14) (the Capper-Volstead Act).
4 See Statement on MF Global: Next Steps, November 16, 2011, available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement111611.
Last Updated: December 12, 2011