May 22, 2012
We need to make our rules more black and white. We can foster cost-effective compliance by clearly articulating the purpose and desired effect of our regulatory requirements. Our objective in implementing the Dodd-Frank Act should be compliance, and not enforcement. Commercial firms utilizing the futures and swaps markets to mitigate risk should be focused on managing that risk, and not on the risk that they will take a misstep into a regulatory trap.
We need to ensure that hedging and price discovery remain cost effective, encourage liquidity, and continue to be the hallmarks of our jurisdictional markets in support of, and attendant to, the goals of the Dodd-Frank Act.
When Alex Flint asked me to speak to this group, I jumped at the opportunity. I have worked extensively in the energy policy arena and miss discussing energy issues including financial challenges, nuclear waste solutions, Separative Work Units, heat rates and financial transmission rights.
My time these days is instead spent discussing margin methodology, swaps and futures clearing, high frequency trading and, of course, a cast of characters including MF Global and J.P. Morgan. My past and present do have a nexus: futures and swaps markets provide the energy markets their primary means of risk mitigation through hedging opportunities and price discovery. Like nuclear energy, financial markets are strongly linked to technology. I have drawn on my energy/technology experience, and more specifically, my work with the nuclear industry, in addressing the tough regulatory issues present in today’s financial markets. One thing I have learned after years of working with nuclear engineers is that the little things matter and specific requirements aimed at producing specified outcomes are always preferred over uncertainty. Today, I would like to expound on these two topics of technology and certainty as they apply to the Dodd-Frank Act rulemakings and our financial markets in general. Before we get too deep into that discussion, I’d like to take a moment and provide a high-level overview of the linkages between the CFTC, financial reforms embodied in the Dodd-Frank Act, which is now a part of the Commodity Exchange Act, and the utility business.
The Dodd-Frank Wall Street Reform and Consumer Protection Act is an 848-page law passed in June 2010 and, like many such statutes, is unimaginatively named after its principal authors, Senator Chris Dodd and Representative Barney Frank. The Dodd-Frank Act is the most significant financial reform since the Great Depression. With respect to the Commodity Futures Trading Commission, which wasn’t even around during the Great Depression (though one of its predecessors, the Grain Futures Administration, was), it implements three main objectives. First, it requires all swap dealers to clear their trades to reduce counterparty risk and the interconnectedness of large financial institutions such as the “Too-Big-To-Fail” banks. Second, it mandates that cleared products be traded on designated contract markets or newly created swap execution facilities. Finally, it requires that all trades whether cleared or traded over-the-counter be reported to a new registered entity called a swap data repository. Within this framework aimed at bringing an unprecedented level of transparency into the $600+ trillion swaps market, end-users and other “Main Street” swaps participants whose operations did not contribute to the financial meltdown are explicitly recognized through exemptions, exceptions, and accommodations from and to many of the clearing, trading and reporting requirements. Remember, part of the title of the legislation is “Wall Street Reform.” However, it is ultimately the role of the CFTC to flesh out the extent to which these commercial entities will be able to continue to hedge their risk and absorb the additional costs without negatively impacting their ability to remain competitive.
Thus far, the Commission has drafted and passed 33 final rules. Roughly half have been deemed “Major Rules” under the Congressional Review Act, meaning that the Office of Management and Budget has determined—based on submissions by the Commission—that each of these rules will result in or is likely to result in: (1) an annual effect on the economy of $100 million or more; (2) a major increase in costs or prices for consumers, individual industries, Federal, state, or local government agencies, or geographic regions; or (3) significant adverse effects on competition, employment, investment, productivity, innovation, or the ability of U.S.-based enterprises to compete with foreign-based enterprises in domestic and export markets.
Unfortunately, many of the rules have shifted the application of statutory mandates from a flexible principles-based regime to a prescriptive rules-based scheme. While I agree that there is generally a preference for the legal certainty that specific versus general mandates provide, many of these new rules are unnecessarily complicated, confusing, and, in some cases, redundant. The result is that entities whose financial resources are already limited by the continued economic downturn must set aside additional resources to pay for more legal and compliance personnel who will be tasked with sorting through thousands of pages of rules to ensure that these entities don’t run afoul of new regulation.
The Commission needs to make its rules more black and white. We can foster cost-effective compliance by clearly articulating the purpose and desired effect of our regulatory requirements. The Commission’s objective in implementing the Dodd-Frank Act should be compliance, and not enforcement. Commercial firms utilizing the futures and swaps markets to mitigate risk should be focused on managing that risk, and not on the risk that they will take a misstep into a regulatory trap.
We need to ensure that hedging and price discovery remain cost effective, encourage liquidity formation, and continue to be the hallmarks of our jurisdictional markets in support of, and attendant to, the goals of the Dodd-Frank Act.
The poster-child for this regulatory confusion is the recently finalized swap dealer definition. Like a multi-step math problem, you need to follow a precise order of operations and show your work in order to get the right answer. While I agree that the de minimis exemption currently set at $8 billion provides a sizeable margin of error, the reality of relying on a de minimis is that, but for the level of the exemption, you are a swap dealer. Would you rather be expressly carved out of the swap dealer designation, or carved out by a temporary technicality subject to change? And how does it make you feel knowing that you could have avoided the order of operations, the de minimis, and ramping up of legal personnel if the Commission had utilized its authority under the statute to simply carve you out based on the nature of your swap trading activities? Don’t forget to show your work.
How It Impacts Energy Producers
One commonality among all end-users is the desire to have clear rules that don’t interfere with their ability to cost-effectively access to swaps and futures markets to hedge commercial risk—which they have in spades. The level of sophistication among commercial firms varies as does the extent of their trading. However, their primary business or ordinary business is producing or manufacturing products, not trading. Futures and swaps markets are both critical to price discovery and hedging. Swap market users, however, generally require more customized trades unique in location, duration or size that don’t neatly match-up with standardized futures contracts.
In implementing the massive Dodd-Frank Act, I believe the Commission has the responsibility to implement clear rules that provide end-users with bright regulatory lines. Unfortunately, I believe we have not achieved that objective and instead have crafted a definition for swap dealers that is vague and complex. Ultimately, this definition will drive some firms out of the market or force them to reduce their market exposure and hurt liquidity. Let me give you a specific example.
Large Municipal Power Case Study: The Problem with the “Special Entity” Threshold
The CFTC’s final entities rule provides for two separate de minimis exemptions from the swap dealer definition based on the nature of the counterparties. There is a general de minimis threshold of $8 billion (which transitions to $3 billion after five years) applicable to all entities and a $25 million sub-threshold for a swap dealer’s dealing with so-called “special entities.”
The term “special entity” is defined in the Dodd-Frank Act to include, among other entities, municipalities. The legislation and newly adopted regulations impose additional external business conduct requirements on swap dealers and major swap participants in connection with their dealings with special entities.
The Commission’s regulations create huge problems for these entities. For example, the Large Public Power Council (LPPC) is an organization representing 24 of the largest public power systems in the nation. Its members own and operate over 86,000 megawatts of generation capacity and nearly 35,000 circuit miles of high voltage transmission lines. Since LPPC members are municipally-owned, they are “special entities” under the Dodd-Frank Act. To date, the majority of LPPC’s utility operations-related swaps are executed with non-bank firms in the regional electric and natural gas industry that are prepared to offer the necessary customized arrangements. Given the size of their operations, the $25 million de minimis threshold was set at an unworkable level, which will drive many non-bank firms—including some of you here today—away from trading with municipal firms in order to avoid the dreaded dealer designation. For example, a single one-year 100 MW swap or a single three-year 10,000 MMBtu/day swap (at a 62% capacity factor) may have a notional value of $25 million. Therefore, a single swap could trigger the requirement that a firm register as a swap dealer for trading as a result of its trade with a municipal utility. This could not possibly have been what Congress intended. Remember, part of the title of the legislation is “Wall Street Reform.”
Without healthy competition in these markets provided by commercial firms, municipalities will be left to trade with the likes of J.P. Morgan, Bank of America, Citigroup and Goldman Sachs. Without competition for that business, we all know what will happen to costs.
I predict that as more people read the swap dealer definition, or more precisely, the preamble—and do pay attention to the footnotes—we will find more examples of misapplied rules that will diminish competition by consolidating swaps trading with Wall Street bank counterparties and by edging out commercial firms. Pricing will go up as liquidity falls. I suspect that firms like yours will have to choose between two equally untenable choices: pay more or hedge less. The ultimate loser is the customer.
The real shame is that the Commission could have been more specific in excluding commercial firms from the swap dealer definition and forcing them to rely on a complicated test that by and large focuses on utilities or cooperatives. Congress was very clear about exempting commercial end-users and small banks from the swap dealer definition. I only wish the Commission could have done the same.
Before I move on to technology, I also would like you to be aware that, as commercial firms, you are all hedging physical and financial risk, and we have protected that activity. In fact, at this point, we have defined hedging four different ways. This of course is good news for your legal counsel, but confusing for your business units.
We have Regulation 1.3(z), we have hedging rules as they apply to determining your position in compliance with position limits, hedge rules for the swap dealer determination (physical only), and hedging rules for determining who is a major swap participant (financial and physical). Another hedge rule is coming out with the final rule end-user exception to clearing, so be ready for that. I suspect most of you won’t need to worry about the hedge exemption in the major swap participant definition, so you only need to focus on three to four different hedge definitions. Lucky you!
As I explained earlier, I spent years working on Capitol Hill primarily focused on energy policy roles including five years as the Senate Clerk of the Energy and Water Subcommittee on Appropriations. I had a dream job of funding cutting edge energy sciences, including nuclear energy, while advancing state of the art computing funded by the U.S. Department of Energy.
One area that I was fascinated with was the role technology played in all aspects of energy research and development. The capacity to perform computer simulation on plant siting, design and material testing greatly reduced the necessity to perform costly trial-and-error experiments. Advances in materials expanded our capacity to increase load, temperature and extend the life of critical components, which can have a direct and material impact on a company’s balance sheet.
A great example of this research partnership was the Nuclear Power 2010 program that cost-shared the design of new modern reactors to increase safety features and lower the engineering and operational costs. By standardizing the design, licensing, training and operations are made identical for each reactor of that design—a far more efficient process than the ad hoc approach used before. We made this program a top priority and increased funding to complete the program as soon as possible. I am pleased to hear that this investment has paid off and a new design has been licensed.
Keeping Pace with an Evolving Market
When I came to the Commission a little over two-and-a-half years ago, I was well aware of the modern trading and matching engines used to trade equities and futures and the explosion in trade volumes across the globe. However, I was struck by the lack of computer surveillance and automation applied in the oversight of our markets. The Commission was not organized to effectively drive automated surveillance of futures and swaps markets. I have made correcting this problem and adapting technology among my top priorities. The good news is that we have reorganized the Commission, creating a new office of Data and Technology. This new group of technology experts and market surveillance staff is now primed to focus on deploying automated surveillance to expand our oversight programs.
Flash Crash – Technology Matters
Technology improvements are not only necessary for the Commission; exchanges and other CFTC registered entities also have made these improvements. Take the Flash Crash of 2010, which also impacted your businesses. To be brief, futures and equities markets dropped 1,000 points and then recovered in the span of 20 minutes. Many of your stocks saw the bottom fall out as traders withdrew their orders from the markets. The sell-off started in the S&P 500 futures contracts, but quickly spread to the equities markets. After careful investigation it was decided that new circuit breakers and automated market pauses were needed to prevent another automated computer sell off.
HFT: Define It, Study It, Make Sense of It
Immediately after the Flash Crash, the blame was largely directed at high frequency traders who some refer to as the new breed of market makers. While these traders behave like others, their presence in the market is growing and their practices are poorly understood. I have established a subcommittee comprised of four working groups within the Technology Advisory Committee, which I chair, to attempt to define this discipline so that it can be studied, monitored, and frankly discussed. I expect the working groups to complete their work and make recommendations to the Commission later this year on defining high frequency trading within the universe of automated trading. Similar efforts to understand high frequency traders and their strategies are underway in other jurisdictions as we all try to get up to speed on their activities and market impact, if any. We can’t ignore the fact that automated trading strategies provide and support increasing, and in some cases a majority of, market liquidity, and yet we have little to no knowledge about their role, trading strategies and methodologies. We need more information. Our first step should be to define them. Next, we need to study them. Only after that will we be best able to develop policy solutions that are appropriate to ensure all market players are operating within the rules and we have in place the appropriate safeguards to prevent dysfunctional markets
Dodd-Frank Rulemakings: We Can Do Better
In closing, let me assure you that I am working very hard to ensure that our rulemaking process is as transparent and open as possible. We are pressed to develop rules without fully understanding the outcomes. We must look at developing a more thorough process for conducting cost-benefit analyses that appropriately inform our rulemakings of the challenges facing the market, especially with regard to the necessary integration of technology across all of the new execution, clearing, and data platforms and models, including swap execution facilities, futures commission merchants, clearinghouses and swap data repositories.
Unfortunately, we have minimized the role of performing a cost benefit analysis to a check-the-box exercise, rather than developing a range of rule alternatives and adopting the most cost-effective.
In February, I asked the Office of Management and Budget for technical assistance in conducting our future cost-benefit analyses, and that request has been answered affirmatively. I am pleased to report that the Commission will get one staff member from the “Cost-Benefit Team” within the Office of Management and Budget to provide technical assistance going forward.
We must be mindful of the massive burden these new regulations will have on all business, but in particular Main Street businesses, who did not contribute to the financial meltdown of 2008 and 2009. Our rule should be clear and protective of end-users who need futures and swap markets to hedge risk. We should be honest and thorough in understanding all of the cumulative costs imposed by these regulations. And finally, we should avoid further consolidating risk within and minimizing competition with the largest Wall Street banks.
I am not at all convinced that these reforms will prevent the “Too-Big-To-Fail” scenario. Yes, we are going to implement comprehensive supervision of Wall Street swap trading and expand access to clearing for all entities. But, in doing so, we must be more sensitive to the massive costs these rules will impose on all entities and the impact this will have on cost-effective risk management.
In broad terms, developing regulatory standards is similar to developing an energy policy that encourages the deployment of a variety of energy sources and technologies. I am skeptical that the government will be any more successful in developing a regulatory scheme that can anticipate and evolve with financial markets innovation than it has in picking winners and losers in energy technologies. Both objectives require regulatory flexibility and the ability to adapt to a changing marketplace.
I will continue to fight for rules that will ensure that commercial firms like yours can cost-effectively hedge both physical and financial risk. I certainly wish you all success in developing cost-effective and safe nuclear technology that addresses our nuclear waste challenges.
Thank you again for allowing me to speak with you today.
Last Updated: May 31, 2012