September 27, 2012
Before I begin, I would like to thank Jan Haizmann for his kind introduction and for inviting me to speak at the European Federation of Energy Traders Parliamentary Evening. I am very pleased to be able to speak to a conference and share with you some of my observations regarding the U.S. efforts to regulate derivatives markets.
While U.S. regulators are working aggressively to implement the Dodd-Frank Act, I understand that European energy markets are also undergoing substantial reforms as well. This evening, I would like to provide you with my perspective on the U.S. efforts and the possible impacts these reforms may have on energy market.
I am very familiar with U.S. energy markets and I have worked hard during the implementation of Dodd-Frank to protect end-users like energy firms, farmers and other commercial entities from the increased cost of hedging their commercial risk. I think people agree that most commercial firms do not pose a systemic risk to the financial system and they will not receive government bailouts or other forms of financial assistance if they fail.
Because of the decreased risk posed by end users, Congress exempted them from many provisions of Dodd-Frank. For example, the exemption from the clearing requirement will allow end-users to execute swaps over-the-counter and not on a regulated trading platform. However, in a mad rush to promulgate all the rules, the Commission has lost sight of the statutory goals of Dodd-Frank and has disregarded the Congressional mandate to preserve end-users’ business. Despite the fact that derivatives end-users did not contribute to the financial crisis, they are now forced to follow ambiguous and inconsistent rules. I am concerned that imposition of unnecessary regulations on end-users will create more economic instability and will impede U.S. competitiveness in the global market.
When the Commission was drafting the swap dealer definition rules, I fought hard to exclude commercial firms from the overbroad and ambiguous swap dealer definition. I also fought and will continue to fight for clear hedging rules in both the position limit rules and the swap dealer definition rules. While it may appear that the Commission is being flexible by adopting five different definitions for bona fide hedge, in reality, this only adds to the regulatory uncertainty. One definition is applicable in some circumstances, but not all, while other definitions apply to other set of circumstances. A better and quite frankly, more logical approach would have been for the Commission to describe the circumstances where end-users employ derivatives to hedge their commercial operations. As adopted, the end-user exception is confusing and defeats the very reason for its existence, which is to allow end-users to mitigate their commercial risk.
As you all know, four years ago, the world was gripped by a financial crisis. The crisis brought into sharp focus what market participants have known for years—namely, that financial institutions are globalized and increasingly interconnected. No question, poor risk management of one institution may have severe and damaging cross-border implications.
In response to the 2008 financial crisis, the G-20 nations issued the Pittsburgh Communique that set forth four core tenets for over-the-counter derivatives reform. First, all standardized over-the-counter contracts should be traded on exchanges, where appropriate. Second, such contracts should be traded through central counterparties (CCPs). Third, such contracts should be reported to trade repositories. Finally, over-the-counter contracts that are not cleared by a CCP should be subject to higher capital requirements.
On the U.S. front, the Commission has been working at a feverish pace to promulgate Dodd-Frank’s implementing regulations. As of today, the Commission has voted roughly on 50 proposals and 39 final and interim final rules. One of the most controversial documents, the proposed Cross–Border Guidance and Exemptive Order, were published at the end of June and some other controversial final rules are still to come, including the final rule for Swap Execution Facilities (SEFs).
I would like to talk about three topics that will be of interest to you. First, I will briefly address a decision by the Intercontinental Exchange (ICE) to list its over-the-counter (OTC) derivatives as futures instead of swaps. Then, I will provide an update on the status of the SEF rules and will share my views about the necessary features of an effective SEF. Finally, I would like to touch on the Commission’s proposed Cross Border Guidance, as its application is going to impact your trading activity, if you currently trade with U.S. persons.
Swap Rules Drive Shift to Security of Futures Markets.
I would like to start with a recent decision by ICE to convert its over-the-counter swaps into futures and list them for trading on its Designated Contract Market (DCM). This may have come as a surprise to some, but not to those who trade in these markets. Given the inconsistency in the Commission’s interpretation of its own rules, the lack of regulatory certainty and the increased cost of compliance with the Commission swaps regulations, including the complicated and controversial swap dealer definition rules, swap customers have turned to futures markets for regulatory certainty. ICE will become the first exchange to take such a step ahead of new financial regulations,1 but I suspect they will not be the last.
Transition to the futures market may reduce flexibility, because futures contracts, unlike swaps contracts, cannot be tailored to meet a company’s specific risk needs. However, the futures market does offer far greater regulatory certainty and deeply liquid markets within which to hedge commercial risk. It also offers capital efficiency to market participants as it allows them to margin their trades in one account rather than two separate segregation regimes. On a bilateral basis, end users will be able to continue to use OTC markets as well as transact on SEFs to hedge bespoke risk without fear of becoming a swap dealer.
While I certainly don’t believe it was the intent of Congress or the Commission to draft rules that would drive people out of the swaps market, the regulatory uncertainty was so great that energy markets voted with their pocket-books and moved their trading business from the regulatory nightmare of swaps markets to the well-functioning futures markets.
Now, I’m not certain that other asset classes will be able to find the same relief from the regulations of swaps, but I am certain that market participants at all levels in all asset classes are discussing the move to futures markets.
It remains to be seen to what extent Commission regulations have impacted the derivatives market, as we continue to finalize the SEF rules, critical capital and margin rules, and the Volcker rule (which will attempt to clarify and distinguish market-making trades from propriety trades by banks). All these rules will put a final price on the cost of over-the-counter trades and will have real consequences for the swaps market.
Swap Execution Facilities – Still a Great Unknown
Obviously, the decision by ICE will impact energy trading on SEFs. This leads me to my next topic, the swap execution space.
The concept of SEFs was heavily negotiated in Congress and at the Commission. Trading on a SEF represents a monumental shift away from the current bilateral trading model to a centrally regulated trading model. Centralized swap execution should offer market participants greater price transparency, increased access to larger pools of liquidity, and improved operational efficiency. Congress envisioned that SEFs would promote price discovery and competitive trade execution in all asset classes, and would facilitate the straight through processing of all swap transactions to clearinghouses.
Last January, the Commission published the proposed SEF rules; and while it was a good start, the Commission missed the mark on the flexibility associated with permissible methods of execution on the SEF platform.
The entire market from buy-side asset managers, pension funds, commercial end-users, farm credit banks and rural power cooperatives to sell-side dealers and even prospective SEFs expressed concern that if the final rules are adopted as proposed, market participants will be restricted in their ability to obtain price discovery because the proposed SEF rules would limit their choice of execution.
I am supportive of the overall objectives of promoting pre-trade price transparency. This is why I have been calling on the Commission to require SEFs to provide a centralized electronic screen that displays live and indicative bids and offers. However, at the same time, I believe that the SEF final rules should allow for flexible methods of execution and should take into account various levels of liquidity for different swaps. I believe that in addition to requiring a centralized electronic screen, the SEF final rules should permit other flexible trading protocols that do not place restrictions on request-for-quote systems (RFQs). These features will protect the confidential trading strategies of asset managers, pension funds, insurance companies, farm credit banks and will provide commercial end-users access to the swap market to fund their long-term capital and infrastructure projects that create jobs.
In addition, I have always maintained that the mandatory clearing and mandatory trading determinations are inextricably connected to determining appropriate methods of execution on a SEF. Last December, the Commission proposed a rule establishing a process for determining whether a swap is made available for trading on a SEF or a DCM. As you may know, in February, the Commission held a public roundtable to address the scope of the made available for trading determination. I hope that the Commission will consider a number of issues that were brought up to the Commission staff’s attention at the roundtable.
Finally, I also hope that the final SEF rules will provide a clear interpretation of the “by any means of interstate commerce” clause contained in the SEF definition. Dodd-Frank defines a SEF as a platform in which multiple participants have the ability to trade swaps by accepting bids and offers made by multiple participants, through any means of interstate commerce.2 Instead of providing further meaning to the “any means of interstate commerce” clause, the proposal focused on two methods of execution on a SEF: an electronic platform and a RFQ.
Some commenters worried the proposal failed to address other methods of execution that may be suitable for certain swaps, while other commenters were concerned that the proposal prohibited the use of voice-based systems for trading swaps that are subject to the trade execution mandate. Congress inserted the “any means of interstate commerce” clause to give participants a choice of execution modes to ensure a smooth transition from bilateral swaps trading on to the centralized trading on SEFs. I hope the final rules will consider Congressional intent and will allow flexible methods of execution on SEFs.
I would now like to turn to my next topic, the Commission’s proposed Cross Border Guidance. I believe that the overall objectives of the Guidance were: (1) to clearly define the scope of the extra-territorial reach of Dodd-Frank and (2) to reinforce the Commission’s commitment to the goals of the G-20 summit by providing a harmonized approach to regulation of swap dealings and by ensuring a level playing field and avoiding fragmentation of markets, protectionism, and regulatory arbitrage.3 All sound goals.
However, the Commission’s proposal has proven to be quite controversial. I am aware of the comments provided by European and Asian regulators questioning both the Commission’s authority and its commitment to “substituted compliance,” through the recognition of ‘equivalent jurisdictions’ as reflected in the European Market Infrastructure Regulation (EMIR) proposal.
I believe the proposed Guidance suffers from a number of flaws. One of my many concerns is that the definitions contained in the Guidance are overbroad and capture activities outside U.S. jurisdiction. These overreaching definitions put U.S. firms at a competitive disadvantage and fail to achieve the goals of global regulatory coordination.
Direct and Significant Connection and U.S. Person
The Guidance reveals an unorthodox interpretation of “the direct and significant connection with U.S. activities” clause contained in Dodd-Frank. According to the clause, Dodd-Frank, will not apply to activities outside of the United States unless such activities have a direct and significant connection with U.S. activities.4
Instead of providing further clarification, the proposed Guidance arbitrarily invokes this clause to trigger Commission jurisdiction over various market participants. For example, Commission regulations exempt U.S. swap dealers from registration if their annual dealing activity is below the de minimis threshold of $8 billion. The proposed Guidance, however, states that each and every swap transaction between one or more U.S. persons other than a swap dealer satisfies the direct and significant connection to U.S. activities and subjects such transactions to the Commission regulatory oversight.
Clearly, the “direct and significant” clause must be clarified and consistently applied among all entities. Specifying those activities and thresholds that do have a direct and significant connection to the U.S. economy will allow the Commission to be more specific as to how these activities can be mitigated through clearing, or if other transaction rules must be applied.
Furthermore, there has been near universal agreement that the U.S. person definition is vague and illogical. According to the definition, non-U.S. counterparties must treat overseas branches of U.S. banks as U.S. persons, however, the definition excludes a foreign affiliate or a subsidiary, even if the swap obligations are guaranteed by a U.S. person. Such inconsistent interpretation puts U.S. firms at a competitive disadvantage.
At a minimum, the definition of U.S. person should provide analogous treatment of similarly situated entities. Ideally, the definition must be narrowed to include only those entities that are residents of the U.S. or have a principle place of business in the U.S., or have majority U.S. ownership.
The Commission has heard from a number of U.S. banks that European and Asian competitors abroad are already trying to entice customers away by warning them that U.S. regulations will raise the costs of doing business with U.S. banks. What happened to the goal of establishing a level playing field as directed by the G-20 summit? Not only does the proposed Guidance leave the playing field uneven for U.S. institutions, but it also violates Commission own regulations, prohibiting the Commission from promulgating regulations that may have anti-competitive effect on U.S. businesses.5
Another problematic issue relating to the proposed Guidance is the concept of “conduits.” A U.S. end-user, that is generally exempt from Commission regulations, may have majority ownership in a non-U.S. end-user entity and thus would be considered a “conduit” entity. Consequently, if the non-U.S. end-user entity decides to execute swaps with other non-U.S. entities, this transaction would be subject to U.S. regulatory reporting requirements, including swap data recordkeeping, SDR reporting, risk management and large trader reporting.
Because of inconsistent interpretation of Commission regulations, I worry that U.S. end-users will face higher hedging costs and reduced hedging choices since many swap dealers will refuse to do business with the non-U.S. end-users that are classified as “conduits.”
Finally, I would like to address the Commission’s proposal in the Guidance to allow non-U.S. swap dealers to comply with their home regulations in lieu of complying with Commission regulations.
At first glance, allowing substituted compliance is an important step towards global regulatory harmonization. But when you get down into the weeds, substituted compliance presents a host of issues that worry U.S. and foreign banks. Under the proposed Guidance, the Commission will review the comparability of non-U.S. regulation in fourteen categories corresponding to the organizational categories that the Commission has used in developing its Dodd-Frank regulations.
In essence, the proposed Guidance views substituted compliance as a rule-by-rule analysis of whether home country regulations are comparable with Commission regulations. Given the Commission’s broad discretion, there is a good chance that the Commission may determine that certain aspects of the foreign regulations do in fact have a comparable regime, however, other areas of the same regulation may not meet the Commission’s standard. Then businesses will face disparate regulatory requirements and piecemeal regulations.
I don’ think this is what the G-20 summit had in mind when they proposed global harmonization of the regulatory oversight of the derivatives market. As I understand, the G-20 summit committed to broad regulatory goals, not to global adoption of the Commission’s paradigm of inconsistent regulations. A principle-based approach to comparability will honor principles of comity and will reasonably restrain the extraterritorial application of Dodd-Frank. Moreover, substituted compliance, as proposed in the Guidance, violates Dodd-Frank’s mandate that requires U.S. regulators to coordinate “on the establishment of consistent international standards with respect to regulation of swaps. . . .”6
Besides, the proposed rule-by-rule analysis will require significant Commission resources. A potential increase of the Commission’s staff and another increase of the Commission’s budget in an era of 16-trillion dollar deficit would not be the best idea, especially for such an unnecessary undertaking.
Improved Reporting by G-20 Members in Physical Commodities
Before I conclude, I would like to make a few remarks about the importance of physical market transparency. I strongly believe the global efforts pioneered by the International Energy Agency to collect and disseminate critical supply, demand and usage information for OECD nations7 have improved transparency into oil markets. However, the growth in oil demand has shifted to non-OECD nations. Thus, we must work on generating the same level of robust and accurate data from those growing markets. In addition to initiating global financial reform, the G20 summit in Pittsburgh also directed G20 members to improve both the quality and quantity of data being produced. The G-20 summit also noted that it is essential to establish an international approach to regulating commodities. While I acknowledge progress in this area, I believe we can do more to improve our insight into new and growing energy demand centers, such as China.
To conclude, I am mindful of the significant and comprehensive impact of the reforms being considered and undertaken by regulators across the world. There is no doubt, each of these decisions will have cost impacts. But these decisions should improve our visibility into markets and promote liquidity and risk management.
In promulgating its rules, the Commission must always be aware of the consequences of final regulations on market activity not just in the United States but all over the globe. In a mad rush to regulate these markets, we often forget to take into account market realities and we end up adopting rules that are unclear, inconsistent and harmful to U.S. businesses.
We can’t possibly anticipate every outcome, but we must not rush through rulemaking without conducting a careful and thorough discussion of our approach.
I am also keenly aware of the fact that the OTC derivatives market is a global market. I recognize that not every jurisdiction is operating on the same timetable as the United States and I believe that the Commission should be more cognizant of this reality.
Regulation of the OTC derivatives market must be consistent across jurisdictions. I want to have an open and continual dialogue with foreign regulators, exchanges, and market participants as we implement a comprehensive and international set of standards for OTC derivatives reform.
2 7 U.S.C. § 1a(50).
3 The G-20 2009 commitment, as revisited by the G-20 in 2010, was to “implement global standards consistently in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage.” Communiqué issued from the meeting of the Group of Twenty Finance Ministers and Central Bank Governors held in Gyeongju, Korea on October 23, 2010.
4 7 U.S.C. §2(i).
5 7 U.S.C. §7(b).
6 The Dodd-Frank Act § 752(a).
7 Thirty four countries signed Convention on the Organization for Economic Cooperation and Development (OECD).
Last Updated: September 27, 2012