November 13, 2012
Jim, thanks for that kind introduction.
I am happy to be here and pleased to see the Mercatus Center, as it often does, putting the spotlight today on an issue that is near and dear to my heart: how government regulation affects the real world. That’s right: government regulation has real-world consequences. What a revolutionary concept. You may take this concept for granted, but too often government regulators fail to understand, or take into account, the effect that regulations will have on markets and market participants. And this problem has been especially true in the past two plus years, as government agencies have rushed to promulgate rules under the Dodd-Frank Act. As you know, we at the CFTC have been in the trenches of Dodd-Frank implementation. I would like to take this opportunity now to provide you with some of my thoughts on this implementation process.
Don’t worry – I won’t take you through an exhaustive review of the Commission’s work because at 39 final Dodd-Frank rules and counting we would be here until tomorrow. Instead, what I would like to do is talk to you about good government. You see, I am the government employee who believes that government doesn’t have all the answers and that it must do a better job of developing “good government” solutions.
What Is Good Government?
You may ask: what do I mean by good government? In a nutshell, good government regulation strikes the right balance in order to develop beneficial rules of the road and to implement them according to a measured and reasonable timeline. This approach requires fact-based analysis in order to come up with cost-effective solutions based on a range of policy options.
So, what does it mean specifically in the context of the Commission’s rulemaking process? For rules that have not yet been proposed, good government means faithful adherence to the statutory authority and a strong understanding of the markets that will be affected by the envisioned regulation. For rules that have not yet been finalized, it means understanding and addressing the concerns of market participants and adopting final rules that are clear, consistent and create a level playing field. For rules that have already been finalized, it means providing transparent implementation guidance that is consistent with the final rules. In addition, good government means being aware of the consequences of Commission regulations on market activity and maintaining the flexibility to reassess and revise such regulations where appropriate.
If we apply this framework of good government regulation to what the Commission has done in the past two plus years, we can see many places where we have fallen short of the standard. One example is the position limits rule, which a federal court recently struck down.1 The Commission will file an appeal, which I don’t support because I agree with the judge’s ruling that the Commission failed to justify its establishment of limits as required by the statute. I would like to point out that the Commission has now been sued three times within the past year on its rulemakings.2
Today I want to focus on three areas in particular of the Commission’s implementation of Dodd-Frank. These are: the October 12 effective date for swap regulations and the resulting ‘futurization’ of the swaps world, the Commission’s final rules for swap execution facilities (SEFs), and the Commission’s guidance on cross-border issues.
The Nightmare of Friday the 12th
I would like to start with the significant date on the Dodd-Frank implementation calendar that we passed last month. On October 12, the joint CFTC-SEC definition of the term swap became effective. This triggered compliance dates for a number of other Commission swaps regulations.
As it turned out, Friday, October 12 was a day of great drama, but certainly not in a good way and certainly not by design. Friday the 13th may have been more appropriate, given the nightmare scenario the Commission was trying to avoid at the absolute last minute. In truth, the nightmare was the fact that we had reached such a point in the first place.
By that evening, the Commission had rushed out 18 no-action letters and guidance documents in a last-minute attempt to mitigate the chaotic impact of all the rules that were to take effect the following Monday. Think about that for a second: 18 relief documents issued on the day before the compliance deadline. We don’t need a study by the Mercatus Center to tell us that this last-minute flurry fell embarrassingly short of the goal of regulatory certainty and the principles of good government regulation.
Good government should take a measured, well-thought out approach to developing a new regulatory regime. To that end, I have repeatedly asked the Commission to publish a clear and specific rulemaking timeline and implementation schedule. Frustratingly, my calls have gone unheeded. A clear and well-reasoned implementation schedule would have allowed the Commission to avoid the hurried, ad-hoc process of temporary relief and interpretations that we witnessed and would have done much to put the Commission’s rulemaking process in the good government category.
Even now, we are not out of the woods yet. The temporary relief provided expires on December 31, and we can’t risk keeping the markets in the dark until the eleventh hour again. The Commission needs to take action by mid-December in order to provide adequate clarity to the markets through the new year. Think of this as the Dodd-Frank Regulatory Cliff.
Let me go back for a minute to October 12. The big storyline is the migration of cleared energy products to the futures markets. In response to regulatory uncertainty in the swaps market, energy customers of both CME and ICE demanded that the markets move to listed futures, instead of swaps. There are good reasons to stay away from the swaps market, including the expansive and ill-defined swap dealer definition and the regulatory consequences of becoming designated as well as uncertainty as to what will be permitted to trade on SEFs. In addition, the capital efficiency of margining all trades in one account is also a powerful financial incentive.
On October 15, the day the new swap rules took effect, the entire market had shifted from a swaps market to the futures market. Liquidity simply dried up in the OTC space. To me, this is evidence of the Commission’s struggle to get swap regulations right.
This futurization of the cleared energy swap market may result in reduced flexibility for some firms because futures contracts, unlike swaps, can’t be individually tailored to meet specific risk needs. However, futures markets offer greater regulatory certainty and provide high liquidity to allow for the efficient hedging of commercial risk.
It was surely not the Commission’s intention to draft rules that would send market participants fleeing from the swaps market. But good government requires more than good intent; it requires good execution of that intent as well. Instead, the Commission has created such a regulatory nightmare that the energy markets have sought cover in the relative safe haven of the futures markets.
And we may very well be at just the start of the futurization of our markets. Again, it’s hard to believe that this brave new world of futurization is what the Commission envisioned would be the end result of its new swaps regulatory regime.
Learning Lessons and Moving Forward
But I bring up these examples not simply to say that the Commission should have done better. Rather, I raise them because learning from mistakes is the crucial first step toward getting us back on the road of good government regulation. And luckily for us, there are several significant rules on the horizon that will give us that opportunity. For example, the Commission has yet to consider final rules on capital and margin requirements. The Volcker rule, which will clarify and distinguish market-making trades from proprietary trading, is also in this category.
These rules will put a final price tag on over-the-counter trades and will have broad and significant consequences for the swaps markets, so it is very important that we get them right. If we make sure to identify concerns raised by market participants and properly address them in the final rules, and then implement the rules in a measured and consistent manner, I am confident that we can get them right.
In any case, those rules are still a bit further down the road. Of more immediate interest are two areas that the Commission will likely consider before the end of the year. These are trade execution, including SEF final rules, and the cross-border guidance.
Swap Execution Facilities
Let me address the SEF rules. This is an area that I am excited about. There are new trading models that offer exciting innovations and ideas that will make the swaps market more transparent and well as more competitive.
As you know, the concept of SEFs was heavily negotiated in Congress as well as at the Commission. SEFs represent a monumental shift away from the current bilateral swap 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.
The Commission published the proposed SEF rules last January. While the proposal was a good start, a broad array of market participants – 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, less liquid swaps will not be able to be executed on the SEF platforms because the proposed SEF rules would limit their choice of execution.
While I am supportive of the overarching objective of promoting pre-trade price transparency, I believe that the SEF final rules should allow for flexible methods of execution including request for quote systems (RFQs). These features will protect the confidential trading strategies of asset managers, pension funds, insurance companies, and farm credit banks and will provide commercial end users access to the swap market to fund their long-term capital and infrastructure projects.
Finally, I 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 on which multiple participants have the ability to trade swaps by accepting bids and offers made by multiple participants, through any means of interstate commerce.3 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 an RFQ.
Currently, the Commission is considering the suite of related execution rules that determine the viability of SEFs and the overall OTC market going forward. These include mandatory clearing, Core Principle 9, and the block and made available for trading rules in addition to the SEF rules. These rules must work together and reflect the new realities of the evolving market in reaction to the Commission’s already finalized rules.
I remain optimistic that we can develop rules that will encourage a competitive and innovative market in swap trading as envisioned by Congress and something the market has been developing over the past decade. It would be a shame if government rules stood in the way of this opportunity.
Regulatory Overreach: The Commission’s Cross-Border Guidance
Moving now to the third topic I want to discuss: the Commission’s Cross-Border Guidance.
Last week the Commission held a public meeting with regulators representing most of the largest markets across the globe, and their criticism of the Commission’s overreaching cross-border Guidance was consistent and firm. I certainly don’t want to see this draft proposal result in a regulatory tit-for-tat that would create an environment where U.S. financial institutions and market participants are put at a competitive disadvantage based on competing regulatory regimes. I am committed to resolving this regulatory matter to the satisfaction of all regulators and minimizing regulatory overlap and confusion so that market participants have a clear understanding of the new global regulatory paradigm. As such, it means we must redraft our cross-border Guidance.
Let me give you some background. The Commission published its proposed Guidance as well as a related exemptive order in July of this year. The objectives of the Guidance were to (1) clearly define the scope of the extra-territorial reach of Title VII of Dodd-Frank and (2) reinforce the Commission’s commitment to the goals of the G-20 summit by providing a harmonized approach to derivatives regulation.4
These are sound objectives. However, the proposed Guidance missed the mark in several respects. Start with the fact that it was issued as guidance and not as a formal rulemaking, which would have required the Commission to conduct a cost-benefit analysis. As proposed, market participants will be deprived of an opportunity to review and comment on a cost-benefit assessment despite the significant costs that the Guidance will impose on them.
More fundamentally, the proposed Guidance exceeded the scope of the Commission’s statutory mandate. The statute provides that Dodd-Frank swaps regulations shall not apply to activities outside of the United States unless those activities have a direct and significant connection with activities in the United States.5 This provision was drafted by Congress as a limitation on our authority, yet the proposed Guidance has interpreted it as the opposite.
As a result, the proposal empowers the Commission to find virtually any swap to have a direct and significant impact on our economy and imposes U.S. rules and obligations, including requirements on transactions, on non-U.S. entities. This has set off alarm bells in foreign capitals across the globe, and the Commission received an unprecedented number of letters from foreign regulators.6 Just a few weeks ago, a strongly worded joint letter from the top finance officials of the UK, France, EU and Japan again urged the Commission to reconsider its approach and engage much more actively with them to coordinate regulatory efforts across borders. And as I mentioned earlier, these views were strongly echoed by representatives of several foreign regulators at a meeting last week of the Commission’s Global Markets Advisory Committee.
The Commission’s statutory overreach is reflected throughout the proposed Guidance. A prime example is the definition of U.S. person, which as drafted in the proposed Guidance sweeps numerous entities that are outside the U.S. into the Commission’s jurisdiction. The proposal requires non-U.S. counterparties to treat overseas branches of U.S. banks, unlike affiliates of U.S. banks, as U.S. persons. If these foreign companies do enough business with foreign-based U.S. banks, they will be subject to U.S. regulation.
The Commission has heard concerns from a number of U.S. banks that foreign competitors are trying to tempt clients away by pointing to the potential increased costs of doing business with U.S. banks as a result of the Commission’s proposed Guidance. Even more disturbing, the Commission has received more recent indications that many foreign firms are no longer doing business with U.S. banks. I’ve said it before and I’ll say it again: I cannot support a Commission proposal that puts U.S. firms at a competitive disadvantage to foreign banks, especially those that operate in the United States.
As I mentioned earlier, good government regulations address the concerns of market participants in drafting a final Commission document. In this case, both the market and foreign regulators have spoken loudly.
So here is what the Commission should do. First, the entire Guidance should be scrapped and the document should be re-drafted as a formal rulemaking that provides an opportunity for public comment and includes a cost-benefit assessment.
Second, the proposal should provide a clear, consistent interpretation of the “direct and significant” connection with a sufficient rationale for the extent of the Commission’s extraterritorial reach. Identifying more accurately those activities that could pose a risk to the U.S. will allow the Commission to assess how such risk could be mitigated through clearing and to determine whether other transaction rules must be applied.
Third, the definition of U.S. person should be narrowed to include only those entities that are residents of the U.S., are organized or have a principle place of business in the U.S., or have majority U.S. ownership. It should exclude a foreign affiliate or subsidiary of a U.S. end user that is guaranteed by that end user. This more reasonable definition is similar to the definition articulated by Commission staff in one of the flurry of no-action letters issued on October 12.
Finally, the rule must clearly interpret the concept of “substituted compliance.” The proposal indicates that the Commission will review the comparability of non-U.S. regulations with Commission rules. This review should be a broad, big-picture assessment of comparability, not a rule-by-rule analysis. A rule-by-rule comparison could result in a hodgepodge of disparate regulatory requirements that would be a compliance nightmare for market participants. It would also undermine the coordinated regulatory effort that G-20 members have agreed to support.
The bottom line is that today’s swaps markets are global in nature and interconnected. Given this reality, the Commission needs to engage much more actively and meaningfully with foreign regulators and develop a more harmonized approach in order to eliminate redundancy and inconsistency among the respective regulatory regimes.
To conclude, I want to emphasize how important it is for the Commission to be mindful of the real and significant impact that its regulations have on market activity. Anyone who doubted this reality needs look no further than October 12, the new world of futurization that we are seeing in our industry and the mounting lawsuits that the Commission is facing.
Therefore, it is crucial that we apply the principles of good government so that our regulations are clear, consistent and not overly burdensome to market participants. As I’ve noted, we have at times failed to live up to these standards. But if we are willing to learn from these lessons, we can do better with the rules we have before us and on the horizon.
Thank you very much for your time.
1 International Swaps and Derivatives Association, et al. v. United States Commodity Futures Trading Commission. The decision is available at: https://ecf.dcd.uscourts.gov/cgi-bin/show_public_doc?2011cv2146-69.
2 The other lawsuits are: Investment Company Institute and Chamber of Commerce of the United States of America v. United States Commodity Futures Trading Commission; Chicago Mercantile Exchange Inc. v. United States Commodity Futures Trading Commission.
3 7 U.S.C. § 1a(50).
4 The G-20 2009 commitment, as reaffirmed 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.
5 7 U.S.C. §2(i).
Last Updated: November 13, 2012