November 30, 2012
Thank you for that kind introduction. As everyone is well aware, the holiday season is upon us. In addition to reconnecting with family and the social gatherings, the holiday's become synonymous with excess: over-eating, over-shopping and in the case of the Commission, over-regulating.
Frankly the holiday frenzy is a welcome distraction from the regulatory frenzy of the past year. The Commission has released roughly 60 draft rules and proposals, and has finalized 40 of these proposals.
Beginning January 1, 2013, all entities that meet the swap dealer definition, which means exceeding the $8 billion de minimis threshold in gross notional swaps trading during the year, must register. This includes international banks serving U.S. persons. Based on the clearing determination rule the Commission adopted this week, swap dealer trades in most interest rate and CDS products must clear beginning March 11, other financial entities have until June 10, and accounts managed by third party investment managers have until September 9. Now, as I noted, there are a host of other rules that have gone or will go into effect shortly. The market is desperately trying to sort out if or how the rules apply to their activities and how they will comply with them.
Clarifying our Regulations – Making an (Exemptions) List and Checking It Twice
Given the regulatory frenzy, it’s not surprising that there are many unintended, overreaching and technologically infeasible provisions in our rules. So, in addition to the rulemaking process, we have in effect been forced to set up a parallel exemptive process to provide relief from these rules.
This became painfully obvious on October 12, just as the Commission’s final swap definition was taking effect and kicking into gear a number of swap regulations. Having been bombarded by market participants with petitions and appeals to delay entire rules or specific elements of the rules, the Commission issued 18 no-action letters, staff interpretations and FAQs to clarify or delay compliance.
Since then, there has been a steady stream of Commission press releases announcing various exemptions over various time periods, making our rulemaking resemble swiss cheese. I characterized this process as a regulatory "train wreck" and I stand by those remarks. The rulemaking process has been rushed and subsequent exemptions have been haphazard. But while I find the process extraordinarily flawed, I can’t argue with the outcome.
Over the next couple of weeks, the Commission will continue to offer similar relief beyond the new December 31, 2012, implementation date for many rules. This brings to mind a promise I make every holiday season: to complete my holiday shopping before Christmas Eve so I can just relax and enjoy the holidays. That same advice should be applied to the upcoming round of the regulatory exemptive process. I recommend that we complete this process by Friday, December 14, so the markets can relax and have a clearer idea of possible delays or no-action relief before the rules go into effect by the end of the year.
Our next Commission rulemaking open meeting is scheduled for December 12, and I am being told to prepare for votes on the swap execution facility (SEF) rule, SEF block rule, Core Principal 9 for designated contract markets (DCMs) and the Made Available for Trade Determination. I also foresee action on the cross-border rules, although I believe it will focus more on delayed compliance than on finalizing the proposed guidance.
I would like to focus today on three topics that will play a significant role in determining the post-Dodd-Frank derivatives landscape. Appropriately enough, they mirror the three stages of gift-giving in the holiday season: the gifts, the bills, and the potential returns and exchanges.
First, I will talk about the upcoming transaction rules that the Commission is currently considering. Next, I want to touch on the capital and margin rules, which are very important rules that will be considered and finalized next year. Finally, I would like to discuss Congress’s role in the upcoming year and the few items I believe they should begin to consider.
Transaction Rules – Will the Market Receive Coal In Its Stockings?
Currently, the Commission is considering the handful of transaction related rules to determine how swaps will transact on exchange. This is one of the more interesting topics of Dodd-Frank and everyone is now wondering whether the Commission will vote out rules that provide a lump of coal in Christmas stockings.
The transaction rules include the definition of a SEF, the SEF block rules, the Made Available to Trade determination and Core Principal 9, which effectively sets the minimum trading threshold for futures exchanges. These rules are significant because in addition to defining both the venue and method for transacting swaps, they will set out the requirements with respect to block sizes and margining. How we finalize these rules will have a significant impact on whether market participants gravitate more toward swaps venues or futures exchanges. We need to do our best to make sure that one is not more attractive, from a regulatory perspective, than the other.
Unfortunately, the Commission’s rulemakings have already disincentivized trading on swaps venues by implementing burdensome swap dealer registration rules and disadvantageous margin requirements for swaps. As a result, energy traders fled from the swaps market to the standardized futures markets in October, a transition dubbed “futurization,” just ahead of the effective date for swaps regulations. Although futures contracts cannot be tailored to meet a company’s specific risk needs, they do offer far greater regulatory certainty, deeply liquid markets within which to hedge commercial risk, and capital efficiency to market participants. As the Commission reviews these transactional rules, it is important to make necessary regulatory adjustments in order to avoid a complete shutdown of the swaps market.
The Need for a Commission Hearing on “Futurization”
If the Commission doesn’t complete the suite of transactions rules in December, then I believe a Commission hearing on the futurization question would be a very useful exercise. Let’s find out what drove the move and how this impacts hedging by commercial firms, and what impact our decisions on block and margin rules have on the success or failure of SEFs going forward. Everyone talks about getting the rules right, not fast – and I hope a hearing will inform the development of the right rules.
SEF Final Rule and Application Process
Now let me focus for a bit on the topic of SEFs. 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 and commercial end users 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. In addition, Congress specifically stated that a SEF is not a DCM and we shouldn’t attempt to develop an identical platform. The Commission must be prepared to consider and approve a variety of different SEF platforms, but I fear that we will try and make everything look like futures exchanges. As the old saying goes, “to a man with a hammer, everything looks like a nail.” The same can be said for a futures regulator.
Dodd-Frank’s definition of a SEF explicitly allows for swap transactions to be executed “by any means of interstate commerce.” The process of interpreting these six words has been a challenge for the Commission. Its draft proposal failed to provide a role for the execution of swap transactions over the telephone, a common mode of execution for swap transactions prior to the enactment of Dodd-Frank. At a minimum, the final SEF rules must provide some way for telephone and electronic systems to work together. I’ll admit, integrating a phone-based system into the SEF framework is not an easy task and it certainly presents new regulatory challenges with respect to Commission oversight and auditing of these systems.
Also, I am mindful that full transparency can pose serious side effects as well. At times, traders need to have the ability to transact away from the swap execution platform by utilizing block trading mechanisms. Therefore, it is crucially important for the Commission to set the appropriate block sizes on a SEF. Block trade sizes on a SEF must take into account the trading liquidity of particular products and must correlate with the block sizes established by DCMs. If not, ramifications could include higher transaction costs based on the smaller number of trades and a sharp price change in a particular swap product. Plus, unreasonably high block sizes on SEFs, as compared to DCMs, will give traders yet another reason to flee the swap market.
Another element I have only recently come to appreciate beyond the challenges of the SEF final rulemaking is the actual registration process. The Commission recently was sued over the registration of swap data repositories (SDRs). The SDR final rule was approved in September 20111 but so far, we have only provisionally registered three SDRs. In fact, our SDR review process has been so inefficient and inconsistent that we were sued in district court by a prospective SDR. Now, an SDR is a fairly straightforward proposition that involves the receipt, storage, and retrieval of data for both regulators and market participants. The licensing of these entities, however, was anything but simple.
This experience does not bode well for the application process for SEFs. Over the course of the past two years I have met with numerous prospective SEF applicants, each anticipating a trading platform different in level of complexity, trading protocol, and technology employed. This variety found in the SEF universe makes a one-size-fits-all approach to SEF registration impossible.
Still, the Commission can learn from its shortcomings in the SDR registration process in order to develop a more consistent and efficient application process for SEFs. One important action the Commission can take to that end is to issue clear written guidance to the public before applicants begin the process, not after the process has begun.
Capital and Margin Rules – When the Bills Come Due
Now that I have discussed the transaction rules, I would like to turn to the capital and margin rules for uncleared swaps. This is the part about the holidays most people regret and involves paying the bills.
Without a doubt, the cost of OTC trading is rising. The rules that will dictate the cost of continuing the practice of OTC trading have not yet been finalized and there is a tremendous amount of work to be done to align the various capital and margining rules among the various regulatory entities across the government. In fact, it is probably months away before we will see final rules in this area. However, like the bills that come in January for the holiday gifts, it will be a sobering time as we begin to realize the impact it will have on the capital positions of various market participants.
Now, I mentioned earlier the futurization of swaps in the energy market that we witnessed in October. The move from swaps to futures helped traders achieve two critical objectives: to avoid the regulatory hazard of being designated as a swap dealer, and to achieve capital efficiency by netting all of the trades in one futures account. The more costly alternative would be to establish separate futures and swap margin accounts and forgo the efficiency provided through netting.
Given this futurization, I have been especially interested in the capital and margin rules and in promoting capital efficiency in the swaps market. While researching this issue I have come across a very relevant paper, “Optimizing the Cost of Customization for OTC Derivatives End Users,” written by Sean Owens and published in the Review of Futures Markets journal.2 Mr. Owens’ study carefully looked at the variety of cost decisions for the variety of OTC market participants and calculated the cost of the new capital and margin rules and new Basel II rules for end users, financial players and the swap dealers and major swap participants.
I am particularly interested in the financial impact of new capital and margin rules on commercial end users, despite clear direction from Congress to exempt end users from the requirements of such rules altogether.3 Mr. Owens confirmed my concerns and correctly pointed out that the counterparty to these end users are the most systemically risky entities and will face higher capital rules and full margin requirements, which, of course, will be passed on to end users. He identified additional regulatory capital, additional collateral requirements for some financial end users, “operational costs associated with central clearing” imposed on end users by futures commission merchants (FCMs), and “potential liquidity driven execution costs” as resulting end user costs.4
In terms of the implications for the market, Mr. Owens’ paper found that end users will see higher prices and may choose not to hedge, or find less customized alternatives such as exchange trading and reliance on netting strategies to conserve capital. In order to do so, firms will increase their “concentration of risk for non-cleared trades with a small number of dealers.”5
In addition, this paper suggested that some corporate end users may be forced to change their funding strategies to include more floating rates, and some “could shorten the duration of derivatives used for hedging purposes, reflecting the relatively high cost associated with long-dated transactions.”6
I don’t believe these are the outcomes envisioned by Congress when it drafted Dodd-Frank, and I will endeavor to implement policy solutions to mitigate the inevitable higher cost of hedging for commercial firms under Dodd-Frank. I will be looking for opportunities to expand the use of netting, regulatory flexibility to encourage on-screen trading to enable risk transfer, and setting comparable margin regimes for products that bear identical risk.
Just like shopping during the holidays, when it helps to keep in mind not just the gifts but the bills that come along with them, we need to ensure that we keep costs down in implementing Dodd-Frank so we can enable firms to better manage risk and benefit our economy.
Congressional Review – What is the Return Policy on Dodd-Frank Gifts?
The final topic I would like to address today is Congressional review. Despite our best intentions and thoughtfulness, there is always a gift or two that gets returned after the holidays. I believe Congress will be going through the rules to see what fits, what doesn’t and what needs to go back for an exchange. This is the natural and appropriate process. Now there are a couple of rules that I would like Congress to review. One obvious candidate for review is the position limits rule, which was recently struck down by a U.S. district court.7
I think the swap dealer rule deserves another look as well. The Commission failed to follow the statute and properly define the four elements of the statutory dealing activities and decided instead to impose a temporary $8 billion de minimis test. This rule caused so much confusion that the entire energy market, which arguably should not be impacted, preferred to flee the swaps market rather than try to figure out whether the definition of swap dealer would apply to them or not. The Commission recently offered additional relief to municipalities that operate energy production and distribution systems. The “munis” responded with a letter8 explaining why the relief was too little too late and that their former non-dealer counterparties still want nothing to do with them.
The aggregation of affiliates is another part of the swap dealer definition that must be clarified, as the Commission has failed to do so. It makes no sense to apply the dealer rules to affiliate entities that trade well below the de minimis level – especially when their trading strategies are independent. We have rules to capture evasion if that is a concern. I want a competitive and liquid swap market, and imposing onerous and duplicative dealer rules is counter to that goal.
I also encourage Congress to provide further guidance on the extraterritorial reach of the Commission’s swap regulations. I say further guidance because Congress already provided in Dodd-Frank that swaps regulations shall not apply to activities outside of the U.S. unless those activities have a direct and significant connection with activities in the U.S.9 This provision was drafted by Congress as a limitation on our authority. However, the Commission’s proposed cross-border guidance turned the limitation on its head, using it to apply Dodd-Frank expansively outside of the U.S. The Commission would be making a significant mistake if it proceeds with its guidance as proposed. In light of the Commission’s misreading of the statute, it would be helpful for Congress to provide clarity on what constitutes a direct and significant connection to U.S. activities. Ideally, it would articulate a standard that is both logical and legally sound and that can be applied consistently by all U.S. regulatory agencies. In addition, Congressional direction on when and to what extent the Commission can rely on substituted compliance with international standards would be welcome as well.
There are other internal, external, and governance standards that Congress should review to determine whether or not the Commission’s rules-based approach and the costs associated with the Commission’s rules are consistent with its original vision. With regard to the consideration of costs and benefits, I strongly encourage Congress to revisit the standards the Commission has applied in its cost-benefit review of its rules. Admittedly, the Commission’s statutory standards for cost-benefit review are low and the Commission has, at times, failed even to meet that low bar. Congress should raise the bar by providing specific minimum requirements that the Commission must satisfy when conducting a cost-benefit analysis. This should include requiring the Commission to consider a range of options in each of its draft rules and to base its cost estimates on reliable and verifiable data.
Finally, I hope that Congress will give careful consideration to customer protection. Following the implementation of Dodd-Frank, two major FCM failures exposed the weakness in our existing bankruptcy rules. Review of third-party segregation, pro-rata distribution and the bankruptcy treatment of customer accounts should all be on the table. It’s been a year since the MF Global failure and customers have received 80 cents on the dollar and are forced to fight for additional funds as a general creditor. If we are serious about putting customers first, then changes need to be made to the bankruptcy code to make this goal a reality.
Okay, I know that I just threw a lot of material your way, so let me sum up it for you – in the form of my holiday wish list, though it’s not an exhaustive one. The first item on my list is that any relief that the Commission is planning to provide from the December 31 implementation date should be issued by December 14, to give certainty to the market as soon as possible. Next, I want a flexible SEF rule, and transaction rules that set fair rules of the road and step aside to allow the industry to decide which products and on what venues to trade. After that, I want capital and margin rules that are sufficiently mindful of the costs imposed on market participants, particularly commercial end users. And finally, I want Congress to review and provide feedback on a few areas of the Commission’s work that need further clarity and guidance.
Thank you again for your time, and happy holidays!
1 76 FR 54538.
2 Owens, Sean. “Optimizing the Cost of Customization for OTC Derivatives End Users.” Review of Futures Markets. Volume 20, Special Edition, July 2012: Pages 69-103.
3 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).
4 Owens at 80-81.
5 Owens at 95.
6 Owens at 94.
7 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.
8 Letter from American Public Power Association, Bonneville Power Administration, Large Public Power Council, and Transmission Access Policy Study Group to Chairman Gary Gensler (November 19, 2012).
9 7 U.S.C. §2(i).
Last Updated: November 30, 2012