March 19, 2013
I want to thank Stephen Strombelline for his kind introduction and for inviting me to speak at this conference. I am truly honored to be the first Commissioner from the CFTC to speak to this audience.
In today’s financial world, there is an undeniable interconnectedness between capital and derivatives markets. These markets continue to grow, driven by both expanding trading volumes in existing products and the development of new products. The magnitude of such interconnectedness requires regulators to better understand such markets and to develop effective regulatory oversight policies that take into account unique characteristics of each market and that promote growth and innovation.
As you well know, two and a half years ago, Congress passed the Dodd-Frank Act that significantly altered the U. S. financial regulatory system. The markets have just begun to assess the far-reaching consequences of the new law and the regulatory regime that it mandated.
One of Dodd-Frank’s key goals is to increase transparency in the over-the-counter (OTC) derivatives markets, which played a key role in igniting the financial crisis and nearly bringing down the global financial system. To that end, Dodd-Frank requires certain swaps to be cleared by a clearinghouse and to be subject to certain price transparency and data reporting requirements.
A similar requirement of transparency was imposed on federal agencies by President Obama when he called on all government agencies “to create an unprecedented level of openness in Government” and “to establish a system of transparency, public participation, and collaboration.”1
As I discuss some significant Commission actions today, I would like for you to decide whether the Commission, while rushing to achieve Dodd-Frank’s transparency goals in the swaps market, has met its own responsibility to maintain transparent government.
I want to discuss four main topics with you today. First, I will go over the Commission’s enforcement program. Second, I’ll address issues concerning data and the Commission’s swap reporting rules. Third, I will talk about a new phenomenon called “futurization.” Finally, I will share my views on areas of harmonization with the SEC.
Transparent Government Must Clearly Define Prohibited Conduct
As a result of Dodd-Frank, the Commission has stepped up its enforcement efforts in a sizeable way. Last Fiscal Year, the Commission filed 102 enforcement actions, representing a significant increase from past years. The Commission also opened more than 350 new investigations, among the highest annual count of new investigations in program history. In addition, the Commission imposed more than $931 million in sanctions, including more than $475 million in civil monetary penalties and more than $456 million in restitution and disgorgement.
Many of you may be familiar with the LIBOR (London Interbank Offer Rate) settlement cases. The Commission ordered UBS to pay a $700 million penalty to settle charges of manipulation and false reporting of LIBOR and other benchmark interest rates. The Commission also issued an order against Royal Bank of Scotland (RBS) and RBS Securities Japan, settling charges of manipulation and false reporting relating to LIBOR and requiring RBS to pay a $325 million in penalty. In addition, the Commission secured $200 million in civil monetary penalties against Barclays for similar violations.
The Commission also filed charges against Peregrine Financial Group Inc., a Futures Commission Merchant, for misappropriation of customer funds.
So, as you look at this unprecedented number of enforcement actions, the question for everyone subject to the Commission’s jurisdiction must be: what does this mean for me?
One thing that can be said with some certainty is that this is not simply a one-year spike. Dodd-Frank vested the Commission with new enforcement powers, including expanded anti-manipulation authority and authority over disruptive trading practices.
Now, the Commission has an easier path to the successful prosecution of cases. For example, the Commission now has a lower standard for establishing manipulation. It no longer needs to prove that a trader’s actions created an artificial price or that the trader acted with specific intent to manipulate the market. Instead, the Commission has the lower burden of showing that the trader made false statements and that the trader acted in recklessly.
Dodd-Frank further expanded the Commission’s enforcement authority by expressly prohibiting disruptive trading practices, such as “spoofing,” violating bids or offers, and disruptive trading during the closing period,2 and left it up to the Commission to interpret these violations.
Given the expanded jurisdiction over a broader range of violations, it is crucially important for the Commission to define these violations in a clear and measurable way to guide market participants in their trading activity. Market participants should have a clear notice of what activities are permissible and what activities are prohibited by the Commission’s regulations.
Protection and Efficient Management of Big Data Is the Responsibility of Transparent Government
Protection of Section 8 Data3
Now to my second main topic: data and the Commission’s swap reporting rules. One emerging issue in this area is the protection of market participants’ confidential information. Because of its expanded jurisdiction, the Commission now obtains and stores a lot of commercially sensitive data, including trading algorithms and other trading strategies that are unique to a specific entity.
Thus, the Commission must ensure that it has necessary system safeguards in place for collecting, storing and distributing such data to the outside parties. I don’t feel the current policies and procedures to protect current and future market data are adequate and must be upgraded.
Big Data Is the Commission’s Biggest Problem
This brings me to the biggest issue with regard to data: the Commission’s ability to receive and use it.
One of the foundational policy reforms of Dodd-Frank is the mandatory reporting of all OTC trades to a Swap Data Repository (SDR). The goal of data reporting is to provide the Commission with the ability to look into the market and identify large swap positions that could have a destabilizing effect on our markets.
Since the beginning of 2013, certain market participants have been required to report their interest rate and credit index swap trades to an SDR.
Unfortunately, I must report that the Commission’s progress in understanding and utilizing the data in its current form and with its current technology is not going well.
Specifically, the data submitted to SDRs and, in turn, to the Commission is not usable in its current form. The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files. Why is that?
In a rush to promulgate the reporting rules, the Commission failed to specify the data format reporting parties must use when sending their swaps to SDRs. In other words, the Commission told the industry what information to report, but didn’t specify which language to use. This has become a serious problem. As it turned out, each reporting party has its own internal nomenclature that is used to compile its swap data.
The end result is that even when market participants submit the correct data to SDRs, the language received from each reporting party is different. In addition, data is being recorded inconsistently from one dealer to another. It means that for each category of swap identified by the 70+ reporting swap dealers, those swaps will be reported in 70+ different data formats because each swap dealer has its own proprietary data format it uses in its internal systems. Now multiply that number by the number of different fields the rules require market participants to report.
To make matters worse, that’s just the swap dealers; the same thing is going to happen when the Commission has major swap participants and end-users reporting. The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?
Aside from the need to receive more uniform data, the Commission must significantly improve its own IT capability. The Commission now receives data on thousands of swaps each day. So far, however, none of our computer programs load this data without crashing. This would seem odd with such a seemingly small number of trades. The problem is that for each swap, the reporting rules require over one thousand data fields of information. This would be bad enough if we actually needed all of this data. We don’t. Many of the data fields we currently receive are not even populated.
Solving our data dilemma must be our priority and we must focus our attention to both better protect the data we have collected and develop a strategy to understand it. Until such time, nobody should be under the illusion that promulgation of the reporting rules will enhance the Commission’s surveillance capabilities. As Chairman of the Technology Advisory Committee, I am more than willing to leverage the expertise of this group to assist in any way I can.
Futurization: Natural Market Shift, or Effect of the Commission’s Failure to Implement Transparent Rules?
I have touched on the status of the Commission’s enforcement program and the Commission’s data dilemma. Now, I will turn to a recent debate that has gripped the Commission and market participants: the “futurization” of the swap market.
On October 15, 2012, IntercontinentalExchange (ICE) converted its existing open interest in cleared over-the-counter energy swaps and options positions into futures positions, leaving all product specifications, including settlement and option expiry, unchanged. CME Group conducted a similar overnight conversion of its products to futures.
There are three major factors that have led to “futurization.” First, the Commission created complicated and unjustifiably expensive compliance requirements for market participants that meet the definition of a swap dealer. Second, the Commission imposed a five-day margin for cleared swaps for interest rate swaps and credit default swaps, but maintained one-day margin for economically equivalent futures. This creates an incentive to trade financial futures over swaps. And third, the market is still waiting for the final Swap Execution Facilities (SEF) rules.
While I would prefer to amend the swap dealer definition and get back to a risk-based margin regime, the Commission still has a chance to promulgate measured, flexible SEF rules that take into account the unique characteristics of swaps trading.
As a procedural matter, the Commission must establish a clear pathway for obtaining temporary SEF registration. This will ensure that the Commission follows a consistent and efficient approval process and preserves the staff’s resources for other Commission priorities.
Regarding the substance of the rule, I support flexible SEF rules that require pre-trade price transparency, but also allow participants (buy-side, sell-side, commercial firms) to execute various products with different levels of trading liquidity at the price acceptable to them.
This means that the SEF rules must permit alternative methods of execution, including a Request for Quote (RFQ) System and some limited voice systems that meet the Dodd-Frank’s definition of a SEF. 4 While Congress intended to create a multiple-to-multiple trading environment on a SEF, there is no statutory mention of any specific minimum number of liquidity providers on an RFQ system.
Moreover, faithful adherence to the statutory language requires the Commission to interpret the “any means of interstate commerce” language found in the SEF definition5 to give market participants clarity and certainty of execution of swaps by telephone.
I believe flexible SEF rules will foster trading on a centralized venue of a vast range of swaps with different characteristics and degrees of liquidity. I don’t believe that the SEF rulemaking alone will stop the “futurization” of swaps, for the reasons I mentioned above. But at least, it may give the swaps and futures market some degree of regulatory parity. I do believe SEFs hold a lot of promise, if done right.
Transparent Government Requires Continued Cooperation between the CFTC and the SEC
Now, let me turn to my last point, CFTC and SEC cooperation. This is a predominantly SEC-centric crowd, so let me share with you my hopes for CFTC/SEC cooperation.
To promote the stability of U.S. financial markets and to further the objectives of Dodd-Frank, it is important for the two Commissions to build on pre-existing relationships and to join efforts in harmonizing some of the Commissions’ rules.
First and foremost, the SEC and the CFTC must find agreement on cross-border rules. Both Commissions should implement rules (not guidance) that are consistent with one another and that contain clear compliance requirements and standards for substituted compliance with the regulatory regimes of foreign jurisdictions.
As part of this coordination, it is crucially important for the two Commissions to come up with a single definition of U.S. person that allows for the analogous treatment of similarly situated entities.
Also, both Commissions must interpret the Dodd-Frank’s requirement that U.S. law will only apply to activities outside the U.S. if such activities have a “direct and significant connection with U.S. activities.”6
Based on what I learned from a meeting of international regulators last week, we have narrowed our differences with foreign regulators. While we share the same goals and objectives, it is my understanding that some significant differences over implementation of transaction rules and application of substituted compliance remain to be resolved. It makes sense for both the CFTC and the SEC to give foreign regulators additional time to work out these differences.
The second important area of harmonization with the SEC is margining efficiency for cleared credit products under the separate jurisdiction of the CFTC and the SEC.
There are few cost savings provisions in Dodd-Frank, so let’s make sure we have cost effective and jointly agreeable margining rules that give customers the same margining standards as clearing banks. Dodd-Frank required the SEC to work with the CFTC to determine how swaps and security-based swaps can be commingled in CFTC and the SEC regulated customer accounts.7
Two weeks ago, the SEC issued its portfolio margining order despite the CFTC’s objections to the SEC’s methodology for setting customer margin.
More importantly, the actual methodology of margin calculation offered by the SEC is not risk-based. CFTC-regulated clearing houses employ a risk-based approach to determining the amount of margin customers must deposit in their accounts. The SEC’s methodology, on the other hand, simply imposes a margin of at least 200% of the clearing house’s calculated portfolio margining amount, without even looking to the underlying risks of the swaps in question.
The entire point of allowing for portfolio margining was to reduce costs on the industry while maintaining appropriate risk mitigation measures. With a margin requirement of 200%, it’s hard to imagine which, if any, market participants will take advantage of this option. What’s the point of allowing for portfolio margining that no one has an economic incentive to use?
As I mentioned above, the SEC’s margin requirement creates a huge disparity between dealers and customers. Presently, clearing houses are allowed to commingle swaps in dealer accounts. This allows dealers to margin all of their swaps in one account. The SEC’s order effectively prevents customers from enjoying the same benefit. Why not allow the same margining process for customer accounts to provide reduced costs to customers with no increase in systemic risk?
The third area of cooperation is technology. I am interested in working with the SEC to build on the cooperation following the May 6, 2010 Flash Crash. I also invite the SEC to join the CFTC’s efforts in researching the issues surrounding high-frequency trading and the impact of such strategies on the financial markets. These types of trading are increasingly prevalent in our markets and, as such, deserve the attention of both regulators.
As the Chairman of the Technology Advisory Committee, I believe that technology must play a major role in the Commission’s overall mission. While economic research and rulemakings are an important part of sound regulatory oversight, they alone cannot assure a viable regulatory protection in the absence of modern technology.
I am very encouraged by the comments of incoming SEC Chairwoman Mary Jo White regarding technology. She said, “Our markets . . . are continuously evolving, and the technology of today is most certainly not the technology of tomorrow. Fast-paced and constantly changing markets require constant monitoring and analysis, and when issues are identified, the investing public deserves appropriate and timely regulatory and enforcement responses.”8
In the aftermath of the financial crisis, it has always been assumed that the lack of adequate industry oversight of the derivatives market contributed to the crisis. That may be true.
But it is also true that even in a rush to close regulatory gaps, both Commissions must adhere to the fundamental principles of transparency, fairness and efficiency. And, at the very time, when the use of technology by market participants is accelerating, both agencies must not get bogged down in endless rulemakings and neglect to utilize modern technology to conduct market surveillance and detect potential violations.
Otherwise, financial market growth and innovation will be halted yet again, but this time, by regulatory uncertainty and the Commissions’ failure to utilize modern technology.
1 Presidential Memorandum, “Transparency and Open Government,” dated January 21, 2009.
2 CEA § 4c(a)(5).
3 CEA § 8 establishes, among other things, the conditions under which the Commission may disclose to the outside parties confidential information obtained in connection with the administration of the CEA.
4 A SEF is defined as a “trading system . . . in which multiple participants have the ability to . . . trade swaps by accepting bids and offers made by multiple participants in the . . . system, through any means of interstate commerce.” CEA § 1(a)(50).
6 CEA § 2(i).
7 713(a) of Dodd-Frank (requiring the Commission to adopt rules to ensure that the Commissions have comparable requirements).
8 Testimony of Mary Jo White before the United States Senate Committee on Banking, Housing and Urban Affairs, March 12, 2013.
Last Updated: March 19, 2013