April 16, 2013
I want to thank Javier Blas for inviting me to speak at the Summit.
First, I would like to remember the victims of the bombing attack in Boston yesterday. Please keep the victims and their families in your thoughts and prayers.
One of the more disturbing aspects of the financial crisis was the need for the United States government to provide taxpayer funds to bankroll undercapitalized companies that engaged in high risk gambling with their shareholders’ money.
The debate is still open as to whether Dodd-Frank puts an end to the idea that large interconnected companies should be guaranteed a bailout. I don’t believe Dodd-Frank fixes the Too Big to Fail (TBTF) problem. To the contrary, in many ways, Dodd-Frank has magnified this problem as a result of highly complex and costly to comply with rules that effectively insulate these large international financial entities from competition – especially in the area of commodity markets. According to a Bloomberg Government study, the top ten U.S. banks now control 77% of U.S. assets, which is up from 55% in 2002.
In addition to the implied taxpayer bailout of TBTF banks, there is also an inherent financial and competitive advantage associated with the federal backstop authority. Today, it is unclear to me whether or not trading houses have this same advantage. I would be interested to know from the panelists whether they believe that there is an implied federal bailout for large merchant firms and whether these firms enjoy an inherent financial and competitive advantage as a result of such an implied advantage.
And as Mr. Blas points out in his Financial Times article titled “Has Glencore become too big to fail” (October 9, 2012), the largest and most recent collapse of a merchant firm, Enron, did not result in any federal relief. No relief to Enron's counter-parties and no relief to retirees who invested and worked for the "crooked E."
While it is my belief that trading firms are not TBTF, I also believe that the Commission’s ability to analyze derivatives data will allow the Commission to monitor the impacts of large trading houses on physical and financial markets. Additionally, this will allow the Commission to determine whether certain trading strategies pose a significant systematic threat to our markets and economy.
In other words, the foundation of the Commission’s capacity to perform its market surveillance function will depend on how successful the Commission is in utilizing data.
In this regard, I would like to begin with discussing the challenges that the Commission faces today with processing and analyzing swaps data. Then, I would like to touch on other important issues that impact commodity markets, specifically, futurization of the swaps market, swap execution facilities, the position limits rule, and the proposed cross-border Guidance.
Topic I – Swap Data Reporting
Let me address the first agenda item - swap data reporting.
I'm sure everyone is familiar with the notorious London Whale trade. A trader at JP Morgan-London Chief Investment Office put on a massive position in credit default swaps which totaled over $150 billion and made up 15% of JP Morgan’s assets. Since this trade happened before the Commission began receiving swaps data, the Commission could only see the cleared positions at the clearing house, but couldn't complete the picture and understand the totality of the exposure without accessing critical over-the-counter data. The London whale episode illustrates why swap data reporting has become a cornerstone of the new derivatives regime created by Dodd-Frank.
In an effort to increase transparency and integrity of the derivatives market, Dodd-Frank requires information about each swap transaction to be reported to a Swap Data Repository (SDR) and to the Commission.
As you know, the Commission promulgated swap data reporting rules1 and dealers began reporting their trades on December 31, 2012. End-users have been provided time-limited relief from reporting obligations. 2
Reporting of swaps data will potentially allow the Commission to track systemic risk by conducting market oversight across various trading venues (Designated Contract Markets (DCMs) and future Swaps Execution Facilities (SEFs)). I say potentially, because, although the rules are done, the implementation and effective use of data is far from finished.
Unfortunately, because the Commission’s rules did not clearly identify the data fields or the format in which such data has to be reported, the Commission has been struggling with managing and analyzing this data. To be clear, inconsistent reporting and variability in the data, as well as technology shortfalls combined with incongruent rules, have made the data presently unusable to the Commission.
It will take many months to improve the quality and consistency of the data to enable the Commission to effectively identify risk positions such as the London Whale trade.
Just to reiterate, I can't think of anything that can have a bigger impact on the Commission’s surveillance of risk in the market than an understanding of the vast new treasure trove of data that is already flowing into the Commission’s computers.
It is important to note that energy markets and financial markets have become more intertwined. More and more energy companies trade financial instruments to manage risk and opportunities effectively. Understanding the financial data will improve the Commission’s overall market view and will offer critical insight into physical trading strategies as well.
While on this topic, I would also like to make a plug for my desire to improve the reporting by developing nations, such as China and India on their use of physical commodities. In the last few years, China has become one of the top energy producers; and China and India have become among the largest energy consumers. As G-20 Members, both nations agreed to improve transparency into physical markets so that market participants would be better informed about commodity usage, storage and production in non- OECD3 nations, as part of the Pittsburgh Communiqué, which also advocated for regulation of derivatives. Improved transparency in physical commodities is long overdue.
At the end of this month, I am convening the Commission’s Technology Advisory Committee (TAC) meeting to bring market participants and the existing and soon-to-be SDRs together to address issues relating to interconnection, data quality, and validation consistency among the reporting entities and the development of automated reports. My hope is that we will achieve agreement among market participants, reporting entities and the Commission and outline the path forward to resolving the outstanding data quality issues.
Topic II – Futurization
Switching gears, I would like to share my views on the debate over futurization.
As many of you know, last year on October 15th, the day the swap dealer and swap definition rules took effect, the IntercontinentalExchange (ICE) converted all of its energy swaps into futures. The exact same products that were swaps the day before were traded seamlessly as futures on a DCM.
I believe there are two primary drivers for this wholesale shift to futurization: unjustifiably complex and vague swap dealer definition rules and arbitrary margin requirements for swaps and futures.
As to the swap dealer definition, the rule fails to provide a bright line test for determining whether a market participant is a swap dealer. Unfortunately, brokers are not the only ones to worry whether they can be labeled as swap dealers. Many other market participants, including energy trading firms and food producers, could conceivably be caught in this definition.
The good news for many companies is that the activity threshold (de minimus exception) above which they might be considered a swap dealer was raised in the final rule to $8 billion. But the facts and circumstances definition does not make it easy to assess whether energy, agricultural or commodity firms are trading swaps to such an extent that they breach the threshold.
Moreover, the regulatory consequences of becoming a swap dealer bear a high price tag. Swap dealers must comply with an array of complex and costly rules in areas such as minimum capital requirements, business conduct, and trade reporting—giving companies a strong incentive to stay away from being labeled a swap dealer.
This leads me to the second major factor that contributed to futurization, namely minimum capital requirements. As you may know, the Commission published a rule requiring all financial products (credit product and interest rates) to be margined at five day liquidation while identical futures products continue to be margined at a one day minimum.4 The difference between these two standards amounts to a significant increase in margin for swaps customers.
Now you see why the idea of becoming a swap dealer did not sit well with many participants, especially considering they can take advantage of transparency, capital efficiency and regulatory certainty by trading in the futures markets.
The downside, however, is the decreased ability of corporations to tailor their risk management strategies using standard futures contracts rather than swaps. I am very interested in this issue. So, I have asked our staff to look at the data before and after the October 15, 2012 futurization move to see what the trade data tells us about the impact of futurization on the energy markets.
But I am pleased to report that the Chairman and I were able to negotiate an agreement whereby all energy, agriculture, and metals products are margined at a one day minimum regardless of whether they are swaps or futures. Once a month, the Chairman and I try to have lunch together at a local Chinese restaurant to discuss some of the more intractable differences we have on policy issues. This one-day margining agreement was reached during one of our MeiWa summits.
Granted, this resolution wouldn't play a factor in the end-users’ decision to move their energy trades to the futures market. But this regulatory differential has caused many firms to reconsider their trading strategies and futures exchanges are attempting to take advantage of this differential by offering standard swap futures contracts. Both the Chicago Mercantile Exchange (CME) and Eris Exchange offer interest rate swap futures.
Mere relabeling of the product will push swaps trading onto futures exchanges, and effectively, swaps products will be cleared as futures. I strongly believe that identical risk should receive identical margin. But changing the product wrapper and ignoring risk fundamentals will lead to mistakes that precipitated the financial collapse in 2008.
Given the market’s move towards futurization, it is especially important for the Commission to finalize the SEF rules correctly.
Topic III –SEFs
This brings me to my third topic-SEFs. This is an area that I am excited about. The SEF concept is not new to the industry, as dealers have been using certain trading platforms for a decade. SEFs will allow market participants to access a more transparent market that will offer new and innovative trading opportunities. Unlike the futures exchanges which are tied to a single clearinghouse, trades executed on SEFs can be cleared at different clearing houses, which will provide a new competitive execution space.
The lack of final rules and the lack of urgency on the Commission’s part to implement final rules have undermined the overall objective of Dodd-Frank to promote centralized execution venues.
The Commission published the proposed SEF rules in December 2011. Today, the Commission is still negotiating the final draft. I mistakenly predicted that the Commission would finalize the rules by Valentine’s Day. Now I am hoping the Commission will get it done before Memorial Day (May 27). I'm ready to vote on the SEF rules. The Commission should do it sooner rather than later, but I am not going to vote for a bad rule just to get it done fast. It must be consistent with the requirements of Dodd-Frank.
Let me share my vision of a successful SEF. I support flexible SEF rules that require pre-trade price transparency, but, at the same time, allow participants (buy-side, sell-side, and commercial firms) to execute various products with different levels of trading liquidity at the price acceptable to them.
This means that the rules must permit alternative methods of execution, including a Request for Quote System and some voice systems that meet the Dodd-Frank definition of a SEF.5
I believe SEFs will have a bright future, if they are done right.
Topic IV-Position Limits Rule
Moving on to the next topic that causes anxiety to market participants, that is the Commission’s position limits rule. As you know, the federal district court in Washington DC struck down the rules that set position limits on futures, options, and swaps on 28 types of commodities. The court held that before setting such position limits, the Commission was required to determine whether position limits were necessary and appropriate to prevent excessive speculation in the commodity markets.
Unfortunately, the Commission failed to do so before it implemented the rule and it has decided to ignore the court’s order now. In other words, the Commission has decided to forego necessary rigorous analysis and instead, it is gearing-up to defend its rule in a court of appeals. At the same time, Commission staff is drafting a new rule that the Commission intends to publish in the fall.
Topic V-Cross-Border Guidance
I’d like to touch upon the last topic that I am sure is of particular concern to this audience; the Commission’s proposed Cross Border Guidance.
As I’ve stated many times before, the Commission and international regulators must find agreement on cross-border rules. Based on what I learned from a meeting of international regulators a few weeks ago, 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 the Commission to extend relief from compliance with the Commission’s Guidance to give foreign regulators additional time to work out these differences. It is my hope that the Commission will provide such relief at the end of summer.
As to the Commission’s proposed Guidance, I hope that the Commission will come up with a workable definition of U.S. person that allows for the analogous treatment of similarly situated entities. Also, the Commission, in its final document, must provide meaning to the requirement of Dodd-Frank r 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
The recent financial crisis has shown how interconnected the financial markets have become. High accumulation of risk in one entity can have a devastating effect on the entire financial system. Thus, as a regulator, the Commission has an obligation to monitor markets for systemic risk. To do so, the Commission must be able to receive consistent data and must be able to analyze such data to detect complicated and opaque risks in the markets.
Also, as a regulator, the Commission must be faithful to the express commands of the Commodity Exchange Act and implement rules that promote efficient, orderly and fair trading in the financial markets.
So, what should the Commission do moving forward? The Commission still has important proposed rules to finalize. I hope this time around, the Commission will do a better job at issuing clear and appropriately measured regulations.
1 17 C.F.R. §§ 43, 45, 46 (2012).
2 See No-Action Relief from Swap Data Reporting Requirements to Swap Counterparties that are not Swap Dealers or Major Swap Participants (granting limited time reporting relief for interest rate and credit swaps, until July 1, 2013, and for equity, foreign exchange and other commodity swaps, until August 19, 2013; and providing non-financial swap counterparties with reporting relief of historic swaps, for all swap asset classes, until October 31, 2013).
3 Organisation for Economic Co-operation and Development (OECD).
4 17 C.F.R. § 39 (Jan. 9, 2012).
5 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).
Last Updated: April 16, 2013