April 26, 2013
As you know all too well, just over four years ago we suffered the worst financial crisis since the Great Depression. In response, Congress passed the Dodd Frank Wall Street Reform and Consumer Protection Act1 (“Dodd-Frank”) with the twin goals of increasing market transparency and reducing systemic risk. Many of the regulatory changes found in Dodd-Frank can be traced back to four principles agreed upon by the G-20 Nations at a September 2009 meeting held to discuss reform of the Over-the-Counter (“OTC”) derivatives market. The four principles include the following: 1-most OTC derivatives should be transitioned to trading on centralized platforms; 2-these derivatives should be cleared through a clearinghouse; 3-data on the derivatives should be reported to a swap data repository (“SDR”); and 4-derivatives that are not cleared should be subject to higher capital requirements.
These four goals were transformed into nearly 170 pages of statutory text that became Title VII of Dodd Frank. In working its own alchemy, the Commission has magically transformed these 170 pages of statute into thousands of pages of regulatory text and guidance.
One would probably guess that in all of these pages, the Commission would have thought of everything, considered, measured and analyzed each and every possible outcome. Of course, anyone paying more than the slightest bit of attention would recognize that this is not the case. One need only review the growing list of exemptive relief, no-action letters and clarifying Q&A documents (over 80 items) and the growing number of lawsuits to recognize that the Commission didn't have all the answers when it drafted the rules. In its haste, the Commission has implemented some rules that have required relief from compliance and some rules that must be rewritten to correct mistakes.
The Commission has entered the implementation phase of the rule process after having spent two years drafting and finalizing Dodd-Frank rules and many other changes to our regulatory system. We have heard from a number of market participants urging the Commission to develop clear rules and establish realistic timelines for compliance. Although the Commission is required to provide a cost-benefit analysis in order to estimate the impact to the market, it is obvious from the rules that the Commission’s capacity and desire to develop a rigorous analysis were lacking. I believe several of the topics I’ll discuss today are of particular concern to you.
I’d like to speak to you today about three examples of Commission regulations that, in hindsight, need to be reexamined; Swap Data reporting, External Business Conduct, and the necessity to harmonize our cross border rules.
G-20 – Directs Action to Resolve Data and Cross Border Issues
This past weekend in Washington, the G-20 central bankers and Finance Ministers met to discuss the economy and layout an agenda for the annual fall meeting in Russia. As part of the official Communique2, they addressed two topics that caught my attention and I believe are among the two most important topics facing the Commission. The first is data. It was the clear intent of the Ministers and bankers that a data sharing arrangement be established to ensure that regulatory bodies are able to identify risk that could lead to financial instability. I couldn’t agree more with the concept that regulators must improve their own capacity and capability to intake data as well as the development of analytical tools to identify and monitor risk.
The other topic focused on urging regulators to come up with a solution that will facilitate global cooperation and oversight, yet respect the different regulatory jurisdictions by the St. Petersburg Summit this September.
Swap Data Reporting
“The price of light is less than the cost of darkness.” This quote is attributed to Arthur Nielsen, the founder of the Nielsen ratings company, and a pioneer in data analysis. I will forgive many of you who thought I was quoting from the Commission’s cost benefit review, as I believe that is about as granular as much of our analysis goes. However, this quote really speaks to the power of data and analytics and the forgone opportunities if you fail to either capture or effectively utilize the data.
Dodd-Frank called for the Commission to implement new rules that require the reporting of three distinct categories of swaps data. First, under Part 43 of the Commission’s regulations swap transactions must be reported in real time so that the market and general public may see the current market price for all publicly traded swaps. Second, Part 45 requires a more detailed, confidential set of information about swap transactions to be reported to SDRs. This allows regulatory agencies to identify large swap positions that pose a threat to the financial stability of the market. Third, Part 46 calls for information for swaps entered into before the new regulatory system was enacted to be reported to SDRs so that existing risk exposures may be identified. These new reporting requirements were a significant departure from existing industry practice and required a phased-in implementation to allow the various reporting parties to get their systems up and running.
On December 31st of last year prospective swap dealers began reporting interest rate and credit default swaps pursuant to Parts 43 and 45. We can now say that we have an actual ticker for both IRS and CDS. Reporting requirements for other asset classes by swap dealers and other market participants will go into effect at various points throughout the rest of this year. These reporting timelines have been altered from what was originally proposed because of the difficulty found by the market in getting computer systems up and running in time for the reporting deadlines.
While it might sound as if reporting has gone off without a hitch, let me assure you, it hasn’t. The Commission had to issue various forms of relief or interpretations because the rules lacked specificity or were simply too difficult to comply with in the time period originally established for regulatory reporting under Parts 43 and 45. For example, the Commission recently delayed the reporting deadline imposed under Parts 43 and 45 for non-financial swap counterparties trading all asset classes of swaps.3 The deadline had to be extended because end-users, such as farmers and commercial merchants, were unable to establish the technological infrastructure necessary to report their trades by the initial deadline. The Commission was also required to issue a finding that clearinghouses had the authority under Part 45 to decide which SDR should receive the swap data.4 This finding was necessary because conflicting statements in Part 45 left the issue unclear and exposed the Commission to potential litigation.
The Commission has had problems with reporting of historical swaps under Part 46 as well. In finalizing the rule for reporting historical swaps under Part 46, the Commission assured the industry that it would provide interpretive guidance to inform the industry how to determine which party to a swap is required to report the transaction when that information isn’t readily available.5 Since the rule’s publication the Commission has yet to issue any such guidance. The Commission has also remained silent as to what the reporting requirements are for historical swaps that were part of an Exchange of Derivatives for Related Position transaction. These transactions involve exchanging a swap for a listed futures contract that is then submitted for clearing.
The problems with our reporting rules affected your industry as well. When drafting Parts 43 and 45 the Commission failed to consider how swap dealers that are part of a prime brokerage relationship would be able to comply with the rules. Both part 43 and 45 are premised on the assumption that there will only be two counterparties and one would possess all the information necessary to report the trade. As you know, that’s not the case in a prime brokerage arrangement where different parties are better suited to report trading information.
In light of this problem, the Financial Market Lawyer’s Association (“FMLG”) submitted a no-action request late last year seeking relief from certain reporting requirements if the parties agree to divide the reporting obligations between the prime broker and executing dealer. In response, the Commission issued a no-action letter allowing for allocation of the reporting responsibilities as requested by the FMLG as long as both parties are registered with the Commission as SDs and the prime broker/ED swap and the prime broker /customer swap have the same economic terms and pricing. I’m glad the Commission took a reasonable approach to solving this issue, but, as I’ll discuss in more detail in a minute, the Commission has yet to provide sufficient relief with respect the requirements imposed by the Business Conduct Standards applicable to prime brokers and executing dealers.
Getting the Commission on Track to Utilize the Data
Now, just because market participants have reported the data doesn’t mean that the Commission is already crunching data received from the SDR to identify and measure risk exposures in the market. To the contrary, just like market participants, we have experienced serious problems in digesting the data. Inconsistent reporting, technical challenges and validation and normalization of the data have crippled our utilization of our data.
Swap data reporting began on December 31st of last year, since that time it has become abundantly clear our current system isn’t working. The breakdown can be traced to one primary factor: The lack of data standards. The Commission failed to provide for a standardized data reporting format and as a result entities are reporting trades using different message types and in varying record formats. Further, inconsistent validation by the SDRs makes acceptance and rejection of data problematic. This makes it incredibly difficult to aggregate the swaps data across all reporting parties. In addition, the Commission’s lack of experience in aggregating, searching and navigating through these varied data structures have made our efforts to develop a basic level of analysis unsuccessful.
Focusing on our Data Dilemma
While our current efforts to develop a thorough and effective analytical capacity are unworkable, I believe this failure can be reversed and we will have complete transparency into the derivatives market. However, there are a number of immediate steps that must be taken to develop a standardized data collection, aggregation and analysis program.
Next week, the Technology Advisory Committee, which I chair, will meet to address solutions to these data challenges. We will take testimony from market participants regarding the challenges they have in complying with the reporting rules and we will hear from the SDRs as to how we can improve the data quality and enable the Commission to utilize the data.
Generally speaking, we have huge challenges with the consistency of reporting across entities and reporting parties. We need to ensure that the data formats are standardized and harmonized within and across all SDRs. While there are fewer trades reported in the swaps space than the futures markets, the level of complexity and customization has challenged the Commission’s capacity to aggregate and sort trades. The next challenge is to develop protocols and the technology for the Commission to access data in the SDR’s portal and to access and aggregate specific data as needed.
We will need to work with the registered SDRs to develop common reporting guidelines and implement a validation process to improve data quality. Longer term, the Commission must work with the SDRs and industry associations to come to terms with universal reporting conventions such as the Universal Product Identifier (UPI) that was mandated under Commission regulation §45.7. Developing a consistent reporting convention will improve data quality and cross-market and international data harmonization as envisioned in the G-20 Communique passed last week.
Establish a Cross-Divisional Data Unit within the CFTC
I don’t believe the Commission was fully prepared for the data challenges when it drafted the rules. We didn’t appreciate the challenges we would face and we certainly aren’t organized to tackle this problem. That is why I have recommended the Commission develop a cross-divisional data unit to address our data deficiencies. I believe a dedicated team focused on: 1) organizing and examining the data for completeness and accuracy; 2) interpreting and analyzing the data; and 3) developing the analytical tools to identify market risk would be time and energy well spent.
Make the Commission’s Technology Program a Priority
Finally, I recently joined the Chairman in testifying before the House Appropriations Committee, Subcommittee on Agriculture to request that the Congress make the investment in technology our number one investment priority. Without a competent technology strategy, we will not be able to credibly support our oversight and enforcement missions unless we have the tools and useful data to develop our cases. I have heard that computers can’t issue subpoenas, but without adequate technology in place to identify problematic trading activity, we won’t even have enough information at hand to build a case.
Let me close this discussion on data with another quote attributed to the management guru W. Edwards Deming who said, “In God we trust, all others must bring data.” I couldn’t agree more, I’m not willing to bring a case before the courts with a “trust us” strategy – we must bring the data as well.
If we implement the changes I have suggested we will not only improve the Commission’s ability to effectively harness technology, but we will improve our oversight capacity to cover more markets and do so by relying more on automation and less on hiring staff to do the same job.
Cross Border – Harmonizing the Definition of Substituted Compliance
Now, let me turn to the other priority of the G-20 Ministers and Bankers and that is solving the issue of cross-border regulatory harmonization. As I’ve consistently stated, the Commission and international regulators must find agreement on a workable cross- border regulatory framework. This imperative was highlighted last week by a few developments. The Financial Stability Board (FSB) issued its fifth progress report on OTC derivatives reform, in which it urged cross-border cooperation to resolve outstanding issues, and the OTC Derivatives Regulators Group issued a report to the G-20 finance ministers.
In addition, a group of eight national finance ministers, including those of the UK, France, Germany and Japan, along with EC Commissioner Michel Barnier, sent a strongly worded joint letter to U.S. regulators regarding cross-border OTC derivatives regulation. They expressed concern at the lack of progress in developing a workable cross-border framework, indirectly called the Commission’s proposed rules unsustainable, and urged better coordination among regulators to avoid conflicts and duplication. This is not the first time that we have heard such sentiments from our fellow regulators.
So, while a fair amount of progress has taken place in the past few months, it is fairly clear that we have some way to go in order to reach a sufficiently harmonized global regulatory scheme. Given this reality, and the fact that the July 12 expiration date of the Commission’s cross-border exemptive relief is rapidly approaching, it makes sense for the Commission to extend this relief. An extension would provide some measure of certainty for the markets and provide the necessary time for regulators to hash out differences and determine a workable regime of substituted compliance.
There are alternative outcomes, and I would like to draw everyone’s attention to them. One alternative is finalizing the cross-border guidance that was proposed last July. Currently there is no draft final guidance before the Commission, but when it arrives I hope that the draft addresses a few key issues. I hope that it will give meaning to the statutory requirement that our regulations will only apply to activities outside the U.S. if such activities have a “direct and significant connection with U.S. activities.” Developing a sufficient rationale for this “direct and significant” standard is important in setting the proper parameters for our extraterritorial reach. In addition, I hope that the final guidance adopted by the Commission will articulate a reasonable, workable definition of U.S. person that provides certainty and clarity to market participants and allows for the analogous treatment of similarly situated entities.
The other alternative to extending relief would be to let the relief expire without finalizing the guidance – in other words, to take no further action. This outcome may seem inconceivable but it is not, due to the complexity of the issues and the number of variables involved.
If the relief simply expires and the guidance is not finalized, all that is left is the statute. This means that firms would be expected to determine on their own whether their activities, and which of their activities, were above the “direct and significant” threshold and thus subject to U.S. regulation. It is hard to imagine a more uncertain, confusing and burdensome outcome for market participants, so hopefully this outcome can be avoided.
External Business Conduct
Finally, I would also like to speak to you today about the Commission’s External Business Conduct Rules (“EBC”). I bring this rule up as an example of how the Commission’s use of a cookie-cutter approach to apply new, uniform regulations across an entire industry has created more problems than it has solved.
Dodd-Frank gave the Commission broad authority to set external business conduct standards for swap dealers in their dealings with counterparties.6 The Commission promulgated the EBC rule to impose certain requirements on swap dealers and major swap participants when dealing with customers.7 The rules address swap dealer and major swap participant requirements with respect to such issues as prohibitions on fraud, counterparty eligibility, disclosure of material information, and suitability. This rule will be of interest to you because swap dealers must comply with the EBC rules in their FX swaps transactions.8 This rule has already caused a great deal of confusion in your industry and many of you have sought relief from the Commission to clarify what you’re actually required to do.
As you know many FX swaps are traded under a Prime Brokerage agreement. That means a swaps customer contracts with a prime broker to centralize all trading and margining functions while negotiating with executing dealers when entering into specific swaps transactions. Under the EBC rules however, only the prime broker is responsible for satisfying all aspects of the EBC rules, even though the executing dealer is best suited to carry out certain parts of the rule.
A better approach would have the EBC rules apply to the prime broker and executing dealer based on their respective roles in the trading relationship. For example, EBC requirements dealing with pre-trade pricing information and disclosures of risks associated with specific swaps are best handled by the executing dealer. EBC requirements dealing with the general prime broker-customer relationship, such as credit limits and risk profile, are best handled by the prime broker as they are the broker actually handling the client relationship. This divided responsibility was exactly what the industry requested when they submitted a request for interpretive guidance in November of last year.9 Staff has been in negotiations with the FMLG to try to come to a resolution to this issue. I am glad to see Commission staff working with the industry to resolve this issue, but of course, the staff has imposed some conditions that I think are unnecessary. Mainly, I am concerned that staff is insisting on joint and several liability for both the prime broker and executing dealer. What this means is that although the prime brokers and the executing dealers will take responsibility for complying with the aspects of the EBC rules that pertain to their actual conduct, the relief will still impose joint and several liability on each party for the violations of the other. This sounds to me like ‘heads I win, tails you lose.” If both entities agree to be responsible for their share of the regulatory obligations, why do we need to hold them responsible for the compliance failings of parties outside their control? If both the prime broker and executing dealer agree to be liable for their respective roles, between the two entities we will achieve compliance with the EBC rules. And that is the main goal, we don’t need to engage in overkill and include joint and several liability
I’ve highlighted this issue with you because this is another example of the Commission issuing new regulations using a standardized approach that will then be applied to the entire industry. Don’t feel like you’re been singled-out though, we have made similar mistakes in our other rules. Take our risk management rules for FCMs for example, we require FCMs to review each order submitted by a customer to ensure that the order was within the customer’s credit limit.10 Unfortunately, we failed to account for the fact that customers quite often use an executing broker and a clearing broker so there was no way for the clearing broker to run this pre-trade credit check. Because we used a one-size-fits-all approach, the industry had to request exemptive relief so that they could build out an IT solution in order to comply with the rule. Keep in mind, this new rule was dreamt up by the Commission. There was no pre-existing problem that needed to be fixed and it wasn’t mandated by Dodd-Frank.
The Commission has spent the better part of the last three years drafting new rules and regulations to implement the new regulatory regime mandated by Dodd-Frank. We are now in the final stages of that process and will soon transition from rule writing to the implementation of those rules. This is an ideal time to step back, examine the work we have done, and make changes were necessary to improve the process by which we will implement this new regulatory system. There is no shame in examining our work and, with the benefit of hindsight, identifying rules we think need to be reconsidered. This is the sign of a conscientious and prudent regulator.
1 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111–203, 124 Stat. 1376
5 77 Federal Register 35200, at 35211.
6 Commodity Exchange Act §4s(h).
7 Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties, 77 Federal Register 9734, 9735
8 See Department of the Treasury, Determination of Foreign Exchange Swaps and Foreign Exchange Forwards under the Commodity Exchange Act, http://www.treasury.gov/presscenter/press- releases/Pages/tg1773.aspx (“Treasury Exemption Release”) page 46.
9 See Financial Markets Lawyers Group – Request for Interpretive Letter for Swap Dealers in Connection with Foreign Exchange Prime Brokerage, November 21, 2012.
10 17 C.F.R. §1.73.
Last Updated: May 15, 2013