May 14, 2013
Thank you very much for inviting me to participate in the discussion.
As I was preparing my speech and reflecting on the most important answers that the Commission must give to market participants, I thought of the famous statement made by former Defense Secretary Donald Rumsfeld, “[t]here are known knowns; there are things we know that we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.”1 It has occurred to me that these three categories could just as easily be applied to the Commission’s implementation of Dodd-Frank.
Today, I will focus on three topics: (1) the Commission’s rule implementation process, (2) the impact of the Commission’s rules on end users and (3) risk management.
Specifically, when discussing my first topic, the Commission’s rule implementation process, I will go over some of the Commission’s final rules that have now become “known knowns.” Then, I will transition to the “known unknowns”: that is, the Commission’s numerous no-action letters that supersede some of the Commission’s final rules, as well the rules that are now being litigated in court and some of the Commission’s proposed rules, such as the proposed Cross Border Guidance. I will also touch upon some of the “unknown unknown” market developments – such as futurization. This was hard to predict at the time the Commission drafted its rules and the role of the Swap Execution Facility Rule (SEF) may accelerate this phenomenon.
I. The Commission’s Rule Implementation Process
Known Knowns: Final Rules
I will begin with the Commission’s rule implementation process. With almost two thirds of the Dodd-Frank rulemakings complete, you would think the industry should have a pretty good sense of the “known knowns.”
For example, market participants are now familiar with the Commission’s definition of a swap. The industry also knows that certain classes of interest rate swaps and credit default swaps are subject to mandatory clearing. Additionally, the rules for Designated Contract Markets (DCMs) and business conduct standards are fairly well understood, as is the Commission process to register as a Swap Data Repository (SDR). And I think we generally understand what Derivatives Clearing Organizations (DCOs) are, though the margin methodology is uncertain.
Let me move now to the “known unknowns.” This list is unfortunately a little longer and seems to be growing. Let me provide you with three examples of known unknowns, which I believe could have been avoided and which contribute to regulatory uncertainty and compliance challenges.
Known Unknown #1: No-Action and Exemptive Relief
In a rush to implement all the rules, the Commission has finalized some rules that are either unworkable or simply make no sense.
Instead of amending these rules, the Commission has issued an unprecedented number of no-action and exemption letters. So far, the Commission has provided 90 exemptions, with a number of these exemptive loopholes providing indefinite relief.
Clearly, this process is at odds with the basic principles of the Administrative Procedure Act (APA). It also violates President Obama’s directive committing the government to create “an unprecedented level of openness in Government” and to working “to establish a system of transparency, public participation, and collaboration,”2 and more specifically his executive order directing independent agencies to consider how best to promote retrospective analysis of existing rules and “to modify, streamline, expand, or repeal them in accordance with what has been learned.”3
Virtually every no-action letter that the CFTC staff issues contains some complicated and needless restriction that results in the relief being available to some entities, but not all. I have yet to see a no-action letter that provides a clear justification for different regulatory treatment of these entities. And those firms that do benefit from the relief are subject to numerous conditions, needless restrictions and arbitrary compliance timelines.
Another negative consequence of this parallel track of Commission actions is that the industry can no longer simply rely on the Commission’s regulations to determine their compliance obligations. Instead, market participants must review all the no-action and exemption letters in addition to the regulations in order to determine the full scope of what they are required to do.
Now that the Commission has started the rule implementation phase, it simply cannot carry out its regulatory oversight in this fashion. Instead, it must re-visit the rules that have proved to be unworkable, incorporate indefinite permanent relief into the amended rules, make the necessary adjustments, and consistently and fairly apply such amended rules to all regulated entities.
Known Unknown #2: Legal Challenges to the Commission’s Final Rules
To force the Commission to provide some clarity and to reconsider some of its rules, the industry resorted to litigation. There have been an unprecedented four lawsuits filed against the Commission regarding Dodd-Frank rules. Let me briefly address three of these.
One example is the Commission’s position limits rule. As you know, last year, the Commission’s position limits rule was struck down by the federal district court in Washington DC. The court held that before setting such position limits, the Commission is required to determine whether position limits were necessary and appropriate to prevent excessive speculation in the commodity markets. Unfortunately, the Commission ignored the court’s order to undertake the necessary analysis; instead, it is gearing up to defend its rule in a court of appeals and at the same time, is drafting a new rule.
Despite the loss in district court, the Commission has failed to learn from its mistakes. We have courted litigation by failing to take the appropriate steps in changing our Part 45 Data Rules, which has resulted in a case filed by the DTCC against the Commission for approving the CME Group’s Rule 1001 amendment regarding the trade reporting obligations of a clearing house. This litigation relates to who must report cleared swap trades and to which SDR they must be reported and whether or not the Commission followed the Administrative Procedures Act in approving CME’s amendment. Again, rulemaking shortcuts and inconsistencies within the rule and among other rules contributed to DTCC’s legal arguments.
Finally, it seems like everyone predicted the Bloomberg lawsuit. And Bloomberg gave the Commission plenty of warning signs of the problem with the Commission’s margin calculation for swaps. But we did not want to listen. Earlier this month, Bloomberg brought a lawsuit, contending that the Commission has created an uneven playing field by making it far more expensive to trade and clear swaps than economically equivalent futures. This is because the Commission’s regulations mandate a minimum liquidation time for financial swaps that is five times the minimum liquidation time for the equivalent exchange-traded swap future.
Known Unknown #3: Proposed Cross-Border Guidance
Aside from the litigation matters, I must mention the Commission’s proposed Cross Border Guidance. Last July, the Commission published a proposed Cross-Border Guidance that has been generally characterized as over-reaching and overly prescriptive. I have noted with interest the strong and vocal opposition to the Commission’s proposed cross-border application of its Dodd-Frank rules. While the goal has been to harmonize our rules, the over-reaching and prescriptive outcomes in the proposed guidance would likely have the opposite effect and create market fragmentation, regulatory uncertainty and a disincentive to trade with U.S. persons.
It remains to be seen what the global derivatives market will look like once Europe and Asia implement their derivatives rules and once the Commission defines substituted compliance in such key areas as clearing and trading.
But I’d like to note that one of the many lessons learned from the financial crisis was that the regulators for major economic markets around the world must work together to ensure that similar principles are enforced around the globe. The issues we need to resolve require international coordination and I encourage the Commission to work with our counterparties around the globe to bring our goals to fruition.
This brings me to the unknown unknowns in the Commission’s rule implementation process. These, of course, by definition are impossible to identify, but in hindsight, they are the result of the Commission’s inconsistent rules.
Unknown Unknown #1: Futurization
The first unknown unknown that comes to mind is “futurization.” It came about as a direct result of two rules that led market participants to make unanticipated changes in their trading behaviors. One is the Commission’s margin calculation rule for swaps that is in litigation now and the second one is the Commission’s vague and complex swap dealer rule. These rules drove energy market participants away from the swaps space to the well-defined futures market.
End User State of the Market Meeting: One Year Anniversary of Futurization
To understand the impact of this move to futures in energy, I have been working with staff to look at data before the October 15, 2012 move and after. At this point we don’t have enough data to form any conclusions, but I would like to hold an End Users State of the Market meeting near the one-year anniversary of the October futurization move. I would like to know how futurization is working for end users and whether end users are able to take advantage of the hedging exemption, and I will report to you on the status of the Commission’s data reporting issues. I invite everyone in the audience to participate in these discussions.
Unknown Unknown #2: SEFs
There is another rule that has the potential to accelerate the move to futures: the SEF rule. To avoid regulatory arbitrage, it is important for the Commission to come up with flexible SEF rules that provide for an efficient and clear registration process and that allow for various execution methods. I am concerned that the Commission’s overly restrictive proposal will impede the innovative capacity and flexibility of these new platforms.
After much delay and great anticipation, the Commission is scheduled to vote on all the transaction rules, including SEFs, swap blocks and the made available to trade rules, this Thursday. I am heading back to Washington DC tonight to continue the final negotiations on these rules.
I remain optimistic that we can find an agreement to develop flexible swap execution platforms that will encourage on-screen trading, as provided in the statute, and that we will do away with the overly prescriptive rules that were included in the original draft.
Minimum RFQ: Let the Data Tell Us the Right Level
One issue that has caused a high level of debate and negotiation is the transition on the minimum number of markets participants that are sent a request for quote (RFQ). The big question is, will the transition be automatic or will we actually look at the data to inform a Commission decision? It seems obvious to me that we would use data and facts to inform our decision. After all, what is the point of collecting all of this data if we aren’t going to effectively utilize it?
Unknown Unknown #3: Volcker Rule
While on the subject of the unknown unknowns, I would like to mention the Volcker rule. The rule was proposed in October 2011. Almost a year and a half and over 18,000 comment letters later, the main issues remain unresolved. For this rule to get done and get done right, the Commission must ensure that the final rule accomplishes the overarching Dodd-Frank goal of reducing systemic risk by providing the Commission with real means to enforce violations of the rules.
Now, turning to my second topic: end users.
II. End users
Known Unknown #1: Swap Dealer Rule
Although many unknowns remain regarding how the Commission will come out on the position limits rule, the SEF rule, and the capital and margin rule, it is nevertheless clear that the over-the-counter (OTC) derivatives world is changing for end users. I agree with Sean Owens, an economist with Woodbine Associates, who stated that under the Dodd-Frank rules, “end-users face a tradeoff between efficient, cost-effective risk transfer and the need for hedge customization. The costs implicit in this tradeoff include: regulatory capital, funding initial margin, market liquidity and structural factors.”4
So far, the Commission has not done its best to protect end users.
The swap dealer rule makes it difficult to determine whether an entity is a swap dealer. Instead of coming up with a specific bright line test, the rule lists numerous factors that should be considered in determining whether an entity is a swap dealer. If an entity determines that it is a swap dealer, it must then determine if its swaps activity is large enough to require registration.
Under our rules, a swap dealer does not need to register with the Commission if its aggregate swap dealing activity on a yearly basis is below the arbitrary $8 billion threshold. By the way, the threshold is reduced to $3 billion following the five-year phase in period.5 According to the rule, market participants are allowed to exclude from this calculation trades executed to hedge physical positions.6
This part sounds good. But who would have guessed that the Commission decides that this rule must have a definition of “hedging activity” that is different from the definition used elsewhere in the Commission’s regulations? For purposes of both simplicity and consistency, the Commission should adopt one uniform definition of hedging applicable across all Commission regulations. And we should certainly not define hedging one way for dealers and another for major swap participants as the rule currently provides.
By the way, hedging is not the only category of transactions that should be removed from the $8 billion de minimis calculation. Swap transactions that are cleared through a DCO ensure that both parties deal at arm’s length and are able to mitigate risk and should be excluded from the de minimis calculation as well.
I would also like to correct the Special Entities definition. When trading with municipal energy companies, such as state, city and county municipalities, the $8 billion threshold drops to $25 million. The reasoning behind this distinction was that Special Entities need special protection because any loss incurred by a Special Entity would result in the public bearing the brunt of the damage.7
Sounds like a noble intention. But, as they say, the road to hell is paved with good intentions. By reducing the threshold to $25 million, the end result has been a reduction in the number of market participants that are willing to do business with Special Entities. Many counterparties that would fall well below the $8 billion de minimis threshold are not willing to trade with Special Entities out of fear of exceeding the $25 million threshold.
Now, in response to repeated requests from various Special Entities, the Commission issued no-action relief allowing the de minimis threshold to be increased to $800 million for utility commodity swaps.8
In trying to protect Special Entities from the perils of trading in the swaps market, we have forced them to trade with large Wall Street banks since no other entity is willing to trade with them for fear of becoming a swap dealer. Instead of providing them greater protection, we have limited the pool of counterparties with which Special Entities can trade, concentrating risk to fewer market participants.
This surely goes against the goal of reducing systemic risk.
Known Unknown #2: Capital and Margin Calculation
Another rule that impacts end users’ activity is the capital and margin rule. Just before the 2010 passage of Dodd-Frank, Senators Dodd and Lincoln, who authored the Senate Dodd-Frank legislation, wrote a letter to their House counterparts stating that “Congress clearly stated that the margin and capital requirements are not to be imposed on end-users.”9
On April 13, 2011, the Commission proposed rules regarding capital and margin requirements for uncleared swaps. I supported the proposal and the exemptive relief that rule proposes to provide to end users. Under the proposal, when swap dealers trade with end users, the end user is not required to post margin. This is consistent with the Congressional intent.
While the margin rules as proposed would provide relief to end users, the capital rules will impact end users as their bank counterparties are forced to apply this charge to all uncleared swap positions.
It is imperative that the Commission’s regulations do not divert working capital into margin accounts in a way that would discourage hedging by end users or impair economic growth. Whether swaps are used by an airline hedging its fuel costs or a manufacturing company hedging its interest rates, derivatives are an important tool that companies use to manage costs and market volatility.
As you may know, the Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) are working to finalize harmonized standards for margin requirements on uncleared derivatives. This effort appears largely consistent with the Commission’s proposal. The decision to harmonize margin requirements was a good step and I support the Commission’s effort to engage in international coordination with foreign regulators.
Finally, turning to my last topic and the main topic of this conference: risk.
III. Managing Risk – Known Unknowns or Unknown Unknowns?
The Commission is struggling to ramp up and meet its new goals and objectives of developing a capacity to understand and monitor risk at the lowest levels of a fund manager to overseeing the systemically important entities like a clearing house. Identifying risk can only be done effectively if we are able to manage our data. Under Dodd-Frank we require a wide variety of new forms and data reporting on every aspect of the markets we oversee. Ingesting, harmonizing, aggregating, and analyzing this data to identify risk patterns is a new skill set we haven’t mastered yet. Recently, a staff presentation pinpointed our challenge when they stated they couldn’t see the London Whale in our data. That obviously set off alarm bells.
Before I describe what we need to do to get our arms around our data dilemma and develop our essential risk tools, let me share with you some numbers regarding the relative size of the margin requirements in the clearing houses today. Keep in mind, the only mandate so far to clear swaps has been on the dealers; funds are not required to clear until mid-June.
In the clearing area alone, the Commission conducts surveillance of about $150 billion in aggregate margin requirements across all DCOs. Today, futures markets makes up 69 percent of the aggregate margin requirement ($101.7 billion), while the swaps market holds $45.2 billion. The two largest cleared swap categories, which I expect to grow significantly, are the interest rate market ($23.6 billion) and the CDS market ($22.6 billion).
Among the largest entities, CME’s margin requirements make up $87 billion of the $146.9 billion total. Another interesting fact is that customer funds make up $87 billion or 59% of the total margin, with clearing member house funds at $60 billion.
To help put these numbers in perspective, the cost to taxpayers for the government’s bailout of Freddie Mac and Fannie Mae peaked at $187.5 billion in 2011. And the Troubled Asset Relief Program provided $419 billion in assistance, now down to less than $23 billion outstanding.10
So obviously these margin amounts are a lot of money, and we are consolidating risk in clearing houses and among the largest clearing houses and clearing members. By driving more trades from the bilateral space we are extending the interconnection and systemic nature to all parties. The obvious benefits of central clearing are that additional funds such as margin and guarantee funds will mitigate the systemic shock to the system or to one or more entities.
However, a recent study by Mark Roe, a professor at Harvard Law School, questions whether the clearing mandate will make the system safer.11 In his study, he states: “clearinghouses are weaker bulwarks again financial contagion, financial panic, and systemic risk than is commonly thought.”12
He goes on to say: “[t]he stakes are high in correctly assessing the value of clearinghouses in containing systemic risk, because the reigning over-confidence in clearinghouses lulls regulators to be satisfied that they have done much to arrest problems of contagion and systemic risk, when they have not.”13 Needless to say, that caught my attention.
Mr. Roe does highlight the fact that clearinghouses are very good at managing the risk of failure of a single firm, but aren’t well suited to manage contagion and system-wide risk. He points out that the financial crisis of 2008-2009 “suffered deeply from both a downward asset price spiral of collateral value and from information contagion.”14 He goes on to say, “Clearinghouses may well reduce counterparty risk. But when they do so, how much systemic risk are they reducing?”15
This is a great question and something that policy makers are struggling with right now. How do you contain Too Big to Fail and where does it reside? Without a doubt, clearinghouses are systemically important and their interconnections spread both to and from a clearinghouse. So what are we going to do about it?
This is where our data and technology mission intersects. And it highlights the importance of the Commission finding the London Whale or any other systemic entities and to better understand their connections.
I have found that we are very good at prescribing appropriate behavior in the market, but not so good at developing our strategy for developing our own tools to prepare for the massive amounts of new data: to integrate, harmonize, aggregate and – most importantly – analyze this data.
Attacking the Data Dilemma to Identify Risk and Oversee Derivatives Markets
So, what are we doing to monitor and manage data? Right now, the Commission receives data that is unusable for the Commission’s oversight mission. It will take some time for the Commission to sort out its data challenges, but I am confident that by working closely with all SDRs, we will resolve these challenges and will be able to utilize transaction data as directed by Congress. There are a few things to note in terms of reaching that objective.
First, each division of the Commission needs to come up with a business and operational plan to support its mission needs with the necessary technology plan and the staffing they need to complete the job. Until we identify our priority needs, we are likely to remain in the known unknown category of government bureaucracy.
Second, as Chairman of the Commission’s Technology Advisory Committee Meeting (TAC), I have committed the TAC to help solve our data challenges. At our most recent TAC meeting on April 30 we had very open and productive discussions about the data reporting challenges, and we are now working with the SDRs and market participants to quickly define critical data standards to improve the harmonization of data that is so essential to perform critical analysis.
The TAC meeting was the first step towards bringing market participants, SDRs and the Commission together to find a solution for harmonization of data across SDRs. Additional meetings will be scheduled to organize and standardize regulatory data as soon as possible.
Third, I have advocated for the creation of a cross-divisional data unit with staff dedicated to organizing and analyzing the data, and most importantly developing the necessary analytical tools to identify market risk.
Under the current structure, although the Division of Market Oversight wrote the data reporting rules, it has very little involvement with their implementation. The Office of Data Technology is now working with the SDRs to implement the rules. I believe robust data reporting can only be achieved if all the Commission’s divisions, including the Division of Clearing and Risk, the Division of Swap Dealer and Intermediate Oversight and the Division of Enforcement, work closely together to integrate, aggregate and analyze data.
Finally, I have called on the Commission to identify in its budget plan how the Commission is spending its technology resources and how the technology budget meets the objectives of Dodd-Frank and the realities of today’s global markets. The ticket to preventing and deterring market abuses is technology. The technology of yesterday will not be able to keep up with the market realities of today. For the Commission to stay on top of its oversight mission, it must have a system that can process and analyze the massive volumes of data.
Derivatives markets are becoming increasingly complex in the new post-Dodd-Frank era, as more and more transactions move to exchanges and clearing houses and market participants are trying to respond to new regulatory demands. In this changing environment, it is crucially important for the Commission to provide regulatory clarity and reduce unknowns for all market participants.
So, what questions should the Commission answer to provide regulatory certainty to the market and to accomplish Dodd-Frank objectives? First and foremost, to be able to effectively conduct its market oversight mission, it should be able to understand and analyze swaps data. Second, the Commission must fix broken rules and not wait for market participants to drag us into litigation. And last but not least, the Commission must ensure that its rules, while implementing the congressional mandate to regulate the derivatives markets, do not harm this country’s vital economic forces: the manufacturers, energy companies, real estate developers, and other businesses that provide important services to the American people.
1 U.S. Secretary of Defense Donald Rumsfeld, February 22, 2002, http://www.defense.gov/transcripts/transcript.aspx?transcriptid=2636.
2 Transparency and Open Government, Memorandum for the Heads of Executive Departments and Agencies, http://www.whitehouse.gov/the_press_office/TransparencyandOpenGovernment.
3 Executive Order 13579 – Regulation and Independent Regulatory Agencies, July 14, 2011, http://www.gpo.gov/fdsys/pkg/FR-2011-07-14/pdf/2011-17953.pdf.
4 See Sean Owens, Optimizing the Cost of Customization, Review of Futures Market (July 2012).
5 See Further Definition of ‘‘Swap Dealer,’’ ‘‘Security-Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ ‘‘Major Security- Based Swap Participant’’ and ‘‘Eligible Contract Participant,” 77 FR 30595 at 30744.
6 17 C.F.R. §1.3(ggg)(6)(iii) of the Commission’s regulations, excluding swap transaction entered into to hedge physical positions from the de minimis swap dealer calculation.
7 See 77 FR at 30628 (referring to documented cases of municipalities losing millions of dollars on swaps transactions because they did not fully understand the underlying risks of the instrument).
8 Staff No-Action Relief: Temporary Relief from the De Minimis Threshold for Certain Swaps with Special Entities, October 12, 2012.
9 June 30, 2010 letter from Senators Lincoln and Dodd to Congressmen Frank and Peterson.
11 The Dodd-Frank Act’s Maginot Line: Clearinghouse Construction, March 5, 2013. http://ssrn.com/abstract=2224305.
12 The Dodd-Frank Act’s Maginot Line, abstract of article.
13 The Dodd-Frank Act’s Maginot Line, abstract of article.
14 The Dodd-Frank Act’s Maginot Line, page 8.
15 The Dodd-Frank Act’s Maginot Line, page 9.
Last Updated: May 14, 2013