June 12, 2013
Thank you very much for the kind introduction and for inviting me to speak here today.
The headline title for this conference is “Beyond Regulation” and the program notes lead in with “in the face of massive regulatory change….” So I guess you don’t need me to tell you that we at the CFTC, as well as regulators here in Europe, have been pretty busy developing new regulations the past three years. These regulations have produced, among other things, a treasure trove of issues to discuss and debate.
I would like to focus on three of these topics with you today. First, cross-border regulatory issues. Second, the Commission’s adoption of rules governing swap execution facilities (SEFs) and related trade execution rules. Third, the Commission’s challenges to manage and utilize data for effective market oversight.
Cross-Border: Extending Relief to Get the Guidance Right
Let me turn first to a topic that is probably on your minds today: the cross-border regulatory framework for derivatives, and specifically the question of how the Commission applies its rules outside the United States.
As you may know, the Commission’s exemptive relief from the cross-border application of its Dodd-Frank rules expires on July 12.1 As that date nears, the Commission has only been given one path forward: finalize its contentious cross-border guidance by July 12, or else leave the market without any clarity on the extraterritorial application of Commission rules following the expiration of the exemptive relief.
There are a number of reasons why the Commission should not be forced into a take-it-or-leave-it decision tied to an arbitrary deadline. Therefore, last week I asked my fellow Commissioners to join me in releasing for public comment a proposed extension of the existing exemptive relief until December 31, 2013.
The take-it option the Commission has been given is to finalize the guidance. If you remember, the proposed guidance was met with less than positive reaction from regulators across the globe.2
The Commission has a draft final guidance before it now. I have significant concerns about this current draft, and I have doubts as to whether the Commission can reach agreement on a final draft before the July 12 deadline. Even if the guidance can be finalized, there is not enough time between now and the deadline for the Commission and its fellow regulators abroad to develop a harmonized cross-border regulatory framework. The guidance, by the way, does not provide the process for substituted compliance, which is the key to harmonization; I am told that the Commission will need to develop that process separately.
The leave-it option, which I find unacceptable, is simply to do nothing and let the relief expire. If the relief expires and the guidance is not finalized, the only relevant authority would be the statutory language articulated by Congress in Dodd-Frank that limits application of the Commission’s swaps rules outside the U.S. to activities with a “direct and significant” connection with, or effect on, the U.S. Firms would then be on their own to determine whether their activities fall within the statute’s “direct and significant” requirement and are thus subject to U.S. regulation. I think we can all agree that this option should be avoided.
There is another option: extend the relief. I have previously expressed my belief that this is the most sensible option, and I believe this even more strongly now with the July 12 deadline fast approaching.
An extension would serve several purposes. First, it would allow the Commission to develop a more workable final guidance that can be adopted when it is ready, not rushed to completion due to an artificial deadline. Second, it would allow much-needed additional time for the Commission and international regulators to continue their ongoing cooperative efforts to harmonize the global regulatory framework. International regulators have consistently urged continued coordination on cross-border harmonization, and just two weeks ago issued an explicit request for the Commission to extend its exemptive order.3
These cooperative efforts depend on other jurisdictions finalizing their remaining rules, and the Commission and international regulators agreeing on and implementing a workable regime of substituted compliance and then making determinations pursuant to this regime. All of these processes require more time. Furthermore, an extension would allow time to improve coordination on our cross-border rules with the U.S. Securities and Exchange Commission (SEC), particularly on the foundational definition of “U.S. person.”
Since the existing relief was issued pursuant to the Commission’s exemptive authority that requires the Commission to provide notice and comment, the extension of such relief must also be subject to the notice-and-comment requirement. This makes sense, but when such a simple change requires notice-and-comment procedural safeguards, I find it revealing that the Commission somehow thought it was appropriate to lay out its entire cross-border framework in the form of guidance, which does not require such safeguards.
Because the process to extend relief takes time and time is running short, I drafted a proposed extension to the exemptive order and last week I asked the Chairman to circulate it for Commission vote.
Even if the Commission may not unanimously agree on whether extending the relief is the best option, we can all agree that an extension is better than simply allowing the relief to expire. And by proposing the extension, all we would be doing is preserving it as an option. Given all that is at stake, and given the looming July 12 deadline, it is imperative for the Commission to have a viable backup plan; failing to do so would be utterly irresponsible.
I will continue to push for keeping all options on the table rather than restricting ourselves to the unpalatable take-it-or-leave-it scenario. In addition, I have scheduled meetings in both London and Brussels this week to discuss the current state of negotiations and the concerns about applying U.S. rules before we have a process for making a determination for substituted compliance, let alone completed EU rules by which to make such a determination.
Let me say a few words about what a Commission final guidance should look like, whenever it is adopted. First, it shouldn’t be in the form of guidance at all. Rather, it should be a notice-and-comment rulemaking, with a robust cost-benefit analysis given the significant burdens that will be placed on market participants. This is the approach taken by the SEC in its cross-border document.
In addition, the Commission must provide meaning to the “direct and significant” requirement in the statute. As I’ve pointed out before, this requirement in Dodd-Frank provides a statutory limitation on the Commission’s extraterritorial reach. As such, the Commission must do a better job of articulating which activities abroad satisfy the requirement.
Furthermore, the Commission must come up with a workable definition of U.S. person. As I mentioned, this definition should be harmonized with the SEC’s definition. Market participants have enough compliance burdens as it is; to force them to deal with two different U.S. person definitions from two U.S. regulators would be beyond unfair. Speaking of fairness, the U.S. person definition should be finalized in a way that does not create disincentives to trading with firms that fall into the definition. Such an uneven playing field would unfairly disadvantage U.S. firms, and that would be unacceptable to me.
Finally, a lot has been said about potential loopholes involving offshore funds and risk from those funds coming back on to U.S. shores. However, I would caution against overreaching to rope in entities into U.S. jurisdiction that would more appropriately be regulated elsewhere pursuant to an effective system of substituted compliance; this could have the perverse effect of creating more risk to the U.S. system and more risk to U.S. taxpayers.
More generally, I dispute the premise that the failure to implement final guidance by the July 12 date would somehow preserve an environment in which U.S. bank affiliates are unregulated across the globe, creating systemic risk that could cause taxpayers to be on the hook for future bailouts. I also dispute the premise that the broad application of U.S. rules to foreign trades, in jurisdictions where similar reforms are underway, will necessarily eliminate all risk and relieve U.S. taxpayers from future bailouts.
In addition, I think the Federal Reserve and the Office of the Comptroller of the Currency would find it interesting to hear that they apparently conduct no oversight of overseas U.S. bank branches. The reality is that foreign branches of U.S. banks are subject to regulatory oversight, and that our exemptive order relieved U.S.-affiliated foreign entities from U.S. rules due to the fact that regulatory rules abroad weren’t yet in place, which otherwise would have put U.S. firms at a competitive disadvantage vis-à-vis their competitors. The status quo will remain unchanged by the July 12 deadline.
Reverse the Process to Find Common Ground
By trying to finalize the cross-border guidance now, I believe we have the process completely backwards. Right now the path is first to dictate the broad application of our complex rules, and then work to reach agreement internationally to establish a substituted compliance regime and conduct a separate and yet to be specified Commission determination as to the comparability of rules.
I would prefer to reverse the order. Let’s continue to work through the negotiations with our regulatory peers, identifying and harmonizing our common regulatory schemes – and then apply the harmonized guidance. This will eliminate cost and inefficiency in overlapping or even conflicting regulatory schemes, and it will provide greater certainty to market participants.
Transaction Rules Finalized: the Good, the Bad, and What Comes Next
I’d like to move now to my second topic. Last month, the Commission finalized long-awaited SEF rules. While not perfect, the final rule is a far cry from the original draft that was circulated to the Commission two years ago. It may seem hard to believe, but the original draft of the proposed rule only allowed a central limit order book as an execution method on a SEF, did not even mention a request for quote (RFQ) system, and explicitly prohibited voice-based execution. As you can see, the original draft would not have passed the “red face” test.
I insisted that both the RFQ and voice-based systems be included in the final rule, and I am pleased that the Commission adopted a more flexible swap execution regime that permits different execution models to accommodate liquidity of various products. And until the Commission issues a clearing determination, the SEF rule allows swaps to be traded by any means of execution.
There is no doubt that the final rule has come a long way. However, I was disappointed that my proposed amendment to the rule, which called for future adjustments to the RFQ requirement to be supported by data, was not adopted by the Commission. Instead, the final rule calls for an automatic increase from two to three required quotes. Nevertheless, I will not give up on arguing that we should insist on using data and the facts to support our decisions, rather than sticking to pre-set determinations no matter what the market realities may tell us.
The Commission did, however, adopt my request for a streamlined temporary registration process to ensure that future SEFs can start operations soon after they file their registration applications and to facilitate a smooth transition to this new trading environment.
So far, one potential SEF has applied for registration.
Commission Must Be Proactive in Answering Remaining Questions
I appreciate that market participants are now digesting the SEF rule and trying to figure out exactly how SEFs will operate in all instances. As part of this process, Commission staff must resolve a number of regulatory uncertainties and provide clarifications as necessary in a timely fashion.
For example, while the rule allows for various execution methods, it remains unclear how some common execution methods, including voice systems, auctions, portfolio matching systems, mid-market matching systems and work-up sessions, will meet the SEF definitional requirements. Also, it is not clear in the rule whether swaps that are not subject to the clearing mandate can be executed on non-SEF platforms. And based on the response to the Commission's proposed cross-border guidance, to the extent there are differences regarding transaction rules we must be mindful of SEFs allowing for trades with U.S. and non-U.S. persons.
Made Available to Trade: Break Out the Government Rubber Stamp
In addition to finalizing SEF rules, the Commission also finalized rules for “making a swap available to trade” (MAT). Unfortunately, the Commission has established a deeply flawed process. The rule allows a SEF or a designated contract market (DCM) to make such determination based solely on one of six factors and allows such SEF or DCM to ignore other considerations that may be of vital importance to the trading liquidity of a particular contract. The lack of specific objective criteria for determining trading liquidity introduces uncertainty into the market and makes it impossible for the Commission to have any meaningful regulatory oversight over the MAT determination process.
What’s even more disconcerting is that one SEF or DCM’s MAT determination binds the entire swaps market to mandatory trade execution. This approach eliminates the Commission’s ability to prevent products with only marginal liquidity from trading in a more restrictive manner on a SEF or DCM. To make things worse, the process for removing MAT determinations lacks any logical or legal basis and is the exact opposite of what is required to make the initial MAT determination. In sum, in the final MAT rule, the Commission relinquishes its regulatory authority to oversee MAT determinations reasonably and effectively.
Clarifying SEF and MAT Implementation Timeline
In terms of SEF and MAT timing, I’ve been told by staff that potential SEFs can receive temporary registration beginning on August 5, the effective date of the SEF rules. Once temporarily registered, a SEF can submit its MAT determinations immediately, so a SEF registered on August 5 can submit MAT determinations beginning on August 5. Staff will stay all initial MAT submissions for 90 days, which would put the date for the earliest MAT determinations around November.
Now, moving to the other trade execution rule that was finalized by the Commission last month: the swaps block rule. As with the SEF and MAT rules, in the block rule, the Commission chose to circumvent the necessary data analysis and decided to impose an arbitrary and automatic increase in block size threshold upon expiration of an initial phase-in period. A better approach would be for the Commission to review trading data currently submitted to Swap Data Repositories (SDRs) pursuant to the Commission’s swap reporting rules and, after thorough analysis, come up with a block threshold that is based on data analysis, and not a superficial number that is simply lower than the proposed number and unsupported by data.
The concept of applying data to inform our decisions reminds me of a quote by Winston Churchill, who said: “however beautiful the strategy, you should occasionally look at the results.” I couldn’t agree more, because the data we collect from the market can vividly illuminate how the market is responding to financial regulatory reforms.
Data Challenges: Managing and Utilizing the Data to Identify Risk
This brings me to my third and final topic today: the Commission’s data challenges. The big question is: what are we doing to manage and effectively utilize data? Right now, the Commission receives data that is unusable for the Commission’s oversight mission. The magnitude of the problem became alarmingly clear when we were informed that we couldn’t see the London Whale in our data.
The Commission’s data problems stem from the fact that our swap data reporting rules were developed without a clear and precise plan for what we would do once we received the data. The Commission’s rules did not clearly identify the data fields or the format in which such data has to be reported. That shortcoming has been exacerbated by a similar lack of standardization in the way that SDRs receive data from market participants.
The importance of resolving these data challenges cannot be overstated. Richard Berner, director of the Treasury Department’s Office of Financial Research, recently remarked that on his list of major challenges that policymakers face in monitoring the financial system, “three of the five involve the need to improve the quality and scope of our financial data.”4
Therefore, as Chairman of the Commission’s Technology Advisory Committee Meeting (TAC), I have committed the TAC to help solve these challenges. At our recent TAC meeting on April 30, we convened panels with representatives from all the SDRs as well as a variety of market participants that report to the SDRs. We had very open and productive discussions about the data reporting challenges. This meeting was a necessary first step towards bringing market participants, SDRs and the Commission together to find a solution for harmonization of data across SDRs.
I am happy to report that next steps have already begun: a working group including Commission staff, the SDRs, and industry groups has been working to improve data harmonization. The primary focus so far has been on developing consistency for the most crucial data fields. This working group will report its progress at the next TAC meeting, which will be held in September.
In addition to the TAC’s efforts, I have advocated for the creation of a cross-divisional data unit. This is because the Commission’s effective managing of data is only the first part of the data challenge; the second part is properly utilizing the data for oversight purposes. This unit would have staff dedicated to organizing and analyzing the data, and more importantly to developing the necessary analytical tools to identify market risk.
Under the current structure, the Commission’s Division of Market Oversight has had little involvement with the implementation of the swap data reporting rules, even though it wrote the rules. The Office of Data Technology has been working with the SDRs to implement the rules, and I have encouraged increased participation by the Division of Market Oversight. In fact, 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 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. Technology is the best, and only, way to leverage our limited resources and have a chance of properly overseeing our markets and preventing and deterring market abuses. 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.
As part of this plan, 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 related staffing they need to complete the job. Unless we identify our priority needs, we are likely to struggle to focus both staff and financial resources, we will take longer to ramp up our technology capabilities, and in the end we will spend more to correct the problem through an ad-hoc approach.
I would like to conclude today by saying a final word on my first topic: cross-border issues. These issues can get incredibly complex when you get into the details, but let’s not overcomplicate the big picture. And here is the big picture: we have all come a long way on developing our rules, and in the past several months we have come a long way in our efforts to coordinate and harmonize the rules. We are now close on harmonization, but we are not quite there yet; we just need a little more time. The Commission should allow for that extra time to get things right.
2 See comment letters from Jonathan Faull, European Commission; Steven Maijoor, European Securities and Markets Authority; David Lawton and Stephen Bland, UK Financial Services Authority; Pierre Moscovici, Christian Noyer, and Jacques Delmas-Marsalet, France Ministry of Economy and Finance, Autorite de controle prudentiel (ACP) and Autorite des marches financiers (AMF); Patrick Raaflaub and Mark Branson, Swiss Financial Market Supervisory Authority; Masamichi Kono and Hideo Hayakawa, Japan Financial Services Agency and Bank of Japan; K.C. Chan, Financial Services and Treasury Bureau of the Hong Kong Special Administrative Region; Belinda Gibson, Malcolm Edey, Arthur Yuen, Keith Lui and Teo Swee Lian, Australian Securities and Investments Commission, Reserve Bank of Australia, Hong Kong Monetary Authority, Hong Kong Securities and Futures Commission, and Monetary Authority of Singapore. These and all public comment letters on the Commission proposed guidance compiled here: http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1234&ctl00_ctl00_cphContentMain_MainContent_gvCommentList.
Last Updated: June 12, 2013