September 26, 2013
Thank you very much for the kind introduction and for inviting me to speak here today.
These certainly are fascinating times in the world of derivatives, and it’s good to see so many people gathered here to discuss and debate the numerous pressing issues facing the industry today.
I would like to thank all of the regulators that took part in yesterday’s discussions regarding the status of the global regulatory framework. Yesterday’s meeting builds on last week’s IOSCO board meeting, which I attended and participated in. I have benefitted from both bilateral and multilateral discussions. Both the message and the goals are of my fellow regulators are clear. We must harmonize our rules to prevent regulatory arbitrage from undermining our comprehensive financial reforms.
Speaking of financial reforms, as you may have noticed, the Commission has been nothing if not busy the past three years. It has been working at a feverish – and sometimes too hurried – pace to implement the Dodd-Frank legislation. To date, the Commission has issued 61 final rules, orders and guidance documents. We have also issued over 100 exemptions and no-action letters – some for an indefinite time – from the very rules we just passed.
Today, I would like to focus on three topics. First, the cross-border regulatory framework. Second, the landscape for swap execution facilities (“SEFs”). And third, upcoming Commission rules on customer protection and position limits.
Cross-Border Framework: Regulatory Harmonization, Not Imperialism
Let me start with my first topic: cross-border issues. Right now we are at a critical juncture in global regulators’ efforts to establish a cross-border regulatory framework for derivatives. Before I get to my thoughts on what must be done in order to ensure an effective, efficient and workable framework, let’s review what has already taken place.
The Commission finalized its cross-border guidance on July 12.1 I had many serious concerns about the document that prevented me from supporting its approval. Let me briefly share a few of these concerns. First, the guidance failed to justify its overbroad extraterritorial reach under the statute’s “direct and significant” standard. This standard was in fact meant to be a limitation on the Commission’s authority, not an invitation to bring the world under the Commission’s jurisdiction.
Second, in staking out such an overbroad position, the guidance failed to give sufficient consideration to principles of international comity.
Third, the Commission should have issued the document as a rulemaking, not as an “interpretive guidance.” That may sound like a trivial distinction, but it is not.
A Commission interpretative guidance document does not have the force of law, in contrast to a Commission rule. Yet this guidance imposes obligations that have a practical binding effect, and market participants cannot afford to ignore these obligations for fear of enforcement or other penalizing action.
The issuance of interpretative guidance instead of a rulemaking had other negative consequences. It allowed the Commission to avoid a proper cost-benefit analysis. In addition, it allowed the Commission to avoid the requirements of the Administrative Procedure Act (“APA”), which was enacted by Congress to ensure fair notice, public participation, and reasoned decision-making and accountability in connection with agency action.
Fourth, and most relevant for our discussion here today, the Commission got the process and order of things all wrong. In finalizing the guidance, it made a preemptive unilateral move that only made more difficult the task of reaching a harmonized global framework with its fellow regulators – imperialist regulation, in other words. What the Commission should have done is the opposite: settle on a framework with international regulators, and then finalize its policy.
Substituted Compliance: Sunlight Is the Best Disinfectant
As the saying goes, “sunlight is the best disinfectant.” And I believe that holds true for the Commission’s substituted compliance process. It was and remains my hope that the previous policy overreach that occurred through the expansive cross-border guidance can be mitigated through a transparent, structured, and consistent process for the Commission’s substituted compliance determinations, a crucial element of the harmonization effort.
As part of such a process, I have emphasized the importance of offering the opportunity for other regulatory bodies to engage directly with the full Commission. This would allow us to better understand how our rules and theirs will work and to minimize the likelihood of regulatory retaliation and inconsistent, duplicative, or conflicting rules.
I have been doing my best to facilitate interaction and dialogue between the Commission and fellow regulators. As I mentioned, last week I attended IOSCO’s annual conference in Luxembourg. There, I participated in the board’s sessions and had productive discussions with regulators from the jurisdictions that have applied, or are planning to apply, for substituted compliance.
Nevertheless, thus far the process for substituted compliance determinations has not been transparent enough. By way of analogy, it suffers from many of the same shortcomings as the concerns with the development of an index developed by a price reporting agency. Both are opaque and one never knows exactly how the methodology is applied.
It’s time to take the process out of the dark, and explain to the rest of the Commission and the applicants how these evaluations will be conducted.
Supervisory MOUs: The Flexible Complement to Substituted Compliance
Besides substituted compliance determinations, there is another important element to the cross-border regulatory framework: supervisory memoranda of understanding (“MOUs”) between the Commission and fellow regulators. These MOUs, if done right, can be a key part of the global harmonization effort.
The reason for this is that the substituted compliance regime cannot, by itself, solve the cross-border puzzle. What substituted compliance will do is to provide a clear understanding of similarities and differences between jurisdictions. What it won’t do – especially because the determinations are to be made by the end of this year, and the rulemaking process is ongoing and fluid in a number of places – is provide the necessary flexibility to fill in any gaps. The MOUs provide this flexibility.
Because the MOUs are so complementary to substituted compliance, the Commission should be able to review them alongside the respective substituted compliance determinations and vote on them at the same time.
Dictating to the rest of the world a one-size-fits-all regulatory standard will not yield long-term regulatory cooperation. While it is important that regulators identify where there are differences in our regulatory regimes, we must also have a mutually agreed upon solution for resolving our differences through bilateral supervisory agreements.
SEFs: To Foster the Landscape, the Commission Must Be Flexible
Now, I would like to move to my second topic: SEFs. We are less than 10 days away from SEFs going live on October 2. As of today, Commission staff has temporarily registered 15 SEFs and has to review four more applications before October 2.
I am very optimistic about the potential SEF platforms and the innovative trading opportunities they can provide. Not only will markets benefit from increased standardization and improved liquidity, but I will be interested to see how the swap/futures trading relationship evolves as a result of these platforms.
On September 12, I chaired a Technology Advisory Committee (“TAC”) meeting where the Commission had an opportunity to hear concerns from different market participants, including SEFs, dealers, and clearing members, regarding the implementation of various regulatory requirements.
Given the concerns raised by market participants, it would make sense to delay the October 2 compliance date, especially because this date is an arbitrary date and is not tied to any legal requirements. Market participants would benefit from getting a time-limited extension to allow for a smooth transition to these new execution venues. If the Commission wants to foster a robust, competitive landscape for SEFs, it must be flexible enough to adjust the compliance date based on market and technology realities, and not stick with an unworkable date simply to adhere to an individual agenda.
A number of TAC panelists raised concerns about various onboarding issues. It was clear from the discussions that market participants need more time to review SEF rule books and participant agreements for consistency and legal compliance. Frankly, I don’t blame them for being extra careful, given the fact that Commission staff publicly announced that it is not going to review SEF applications for substantive compliance.
Another troublesome issue that was brought up during the TAC meeting involves notorious Footnote 88 in the SEF final rules.
The rules require existing multiple-to-multiple swap trading venues to register as SEFs, even if they only offer products that are not yet subject to the trade execution mandate. This has resulted in venues offering products like non-deliverable forwards and foreign exchange options to rush to get registration applications completed on time.
However, Footnote 88 allows other platforms, such as single dealer platforms, to continue trading swaps not subject to the trade execution mandate and without having to register with the Commission.
Another issue that causes a lot of anxiety among SEFs is the requirement to report permitted transactions (i.e. transactions that are not subject to the trade execution mandate) to a swap data repository (“SDR”).
Based on the proposed rules, SEFs did not anticipate that the Commission would require these transactions to be executed on a SEF. Thus, SEFs do not have sufficient time to build the technology infrastructure for the reporting of these transactions.
Many of these permitted transactions are not electronically executed and are, by nature, less standardized than required transactions. Thus, from a technology perspective, SEFs are concerned that the trade reporting mechanisms will simply not be in place by October 2.
Our track record on utilizing and analyzing data has not been good and the Commission struggles to effectively understand and organize SDR data. The last thing we can afford is to implement an untested and unprepared reporting system based on an arbitrary date.
Market participants are also concerned about Commission staff’s sudden announcement via an email message that SEFs are required to provide for pre-execution credit checks.
Without certainty of clearing at the point of execution, counterparties are exposed to the potentially significant costs of a trade failure. Some type of pre-trade credit-checking is necessary to ensure that clearing members will extend sufficient credit. This is a policy that I support.
However, since neither the SEF proposed rule nor the final rule addressed this requirement, market participants are scrambling to understand the requirement and the pros and cons of various technology models that could be utilized to set these credit limits.
First, the Commission must be clear about its expectations regarding guarantee arrangements and what the market should do if a trade is broken because of credit issues. Second, if these expectations require additional technology investments, I believe that the Commission needs to give industry more time to build the necessary technology infrastructure as well as to iron out various workflow issues.
Last but not least, the Commission is facing serious problems regarding its treatment of EU-regulated multilateral trading facilities (“MTFs”). In the Barnier-Gensler “Path Forward” document,2 the Commission assured European regulators that it will extend appropriate time-limited transitional relief to certain EU-regulated MTFs, in the event that the Commission’s trade execution requirement is triggered before March 15, 2014.
However, the flexibility embodied in this agreement appears to be in direct contradiction to the SEF final rules that expressly require all platforms meeting a SEF definition to register by October 2, or cease operation. I don’t think the current registration requirement on October 2 is consistent with either the spirit or the letter of the “Path Forward” document. It is unclear to me what the impact on liquidity will be if as a result of this problem, all U.S. persons are required to trade exclusively on U.S. SEF platforms or else to be forced to revert to bilateral trading.
Upcoming Rules: Customer Protection and Position Limits
My third and final topic is to share some of my thoughts on two important rules currently being considered by the Commission.
One is a final rule on enhanced customer protection measures. In the wake of the major failures of MF Global and Peregrine Financial, the Commission and the industry are looking carefully at ways to make enhancements to customer protection.
One improvement already in place is an electronic customer funds confirmation network that will confirm the customer balances held at FCMs and custodian banks. This initiative, funded entirely by the industry, was first contemplated at an emergency TAC meeting I convened in July 2012 to discuss customer protection. Its operation today will ensure that customer funds can’t be used for unauthorized purposes.
Currently before the Commission is a draft final rule to make various reforms to accounting standards, reporting requirements and a controversial new provision requiring FCMs to maintain enough residual interest in their segregated customer accounts in an amount that would ensure that at no point does one customer’s funds margin or extend credit to another customer.
Residual Interest: A Change of Interpretation
This proposal has been met with great concern across the entire industry, in large part because the proposal is at odds with the Commission’s long-held interpretations spanning the past 50 years. Historically the Commission has allowed FCMs to meet their residual interest requirement by maintaining additional funds in an amount equal to the net margin deficit the FCM predicted for its segregated account. This calculation was required to be made once a day, not in real time.3
With the Commission’s reinterpretation, FCMs would be required to change their practices to hold enough residual interest to make up for the margin deficiency of all customers at all times on a gross basis. This means that a firm would be required to calculate the potential margin deficit for each customer throughout the trading day and set aside an amount equal to that estimated deficit so that no customer’s margin excess is used to margin the position of another customer.
If the Commission maintains its original standard of compliance “at all times,” we will have an enormous increase in the capital required to participate in these markets. According to a review conducted by FIA, this new residual interest rule will require clearing members on U.S. futures exchanges, and most likely their customers, to put up an additional $100 billion in order to meet the requirement.4
I have heard from a large number of agricultural interests – farmers, ranchers and many smaller FCMs who serve these customers – that believe this provision will raise their costs significantly. Commercial firms who would be most impacted by this policy change have indicated they aren’t able to shift funds like large commercial banks and need flexibility to make their margin payments to the FCM.
If, on the other hand, the Commission moves away from the “at all times” standard, we would have to articulate how a margin calculation done at any other time interval satisfies the supposed statutory requirements of requiring margin “at all times.”
Weak Cost-Benefit Analysis
I think we must also look at this residual interest issue in the context of the cost-benefit analysis. As you know, I have frequently cited the Commission’s cost-benefit analysis as a source of weakness when the agency justifies the imposition of a new regulatory requirement on the industry. Unfortunately I think the same criticism can be made here.
The Commission’s proposal does acknowledge that it is very likely that FCMs will pass along the additional cost of compliance to their customers. However, it makes no effort to quantify the cost borne by those customers, or to link that cost directly to the actual risk those customers introduce into the derivatives markets.
I appreciate the fact the rule change is intended to increase protection for customer funds. But, when the rules propose reforms that significantly increase the cost to a point that it becomes uneconomic to hedge, it is hard to argue that we are protecting customers.
This is why I believe it is so important the Commission quantify the cost versus the benefits. We also need to take a clear look at what actual protection this change will provide based on past practice. I believe through improved surveillance and the use of technology to monitor customer flows, we can make improvements to current practice and still provide the flexibility to commercial firms to make timely margin payments, without imposing unreasonable costs.
The Commission is also considering a new proposed rule on position limits. As a preliminary matter, I question the unsavory maneuver of proposing a new rule while simultaneously continuing to argue in the courts that the original, vacated rule was valid. Putting that aside, I will focus mainly on a few key areas as I consider the new proposal.
First, statutory justification: the Commission must do the necessary homework it failed to do in the vacated rule in order to justify establishing any limits. Second, bona fide hedging: the Commission must articulate a definition of hedging that reflects the realities of how commercial firms use the derivatives markets to manage risk, in order for these activities to be exempted from any limits. And third, aggregation of positions: the Commission’s aggregation policy must be reasonable in principle, and it must be workable in practice given complicating factors such as complex corporate structures and relationships as well as laws that prohibit information-sharing.
I would like to conclude today by returning to my first topic: the cross-border framework. Today’s derivatives markets are undoubtedly global and highly interconnected. Just as we must accept this reality, we must also accept that the Commission is not the global regulatory authority. It simply cannot be, not least because of resource limitations – but more than that, it should not want to be.
The only workable and effective way to regulate these markets is for regulators to work together and establish a harmonized framework that avoids overreach, duplication, inconsistency, and conflict. To achieve this, the Commission must implement a transparent process for substituted compliance. This process must include active engagement with fellow regulators. And the Commission must complement this substituted compliance regime with a set of flexible MOUs. If it does these things, the Commission can rightly take credit for choosing the path of regulatory harmonization over the path of regulatory imperialism.
Thank you very much for your time.
3 See 17 CFR §1.32, which calls for an FCM to compute at the close of each business day the total amount of futures customer funds on deposit in segregated accounts, the amount of futures customer funds required under the Commodity Exchange Act and Commission regulations to be on deposit, and the amount of the FCM’s residual interest in customer funds.
4 See FIA comment letter dated February 15, 2013, available at http://www.futuresindustry.org/downloads/Enhanced_Customer_Protection_021513.pdf.
Last Updated: September 26, 2013