October 17, 2013
The topic of today's conference is "Compliance and Implementation Issues." I must say such a topic gives us plenty of room to have a wide-ranging discussion, as there are so many questions and concerns regarding industry compliance and on-going implementation.
As we all know, the Dodd-Frank Act was enacted following the G-20 agreement in Pittsburgh in September 2009 to undertake comprehensive financial reform. The G-20 agreement proposed four main objectives of derivatives reform. First, report all data to a data repository. Second, require that all standardized derivatives contracts be exchange traded "as appropriate." Third, require clearing to be done through central counter parties. Fourth, impose higher collateral charges for all uncleared over-the-counter (OTC) products.
Since the passage of Dodd-Frank, the CFTC has been busy with an aggressive schedule of rule promulgation. Today we have finalized just over 60 rules including Dodd-Frank and non-Dodd Frank rule.
This new regulatory regime has had a profound impact on market structure as it has imposed new obligations, higher levels of transparency, and higher standards for risk management. Many of these new rules will have a positive impact on financial markets.
However, I have serious concerns about the Commission’s rule making process and schedule, as well as the statutory foundation of many rules and their overall impact on end-users.
Today, I would like to discuss three topics. First, I would like to address the implementation of the rules, both in terms of compliance already under way and what we need to think about going forward. Second, I would like to discuss the regulatory impact on end-users. Finally, I would like to discuss my concerns about the Commission’s preparedness to oversee the implementation of the Dodd-Frank regulatory regime.
The Process: Sacrificing Transparency and Certainty for Speed
From the beginning of my time at the Commission, I have been very concerned with the Commission's rulemaking process. As you may know, I have been disappointed with the Commission’s failure to develop a transparent rulemaking schedule that would enable market participants to plan for compliance with the massive new obligations imposed by these rules. In addition, I believe the Commission has rushed the rulemaking process, prioritizing getting rules done fast over getting them done right. This approach has compromised the legal soundness and consistency of our rules.
Stark evidence of the Commission’s flawed rules, and their unachievable compliance deadlines, can be seen in the massive number of exemptions and staff no-action letters issued to provide relief from them. To date, we have issued over 130 exemptions and staff no-action letters. That amounts to more than two exemptions for every rule passed. In nearly two dozen cases, the relief provided is for an indefinite period of time – thus making them de facto rulemakings, which didn't go through the Administrative Procedure Act or proper cost-benefit analysis. It is clear that the Commission has abused the no-action relief process.
Market participants are confused regarding the application of our rules, and how or when they must be applied. Further, since the Commission doesn't vote on staff no-action letters, they don't appear in the Federal Register. And you won't find the exemptive letters in our rulebook either. This lack of transparency and consistency will drive a compliance officer crazy.
One area where the Commission has made one of its biggest process fouls is the lack of robust cost-benefit analysis. Without a doubt, the comprehensive nature of the Dodd-Frank regulatory regime will have a significant cost impact on all market participants, and yet the Commission has failed to conduct appropriate and rigorous quantitative and qualitative analysis of our proposed rules. Understanding whether the benefits of the rules outweigh the costs is a common sense tool to determine the least burdensome solution to the problem.
The Commission has so far been able to get away with such inadequate cost-benefit analysis because the current governing statute sets a low bar. I support Congressional efforts to revise our statutory cost-benefit obligations in order to require the Commission to undertake a more rigorous quantitative and qualitative analysis, putting us on par with other federal agencies. I support Chairman Conaway's efforts (H.R. 1003) and hope the House and Senate will pass this legislation.
Implementation: What's Coming
While I have a longer list of process fouls committed by the Commission, I would like to turn to upcoming rules that will have a significant impact on end-users in particular.
The Commission is currently considering the position limit rule do-over. When I say the Commission, I mean that literally. During the shutdown there is no staff available to discuss this rule proposal. We can't make revisions. We can't ask questions about the rationale or justification. We can't even discuss with staff whether or not the proposed limits would have an appropriate impact to curb "excessive speculation."
The Commission is pursuing a dual track on position limits. Later this year, an appeals court will hear our argument urging it to overturn a federal district court’s ruling to vacate the original position limit rule. The district court found that the Commission failed to provide a finding of necessity as directed by the statute. Simultaneously, we are drafting a nearly identical rule arguing more strenuously that Congress made us do it, and that Congress really didn't want to know whether these rules are "necessary" or "appropriate."
Frankly, I find it interesting that the proposed rule will argue on one hand that Congress wanted position limits and that we aren't bound to apply an appropriateness standard – and then, on the other hand, argue in the cost-benefit analysis that these rules are well considered and will have the intended impact based on our analysis.
Another important rulemaking that will be before the Commission shortly is the application of capital and margin for all OTC trades. While I am pleased that the international community has worked together to make the standards consistent, make no mistake: these rules will increase the cost of hedging. End-users will be spared from mandatory margin exchange. However, nobody will receive a break from the new capital charges. These are new costs imposed on banks to offset the risk posed by OTC trades. Needless to say, these costs will be passed on to end-users.
I agree with Sean Owens, an economist with Woodbine Associates, who stated that under Dodd-Frank, "end users face a tradeoff between efficient, cost-effective risk transfer and the need for hedge customization. The cost implicit in this trade off include: regulatory capital, funding initial margin, market liquidity and structural factors."1
There is no doubt that these new requirements will have serious economic consequences for financial markets. And regulators should not take this lightly. In an effort to coordinate with international regulators, the Commission will re-propose its capital and margin rules. But even under the more accommodating margin requirements, the Commission must evaluate additional costs to end-users by conducting an in-depth cost-benefit analysis.
Happy Anniversary: 1st Anniversary of Futurization
It was one year ago, almost to the day, that the energy markets switched from trading swaps to futures. This huge shift was triggered by the then-impending effective date of the swap and swap dealer definitions. To avoid trading swaps and being caught in the unnecessary, costly and highly complex de minimis calculation imposed on swap dealers, energy firms shifted their trading from swaps to futures, literally overnight.
Based on the complexity of our swaps rules and the cost-efficiency of trading futures, it makes sense that participants would make this change. I'm interested to hear more from end-users like you how this shift has impacted your hedging strategies.
I must warn you that there are several more changes coming up that will continue to impact energy markets. First, the Commission is considering a draft futures block rule that will be proposed to limit the availability of block trades.
Second, as I noted before, OTC margin and capital rules will increase the cost of OTC bilateral deals. This draft rule should be published by the end of the year.
Third, the European Union (EU) is considering whether it will find acceptable the U.S. rules allowing a minimum one-day margin liquidation requirement for futures and swaps on energy products. Europe might not recognize U.S. centralized counterparties as qualified and, as a result, ban EU persons from accessing these markets. The EU is insisting on a two-day margin liquidation minimum. I am told that this would have the practical effect of increasing margin requirements for energy trades by 40 percent. I’m not sure how this will be resolved, but I suspect it will be closely tied to U.S. recognition of the European regulatory regime.
Now let me turn to my second topic: how our rules treat end-users.
Congress was very clear about protecting end-users from Dodd-Frank's expansive regulatory reach. As a result, many end-users assumed that they wouldn't be impacted by these rules. Clearly, they are no longer under such misconceptions.
The swap dealer definition is a good example of how the Commission failed to accurately interpret Dodd-Frank and broadly applied the swap dealer definition to all market participants. The Commission ignored the express statutory mandate to exclude end-users from its reach. The swap dealer final rule requires entities to navigate through a complex set of factors on a trade-by-trade basis, rather than provide a bright line test. While I appreciate that the Commission set an $8 billion de minimis level to exclude trades from a dealer designation, it remains challenging to determine what is in and what is out from this safe harbor.
As part of the complexity of the swap dealer definition, the Commission has applied inconsistent and incoherent requirements around bona fide hedging as part of the dealer calculation. The hedge exclusion from the dealer definition applies only to physical, but not financial, transactions. The Commission should apply a consistent definition for hedging.
Another complexity that the Commission has imposed on end-users is the definition of a volumetric option. Specifically, to determine whether a volumetric option is a forward or a swap, the rule applies a seven-part test. But the real kicker is that under the seventh factor, contracts with embedded volumetric optionality may qualify for the forward contract exclusion only if exercise of the optionality is based on physical factors that are outside the control of the parties. This is in contradiction to how volumetric options have been traditionally used by market participants, makes no sense and provides absolutely no certainty for market participants.
The Commission has seemingly gone out of its way to create complex rules that generally result in an outcome of heads we win, tails you lose. We need to clean up the definition and create reliable and well-defined safe harbors. If we don't, I would encourage Congress to revisit the statute.
Commission Readiness: The Consequences of a “Ready, Fire, Aim” Approach
Let me move now to my third main topic: Commission readiness to properly oversee the implementation of its Dodd-Frank regulatory regime. There are two questions I have regarding this issue. The first question is pretty straightforward: is the Commission prepared to effectively oversee the new swaps markets? I believe the answer to this question is "no."
Take the area of registration. The Commission’s new swaps regime has created multiple new categories of Commission registrants, and in each category there has been an inconsistent and uncertain process with the bar constantly moving for applicants. For example, it has been ten months since the first swap dealer application arrived. Today, we have 89 temporarily registered applications totaling over 180,000 pages and we haven’t signed off on single application as complete or final.
With regard to swap data repository (SDR) registration, it has taken the Commission eight to ten months to register just three SDRs under temporary status. We have exceeded our own self-imposed limit of 180 days in some cases and we still haven’t issued a final SDR determination.
As for the registration of swap execution facilities (SEFs), while we have registered 18 entities under a temporary basis, I can only imagine how long it will take for a SEF to secure final approval, especially when we admit that we didn’t read the rulebooks in order to meet the arbitrary October 2 effective date. My guess is that it will be a long and painful process as we insist on evolving revisions to SEF rulebooks while trading is going on.
Another area where the Commission has not been adequately prepared to do its job is in connection with swap data being submitted under new reporting regulations. Despite imposing aggressive compliance requirements on the market, the Commission doesn't have the tools in place to effectively utilize the new data being reported to SDRs, and it doesn't have a surveillance system in either the futures or swaps market that I would regard as adequate or modern.
Today, the data we receive from SDRs requires extensive cleaning and changes to make it useful. As chairman of the Commission’s Technology Advisory Committee (TAC), I have devoted significant TAC attention and resources to aid this effort. Stemming from our TAC meeting in April, a working group including Commission staff and the SDRs has been established and is working to harmonize data fields to aid in our ability to easily aggregate and analyze data across SDR platforms. It will take time before we are able to access, aggregate and analyze data efficiently.
I am also disappointed with our current stance on the oversight of SEFs. Despite the October 2 start-up date for SEFs, the Commission relies on self-regulatory organizations to send data via Excel spreadsheet. There is no aggregation capacity and I am not aware of any plan to automate this process for the less than two thousand swap trades that occur on a daily basis.
My second question: is the Commission sufficiently familiar with the readiness of the market to adapt to our rules? The answer to this question is also "no." As I discussed earlier, evidence of this failure can be found in the Commission’s extensive use of no-action relief tied to arbitrary deadlines. The Commission needs to do a better job of understanding the significant compliance challenges facing market participants as a result of new regulations.
Pre-Trade Credit Checks: Time for the TAC to Revisit the Issue
Let me give you a brief example of one challenge we are dealing with today. The Commission has been working toward a goal of straight-through processing of trades and clearing to prevent any trade failures due to credit issues. Just recently, the Commission has started insisting that SEFs provide functionality to pre-check all trades for adequate credit at the futures commission merchant (FCM) to guarantee a trade. In general, I support this objective. However, market participants were not prepared to comply with this new requirement by October 2, the date SEFs began operation.
Consistent with the Commission’s practice of issuing last-minute ad-hoc relief, the day before the SEF start-up date, staff issued a delay of the pre-trade credit checks for one month until November 1. We are just two weeks away from this new deadline and it is clear that not all SEFs, FCMs, credit hubs and customers are fully interconnected. Without end-to-end fully tested connectivity, I suspect trades will continue to be done over the phone – stalling limit order book trading.
This is a topic that we discussed at the recent TAC meeting on September 12. It was clear at that meeting that the pieces were not in place and additional time is needed.
With the arbitrary November 1 deadline looming and the Commission yet to provide confused swap market participants with necessary guidance on a host of unresolved issues, often stemming from a lack of clarity in the SEF rules, I believe additional time is required. The Commission has not provided adequate time to complete the on-boarding process and conduct the technology testing and validation that is necessary. We should also consider phasing in participants, similar to our approach with clearing, in order to avoid a big bang integration issue.
Again, I offer to use the TAC to identify a path forward if that will be useful, but the issues identified in September still remain.
In many respects it is quite remarkable the work that has been accomplished – by both the Commission and the market – to put in place trade reporting, mandatory clearing, and now the first stages of swap exchange trading. However, the Commission process by which all of this was accomplished is certainly not to be replicated.
We need to continue to make sure we follow Congressional direction to protect end-users and focus more on outcomes rather than setting arbitrary timetables tied to an individual agenda. Rather than relying on the ad-hoc no-action process, the Commission should take responsibility of fixing the unworkable rules – swap data reporting and the swap dealer definition come to mind.
If we are going to impose rules, let’s make sure they are informed by data and will not interfere with the fundamental function of hedging and price discovery in the markets – I’m thinking about position limits and our proposed futures blocks.
Finally, let's keep an eye on the costs – putting these markets out of reach for commercial hedgers doesn't help anyone. Let's sharpen the pencil and consider all the options. There is no reason why we should not be able to quantify the solution as the most cost-effective rule for the market.
Thank you again for the opportunity to speak with you today.
1 See Sean Owens, Optimizing the Cost of Customization, Review of Futures Market (July 2012).
Last Updated: October 17, 2013