January 27, 2014
Thank you very much for the kind introduction and for inviting me to speak here today.
While it is an honor to be offered a speaking spot, I am also very interested in participating in this conference to learn more about changes that are in store for the commodity merchant businesses. Recent headlines herald the exit of banks from this business. The landscape is changing since the Volcker rule now limits proprietary trading by banks and the Federal Reserve may start assessing new capital charges on bank commodity activities.
Let’s not forget the change that has already come to the commodity space as a result of Dodd-Frank, including the swap dealer definition rule, the position limits final rule and re-proposal, the evolving hedge definitions and the futurization of swaps.
Considering these changes, it is amazing you have let me within a mile of this place, let alone offered me a speaking slot.
Today, I will address three areas where the Commission must make changes. First, I will discuss positive developments in meeting the Commission’s data challenges and our much needed investment in technology. Next, I will discuss challenges in swap trade execution. Finally, I will talk about solutions and possible reforms to rules that negatively impact end-users.
In my opinion, the Commission must make the necessary adjustment to improve our rules when we encounter unexpected outcomes of our rulemakings. In fact, it would be irresponsible of the Commission to ignore problems and to continue implementing its unworkable regulations. The topics I will discuss today are candidates for rule revisions. In the case of data and end users, we will need significant changes. Swap trade execution, on the other hand, requires more targeted reforms.
1. The Commission’s Progress on the Data Front
First, I’d like to address the Commission’s ability to receive and utilize data. I am pleased to announce that the Commission is making progress towards improving the quality of its data. On January 21, the Commission announced that it will establish a cross-divisional team to identify data utilization problems faced by each division and to recommend appropriate solutions.
Until now, nobody has taken ownership to fix our data problems. At last, this will change. In March, the Commission will provide a comment period for market participants to offer suggestions to improve reporting. Based on the comments and its own self-evaluation, the data team will make recommendations to the Commission in June.
I can’t emphasize enough how important it is for the Commission to improve our data quality so it can have an accurate and complete picture of the swaps market. Our ability to perform risk assessments and market oversight will hinge on the quality of our data.
In this regard, I would also like to emphasize the importance of harmonizing the Commission reporting rules with the reporting rules of foreign jurisdictions.
I hope the Commission will reengage with the various jurisdictions that have trade repositories to come up with a global solution to data reporting. As you may know, the European Union reporting rules will be effective on Feb 12, 2014.
By recognizing E.U. trade repositories, we would eliminate the need for dual reporting by U.S. persons trading in Europe and non-U.S. persons trading in the United States. Both regimes can work together to agree on a data standard and taxonomy that can be readily used for identifying risk and performing market surveillance.
Speaking of market surveillance, the Commission’s major oversight functions will be severely impaired if we do not invest in new technology. Investing in technology must be the Commission’s top investment priority.
While on the subject of the Commission’s investment priorities, I would like to note that I appreciate Congressional efforts to provide the Commission with an appropriation of $215 million, a modest increase in current spending levels. It is quite clear from this funding level that the Commission will need to pick its funding priorities carefully.
Tony Blair once said, “It is not an arrogant government that choses priorities, it is an irresponsible government that fails to choose.” I look forward to working with my fellow Commissioners and staff to develop a responsible spending plan with clear deliverable goals that makes technology investment our top priority.
I realize that technology doesn’t run itself, but we must acknowledge we live in a digital age where over 90 percent of markets trade electronically. The future of our compliance and oversight mission must be electronic and data driven. In other words, this agency needs to become a 21st century regulator. So far, we have not articulated our mission and technology priorities, but I believe we can do better.
To ensure that we continue to identify the appropriate corrections, I have included a panel on data at the upcoming February 10 Technology Advisory Committee (TAC) meeting, which I chair. At the TAC meeting, the pertinent Commission Division Directors will share their challenges in utilizing our swaps data.
2. Swap Trade Execution–Positive Progress Report
Now let’s turn to my second topic: swap trade execution.
Although it has been off to a rocky start, we now have twenty-one temporarily registered and operational swap execution facilities (SEFs). I am excited about the opportunity for SEFs to bring transparency to the swaps market.
Still unknown is whether SEFs will become a spitting image of a designated contract market (DCM) or whether they open the door for competition, innovation and transparency in the derivatives markets. As the Commission progresses to the permanent registration phase, it is important to remember that Dodd-Frank did not intend SEFs to look like DCMs. SEFs’ trading protocols must reflect the diversity of market participants and diversity of products traded on these platforms. The Commission must resist the temptation to impose a one-size-fits-all approach to SEF platforms.
Unfortunately, we have already started seeing the results of the Commission’s overly prescriptive regulatory approach when Commission staff deemed certified Javelin and TrueEx’s made available to trade (MAT) requests for standard interest rate benchmark swaps. Staff also noted that any packaged transactions involving these mandatorily traded swaps are subject to the mandatory trade execution requirements. However, in the same breath, staff is now contemplating some relief from the mandatory trade execution requirement for packaged transactions.
In my view, the real break down in the MAT certifications process occurred when the Commission gave up its authority to review these first-of-a-kind products. The Commission and not staff should be making these decisions.
Today, the market trades multi-leg butterfly and curve trades as well as combinations of swaps and Treasury bonds that are subject to Securities and Exchange Commission (SEC) jurisdiction. I understand it is more cost-effective to trade these products as a package. Unfortunately, the SEF rules have not caught up to the realities of today’s market. This is another area where we can do better.
I hope the Commission will identify the critical components of a solution that involves trading, clearing, and reporting of these packaged trades. The Commission must encourage trading on SEF platforms, while, at the same time, protecting the efficiency of trading various combination products. It is also important to recognize that the energy markets utilize packaged transactions. The solutions we develop today will likely impact energy market swaps trading in the future.
The TAC meeting will also address SEF trading to better understand the challenges and opportunities for SEF traded packaged transactions. In my view, Commission staff should have held a MAT roundtable prior to the effective date of the first MAT self-certification. But at least, we will discuss the available options at the TAC meeting before February 17, the mandatory trade execution deadline.
3. Let’s Help End-Users–We Must Do Better
Now, let me turn to my third topic, helping end-users. Yesterday, you heard from former Senator Chris Dodd, whose name appears on the landmark Dodd-Frank legislation. Senator Dodd was quite clear during the legislative debate about the importance of protecting end-users. And, in their letter to the House, both Senators Dodd and Lincoln emphasized the importance of allowing end-users to continue to hedge commercial risk and ensuring that Dodd-Frank regulatory reform does not make this legitimate activity prohibitively expensive.
Regrettably, it has been an uphill battle to get the Commission to follow the express directive from Congress to protect end-users from the reach of Dodd-Frank. As the Commission moves into the rule implementation phase, the impact of our regulations on end-users is becoming more visible. End-users must spend far too much time and resources in order to get the necessary reassurance from the Commission that they are in fact entitled to the protection that Congress afforded them in Dodd-Frank.
It is troubling that our rules require end-users to file numerous forms, filings and reports to validate their commercial behavior, only to be later second-guessed by the Commission regarding what is and what is not a legitimate commercial risk mitigating behavior.
The Swap Dealer Rule Should be Amended to Better Protect End-Users
One rule that must be revisited to provide end-users greater certainty is the swap dealer rule. 1 The rule broadly applies the swap dealer definition to all market participants and then allows for some limited conditional relief, but only if those end-users manage to navigate the market-making definition and do not fall into the trap of the de minimis threshold. To escape entanglement in this regulatory web, it is better to focus on the characteristics of entities rather than their activities.
To give end-users greater certainty, I propose a modest fix that would exclude all cleared trades from the calculation toward any de minimis threshold. This safe harbor would encourage end-users to clear their trades and would provide an additional buffer from being captured in this regulatory mesh. The swap dealer definition was meant to capture entities engaging in dealing activities that could become systemic to their counterparties.2 To the extent that end-users utilize clearing, they should never have been caught up in the de minimis calculation.
Another element of the swap dealer rule that must be corrected is the Special Entity definition. Under this rule, when dealing with Special Entities, such as state, city and county municipal utilities, the $8 billion threshold drops to $25 million. The reasoning behind this distinction was to afford Special Entities special protections, because any loss incurred by a Special Entity would result in members of the public bearing the brunt of the damage.3
That sounds like a noble intention. But, by reducing the threshold, the Commission has limited the number of swap counterparties to the Wall Street dealer banks. In a quick fix, the Commission has since raised the $25million de minimis threshold to $800 million, but this has done nothing to attract commercial participants. These municipal energy firms are large and savvy market participants and should be treated like any other commercial entity. The Commission must fix the paradoxical result of this rule so that commercial counterparties will come back to the market to do business with Special Entities, and Special Entities are not forced to trade exclusively with dealer firms.
Forward Contracts with Volumetric Optionality are Not Swaps
In addition, end-users have been struggling to decipher the Commission swap definition rules4 to determine whether and under what conditions a forward contract with embedded volumetric optionality falls within the forward exclusion.5 To determine whether a volumetric option is a forward or a swap, the rule applies a seven-part test. However, 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 complete contradiction as to how volumetric options have been traditionally used by market participants. We need to fix the definition and create reliable and well-defined safe harbors. I also note that both Senators Lincoln and Dodd believe these contracts should not be captured by the swap definition.
Commission Rule 1.35 is Burdensome on Smaller Institutions
There are a handful of rules where the Commission has failed to carefully consider the impact to end-users due to the lack of appropriate cost-benefit analysis. Let’s take Rule 1.35 as an example. 6
This rule requires futures commission merchants (FCMs) and introducing brokers (IBs) to record all electronic communications as part of a trade record, including preliminary conversations that may occur over cell phones if they relate to trading or if they start a conversation that may lead to execution of orders.
In essence, the rule requires the use of hindsight to know if a certain personal conversation led to a trade further down the road, and then it requires that this conversation is recorded in a searchable format. To comply with this rule, FCMs and IBs will need to purchase expensive recording technology.
While large banking institutions will have the means to find a compliance solution, smaller institutions will take the heavy brunt of regulatory compliance. To avoid this situation, the Commission should have performed the necessary analysis beforehand to determine whether the cost, especially to small market participants, outweighed the benefits of this requirement.
The Commission Position Limits Re-proposal Does Not Reflect Commercial Realities
The Commission position limits re-proposal is yet another example of a rule that ignores the realities of end-users’ commercial and risk mitigation operations. For some reason, in the new and supposedly “improved” position limits re-proposal, the Commission has decided to scale back the bona fide hedging exemption.
To put things in perspective, a broader bona fide hedging definition has been in effect since the 1970s. To my knowledge, the previous hedging exemption worked well in the market and the Commission did not encounter any serious regulatory abuses or violations. More importantly, the hedging exemption did not contribute to the financial crisis.
With the passage of Dodd-Frank, Congress gave the Commission a difficult job in setting position limits. On one hand, the Commission is supposed to stop excessive speculation and manipulation, but on the other hand, the Commission must protect the essential price discovery and hedging function of the futures and swaps markets. This is not an easy line to walk.
The Commission must take caution before it prohibits these longstanding and legitimate hedging activities. Unfortunately, this is just another example of where end-users might feel they are on the short end of the stick when it comes to Commission rulemaking, especially when the statute specifically authorizes such activity.7
Again, I have just scratched the surface of some of the issues where the Commission has failed to heed Congressional mandates to protect end-users. Instead, it has imposed massive new documentation and compliance requirements that force end-users to justify their commercial and business operations. These entities did not contribute to the financial crisis, but they will spend an enormous amount of time, money, and effort navigating the new regulatory order.
I believe we can do better. When the Commission spots a rule that imposes unnecessary or undue burdens—or doesn’t have the data to validate the position—the Commission must consider revising the rule to offer cost-effective alternatives, not another barrage of reflexive no-action letters.
The Commission has an express directive from Congress to accomplish two competing objectives: reduce systemic risk in the derivatives markets and protect end-users. In a rush to reduce systemic risk, the Commission has neglected to safeguard end-users from costly compliance with our regulations. It is the Commission’s responsibility to provide the necessary relief to end-users.
I have shared with you three broad areas where I believe the Commission should reconsider its rules to make critical and necessary modifications to take into account commercial interests of end-users.
Finally, I am pleased that we are making the initial strides to improve data quality. But we cannot continue to ignore the technology needs of this Commission. It’s time to focus on technology. The Commission must make the investment that drives its mission. This will certainly make us better.
I look forward to working with the new Commission to address these issues.
1 Further Definition of ‘‘Swap Dealer,’’ ‘‘Security-Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ ‘‘Major Security- Based Swap Participant’’ and ‘‘Eligible Contract Participant,” 77 Fed. Reg. 30595 (May 23, 2012).
2 Id. at 30744.
3 Id. 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.
4 See Further Definition of ‘‘Swap,’ ’‘‘Security-Based Swap,’’ and ‘‘Security-Based Swap Agreement,’’ Mixed Swaps; Security-Based Swap, Agreement Recordkeeping, 77 FR 48208 (Aug. 13, 2012).
5 The seventh criterion states that the exclusion applies only when “[t]he exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors, or regulatory requirements, that are outside the control of the parties and influencing demand for, or supply of the nonfinancial commodity.” Id. at 48238 n. 341.
6 17 C.F.R. § 1.35.
7 7 U.S.C. § 6a.
Last Updated: January 27, 2014