We Have the Power to Reverse the Negative Impacts of the Commission’s Rules on Market Structure
May 6, 2014
Thank you for the kind introduction and for the opportunity to serve as your closing keynote speaker. It is my pleasure to engage with you here today and discuss market structure changes. Also, thank you to Larry Tabb and his great staff who contribute to this debate with opinions and research on a daily basis. It is my pleasure to have Larry Tabb contribute to the Technology Advisory Committee (“TAC”) work and in particular the high-frequency trading (“HFT”) discussion. I would also like to remind everyone that today is the fourth anniversary of the Flash Crash so it is particularly apt that we discuss evolving market structure at this conference.
Now that the final framework for derivatives regulation in the United States (“U.S.”) is largely in place, we have been witnessing some negative impacts on market structure of the Commission’s rules. Some people criticize the Commission for promulgating rules too fast and without taking the time to anticipate the impacts of its rules. I do not disagree with this assessment and, in fact, have made the same argument. As evidence, in the past three years, the Commission has finalized 68 rules and has issued 188 – that’s right 188 – staff no-action letters, staff guidance, and advisories to correct unintended consequences of its rules.
Last week, there was a funny headline in Risk.net that read “Scott O’Malia, It’s Your Fault.”1 This eye-catching story builds on some thorough reporting by Risk.net reporter Peter Madigan, who found that the Commission’s cross-border guidance has led to serious liquidity fragmentation between U.S. and European traders, who are doing everything possible to avoid getting caught up in the jurisdictional web of the Commission’s guidance.2 The story quotes me as saying that if the Commission’s rules contributed to such fracturing of liquidity, “…it means we have screwed up in the regulation somewhere.”3 While I did not vote for the onerous cross-border guidance, I am committed to fixing the guidance and every other rule that has cast the regulatory net too broadly or resulted in an outcome that has missed the mark.
In keeping with the spirit of today’s conference, I will focus on three topics that have contributed to changes in the derivatives market structure and discuss ways for the Commission to fix the negative impacts of its rules. First, I will address the recent HFT debate and provide a preview of the next TAC meeting, which will take this debate head-on as it relates to the derivatives market. Next, I will discuss the importance for regulators to refocus our efforts on outstanding cross-border harmonization issues so that liquidity fragmentation in the swaps market does not become permanent. Finally, I will discuss the Commission’s regulatory path forward, including the necessity to fix unworkable rules that have negatively impacted market structure.
High-Frequency Trading: The Next TAC Meeting Will Answer the Charges in Lewis’s Book Flash Boys
Michael Lewis’s book Flash Boys has stirred up quite a debate about HFT and market structure over the last month. The book claims that the stock market is “rigged” by HFTs that are front-running other traders’ orders. The book raises other concerning issues, such as HFTs having faster data feeds than other traders, exchanges paying brokers to take or provide liquidity, and HFTs co-locating within the exchanges. Although Flash Boys focuses on the equity market, several charges in the book could apply to the derivatives market. By CME Group’s own admission, HFTs account for about 30 percent of its trading volumes.4
HFT and automated trading is not a new topic for the TAC. The TAC has focused on this issue since I reconstituted it in July 2010, and since then, 9 out of 11 TAC meetings have focused on some element of automated trading. As Chairman of the TAC, I also established the Subcommittee on Automated and High Frequency Trading in 2012. The TAC has committed significant time and resources to better understand automated markets and their evolving structures. We will do so again at the next TAC meeting.
TAC Panel I: Answering the Charges Against HFT
As Securities and Exchange Commission (“SEC”) Chair Mary Jo White said about the equities market, I do not believe that our markets are rigged.5 At the next TAC meeting on June 3rd, I plan to have the first panel focus on HFT and respond to the charges in Lewis’s book from a derivatives market perspective to validate my belief. We will have an in depth discussion of data feeds, pricing, co-location, direct market access, order cancellation policies, among other issues and ask whether the right protections are in place. We will also discuss how these issues may impact the swaps market with its horizontally-integrated nascent swap execution facilities (“SEFs”). HFTs and non-HFTs will also provide their perspectives. I expect a robust discussion of these issues given the fire that Flash Boys has reignited around HFT.
I am committed to using TAC resources to continue examining the issues surrounding automated trading so that the Commission has all the facts and information before taking regulatory action to improve market structure, if necessary. The TAC first discussed risk controls and system safeguards back in 2010, and has continued to discuss these issues in subsequent meetings. These discussions directly contributed to the Commission’s Concept Release on Risk Controls and System Safeguards for Automated Trading Environments that was published last September.6 The concept release is a good start and asked over 120 questions in an attempt to further benefit from industry knowledge about automated trading.
I understand that Commission staff is starting to work on a proposed rule. I hope that Commission staff is carefully considering the comments and the previous TAC discussions, which, by the way, are all available on the Commission’s website,7 when formulating this proposal. I also hope that Commission staff is researching and analyzing the current market structure and anticipating the impact of any rules in order to avoid negative consequences.
TAC Panel II: Designing a Twenty-First Century Surveillance System
After we address the charges in the Lewis book, the second panel will address the Commission’s own market surveillance capability. I do not believe that the Commission’s systems are adequate to oversee today’s fast and complex derivatives markets. Previously, I have expressed my frustration with the lack of a strategic technology plan. It is more than a little ironic that the Commission has been so thorough in dictating the regulatory requirements under Dodd-Frank, but is unwilling to set its priorities for technology upgrades. The Commission will continue to have an incomplete picture of today’s highly automated markets, thus hampering its ability to make well-informed regulatory decisions and surveil the markets, unless the Commission invests in a strategic technology plan.
Frankly, I am tired of asking the Commission for its preferred strategy so I am instead going to seek input from the exchanges, other self-regulatory organizations, and HFTs, who have invested millions of dollars in their own technology, for their thoughts on how the Commission should design the twenty-first century mouse trap to spot disruptive and manipulative trading practices – at any speed. I think it is important to recall that an HFT firm designed the SEC’s Midas surveillance platform.
Mr. Lewis’s book highlighted the rapid cancellation of orders by HFTs. Currently, the Commission does not have an order message data collection and analysis system. Without such a system, the Commission does not have access to the millions of order messages that inundate the exchanges on a minute-by-minute basis. How can the Commission understand and make decisions about today’s automated trading strategies without this system? With the high trade-to-cancel ratios, I would like to understand how the Commission can develop systems that are able to identify spoofing and momentum ignition strategies.
In addition, Flash Boys highlighted the interconnectedness of today’s markets. The Commission does not have cross-product and cross-market analytical tools. The Commission must develop a database to link the futures, swaps, and options markets to perform this cross-market analysis and surveillance. Again, without such tools, the Commission cannot effectively oversee today’s automated markets.
These are just two examples of the surveillance capabilities that we will discuss at the next TAC meeting. I also want to hear from market participants, exchanges, vendors, and other interested parties beyond the TAC meeting about their specific ideas regarding the Commission’s development of a twenty-first century surveillance system. So, after the June 3rd TAC meeting, I plan to put a link on the TAC website so that parties can submit their proposals or ideas about how the Commission should develop such a surveillance system. I hope that many interested parties will submit comprehensive plans and that the Commission will seriously review these proposals in developing its technology strategy.
TAC Panel III: Increasing Buy Side Participation on SEFs
Moving away from HFT, the final TAC topic will discuss buy side participation on SEFs. I have been a little concerned that the buy side has been slow to get involved in SEF trading. I am also concerned about the decline in SEF trading over the last month and would like to better understand the cause.8 We will hear from the buy side about any remaining obstacles for them to actively trade on SEFs and discuss potential solutions. I would also like to hear about any lingering problems with the SEF rules.
We will have a busy TAC agenda with these three very important and timely topics so I hope that you will tune in to the discussion.
Cross-Border: Let’s Close the Deal on International Harmonization
My second topic is cross-border harmonization – or the lack thereof.
Of course the swaps market is a global market and shifts in its market structure are also happening outside of the U.S. Last December when the Commission made its extremely narrow substituted compliance determinations, I advocated for a much more expansive effort to recognize the on-going international efforts by regulatory colleagues.9 That approach would minimize disruption in the changing landscape and alleviate the burden of regulatory uncertainty and duplicative compliance with both U.S. and foreign regulations. I also advocated for a flexible, outcomes-based approach to the substituted compliance process, consistent with the agreement of the Over-the-Counter (“OTC”) Derivatives Regulators Group (“ODRG”).10
The Commission has not made any additional substituted compliance determinations since last December, which is having the tangible and negative effect of fragmenting liquidity in the swaps market.11 Unless the Commission and foreign regulators undertake serious efforts to recognize each other’s regulatory regimes on data, clearing, and execution based on a flexible, outcomes-based approach, we risk developing micro-solutions that highlight our differences rather than our commonality. I urge the Commission and foreign regulators to demonstrate our commitment to G20 principles by quickly “closing the deal” on data and clearing recognition and solving for the difference in timing on exchange trading.
Data: It’s Time for “Project Harmonization”
European Union (“EU”) reporting rules under the European Market Infrastructure Regulation (“EMIR”) became effective almost three months ago, but there is still no international data sharing agreement between the U.S. and EU and no mutual recognition of swap data repositories and EU trade repositories. These agreements are crucial so regulators can compare and aggregate data in order to monitor and analyze risks in the global financial system. It is also important so that market participants are not burdened by duplicative reporting requirements.
I am pleased that the Commission and other regulators have been working diligently on the data challenges here in the U.S. I thank U.S. Treasury Acting Deputy Secretary and Under Secretary for Domestic Finance Mary Miller for her support for improving swaps data reporting, standardization, and sharing. I also thank the U.S. Treasury’s Office of Financial Research for their assistance in working with the Commission to improve its swaps data quality.
Regulators have devoted much work to the swaps data challenges; now it is time to quickly resolve the outstanding issues. Both the Dodd-Frank Act and EMIR12 included provisions for international data sharing so that our two jurisdictions could cooperate in carrying out the G20 OTC derivatives reform mandates. In keeping with these provisions and the ODRG agreement, I call on the Commission and the EU to sign an international data sharing agreement, collaborate to harmonize both the form and format of data being reported, and recognize each other’s swap trade repositories. We must get back to the substituted compliance process and follow a flexible, outcomes-based approach.
Qualifying Multilateral Trading Facilities: Is This the Right Solution?
Last month, Commission staff issued a clarification to its conditional relief for Qualifying Multilateral Trading Facilities (“Qualifying MTFs”).13 In order for an MTF to qualify for this relief from the SEF registration requirement, it basically has to look like a SEF and comply with the Commission’s reporting and clearing requirements. In addition, Commission staff may pull the relief if a significant proportion of the participants are U.S. persons and a significant proportion of the growth in trading is attributable to U.S. persons.
Given the detailed conditions in the relief and the possibility of having the relief pulled, it is not surprising that MTFs are not signing up for such recognition. Once again, the Commission will not be able to achieve mutual recognition with foreign regulators if it continues to impose the SEF regime on foreign execution platforms. The Commission’s approach thus far also does not bode well for any future exempt SEF rulemaking.
There is recent evidence that the lack of substituted compliance is bifurcating liquidity into U.S. and non-U.S. pools, with U.S. persons suffering the consequences.14 An article last week by Risk.net provided a good analysis of the issue, noting that non-U.S. persons are refusing to trade with U.S. persons, and instead, insisting on trading with U.S. banks’ non-guaranteed affiliates to avoid the Commission’s regulations.15 This means U.S. persons cannot directly access non-U.S. pools of liquidity and must instead trade through the banks.16 The story also points out that the Qualifying MTF relief has not helped because it basically provides for a SEF regime and the only way to reverse the fragmentation is through mutual recognition.17
The Commission and foreign regulators have the power to reverse this liquidity fragmentation before it becomes permanent. However, the Commission must work with foreign regulators and follow a flexible, outcomes-based substituted compliance approach to do so.
Let’s Declare Victory on Clearing and Move to Implementation
Another area that is ripe for substituted compliance is clearing. Thanks to the good work of the International Organization of Securities Commissions (“IOSCO”), regulators have established international standards for central counterparties (“CCPs”) known as the Principles for Financial Market Infrastructures (“PFMIs”).18
Today, I am sending a letter to European Commissioner for Internal Market and Services Michel Barnier that is in the same spirit of the “Path Forward Statement,”19 asking him to move forward with U.S. equivalence and CCP recognition under EMIR. In this letter, I offer my assistance to make this happen by the June 15th deadline under the Capital Requirements Directive (“CRD IV”). I am concerned that further delay by the European Commission (“EC”) in making an equivalence decision for the U.S. derivatives regulatory regime will impede the European Securities Market Authority from recognizing U.S. CCPs by this deadline.
Last year, the Commission finished adopting the PFMIs. Without recognition, U.S. CCPs will not qualify as Qualifying CCPs (“QCCPs”) for purposes of the Basel III risk-weighting approach for banking institutions. U.S. CCPs will also be unable to maintain direct clearing member relationships with EU firms and will be ineligible to clear contracts subject to the EU clearing mandate next year. These scenarios would be detrimental to both U.S. and EU interests by leading to market fragmentation and contraction of liquidity, as well as market disruption and dislocation.
In the spirit of international harmonization, I urge the EC to quickly resolve any outstanding issues so that equivalence and CCP recognition is achieved by June 15th.
I fear that without tangible evidence of flexible, outcomes-based recognition, regulators may be left with one-off rule based solutions. It is time we bring G20 members back to the table to: 1) sign an agreement on data and work to harmonize data to enable sharing, 2) begin discussions on exchange trading standards so that we can stop implementing solutions that fracture liquidity, and 3) provide mutual recognition for those entities that meet the PFMIs so that the market can move forward on mandatory clearing.
Regulatory Path Forward: Let’s Fix What’s Broken
Now, let me turn to my last topic — the Commission’s regulatory path forward. The Commission is moving forward on a number of issues that impact market structure, but the Commission must also spend the time to fix unworkable rules in order to alleviate the negative impacts on the market.
Last week, Commission staff issued a no-action letter phasing-in package trades.20 As of May 16, 2014, all package transactions where each component of the transaction is subject to the trade execution mandate are required to be executed on a SEF through either the order book or the request-for-quote to 2 or on a designated contract market (“DCM”). Commission staff provided further relief for other types of package trades, such as those involving a future, an uncleared swap, or a swap that is not within the Commission’s exclusive jurisdiction.
I believe that the no-action letter strikes an appropriate balance between promoting trading on SEFs and the need to preserve orderly markets. Deriving a workable solution for these complex transactions is essential to ensuring a level, competitive playing field, and preserving orderly markets so I hope that Commission staff will continue to work on solutions for package transactions that received further relief.
Clearing Mandate for Non-Deliverable Forwards
Commission staff is finalizing a proposal to establish a clearing requirement for certain non-deliverable forwards (“NDFs”). Market interest in clearing NDFs is driven by forthcoming requirements to hold additional capital and post initial margin against non-centrally cleared derivatives. Similar to the clearing mandates for interest rate and credit default swaps, the NDF proposal will allow for phased-in compliance and will set in motion a shift from OTC trading to a more transparent trading environment. I understand that the workflow to achieve clearing and straight-through-processing for NDFs is more complicated than for interest rate and credit default swaps so I hope that Commission staff highlights these issues in its future proposal.
It is also important to note that NDF participants should prepare for a quick transition to mandatory SEF trading after the clearing requirement takes effect because the Commission does not have much say in made available-to-trade determinations. I hope that the proposed NDF rule will ask questions about any SEF trading issues so that the Commission can provide market participants with sufficient time to ensure that they have the necessary technology in place to trade NDFs on SEFs. I encourage commenters to opine on these and other issues when the Commission publishes the proposal.
Several other rulemakings are forthcoming, but it is not clear whether they will wait until after the full Commission is seated. The Commission has been considering for some time a futures block rule proposal that will limit the availability of block trades. Exchanges have facilitated the transition from swaps to futures by establishing low threshold sizes for block trades in futures contracts. It remains to be seen how Commission rules would affect this transition.21
Additionally, all of the Commission nominees have committed to finalizing the position limits rule. Setting position limits is not an easy task. The Commission is supposed to stop excessive speculation and manipulation, but must also protect the essential price discovery process and hedging function in the markets. The new commissioners will have their work cut out for them on this rule.
In addition to promulgating rules, the Commission must take a closer look at its rule implementation process, re-visit unworkable rules, and articulate a roadmap for market participants so that they can comply with our new rules. Unfortunately, the Commission has not always been up to par on these responsibilities.
Recordkeeping Rule 1.35(a)
The recordkeeping rule 1.35(a) provides a good example.22 In general, the rule requires Futures Commission Merchants, Introducing Brokers, and members of DCMs and SEFs that are registered or required to be registered with the Commission to record all oral communications as part of a trade record, including preliminary conversations that occur over cell phones if they lead to the execution of a transaction.23
One adverse impact of the rule is the increased recordkeeping requirements for SEF members. Until the SEF rule became final, Commodity Trading Advisors (“CTAs”) operated under the assumption that asset managers and their clients would not be “members” of SEFs, but simply participants using a SEF platform as an execution venue for their trades. However, the term “member” is unclear and thus CTAs have been dragged into the scope of rule 1.35(a). I am pleased that Commission staff hosted a roundtable on this issue to obtain feedback from market participants and provided relief from compliance with the oral recording requirement for CTAs until the end of this year.24
But entities that do not qualify for the exemption will need to purchase expensive recording technology to comply with the requirements of the rule. While large banking institutions will have the means to find a compliance solution, smaller institutions will take the heavy brunt of regulatory compliance.
I hope that the Commission will implement a workable rule amendment that strikes an appropriate balance between the Commission’s interest in preserving its enforcement authority and imposing on market participants workable and cost-effective requirements.
Forward Contracts with Volumetric Optionality
Speaking of workable solutions, as you all know, end-users have been raising concerns about the definition of a volumetric option. According to the Commission’s rules, 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.25 This logic contradicts how market participants have traditionally used volumetric options. Commission staff’s recent roundtable discussed this issue so I now encourage the Commission to implement a workable solution through a rule amendment.
Although shifts in market structure are inevitable, regulators should ensure a smooth transition for the market. Before promulgating rules, the Commission must research and analyze current market structure and anticipate the impact of any rule changes.
I understand that it is impossible to anticipate all of the negative impacts of all of the Commission’s complex rules. However, once the Commission discovers a negative impact, it must re-visit unworkable rules and quickly identify solutions through a rule amendment.
Finally, the Commission and foreign regulators must work together to harmonize their regulatory regimes so that swaps market trading remains global. Fragmented swaps liquidity in today’s market is a reminder of the negative effect of the regulators’ failure to harmonize our regimes. The best way for regulators to reverse this market fragmentation is to adopt a flexible, outcomes-based substituted compliance approach.
Thank you very much for your time.
Note: The Letter to Commissioner Michel Barnier is available under Related Links.
1 Duncan Wood, Scott O’Malia, It’s Your Fault, Risk.net, May 1, 2014, available at http://www.risk.net/risk-magazine/opinion/2342391/scott-omalia-its-your-fault.
2 Peter Madigan, US end-users are losers in swaps liquidity split, Risk.net, Apr. 28, 2014, available at http://www.risk.net/risk-magazine/feature/2340854/us-end-users-are-the-losers-in-swaps-liquidity-split.
4 Neil Munshi, CME says high-frequency trading outcry should not hit futures, Financial Times, May 1, 2014, available at http://www.ft.com/intl/cms/s/0/df5e54ea-d126-11e3-bdbb-00144feabdc0.html#axzz30aT9KqtU.
5 Sarah N. Lynch, SEC chair to Congress: ‘The markets are not rigged’, Reuters, Apr. 29, 2014, available at http://www.reuters.com/article/2014/04/29/us-sec-highspeed-trading-idUSBREA3S0OO20140429.
6 Concept Release on Risk Controls and System Safeguards for Automated Trading Environments, 78 FR 56542 (Sep. 12, 2013).
7 TAC meeting transcripts and presentations are available at http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.
8 The Clarus blog shows declining SEF volumes since March, available at http://www.clarusft.com/sef-week-30/.
9 Statement of Dissent by Commissioner Scott D. O’Malia, Comparability Determinations for Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland: Certain Entity and Transaction-Level Requirements (Dec. 20, 2013), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement122013.
10 ODRG report to the G20, available at http://www.cftc.gov/PressRoom/PressReleases/pr6678-13.
11 Peter Madigan, US end-users are losers in swaps liquidity split, Risk.net, Apr. 28, 2014.
12 European Market Infrastructure Regulation, Regulation (EU) 648/2012, of the European Parliament and of the Council of 4 July 2012 on OTC Derivatives, Central Counterparties and Trade Repositories, available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2012:201:0001:0059:EN:PDF.
13 CFTC Letter No. 14-46 (Apr. 9, 2014), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-46.pdf.
14 Peter Madigan, US end-users are losers in swaps liquidity split, Risk.net, Apr. 28, 2014.
18 Derivatives Clearing Organizations and International Standards, 78 FR 72476 (Dec. 2, 2013).
19 The European Commission and the CFTC reach a Common Path Forward on Derivatives, available at http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.
20 CFTC Letter No. 14-62 (May 1, 2014), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-62.pdf.
21 Keynote Address by Commissioner Scott D. O’Malia, New Risk in Energy 2014: Energy Trading Risk and the Policy that Drives It, available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/omaliapresentation040714.pdf. See Futures block data on pages 6-8 of the presentation.
22 17 CFR 1.35(a).
24 CFTC Letter No. 14-60 (Apr. 25, 2014), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-60.pdf.
25 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).
Last Updated: May 7, 2014