Thursday, May 5, 2011
“However beautiful the strategy, you should occasionally look at the results.”
First, I’d like to thank the Federal Reserve Board of Chicago for hosting this conference and for inviting me to speak with you. Having been born in Indiana and raised in a small town in Michigan, I always enjoy opportunities like this to come back home to the mid-west. In fact, when I first arrived at the Commission I received advice from one of our senior staff members to get out from behind my desk and go speak to people. Actually, he said go listen to people outside of Washington. Hopefully, we will have some time to hear from the audience about your priorities and concerns.
I know that I don’t have to tell you that the Commission has been extraordinarily busy. I’m proud of the great effort that the staff is making to fulfill the regulatory mandates of the Dodd-Frank Act. To date, the Commission has put forward 66 proposed and final rules under Dodd-Frank. Not even counting the last four rule proposals the Commission voted on, we’re at over 1,046 dense, Federal Register pages filled with legal jargon and regulatory requirements. If you were to run the comment periods on all of those proposals consecutively, it would take 2,964 days, or a little over 8 years. I doubt I have to give those numbers much context; they speak for themselves. But just for fun, if you were to lie each of those Federal Register pages end to end, they’d stretch two-thirds of the way up the newly renamed Willis Tower. And we’re not done yet, so I am sure we’ll reach the top of tower before this is all over.
Sequencing and Implementation
When you’re putting out that much paper, I think you should have a plan for how to get through it. We are nearly halfway through the rulemaking process and we are just about to start consideration of the final rules. As Winston Churchill once advised, “If you are going through hell, keep going.” I’m going to accept that advice, but I have made two recommendations for the Chairman to make our trip a little better.
First, I have asked the Chairman to put forward a proposed sequencing of the final rules to allow the market to comment on where you think we got it right and, of course, where we can do better. Second, and even more importantly, the Commission should put forward an implementation schedule for all of the Dodd-Frank rules to be published in the Federal Register for comment. This will allow the market to suggest changes before the Commission misses the mark. Finally, the market needs to know when they will be expected to implement the rules so appropriate investments, staffing and reorganization decisions can be made. Until a final schedule is published, market participants will continue to play a very high stakes game of pin the tail on the donkey. Providing an additional level of transparency is entirely appropriate. We have already conceded we can’t meet the Congressionally implemented deadline in the first place, so providing a plan will not keep the Commission from meeting that date.
On Monday and Tuesday of this week, the CFTC and SEC conducted a roundtable discussion on implementation. I took away three very clear messages that the public was sending the Commission.
First, give us an implementation schedule so we can make investments to comply with the rules. Second, there is nothing the market can’t build, integrate and execute, but the Commission must provide clear rules and enough time to implement the rules. The panelists made it clear they needed months, not years to implement these rules. Third, phased implementation of the rules is essential to ensure that all the pieces work together.
What was not clear from this discussion, however, was the appropriate phasing. There wasn’t consensus if we should start with participants, products or both, and how the Commission will handle the clearing mandate presents challenges. So, we have more work to do on this front. The ball is now in our court. The market has been frank about the challenges and has only asked for schedules, regulatory certainty and patience.
Regulating the Swaps Markets
Still, we are making a good deal of progress in our rulemaking process. In fact, we are exceeding expectations. At our last Commission open meeting, we finally released the much anticipated joint proposal with the Securities Exchange Commission (SEC) on product definitions, including swaps. As you know, the Commission had previously released proposals addressing swap execution facilities (SEFs), and the definitions of swap dealers and major swap participants. While we all share as common ground the goal of reducing systemic risk, we do have some differences of opinion as to the best way to meet that goal.
Swap Dealer and End-User Definitions
For example, I believe our proposed definition of swap dealer is overly broad and will likely capture commercial entities that use swaps primarily to hedge their risks. As a result, these entities, which do not pose systemic risk, will see their costs go up. In contrast, the end-user definition proposal was too narrow. That proposal even missed an uncontroversial opportunity to clearly exempt certain farm credit system (FCS) financial entities – or FCS banks - from clearing requirements. Congress made it clear that regulators were permitted to exempt these banks. The Commission failed to make it clear that their swap transactions would qualify for the bona fide hedging exemption.
Capital and Margin
My concerns with the swap dealer and end user definitions also have implications in the recently proposed capital and margin rules. For example, if the swap dealer definition captures commercial end-users then they will be required to take a direct capital charge for the credit and market risks associated with each swap they enter into with other commercial end-users. Also, there is no language in the margin proposal that makes it clear that end-users won’t be assessed margin. Instead, the proposal states that each swap dealer may accept margin in a manner agreed to by the parties in a credit support arrangement. In stark contrast, the prudential regulators have put forward draft rules that prohibit bank swap dealers from posting margin to their counterparties and provide no capital thresholds exemptions for end users.
What does all of this mean? I believe costs for commercial end-users will increase. Congress did not want us to impose increased costs on non-systemically relevant commercial firms and force those firms to decide between hedging risk and investing in their business. Unfortunately, I believe the draft rules ignored Congressional direction.
Swap Execution Facilities (SEFs)
One element of the new market structure, which seems to have captured everyone’s imagination, is the Swap Execution Facility. This new exchange offers the best opportunity to improve swap market transparency and improve our ability to manage risk with real time pricing, contract standardization and better liquidity. I am often reminded that the swap market developed in parallel to the futures market because of the important differences between those markets. A one-size-fits-all approach – namely a central limit order book -- will not work in the less liquid swaps market. The Commission’s SEF proposal allows for both limit order book and request-for-quote approaches in order to bring flexibility and encourage liquidity formation.
I believe the number and variety of SEF platforms in existence and under development highlights the innovative capabilities of this market, and confirms that no technological challenge is too big for it. To highlight what the market is capable of when it is given clear direction, back at the end of March, I hosted the SEF Showcase at the CFTC headquarters in Washington, DC. I offered any SEF platform that wanted to participate the opportunity to show off its technology. No one was turned away, and the interchange of ideas between the 16 SEF platforms present, representing all asset classes, lasted all day.
I was impressed with how quickly and creatively potential SEFs met the proposed requirements outlined in the Commission’s rulemaking, but I think we need to continue to provide flexibility in our rules to allow SEFs to innovate and compete for business. Also, I want to make sure this market can transact sufficient size without penalty. We’ve received feedback from the public that the requirement for less liquid swaps that bids are shown to at least five dealers, and a requirement that any order be visible to the market for at least 15 seconds, which are noticeable differences between the SEC and CFTC rules, would harm the market.
We have massive new responsibilities under the Dodd-Frank Act that will require a heightened focus on technology investments, data management and analysis. We cannot continue to use yesterday’s solutions for today’s problems. We can’t continue to ignore that the markets we regulate are no longer dominated by traders who took orders over land line telephones and stood in crowded pits yelling out bids and offers that only the initiated understood. I don’t need to tell anyone from Chicago that those scenes are more part of our past than our present. Today, the futures and swaps markets are by and large electronic markets, heavily dependent upon advanced technologies. It’s time that the CFTC adapts to that reality.
If we are to establish a credible surveillance and oversight program of both the futures and swaps markets, the Commission needs to move past its antiquated ways of doing business. I am repeatedly struck by the lack of technological capacity at the agency. Our forms and filings are not required to be filed electronically, and those that are don’t automatically populate our trade surveillance data bases. We have only a few automated surveillance alerts. None of those monitor real-time trading. While we rely on each designated contract market (DCM) to police its own trading to a certain degree, we have long recognized the interconnectedness of the market as a whole but have done little to address that reality.
Anniversary of the Flash Crash
Tomorrow is the anniversary of the Flash Crash, an event that “highlighted the interconnectedness of the equities and derivatives markets.” In minutes the markets dropped an unprecedented $1 trillion dollars. Thankfully, the market recovered, but not before it gave us a terrible example of how badly things can go when we don’t have the right safeguards in place.
On February 18, 2011, over nine months after the flash crash, a joint CFTC-SEC Advisory Committee released a report that contained 14 recommendations. Both Commissions will seek to integrate most of the recommendations into the Dodd Frank rulemakings. They included: putting circuit breakers or pauses in place; requiring DCMs to have strict supervisory requirements for firms implementing algorithmic trading; reporting measures; and pre-trade risk safeguards. The Technology Advisory Committee (TAC), which I chair at the CFTC, formed a subcommittee to also look at safeguards, or pre-trade practices for firms that engage in direct market access. The subcommittee came up with several pre-trade risk management measures, including: pre-trade quantity limits on individual orders and price collars; execution and message throttles; a kill button on existing orders; clear error trade and order cancellation policies at the exchange level; and trading functionalities that operate within parameters set by clearing firms.
But since May 6th, the Joint Committee notes that there have been three other “crashes” related to algorithmic trading, which I believe have shaken market confidence and will undermine the important role both the equities and futures markets play. The CFTC can’t possibly review each and every algorithm and certify its performance – that would be impossible. Instead, we are hoping to establish rigorous standards by which all firms must comply if they are going to utilize algorithms in their trading strategy.
CFTC’s Own Technological Divide
As the market makes investments in its technological capabilities to keep up with the ever improving speed of business, the CFTC must also make critical investments in our own capabilities. For the past year, I have requested the Commission be reorganized to create an Office of Data Collection and Analysis. This office should focus on securing and managing all of the Commission’s trade and surveillance data, working with all other Divisions to monitor the futures and swaps markets, performing broad risk analysis for the Commission. This Office can drive the automation of cross market surveillance programs including the development of our own algorithms, enabling the Commission to keep pace with new computer-generated trading styles as well as nefarious activities. Using the additional resources provided by Congress we should attack our highest priority technology challenge such automating our surveillance and integrating the swaps market data with futures market data.
Technology Advisory Committee
Finally, if we are going to keep pace with the markets’ appetite for new technological capabilities, we have got to keep a dialogue going with the market about where it’s headed. I mentioned the work of the TAC to help identify possible safeguards in response to the events of May 6th. I recently established another TAC subcommittee to focus on developing standardized reference data for the universe of legal and financial terms used to describe, define and value various derivatives and other financial instruments. The creation of standardized reference points and data terms will aid in the development of universal entity, product, and/or instrument identifiers and provide greater consistency in the collection, reporting, and management of individual transactions.
Sound and Fury Signifying Nothing?
It’s easy to focus on how much is changing with Dodd-Frank. The CFTC and the other federal financial regulators are writing rules at a frenetic pace and the market is already positioning itself to deal with the changes to come. There’s no doubt about it; much is changing, and there is a lot of good that will come of it. Since, I opened with Winston Churchill, let me close with some of his good advice, “However beautiful the strategy, you should occasionally look at the results.”
As such, I find myself asking if we are really going to change the fundamentals of the market. If we take the flexibility out of the swaps market by trying to make those unique instruments trade as though they’re futures, and ignore the characteristics that make them useful tools to hedge risk, aren’t we sacrificing market innovation for the lazy comfort of sticking to what is more familiar?
The way the draft rules seem to be shaping up, the dealers will remain in a key market making role, albeit a more expensive responsibility. Do we want a market that leaves dealers as the prime market makers, offering less and not more competition in the swaps arena? Much of this will depend whether or not we can move to more standard products and reduce the customization of these products.
While I didn’t mention it in this speech, I am interested to know what you think the impacts of establishing two different margining regimes for futures and swaps. Will there be any opportunities to better manage this exposure between markets? Will capital flee into fewer but more esoteric, bespoke products traded in dark, over-the-counter markets that can’t be cleared?
And finally, a question that this conference is uniquely qualified to consider: if we have perpetuated concentrations of risk and harm competition, have we really fixed the nemesis that is “too big to fail”? If we haven’t, I’m afraid that at the end of the day, we may have created a good deal of sound and fury that for the American people will signify nothing.
I’m looking forward to the discussion today, and doing some of that listening that I was counseled I should do. I know that if we are going to find answers to any of these questions; it will be because we were thoughtful and took into consideration the views of the entire market. Thank you, again, for this opportunity to hear your thoughts on where we’re headed.
Last Updated: May 5, 2011