November 30, 2011
Before I begin, I would like to thank Mr. Damgard for his kind introduction and FIA Asia for inviting me to speak at the 7th Annual Asia Derivatives Conference.
It has been three years since the financial crisis engulfed the world. The crisis brought into sharp focus what market participants had known for years – namely, that financial institutions are globalized and increasingly interconnected. The unfolding European sovereign debt crisis and the recent MF Global bankruptcy have validated the existence of such interconnectedness. I am keenly aware that poor risk management of one institution may have severe and damaging cross-border implications.
It is my honor to accept the invitation from the FIA to travel to Singapore to meet with my regulatory counterparts, not only from Singapore but from many other nations. The meeting of regulators yesterday reminded me that, while there are thousands of miles of oceans separating us, our challenges and our priorities are very similar.
I am also mindful of the fact that while it took me over 16 hours to travel from Washington to Singapore, it only takes 40-50 milliseconds for a trader in New York to execute trades here in Singapore. Our challenge is to develop rules and regulations – in a coordinated manner – that will benefit the global, highly-interconnected, and ultra high-speed markets. In addition to meeting with my regulatory counterparts, I am looking forward to greater dialogue with exchange leaders in both Singapore and Hong Kong, as well as market participants throughout the region.
In response to the 2008 financial crisis, the G-20 nations issued the Pittsburgh Communiqué that set forth four core tenets for over-the-counter (“OTC”) derivatives reform. First, all standardized OTC contracts should be traded on exchanges. Second, such contracts should be cleared through central counterparties (“CCPs”). Third, such contracts should be reported to trade repositories. Finally, OTC contracts that are not cleared by a CCP should be subject to higher capital requirements.
I believe that we can achieve all four tenets of the Pittsburgh Communiqué in a manner that better protects our markets. That is not to say, however, that this system – or any system – is fool-proof and will immunize the financial markets from failure. However, we must be respectful of the market structures and systems that have not proven harmful as we move forward to implement the G-20 objectives.
To implement the Pittsburgh Communiqué, the United States passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) on July 21, 2011. Since that date, the Commodity Futures Trading Commission (the “Commission”) has been working at a feverish pace to promulgate implementing regulations. For the past year and a half, the Commission has voted on roughly 60 proposed rules and 18 final and interim rules. Some of the most controversial proposals are still to come, including the proposal defining the scope of Commission jurisdiction outside of the United States. In general, the Commission has proposed and finalized rules in a less than orderly manner. Therefore, I would like to reiterate my very strong desire for the Commission to publish a complete rule implementation schedule. Such a schedule would advance President Obama’s initiative to increase government transparency. Further, such a schedule would help accelerate market compliance with our rules. Finally, such a schedule would give our regulatory counterparts – in Asia and Europe – a more definitive sense of when the Commission anticipates completing implementation of each G-20 commitment. I do believe that we can meet the G-20 clearing deadline – currently, the end of 2012.
On Monday, when I return to the United States, the Commission will vote on two more final rules and two proposed rules. The final rules include regulations pertaining to foreign boards of trade, as well as regulations pertaining to permitted investments of segregated customer funds. If members of the audience have any questions or concerns regarding such final regulations, please let me know.
I would like to devote my remaining time today to describing certain of the specific challenges that the Commission has faced with respect to international coordination on OTC derivatives reform. Specifically, I want to touch on clearing, trading, and trade data reporting. I would like to close with some thoughts on technology.
International Coordination: Specific Challenges
I perceive three main challenges relating to international coordination. First, jurisdictions around the world need to agree on the contours of their regulatory reach. The Dodd-Frank Act establishes a broad regulatory mandate to oversee financial markets (and market participants) if they impact the United States. As I noted earlier, the OTC derivatives industry is global and defining where United States jurisdiction starts and ends will involve considerable debate. Currently, the Commission is working on a proposed rule interpreting section 722(d) of the Dodd-Frank Act. This section states that our regulations will not apply to activities outside of the United States unless those activities have a direct and significant connection or effect on commerce in the United States. Such proposed rule will be open to public consultation before being finalized. The Commission will not consider the proposed rule before the end of this year.
Second, jurisdictions around the world have to agree on the principles and standards of OTC derivatives reform. As mentioned above, the G-20 nations have agreed on the four general tenets in the Pittsburgh Communiqué. However, jurisdictions have yet to reach accord on more detailed principles. For example, the Bank for International Settlements’ (“BIS”) Committee on Payment and Settlement Systems (“CPSS”) and the Technical Committee of the International Organization of Securities Commissions (“IOSCO”) are still finalizing the Principles for Financial Market Infrastructures. Similarly, the Basel Committee on Banking Supervision, CPSS, IOSCO, and the BIS Committee on the Global Financial System are planning to issue a consultation on margining of non-cleared OTC derivatives contracts in mid-2012. Achieving international agreement on detailed principles and standards governing OTC derivatives reform will be central to facilitating global regulatory convergence.
Third, in addition to agreeing on detailed principles and standards, jurisdictions around the world should actively consult as they move towards promulgating legislation and regulation. The Commission has been in active dialogue with our Asian and European counterparts on proposed and final rules under the Dodd-Frank Act. The more jurisdictions can harmonize implementing legislation and regulations, the easier it will be for nations to institute mutual recognition. Mutual recognition, or some form of mutual accommodation, is essential to avoiding duplicative or contradictory regulatory obligations for participants in the OTC derivatives markets.
Clearing: “Who” and “What”
The Dodd-Frank Act made clearing the foundation of systemic risk management in the swaps market. In general, there are two primary factors the Commission is charged with considering in expanding the use of clearing. The first factor is “who” – who can become a CCP member. The second factor is “what” – what should be cleared and what factors are relevant to such a determination.
First, let me address the “who.” The Commission finalized regulations governing CCP operations in October. As part of such rulemaking, the Commission implemented the Dodd-Frank Act provision on “open access.” This provision required a CCP to permit any entity meeting objective and risk-based membership standards to become a clearing member. Prior to the Dodd-Frank Act, CCP membership was exclusive due to stringent financial and operational requirements, which some considered excessive. Our final CCP regulations lower CCP membership standards to ensure open access. However, in these regulations, the Commission failed to clarify exactly how a CCP could legitimately balance risk management with open access. I am particularly concerned with, among other things, the prudence of prohibiting a CCP from requiring an entity to have more than $50 million in capital to become a clearing member for OTC derivatives contracts.1 My concerns have only deepened with the failure of MF Global, one of the main proponents of such a prohibition. I remain hopeful that the Commission will permit a CCP to have more flexibility to adjust its membership requirements to reflect risk management. A more principles-based regulatory approach would better accord with the CPSS-IOSCO consultation on the Principles for Financial Market Infrastructures and presumably with the final Principles.
The other factor in “who” relates to the cost of clearing. We cannot afford to make clearing needlessly expensive, so that it becomes “too costly to clear.” Mandatory clearing will only reduce systemic risk if CCPs are subject to appropriate regulation. By “appropriate,” I mean regulation that balances safety and cost. OTC derivatives contracts are important risk-hedging tools for commercial firms and non-bank financial entities (e.g., pension funds). If new regulations dramatically increase the cost of clearing, entities may choose to cease either voluntarily clearing or hedging risk. Neither alternative is optimal if our goal is to mitigate systemic risk.
Now let me address the question of “what is clearable.” The Dodd-Frank Act requires the Commission to determine which OTC derivatives contracts are standardized enough for mandatory clearing. In making this determination, the Commission is supposed to consider five factors, including liquidity, pricing, systemic risk mitigation, competitive effects, and whether appropriate legal and operational frameworks exist to support mandatory clearing. The Commission has not yet discussed how it will weigh and apply each of the five factors in making a mandatory clearing determination. I have urged the Commission to hold a public roundtable on the five factors, and on the interconnection between mandatory clearing and mandatory trading. I remain hopeful that the Commission will hold this public roundtable before it makes any mandatory clearing determinations.
As recently as last month, G-20 leaders reaffirmed the end-of-2012 deadline for the clearing mandate. While our rulemaking schedule is opaque, I believe that we can expect the mandatory clearing requirements to apply to swap dealers (“SDs”), major swap participants (“MSPs”), and certain other sophisticated market participants by the third quarter of 2012.
One of the central debates in Asia, I understand, is whether to rely on international clearing structures or to establish domestic clearing structures. I am very interested in hearing from both sides of the debate. On the one hand, I am sensitive to the concerns regarding fragmentation, especially since fragmentation may increase the overall amount of collateral necessary to support clearing. On the other hand, I understand that jurisdictions with prominent local participants, but no clearing organizations, may consider it inefficient and impractical to require such participants to gain direct or indirect access to an international clearing structure. I am particularly interested in exploring the risk implications of international centralization versus local fragmentation.
One element of the reforms, which I find particularly interesting, is the emphasis on execution of swap transactions on platforms. For nearly 15 years, swap execution platforms have been in existence. Market demands, and not legislative mandates, have prioritized more transparent execution, which platforms have competed to provide. While I believe that the Commission could and should do more to put trading on screen, I also believe there is no “one-size-fits-all” trading solution that can be applied across asset classes, regardless of current levels of liquidity.
Last December, the Commission promulgated a proposal on the operation of swap execution facilities (“SEFs”). The proposal sought to modify the way that pre-existing swap execution platforms functioned. Preliminarily, I would note that certain aspects of the SEF proposal may create significant barriers to entry, which would likely limit the number of SEFs to no more than 20. While I supported the SEF proposal, I hope that the Commission will continue to allow SEFs to offer both limit order books and request-for-quote platforms. Additionally, I do question whether the SEF proposal would enhance or fracture liquidity in OTC derivatives contracts. Currently, the Commission is considering amending the SEF proposal to impose additional order interaction requirements between the limit order book and the request-for-quote platform. This potential amendment raises many questions, including those relating to the interaction between algorithmic trade matching and human decision-making. In general, I would prefer electronic trading to grow organically and for SEFs to have the flexibility to innovate. I would be curious to hear your perspective about electronic trading here in Asia.
Pursuant to the Dodd-Frank Act, mandatory clearing is inextricably connected to mandatory trading. If the Commission determines that an OTC derivatives contract must be cleared, then most market participants must execute such contract on a registered trading platform, unless no such platform makes the contract “available to trade.” The Commission is in the middle of proposing a process by which a registered trading platform could determine, subject to Commission oversight, whether it has made an OTC derivatives contract “available to trade.” The Commission will likely consider this proposal on December 5, 2011. I hope that the Commission will not stop with approving only a process, but will provide additional guidance on how it will evaluate whether submissions by a registered trading platform are complete and convincing. Specifically, I hope that the Commission will further explore differences between clearing and trading liquidity, and whether it makes sense to mandate clearing for OTC derivatives contracts that may not have sufficient liquidity to support trading. As mentioned above, I have called for a public roundtable on mandatory clearing and trading to have a more thorough debate that involves market participants.
Mandatory Trade Reporting
The Commission’s rulemaking under the Dodd-Frank Act will establish swap data reporting requirements for swap counterparties and regulated entities, including SEFs, designated contract markets (“DCMs”), CCPs, swap data repositories (“SDRs”), SDs, MSPs, and counterparties who are neither SDs nor MSPs. The reporting requirements will provide transaction information to market participants in real-time and comprehensive information to the Commission, the Securities and Exchange Commission (“SEC”), and America’s prudential regulators. The fundamental goal of mandatory trade reporting is twofold. First, important swap transaction-level data will be made available to market participants to improve transparency, price discovery, and market integrity. Second, regulatory reporting will ensure that complete data concerning all swaps subject to the Commission’s jurisdiction is maintained in SDRs, where it would be available to the Commission and other financial regulators to fulfill their regulatory mandates, including systemic risk mitigation, market monitoring, and market abuse prevention.
In terms of technology, the Commission has a long way to go to improve its capacity to aggregate data from both the swaps and futures markets, but increasing such capacity is a first step in terms of expanding our broader market surveillance mission. Frankly, if we can’t master the task of aggregating data, we will have a more challenging experience in taking the next steps to develop real-time market monitoring or risk surveillance.
It is imperative that an issuer for global I.D.s (Legal Entity Identifiers – LEI) be established without delay. This will establish the foundation for global data sharing, which is essential if we hope to expand and improve our global coordination. This is an easy step that must be done immediately.
Capital and Margin Requirements for Uncleared Swaps
In general, the Dodd-Frank Act requires the Commission, the SEC, and the prudential regulators to each promulgate capital and margin requirements for OTC SDs and MSPs falling within its jurisdiction. The Commission and the prudential regulators proposed both capital and margin requirements this spring. The SEC has yet to propose such requirements. From my perspective, the main challenges to capital and margin regulations are both domestic and international harmonization. Whereas international agreement on the Basel III capital framework is advanced, international agreement on margining for non-cleared OTC derivatives contracts is nascent. At this point, the Commission can make substantial contributions to increasing regulatory certainty by (i) more clearly defining the reach of its capital and margin requirements outside of the United States and (ii) more closely synchronizing its implementation schedule to international capital and margin developments.
Challenges Separate and Apart from Dodd-Frank Rulemaking
Restoring Confidence in Segregation
It has been nearly a month since MF Global was placed into insolvency. The Commission is in the process of investigating the events leading up to the insolvency, including the whereabouts of a substantial portion of segregated customer funds. In the meantime, the Commission is working with the bankruptcy trustee to ensure that any transfer or disbursement of remaining segregated customer funds occurs as soon as possible. Our staff is working very hard to identify and recover customer funds.
In a statement last month, I urged the Commission to take immediate action to restore public confidence in our segregation regime, including (i) instituting random spot checks for segregation and (ii) providing additional transparency to customers regarding the risk profiles of intermediaries.2 I have further urged the Commission to improve coordination with domestic and international regulators. I see that FIA Asia has added a panel entitled “Responding to the Default of a Global Intermediary.” I would be interested in hearing about the Asian response to the MF Global insolvency, and the perceived successes and shortcomings of such response.
High Frequency Trading and the Importance of Automated Surveillance
The role that high frequency trading (“HFT”) plays in global financial markets has been a constant topic of discussion among market participants, regulators, academia, and the media as their market share has grown. According to some estimates, high frequency traders may participate in more than half of the trading volume in liquid futures contracts. Given their share of trading, many have called for governments to register, surveil, and regulate high frequency traders. Unfortunately, there is no consensus on what HFT is and who should be categorically included in a definition of high frequency trader. I have repeatedly urged industry, academia, and the public to come forward with a definition of HFT to no avail. In order to advance the debate, I have proposed a set of seven attributes as the building blocks of an HFT definition. I chair the Technology Advisory Committee at the Commission, and I have requested that its members provide feedback on the proposal.
Though I do not purport to have a perfect definition, I believe that these seven points will provide the basis for a robust dialogue on this issue. I hope that we can accurately define the various attributes of HFT, so that we can move forward on identifying and analyzing the impact of HFT on the markets.
Since HFTs trade in milliseconds, human observation is impossible. This necessitates the use of automated surveillance technologies to give regulators real-time oversight of financial markets. Since joining the Commission two years ago, I have fought vigorously for the Commission to devote resources to developing a comprehensive automated surveillance program. I appreciate that President Obama and Congress have embraced this goal. The FY2011 Continuing Resolution directed the Commission to invest additional funds into new technology that will expand our capacity to keep up with an increasingly electronic marketplace. The Commission’s new budget for FY2012 provides an increase in funding with $55 million prioritized for information technology investments. This renewed focus on information technology will allow the Commission to modernize and automate the important functions of market surveillance and market risk analysis – further increasing the capacity of the Commission.
I am mindful of the significant and comprehensive impact of the reforms being considered and undertaken by regulators across the world. Each of these decisions will have cost impacts, but will also improve our visibility into markets, as well as improve liquidity and risk management. We also must understand that we can’t possibly anticipate all of the ramifications of our decisions. For example, when SEC Chairman Arthur Levitt implemented decimalization in the equities market, do you think he anticipated the rise of the machines and HFT trading as the outcome? Many believe this policy decision, combined with the right technological environment, would make Mr. Levitt the “Father of High Frequency Trading.” We can’t possibly anticipate every outcome, but we must not rush through rulemaking without conducting a careful and thorough discussion of our proposals.
I am also keenly aware of the fact that the OTC derivatives market is a global market. I recognize that not every jurisdiction is operating on the same timetable as the United States. Regulation of the OTC derivatives market must be consistent across jurisdictions, which is why I have traveled here today. I want to have an open and continual dialogue with Asian regulators, exchanges, and market participants as we move toward a comprehensive and international set of standards for OTC derivatives reform.
Thank you. I will be happy to take questions.
1 See Statement of Dissent, Final Rulemaking on Derivatives Clearing Organizations, October 18, 2011, available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement101811b.
2 See Statement on MF Global: Next Steps, November 16, 2011, available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement111611.
Last Updated: November 30, 2011