September 30, 2010
Thank you for that kind welcome. It is an honor to be here today with the Capital Markets Consortium to discuss new clearing mandates imposed by Dodd-Frank, the current state of regulatory reform at the CFTC, where I think the CFTC will be heading in the next year or so, and what I believe are some of the more difficult challenges the CFTC and market participants will face as the Dodd-Frank Wall Street Reform and Consumer Protection Act is implemented.
This conference could not come at a more crucial time. Not since the Commodity Exchange Act (CEA) and the securities laws were passed in the 1930s has there been such a dramatic reshaping of financial markets to better serve the public by strengthening regulation where needed and eliminating inefficiencies where possible. This audience more than anyone understands the challenges that regulators face in implementing such a vast regulatory regime, which includes moving the massive over-the-counter swaps markets onto regulated exchanges or swap execution facilities and into a transparent cleared environment. As regulators face these challenges, it is my hope that you all are engaged in the process and provide any input you think we should have so we make the best decisions possible as we craft a regulatory regime that advances the public interest and protects these vital markets.
Now that Congress has done its part over the last year and given us Dodd-Frank, regulators are tasked with putting meat on the bones by crafting the many regulations required to give effect to the statute. As you all know, in many areas, the authority of regulatory agencies has dramatically expanded. Along with that dramatically expanded authority, there are currently more questions than answers, and the questions surrounding most issues are enormously complex and require thoughtful resolution.
Generally, the headline from Dodd-Frank is that that the OTC swap markets will now be subject to stringent regulatory oversight, will be cleared, and will be transparent. To implement this regulatory oversight, at the Commission we have set up 30 rule writing teams that will draft dozens of regulations that the Chairman expects the Commission to formally propose before the end of this year. This is a very ambitious agenda, but Congress has given us little choice with the statutory deadlines imposed. Of these 30 teams, 5 of them are drafting rules specifically relating to clearing.
Many of the regulations that the teams are drafting will address Dodd-Frank’s “big ticket” market structure items such as exchange or swap execution facility (SEF) trading requirements, clearing requirements, who will be a swap dealer or major swap participant, what business conduct standards will apply, and transparency and reporting requirements. Other regulations, however, deal with areas of Dodd-Frank that bear no relation to the headline I just mentioned, and do not even relate to any swaps activity. Some of these areas include the CFTC’s authority to move away from the flexible core principle regulatory regime in favor of a prescriptive rules-based regime, and the expanded authority the CFTC now has to mitigate conflicts of interest in designated contract market (DCM), derivatives clearing organization (DCO), and SEF governance. (More about these two areas later.)
We will also include a number of items that have been on the CFTC agenda for quite some time and include them in the rule writing process with similar issues areas. Block trading is one example of that. We first proposed block trading rules for the futures markets in 2004 and have yet to finalize them because of the complicated nature of the rule. Yet, the intent is to combine this rule with a block trading rule relating to swaps data reporting. The massive Dodd-Frank rule writing effort has become a convenient vehicle to attach these type of pending issues to. Some of these issues, such as block trading, still present us with intricate and often thorny choices but it makes sense to combine these rules with Dodd-Frank to ensure consistent analysis and formulations are used.
While the rule writing teams have already been working for months and have a daunting amount of work ahead of them, the Commission has already begun the process of publishing rules. Last month, we published final rules relating to retail FOREX trading, a project that dates back to passage of the 2008 Farm Bill and that was also included in Dodd-Frank. Going forward, the process of proposing new rules will begin rather quickly. This Friday, October 1st, the Commission will hold a public meeting to vote on an interim final rule relating to reporting pre-enactment unexpired swaps to a swap data repository or to the Commission, proposed rules regarding financial resources requirements for clearing organizations, including those deemed systemically important, and a proposal regarding governance and conflict of interest rules for DCOs, DCMs and SEFs.
I fully expect there to be many more such meetings where the Commission will publically deliberate and vote on proposed rules. Typically, these meetings are NOT a forum for the public or market participants to comment or participate. Commission staff typically presents recommendations to the Commission, the Commission considers the recommendations, debates, deliberates, and then votes on the proposal. Where we need market participants to comment is during any roundtables the agencies host and certainly during the formal comment process for each proposed regulation. In addition, before a regulation is proposed, the CFTC is equipped to take comments from the public and market participants. There are mailboxes set up at CFTC.GOV that are arranged by topic area. Commenting before a regulation is proposed can be very helpful, as these comments will be reviewed while staff is actually drafting the various proposals.
As the Commission moves forward into comprehensive regulation and oversight of OTC swap markets, it is interesting to take a moment and look in the rear view mirror to see where we have been before.
Congress created the CFTC in 1974 as an independent federal agency with the mandate to regulate commodity futures and option markets in the United States. At that time, most futures trading took place in the agricultural sector, and swap markets had not yet developed. Contracts on products such as wheat, corn and cattle were traded in open outcry pits where traders wearing colorful jackets flashed hand signals and jostled each other for position. Back then, co-location meant that a firm’s desk was closer to the pit than another firm’s desk, or a firm’s trader was taller than other traders and was more easily seen in the pit.
Since 1974, the CFTC’s mission has been to protect market users and the public from fraud, manipulation, and abusive trading practices related to the sale of physical and financial futures and options, and to foster open, competitive, and financially sound markets. The CFTC has always endeavored to ensure the economic utility of our markets through a strong regulatory oversight program that includes market surveillance to detect and prevent manipulation, and by ensuring the financial integrity of the clearing process. Through effective oversight, the CFTC facilitates the important hedging and price discovery functions that the futures markets were designed to serve. As testament to the futures markets and the CFTC’s oversight regime, as you all know, regulated futures exchanges and futures commission merchants performed well throughout the financial crisis.
Over time, increasingly complex financial products developed. Today, agricultural trading makes up a small fraction of futures market trading, and while limited open outcry trading still exists, today’s markets encompass a vast array of financial contracts traded at lightning speed through electronic networks. Moreover, swap markets now dwarf futures markets and are so interconnected that, as we all know, contagion can happen very quickly with potentially devastating effects.
Since the inception of futures trading in the mid 1800s and until recently, futures markets offered the primary means by which commercial entities could manage their physical market price risks. During the 1980s, however, OTC derivative contracts were developed that offered similar risk management benefits. In 1981, the World Bank and IBM entered into what has become known as a currency swap. Before long, the utility of swaps as hedging and speculative vehicles led to significant growth in the swaps market.
The development of the swaps markets did not go unnoticed at the CFTC. As many of you know, during the time between 1974 and now, on a number of occasions the CFTC took action, or attempted to take action, relating to swaps markets.
Statutory and regulatory provisions relating to swap transactions date back to the mid-1980s. The Commission’s initial regulatory action related to swaps was the publication of an advance notice of proposed rulemaking in 1987. The notice made reference to the development of certain OTC “hybrid instruments,” including commodity swaps, which appeared to possess, in varying combinations, characteristics of forward contracts, futures contracts, option contracts, debt instruments, bank deposits and other instruments. The Commission sought comment concerning measures to clarify the status of these types of instruments and to assure that the Commission’s regulatory program adequately addressed the developing market in such instruments.
In July 1989, the Commission published its 1989 Swaps Policy Statement. This statement reflected the Commission’s view that most swap transactions, although possessing elements of futures or option contracts, were not appropriately regulated as such under the Act and Commission regulations. This was important because the Commodity Exchange Act required all futures contracts to be traded on exchange. The policy statement allowed these transactions to continue trading off-exchange by creating a “non-exclusive safe harbor” for transactions satisfying certain requirements. The safe harbor requirements included five elements: (1) individually-tailored terms; (2) absence of exchange-style offset; (3) absence of clearing organization or margin system; (4) the transaction is undertaken in conjunction with a line of business; and (5) a prohibition against marketing to the public.
On October 28, 1992, the Futures Trading Practices Act of 1992 was signed into law and added section 4(c) to the Act. Section 4(c) authorizes the Commission to exempt any agreement, contract or transaction, or class thereof, from the exchange-trading requirements of section 4(a), or any other provision of the Act, subject to certain conditions. When including the 4(c) exemptive authority in the Act, Congress specifically took note of swap transactions by including in section 4(c) the statement that the Commission may:
promptly following the enactment of this subsection … exercise its exemptive authority … with respect to classes of swap agreements.
Consistent with what appeared to be clear Congressional intent, less than three weeks later on November 12, 1992, the Commission proposed rules generally exempting swap agreements meeting specified criteria from regulation under the Act. These rules were finalized on January 22, 1993 and were adopted as Part 35 of the Commission’s regulations to exempt swap agreements from all provisions of the Act (except fraud and manipulation provisions).
In the late 1990s, the Commission considered whether it was appropriate to review whether regulation of the swaps markets was appropriate. This effort was very controversial at the time and did not get far, as it was not well received by Congress or the Clinton Administration.
Thereafter, in 2000, the Commodity Futures Modernization Act of 2000 added section 2(g) of the Act, which largely excluded swaps from virtually all of the provisions of the Act (including the fraud and manipulation prohibitions).
Throughout this time, and throughout the evolution of organized derivatives markets, clearing has been a hallmark of risk mitigation. Moreover, the Commission has allowed clearing of contracts that had not previously been cleared. For example, on many occasions the Commission has authorized the clearing of agricultural swaps. This has been a positive development for market participants. In addition, the Commission has allowed Clearport to operate, which allowed contracts to be listed for trading on a futures market so that post-execution, swaps traded over-the-counter could be dropped into Clearport for clearing purposes only. I think these steps were positive developments that moved many contracts into clearing.
Another area that could have been of great benefit to market participants if it had taken off was the attempt to move credit event contracts on-exchange. In 2007, CBOE, under the jurisdiction of the SEC, and CME, under the jurisdiction of the CFTC, both listed credit event contracts. These contracts were very similar to credit default swaps which greatly exacerbated the financial crisis. Unfortunately, these products never gained traction. I believe that had credit default swaps moved onto organized exchanges, where they would have been cleared, the risk that these contracts posed to the entire financial system could have been greatly reduced. It remains to be seen how the Dodd-Frank trading and clearing requirements for standardized swaps will alter the landscape.
Generally, a comprehensively regulated clearinghouse should help reduce systemic risks by facilitating the netting of transactions and by mutualizing credit risks. When a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is “novated” to the clearinghouse. As such, the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller. Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function and to avoid losses at the clearinghouse. Moreover, the CFTC has closely monitored these risk management practices at the clearinghouse level and at the futures commission merchant level to ensure risk is properly being managed. The Commission has always recognized that the clearinghouse must protect itself from unnecessary risk, and if it failed to do so, large segments of the markets and market participants could be put at unnecessary risk as well.
Clearinghouses mitigate risk through the daily discipline of marking to the market price, at least once each business day, each position cleared through the use of prices that are independently determined by the clearinghouse. All gains and losses that arise as a result of the mark-to-market process are settled (i.e., paid and received) each day. Clearinghouses also require the daily posting of margin to cover the daily changes in the value of all positions as extra protection against potential market changes that are not covered by the daily mark-to-market. The methodology used by clearinghouses to calculate such margin requirements are subject to regulatory review and approval.
With respect to CFTC regulated clearinghouses, it should be noted that they are subject to the requirements of the Commodity Exchange Act (as amended by the Wall Street Transparency and Accountability Act of 2010). These statutory requirements include the requirement to register with the CFTC and the compliance, at all times, with eighteen core principles, as augmented by Commission regulations, a number of which are in the process of being written to manage the process by which swaps will be moved into a cleared environment.
With the mandated use of a regulated clearinghouse coupled with effective risk management practices, the failure of a single large trader, like AIG, would be much less likely to jeopardize all of the counterparties to its trades. I must stress, however, all risk is not eliminated, but it is substantially reduced. One of the lessons that emerged from the recent financial crisis was that institutions were not just “too big to fail,” but also too interconnected through non-transparent swaps that the institutions did not effectively manage. By mandating the use of central clearinghouses, institutions would become much less interconnected, mitigating risk and increasing transparency. Throughout this entire financial crisis, trades that were carried out through regulated exchanges and clearinghouses continued to be cleared and settled.
After the financial crisis in 2008, consensus formed quickly that the CFTC’s regulatory authority should be extended to OTC derivatives and that transparency must be brought to these markets.
It may not be a secret that I was not supportive of some of the mandates included in Dodd-Frank. The parallel I like to give is to knowing you need regulatory reform to knowing you need to lease a new car. If you know that you are only financially capable of leasing a Honda Accord, it is probably not a good idea to go to the Bentley, Lamborghini and Rolls Royce dealerships. The car we leased is one we cannot afford. Nevertheless, in a post Dodd-Frank world, we are tasked with establishing comprehensive regulation of the OTC swap markets by July 2011. This comprehensive regulatory framework will be specifically designed to regulate both the OTC derivatives dealers and the OTC derivatives markets on which these products will trade. In this regard, Dodd-Frank:
Many of these areas are much more complex than they may first appear. Adding to the complexity, many of the provisions require multi-agency coordination, and joint rules to be proposed by the CFTC and the SEC. Historically, the SEC and CFTC have not been very successful proposing joint rules, even when directed by Congress to do so. This time, however, may actually be different. Last year, as part of Treasury’s effort to develop a framework for regulatory reform, the CFTC and the SEC were required to submit a report to Congress identifying conflicts in how the two agencies regulate similar financial products and to either explain why those differences further important policy goals, or recommend resolutions. The mandates of the two agencies are very different so naturally there are features that are unique to the markets we each oversee, but the focus of the Report was on identifying areas of blurred jurisdictional lines, or places where regulatory gaps exist. Beyond preparing the joint report and submitting it to Congress, for the first time ever, the agencies held joint meetings last September with the participation of nine sitting commissioners, and earlier this year, formed a Joint Advisory Committee that is currently examining the market events of May 6th.
I am hopeful that the new spirit of cooperation between the two Commissions and the leadership of Gary Gensler and Mary Shapiro will lead to continued progress and to seamless joint rule proposals. Without continued progress and consistent joint rule proposals, the agencies risk injecting additional uncertainly into an already complex process by which OTC markets and participants will come under the regulatory regimes of one or both agencies. In my view, additional uncertainty could be devastating and I will do all I can to avoid such an outcome.
One of the areas that has caused a great deal of concern among many market participants is whether they will be classified as a swap dealer or major swap participant. Such a classification brings with it the imposition of capital, margin, recordkeeping and retention and business conduct rules, and rules for segregating customer funds. Currently six rule writing teams are working on this area. One is working on a series of definitions, including swap dealer and major swap participant, one is working on registration requirements, and others are working on business conduct standards, capital, margin, and segregation issues.
The CFTC’s Chairman has stated that initial estimates are that there could be in excess of 200 entities that will be swept up into the definition of swap dealer based upon current ISDA primary member status. Registering and regulating that many swap dealers will be a huge task for the CFTC and will have very important implications for those entities and their businesses. Comparatively, we now have about 127 FCMs that are registered with the Commission. In my view it is critical that we ensure that this new regulatory regime intersects seamlessly with our existing regime to ensure that registrants and their customers suffer no disruption in their business and hedging strategies. I have asked staff to estimate the number of entities that may be swept into the definition of major swap participant. Unfortunately, they have not yet been able to do so. This uncertainty raises concerns about ensuring a disruption-free transition, an issue that the Commission and staff will be closely monitoring.
An area that I am very interested in, as are many other market participants, is what the requirements of trading swaps on a SEF will be. The CFTC and SEC heard a great deal of concern about this issue from market participants at a joint roundtable on September 15th. CFTC staff has recently estimated that 30-40 entities will register as SEFs or designated contract markets. The designated contract market model is easy for the Commission and market participants to deal with. We know how they work, and market participants know how they work. SEFs are new, and the relevant statutory language is not very clear. When you read the new statutory language in conjunction with existing statutory language, it raises some questions.
Section 1(a)(34) of the CEA defines “trading facility.” It is a definition that the CFTC and market participants have been working with for years. In essence, a trading facility is a physical or electronic facility or system wherein multiple participants can execute or trade agreements by interacting and accepting bids or offers of multiple other participants. A many-to-many type model.
In defining what a SEF is in Section 721 of Dodd-Frank, Congress did not require that a SEF be a trading facility. Instead, Congress defined a SEF as a “a trading system or platform” in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that (A) facilitates the execution of swaps between persons; and (B) is not a designated contract market." (emphasis added).
So clearly, by this definition Congress intended that a trading facility could be a SEF, but that a SEF did not have to be a trading facility because Congress used the words “trading system or platform” to define SEFs. In my view, by introducing the term “trading system or platform” when we already have “trading facility” as a defined term means that Congress must have intended a SEF to be different from a trading facility.
I favor the view expressed by many participants at the September 15th roundtable that the definition of SEF must encompass multiple models and must be flexible enough to allow several ways to buy and sell contracts on SEFs. After all, our goal is to encourage market participants to execute transactions on exchanges and SEFs. If we are overly restrictive and inflexible when establishing the SEF model, the Commission will be acting in a manner contrary to its own goal of moving swaps onto exchanges or SEFs and will do so to the detriment of market participants and the public. This would not be my favored outcome.
As for the clearing mandate in Dodd-Frank, the Commission is working to establish a framework for the clearing of OTC swaps. The Commission has a great deal of authority in this area, and can make the ultimate determination of whether a swap must be cleared. Generally, Dodd-Frank requires DCOs to submit to the Commission “each swap, or any group, category, type, or class of swaps” that it plans to accept for clearing. Dodd-Frank requires the Commission to adopt rules for review of a swap, (including a group, category, type, or class of swaps) that will be submitted for clearing and sets out a 90-day deadline for the Commission to conduct such a review. In addition, Dodd-Frank requires the Commission to review on an ongoing basis swaps not submitted by a DCO for clearing, to determine whether they should be required to be cleared. The Commission is working through these issues and is also working through allowable exemptions from clearing for end-users. The authority to review swaps and determine what must be cleared is new authority for the Commission. In my view, clearinghouses are best equipped to make these determinations by evaluating the risks involved with each contract. It is my hope that the Commission does not use its new authority to completely substitute its judgment for the judgment of clearinghouses. I view this new authority as a tool for the Commission to make sure that clearing requirements are not being purposefully evaded, and to prevent a situation where contracts that should be cleared are purposefully not cleared in order to gain some financial advantage.
I mentioned two issues earlier that I described as unrelated to “big ticket” market structure items such as exchange or SEF trading requirements, clearing requirements, who will be a swap dealer or major swap participant, what business conduct standards will apply, and transparency and reporting requirements. The first of these issues relates to the future of the flexible Core Principles regime under the Commodity Exchange Act. The Core Principles were designed to allow exchanges and clearinghouses flexibility in the manner in which they complied with the Core Principle requirements. On occasion, the Commission published Acceptable Practices for some Core Principles that were designed as guidance or as a “Safe Harbor” for compliance purposes. If an exchange or clearinghouse strictly complied with the Acceptable Practices, it was deemed to be in compliance with the Core Principle. DCMs and DCOs also had “substituted compliance” available to them, whereby they could fashion their own manner in which to comply with the Core Principles. This was a flexible approach, and in my view it worked rather well. Certainly nothing that happened during the financial crisis resulted from the CFTC’s flexible Core Principle approach to regulation. While the Core Principle regime worked well, the new Core Principles have very important language added to them by Dodd-Frank. This language states that, unless otherwise determined by the Commission by rule or regulation, a board of trade, a SEF, or a clearinghouse, shall have reasonable discretion in establishing the manner of compliance with Core Principles. You can find this language in Sections 725, 733, and 735 of Dodd-Frank. This language gives the Commission the authority to take away the ability of entities to establish their own flexible manner of compliance. In essence, if the CFTC chooses to be completely “rules based” it can do so.
The second of these issues is that separate from promulgating rules relating to Core Principles, the Commission has been given broad authority to promulgate rules to mitigate conflicts of interest. The Commission will be voting this Friday on proposed conflict of interest rules that address voting equity rights and Board of Director composition for DCMs, DCOs, and SEFs. I expect these proposed rules to be very broad and far reaching, more far reaching than Commission has ever gone in this area.
There are many other issues I can talk about, but I wanted to finish up with a brief discussion of position limits. In January the Commission proposed position limits for certain energy contracts. I had grave concerns about the proposal and was the only Commissioner to vote against the proposal. I must say, I still have grave concerns in this area.
Since the early 1990s, there has been an influx of new traders into the futures markets, including investors seeking exposure to commodities as an asset class through passive long-term investment in commodity index funds. Since that time, the Commission has granted hedge exemptions from federal position limits to swap dealers who offset their net price risk resulting from a combination of OTC activities, which may include acting as counterparties to index traders, as well as to traditional commercial entities such as airlines hedging their fuel costs through customized swaps, and speculators seeking to gain price exposure.
As prices escalated in 2007 and 2008, concerns were raised about whether money flowing into the futures markets from index trading was artificially inflating commodity prices and whether speculators were exceeding position limits and accountability levels by entering into transactions with swap dealers. To better understand the activities of index traders and swap dealers and their potential to influence futures markets, in 2008 the Commission began requiring these entities to disclose their OTC activities to the CFTC, and now quantifies and publishes index investment data on a monthly basis.
Last year, Commission staff withdrew two no-action letters which had granted relief from federal speculative limits in wheat, corn, and soybeans to entities offering index fund investment strategies. This no-action relief was not consistent with the traditional commercial hedge exemptions we typically grant and was considered not consistent with the implementation of hard position limits across all commodities as we are now required by Dodd/Frank to impose on agricultural and energy commodities.
The issues surrounding position limits and hedge exemptions are enormously complex. Every market has its own characteristics so what works for soybean markets, for example, may not be appropriate for natural gas markets. And trading linked to commodity indexes, exchange traded funds and exchange traded notes presents a whole new and different set of questions for us as regulators.
Complicating all of that are the provisions of Dodd-Frank. The CFTC and SEC have 360 days to issue regulations establishing swap data repositories to which swap data will be reported. The Commission has 180 days for energy and 270 days for agriculture to propose aggregate position limits across futures markets and equivalent OTC markets. The problem is, Dodd-Frank requires us to propose position limits months before a mechanism is in place for obtaining the necessary data from the OTC swap markets. In order to propose appropriate limits, we must know the size of these markets. Without the necessary data for OTC markets, we will not really have all the information we need to propose appropriate limits. But, the law is the law so we will propose limits and hope they are at such a level that they do not cause damage to these markets.
One other area about position limits is noteworthy. Section 737 of Dodd-Frank states: “In establishing the limits required under subparagraph (A), the Commission shall strive to ensure that trading on foreign boards of trade in the same commodity will be subject to comparable limits and that any limits to be imposed by the Commission will not cause price discovery in the commodity to shift to trading on the foreign boards of trade.”
This is a great goal, but I am not exactly sure how we achieve it. I am mindful of the danger of driving markets overseas with inconsistent regulations and will do all I can to ensure that does not happen. To that end we are working closely with our international regulatory counterparts. Just last week at a public hearing on the Markets in Financial Instruments Directive, European Commission member Michel Barnier called for position limits to “counter the excessive movement” in commodity prices and on Tuesday of this week our Chairman Gary Gensler was in Brussels to stress the importance of global consistency. I hope to continue this progress with our colleagues toward establishing some sort of global standard for position limits. And broadly speaking, I hope to continue the dialogue with both the EU and the Japanese FSA at the CFTC’s Global Markets Advisory Committee meeting on Tuesday of next week.
It goes without saying that market regulators have their hands full. Achieving these reforms will take time and comprehensively changing the regulatory landscape in such a short time period will not be easy. I recognize that it is imperative that we get it right and that our goal as regulators is “smart regulation”. We can do damage to these vital markets without that goal. I fully intend to do all I can to make sure we don’t get it wrong and that our markets continue to thrive.
Thank you for having me here today and thank you to the Capital Markets Consortium for organizing this important and informative conference.
Last Updated: January 18, 2011