October 21, 2010
Good morning. It is an honor to be here today at the 3rd Annual Risk Management in Energy Trading Conference to discuss the current state of regulatory reform at the Commodity Futures Trading Commission (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.
But first, a little background. Commodity futures markets have existed in the U.S. since the 1800s and have been regulated at the federal level in one form or another since the Cotton Futures Act was passed in 1916. The Grain Futures Act of 1922 followed, which was replaced by the Commodity Exchange Act (CEA or Act) in 1936. At that time, futures markets were confined to agricultural products and so oversight logically fell to the Department of Agriculture. By the 1970s, when Congress created the CFTC as an independent regulatory agency, most futures trading was still limited to the agricultural sector and swaps markets had not yet developed. Exchange trading took place in open outcry pits where floor brokers wearing colorful jackets flashed hand signals and jostled each other for position. Back then, co-location meant that a firm’s trading desk was closer to the pit than another firm’s desk, or a firm’s broker was taller than other traders and more easily seen by potential counterparties. While a small percentage of trading is still devoted to agricultural products and limited open outcry trading still exists, today’s markets include a vast array of futures and options on financial, energy and metals products executed at lightning speed through electronic networks. Over the past 20 years, trading in over-the-counter (OTC) derivatives or swaps, which can serve as substitutes for or be economically equivalent to futures contracts, also gained traction. These markets now dwarf exchange traded futures.
As the markets evolved, so did regulation. While the CFTC’s mission has always been to protect and foster the crucial risk management and price discovery functions of futures markets by detecting and deterring fraud, manipulation and abusive trading practices, Congress has amended the Commission’s mandate in significant ways over the years to respond to changing market conditions and prevailing regulatory philosophies.
In 1992, taking note of the developing swaps markets, Congress gave the CFTC authority to exempt certain transactions from any provision of the CEA, including the exchange trading requirement, in order to promote responsible economic or financial innovation and fair competition. In response the Commission adopted Part 35 of its regulations, which exempted swaps transactions meeting certain specified criteria from all provisions of the Act except those prohibiting fraud and manipulation. As the OTC swaps markets continued to develop, however, the line between legal OTC instruments and illegal off-exchange futures contracts began to blur. In 1998, the CFTC issued a concept release seeking public comment on whether it should reexamine its approach to the OTC derivatives markets. This was not well received by Congress or the Clinton administration and led to legislation preventing the CFTC from taking further action.
Then, in 2000, Congress passed the Commodity Futures Modernization Act, which replaced the CEA’s one-size-fits-all, rules-based regulatory regime with a flexible, principles-based regime, and gave legal certainty to the OTC markets. It did this by requiring exchanges and clearinghouses to comply with broad Core Principles as self-regulatory organizations, while tasking the CFTC with oversight responsibility. Lesser levels of regulation were allowed for sophisticated market participants trading in products other than agricultural commodities (although the CFTC retained its power to exempt agricultural products under appropriate circumstances, which it continued to do). And importantly, for the first time, standardized OTC derivatives were allowed to be cleared. In the energy sphere, the new regulatory landscape led to a proliferation of dealer markets (known as one-to-many markets), which were excluded from regulation, and a number of exempt commercial markets in which multiple participants could transact electronically with multiple other participants (known as many-to-many markets), which were lightly regulated. It also led to an increasing percentage of swaps being cleared.
Fast forward to 2010. It seems we have come full-circle. Generally, the headline from Dodd-Frank is that swaps will now be subject to stringent regulatory oversight. In particular, Dodd-Frank:
Another big ticket item from Dodd-Frank is that federal speculative position limits must be promulgated, as appropriate, for all futures, options and economically equivalent swaps positions based on physical commodities, and for swaps that perform a significant price discovery function. These limits must apply in the aggregate across all markets in the same commodity.
To implement this massive regulatory restructuring, the Commission has formed 30 rule writing teams that will draft dozens of regulations under very tight deadlines required by Dodd-Frank. Generally, most rules must be finalized within 360 days of bill’s enactment. Certain rules, including those governing position limits, must be finalized sooner—180 days for energy and metals products and 270 days for agricultural products. The challenges that regulators face in implementing this many rules within the statutory deadlines are unprecedented. In many of the rule writing areas there are currently more questions than answers, and the questions surrounding most issues are enormously complex.
Adding to the complexity, many of the provisions require multi-agency coordination, and joint rules to be promulgated by the CFTC and the Securities and Exchange Commission (SEC). Historically, the SEC and the CFTC have not been very successful in adopting joint rules, even when directed to do so by Congress. 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 joint report to Congress identifying conflicts in how the two agencies regulate similar financial products and to either explain why those differences furthered 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. The focus of the report, however, was on identifying areas of blurred jurisdiction or regulatory gaps. To assist in preparing the report the agencies held joint meetings for the first time ever, 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. CFTC and SEC staff continue to collaborate on rulemakings and have held several joint roundtables to solicit the views of the public. I am hopeful that the new spirit of cooperation between the two Commissions under the leadership of Gary Gensler and Mary Shapiro will result in continued progress and seamless joint rule proposals. Without such progress and consistency, the agencies risk injecting additional uncertainty into an already complex process.
One area that has caused a great deal of concern among many market participants is whether they will be classified as swap dealers or major swap participants. As I mentioned, this classification brings with it the imposition of capital, margin, recordkeeping and business conduct requirements, and rules for segregating customer funds. Six rule writing teams are currently working in this area. One is working on a series of joint CFTC-SEC definitions, including those for swap dealer and major swap participant, and others are working on business conduct standards, capital, margin and segregation issues.
The CFTC’s Chairman has estimated that more than 200 entities could be swept 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 registered FCMs. I have asked staff to estimate the number of major swap participants that may have to register, but they have not yet been able to do so. In my view, it is critical that the new regulatory regime for swap dealers and major swap participants intersect seamlessly with our existing regime to ensure that registrants and their customers suffer no disruption in their business and hedging strategies. This is an area that the Commission and staff will be closely monitoring.
Another area I am very interested in, as are many market participants, is whether the model for SEF trading will be broad or narrow in scope. The CFTC and SEC heard a great deal of concern about this issue from market participants at a joint roundtable on September 15th. A member of the Commission’s Technology Advisory Committee stated at a meeting last week that more than 100 entities may seek SEF registration. While the DCM central limit order book model is well understood and easy for the Commission and market participants to work with, SEFs are new and the legislation defining SEFs is not very clear. Until the SEF model is further defined by the Commission, the impact on current methods of OTC trading will be unknown.
The statutory language governing SEFs requires that multiple participants have the ability to execute swaps with multiple other participants through a “trading system or platform,” including a “trading facility.” The term “trading facility” is defined in the Act, but the terms “trading system” and “platform” are not. By introducing these new, undefined terms into the Act, it appears that Congress contemplated a model that is broader in scope than the “trading facility” model, which is one type of many-to-many market. I support the view expressed by many participants at the September 15th roundtable and last week’s Technology Advisory Committee meeting that the SEF definition must encompass multiple models and be flexible enough to allow several ways to buy and sell contracts. After all, the goal is to move the execution of bilateral swaps to transparent markets. If we are overly restrictive and inflexible when establishing the SEF model, we run the risk of preventing certain mechanisms for trading, such as requests for quotes, from migrating to SEFs.
While I am on the subject of flexibility, I would like address an area that has not received much attention so far, which is the future flexibility of the CEA’s Core Principles regime. The Core Principles were designed to allow exchanges and clearinghouses flexibility in the manner in which they complied with the requirements for operation. DCMs and DCOs could demonstrate compliance by following guidance and acceptable practices published by the Commission. The acceptable practices operated as safe harbors; if a DCM or DCO strictly followed an acceptable practice, it was deemed to be in compliance with the Core Principle. Exchanges and clearinghouses remained free, however, to fashion their own methods of compliance so long as they satisfied the Commission that their chosen method was sufficient to protect the functioning of the markets. This was a flexible approach, which in my view, worked rather well. Certainly nothing that happened during the financial crisis resulted from the CFTC’s flexible Core Principles approach to regulation. While Dodd-Frank retained Core Principles for DCOs, DCMs, and now SEFs, it added new authority which allows the CFTC to prescribe rules for compliance. Specifically, Dodd-Frank provides that, unless otherwise determined by the Commission by rule or regulation, DCMs, DCOs and SEFs shall have reasonable discretion in establishing the manner of compliance with Core Principles. In essence, if the CFTC chooses to be completely “rules-based” it can do so.
There are many other issues I can talk about, but I wanted to finish up with a brief discussion of position limits. In January of this year, the Commission proposed speculative position limits for certain energy contracts, which were later withdrawn given the new requirements for position limits under Dodd-Frank. I had grave concerns about the proposal and was the only Commissioner to vote against it. I must say that I still have grave concerns in this area.
As I mentioned earlier, Dodd-Frank gave the Commission 180 days to establish position limits for energy contracts and 270 days to establish limits for agricultural contracts. These limits must be applied on an aggregate basis across all markets offering the same commodity, and to swaps that are economically equivalent to futures or that serve a significant price discovery function.
In an effort to begin gathering the data we need to calculate the position limits, the Commission approved a proposal on Tuesday to establish a large trader reporting system for OTC swaps that would require clearing organizations, their members and swap dealers to report positions on economically equivalent swaps to the Commission on a daily basis. Eventually we hope swap data repositories will have the data on which to base position limits, but until then we need to rely on this reporting system. This is where it becomes challenging for us. I believe that, optimistically, the earliest that reporting to SDRs can occur is towards the end of 2011, well after the limits are imposed. We must somehow calculate the size of these markets, but we will not have complete information until SDRs are up and running.
During the Open Meeting on Tuesday, the Commission discussed Section 737 of Dodd-Frank, which states that the Commission shall by rule, regulation, or order establish limits on the amount of positions, as appropriate, that may be held by any person. Our General Counsel stated that he believed we may have some flexibility in meeting the deadlines because of the “as appropriate” language. In my view, no position limit is appropriate if it is imposed without the benefit of receiving and fully analyzing complete data concerning the open interest in each market.
The Commission is tentatively planning a November 30 public meeting to vote on proposed speculative position limits for exempt and agricultural commodities. I am hopeful the Commission will consider utilizing the flexibility in the statutory language to delay the implementation of position limits until we can properly calibrate an appropriate limit for each market through the information we will get from SDRs.
One other issue concerning position limits is noteworthy. Section 737 of Dodd-Frank also states that, “[i]n establishing the limits . . . 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.” That is an admirable goal, but I am not exactly sure how we achieve it. Recently, European Commission member Michel Barnier called for position limits to “counter the excessive movement” in commodity prices and although we are working closely with our international regulatory counterparts on many fronts, identical rules may not always be possible. 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, earlier this month I chaired a meeting of the CFTC’s Global Markets Advisory Committee, where representatives of the European Commission and the Japanese FSA described their ongoing regulatory initiatives. While I was encouraged by the number of areas where we seem to be on the same page, the United States is clearly moving ahead to implement our G-20 commitments in areas such as mandatory execution of standardized OTC derivatives on exchanges or platforms. Other jurisdictions seem to feel that this type of market evolution is better suited to incentives rather than prescriptive rules. Global consistency is an integral part of the success of such sweeping changes to financial regulation. It is very important to me and I hope to continue to play a role that effort.
The new regulatory regime will have profound implications for the way energy traders do business. It may not be a secret that I was not supportive of some of the mandates included in Dodd-Frank. The futures markets worked well throughout the financial crisis. While there was certainly room for improvement, I am skeptical that the benefits will outweigh the costs in certain areas.
An analogy I like to give is to leasing a car. When you know you can only afford 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 not one we can afford given our current resource restraints. It is estimated that we will need to add hundreds of qualified staff to the agency in order to properly implement the new statutory provisions. Yet, we are not certain Congress will approve the budget to allow us to do that. Nevertheless, in a post Dodd-Frank world we are tasked with establishing comprehensive regulation of the OTC swaps markets by July 2011.
To get this done, the Commission will continue to roll out proposed rulemakings throughout the rest of the year. We need your input to get it right, so please participate in the comment periods. Mailboxes for receiving comments in each of the 30 rulemaking areas are set up on the Commission’s website at cftc.gov. Achieving these reforms in such a short time period will not be easy. We will all have to work overtime in the coming months. But I am committed to getting it right and recognize that our goal as regulators is “smart regulation.” We can do damage to these vital markets without keeping that goal in mind. I fully intend to do all I can to make sure that we do not get it wrong and that our markets continue to thrive.
Thank you for having me here today and to Marcus Evans for organizing this important and informative conference.
Last Updated: January 18, 2011