March 7, 2011
Thank you for inviting me here today to discuss the new regulatory landscape for swaps transactions under the Dodd-Frank Wall Street Reform and Consumer Protection Act. It seems your annual Washington conference could not have come at a better time to hear from legislators and regulators on the implementation of Dodd Frank. To say that the Act presents a large number of complex issues for market participants and regulators is an understatement. At my last count, the Commission had published 55 proposed rules, notices, or other requests seeking public comment on Dodd-Frank related issues. Other important items on our agenda, including proposed rules setting capital and margin requirements for swap dealers (SDs) and major swap participants (MSPs), and a joint proposal with the Securities and Exchange Commission (SEC) defining swaps and security-based swaps, remain in the queue. Given our limited time this afternoon, I will focus on just a few of the issues that I believe are of particular interest to this organization.
In preparing for this talk I reviewed the IIB’s comment letter filed in response to the CFTC’s proposals for defining and registering SDs and MSPs, in which you emphasized the importance of establishing an appropriate regulatory framework for the cross-border swaps activities of foreign banks. As Chairman of the Commission’s Global Markets Advisory Committee this issue is also of particular interest to me, and I couldn’t agree with you more.
As the Supreme Court recently reaffirmed in Morrison v. National Australia Bank, Ltd., 130 S.Ct. 2869 (2010), it is a longstanding principle of American law that unless Congress clearly expresses an affirmative intention to give a statute extraterritorial effect, “we must presume it is primarily concerned with domestic conditions.” Id. at 2877 (internal quotation marks omitted). In Dodd-Frank Congress did express intent for the statute to apply to activities abroad in certain circumstances, but unfortunately the reach of that intent is not crystal clear. Specifically, Section 722(d) of Dodd-Frank states that the provisions of the Act shall not apply to activities outside the U.S. unless those activities (1) have a direct and significant connection with activities in, or effect on, U.S. commerce, or (2) contravene rules or regulations the Commission may prescribe to prevent the evasion of any of the Dodd-Frank requirements. While this gives us some direction, the Commission has not yet addressed how broadly or narrowly it intends to interpret the scope of this limitation.
As your comment letter observes, there are a number of ways in which cross-border swaps markets currently operate, ranging from foreign banks that deal directly with U.S. customers, to transactions between non-U.S. affiliates of a U.S. person. I believe most people would agree that when a foreign bank deals directly with U.S. customers its connection to U.S. commerce is direct and significant within the meaning of Section 722(d) and should give rise to a registration requirement. On the other hand, there are good arguments for not requiring the registration of a foreign bank that conducts business indirectly with U.S. customers through a U.S.-registered affiliate, where the affiliate is responsible for Dodd-Frank compliance with respect to those customers. I believe the CFTC should not be directly involved in regulating transactions that are international in scope but only tangentially related to U.S. markets.
Your comment letter raises other important issues that must be resolved, such as the allocation of supervisory responsibility between and among foreign and domestic regulators for the cross-border banking operations of foreign banks, and whether the Federal Reserve Board’s practice of deferring to home country supervision with respect to capital and margin will carry over in a post Dodd-Frank world. There is no settled opinion on how jurisdictions will split supervisory responsibility for swap entities and swaps transactions that span multiple jurisdictions. The CFTC has a long history of recognizing comparable regulatory structures when it comes to cross-border issues, and I am hopeful that our experience in this area and the relationships we have developed with foreign regulators will be helpful in structuring a rational regulatory regime for global swaps markets.
Setting the precise scope of Dodd-Frank with respect to the cross-border activities of foreign banks is crucial to preserving the continuity of global business operations and the risk management tools that swaps provide. Harmonizing our rules to the greatest extent possible with the SEC, other U.S. regulators and our foreign regulatory counterparts is necessary for ensuring that we accomplish the overall objectives of reducing systemic risk and limiting opportunities for regulatory arbitrage. As required by Dodd-Frank, and in keeping with the commitments reached by the G-20 Leaders in Pittsburgh in September of 2009, Commission staff has been in constant contact with our counterparts in London, the European Union (EU) and elsewhere. This has proven very successful in eliminating many differences that have existed throughout the legislative process in several jurisdictions. However, there are still some critical inconsistencies that must be resolved.
Through our participation in the International Organization of Securities Commissions (IOSCO), the CFTC is co-chairing the Task Force on over-the-counter (OTC) Derivatives with the U.S. SEC, the UK FSA and the Securities and Exchange Board of India. The task force was launched in October of 2010 and in response to a request from the Financial Stability Board, the task force issued its first Report on Trading of OTC Derivatives on February 18, 2011. The report analyzes the benefits, costs, and challenges associated with increasing exchange and electronic trading of OTC derivative products and contains recommendations to assist the transition of trading in standardized derivatives products from OTC venues onto exchanges and electronic trading platforms. The Report is in response to the G-20 Leaders’ commitments on this issue and their stated objectives of improving transparency, mitigating systemic risk, and protecting against market abuse in the derivatives markets. The task force will produce two further reports, one on Data Reporting and Aggregation and another on International Standards. All three of these reports will address some of the most controversial issues that decision makers will face while creating a regulatory framework for OTC Derivatives. The challenge lies in building a consistent philosophy for how the pieces of this framework will fit together while maintaining the ease of cross-border swaps activities.
One of my primary concerns is that the CFTC is moving out of step in time, substance, or both with the SEC and the rest of the world in implementing trade execution requirements for standardized swaps. Through discussions it is becoming clear to me than any execution requirement, if enacted in foreign jurisdictions, will not be in place before the end of 2012 as envisioned by the G-20 deadline. The European Commission (EC) is still in the consultation phase on revising its Markets in Financial Instruments Directive (MIFID) to introduce such a requirement, and the proposal it is considering is fundamentally different from the model proposed by the CFTC for swap execution facilities (SEFs). The MIFID revisions, if they are adopted, may allow swaps to be executed through single dealer platforms. The SEC’s proposed rule likewise would allow requests-for-quotes (RFQs) to be sent to a single dealer, or to multiple dealers depending on the end-user’s preference. The proposal issued by the CFTC would require RFQs to be sent to at least five dealers. I support the more flexible approach being considered elsewhere.
The goals for SEFs as expressed in Dodd-Frank are “to promote the trading of swaps on swap execution facilities and to promote pre-trade price transparency in the swaps market.” In my view, the best way to achieve these twin goals is to adopt a model that provides the maximum amount of flexibility as to the method of trading for swaps, whether cleared, uncleared, liquid or bespoke. The CFTC’s proposal reflects an overly restrictive reading of the statute and I voted against it. Hopefully, after considering the public comments, the Commission will be persuaded to adopt final rules that are consistent with the views of our fellow regulators.
Another area of inconsistency which is of concern to me is the setting of position limits. The Dodd-Frank Act authorizes the Commission to establish position limits as appropriate for futures, options, economically equivalent swaps and swaps that serve a significant price discovery function. These limits must be aggregated across all markets in the same commodity, including contracts listed on foreign boards of trade that are linked to U.S. contracts. The statute also directs that in setting such 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 . . . imposed by the Commission will not cause price discovery in the commodity to shift to trading on the foreign boards of trade.”
In January the Commission proposed the establishment of position limits on physical commodity derivatives in two phases: the initial transitional phase would set spot-month position limits only; the second phase would add non-spot-month position limits consisting of aggregate single-month and all-months-combined limits that would apply to futures and options and all swaps. We proposed these aggregate position limits for futures, options and swaps despite the fact that we lack data on the size of the swaps markets. In the absence of reliable data, I do not believe that we are in a position to set effective limits. I objected to the proposal for this reason, among others, including our failure to engage in any analysis as to whether setting limits in the U.S will potentially drive business overseas. While the EC is, for the first time, considering the use of position limits, there are fundamental differences from the CFTC’s approach. In general, the EC has proposed only to give EU national regulators the option of setting position limits, and has suggested that it possibly may require limits only for agricultural commodities. CFTC staff is continually speaking with staff at the EC to inform them of our experience with a position limit regime.
The Commission has also departed from the EC in its approach to addressing conflicts of interest that may arise in connection with the execution or clearing of swaps. I fully support the imposition of rational governance rules for clearing houses and other market infrastructures, including strong rules for mitigating conflicts of interest, but I question the sensibility of the voting equity and ownership limitations proposed by the Commission last October. In my view, the limits are not necessary or appropriate to address the perceived conflicts and may do more harm than good to the emerging marketplace for trading and clearing swaps. I agree with the view expressed by the EC in its September 2010 proposal that such limitations on ownership may have “undesirable consequences on market structures.”
Before I close I would like to address the timing and order of the Commission’s regulatory proposals, and the implementation of final rules, which the IIB and many others have commented on. The aggressive deadlines Congress gave us for promulgating the Dodd-Frank rules has put regulators and market participants in the difficult position of processing a massive amount of highly complex information in a brief period of time. Complicating matters, the proposals issued by the Commission have not followed a logical progression, beginning with basic definitions and building from there. Without final rules defining the entities and products covered by Dodd-Frank, market participants cannot know for sure whether their activities will be captured and whether or how they should comment on various proposals. I understand the benefits that legal certainty would provide during this time of extreme ambiguity. I would support a process that would extend comment periods for rules that use terms that were not defined when the rules were proposed to give all parties a meaningful opportunity to comment. It is also my hope that we phase in the implementation of final rules to allow realistic timeframes for coming into compliance. A mass exodus from the markets due to an inability to comply with unrealistic deadlines is not in the public’s interest. I believe we can avoid this type of adverse consequence by recognizing diverse market structures and adopting a flexible approach to accomplishing our objectives.
Finally, before finalizing any new rule it is imperative that the Commission conduct a thorough and meaningful cost-benefit analysis. The proposals we have issued thus far contain cursory, boilerplate cost-benefit analysis sections in which we have not attempted to quantify the costs because we are not required to do so under the Commodity Exchange Act. All we are required to do under the Act is to “consider” the costs; we need not determine whether the benefits outweigh the costs.
From a good government perspective, while it is true that the Commodity Exchange Act does not require the Commission to quantify the cost of a proposal, or to determine whether the benefits outweigh the costs, the Act certainly does not prohibit the Commission from doing so. We simply have chosen not to.
Clearly, when it comes to cost-benefit analyses, the Commission is merely complying with the absolute minimum. That is not in keeping with the spirit of the President’s recent Executive Order on “Improving Regulation and Regulatory Review.” We owe the American public more than the absolute minimum. As we add layer upon layer of rules, regulations, restrictions and new duties, we should be attempting to quantify the costs of what we are proposing. And we should most certainly attempt to determine whether the costs outweigh the benefits. The public deserves this information and deserves the opportunity to comment on our analysis. I am hopeful that this analysis will be undertaken before we get to the stage of finalizing these rules.
I believe one of the most important components of this new regulatory landscape for swap transactions is to achieve global consistency and cooperation. Most of the proposals we have published have some correlation to the global marketplace. Although the CFTC is engaging in regular dialogue with other international regulators, I encourage you all to stay involved in the process. Your substantive comments, counsel and recommendations are an important part of public consultation. I believe we must maintain clear sight of our global objectives of improving transparency, mitigating systemic risk and protecting against market abuse in the derivatives markets as we address the challenges in front of us.
Thank you for inviting me to speak today.
Last Updated: March 7, 2011