April 6, 2011
Good morning and thank you Kevin 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 (Dodd-Frank or Act). It looks to me that the agenda for the next two days is very relevant to what we at the CFTC have been working on to implement Dodd-Frank. The coming changes in the regulatory structure will be very technology-intensive and will require increased risk-based assessments surrounding the clearing and trading of products. I am glad to see that these areas are prominently featured in the agenda.
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 more than 50 proposed rules, notices, or other requests seeking public comment on Dodd-Frank related issues. Despite this, very important items on our agenda, including a joint proposal with the Securities and Exchange Commission (SEC) defining swaps and security-based swaps, proposed rules setting capital and margin requirements for swap dealers and major swap participants , as well as segregation and bankruptcy treatment for cleared over-the-counter (OTC) derivatives are still being debated and drafted internally. Some of these are critical lynchpins to the entire regulatory regime that is being created, and I find it very unfortunate that we have not yet issued these proposals.
If one attempted to simply explain the focus of this new regulatory regime, I think you could say that the focus is generally on three areas: reporting transactions; clearing transactions; and executing transactions on organized platforms. Within these three broad areas, however, there are a myriad of critical issues that we have been working on for nearly nine months now.
Of these issues, market participants seem particularly interested in who will have new duties as a result of the new regime, and what products will be subject to the regime. To state it more simply, the question is, who will be a swap dealer (SD) and who will be a major swap participant (MSP)?
On December 1, 2010, the CFTC and SEC proposed a joint rule to further define the terms “swap dealer,” “major swap participant,” “security-based swap dealer,” “security-based major swap participant” and “eligible contract participant.” The comment period closed on February 22, 2011. As of last Friday there were 186 comments in the comment file.
The criteria laid out in the statute for one to be considered a swap dealer are whether one makes a market in swaps, holds itself out as a swap dealer, regularly enters into swaps with counterparties as an ordinary course of business for its own account, or engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps. This statutory definition is very broad, but it does contain two important limitations. First, the CFTC has the authority to designate an entity as a limited purpose swap dealer for a single type or class of swap. Second, the statute directs the CFTC to exempt from designation as a swap dealer any entity that engages in a de minimis quantity of swap dealing.
Last week, CFTC Chairman Gary Gensler testified before the House Agriculture Committee on the CFTC’s progress thus far on rules relating to entity and product definitions. At that hearing, Committee Chairman Frank Lucas noted that that CFTC has proposed very broad and far-reaching definitions, but very narrow interpretations of the exemptions Congress authorized. Chairman Lucas also noted that the spectrum of market participants could be subject to a new and sweeping regulatory regime far exceeds the risks those entities pose to the financial system or their counterparties, resulting in entities that do not threaten financial stability and who had no role in the financial crisis being regulated in the same way as those who do.
I agree with Chairman Lucas. The definitions, as proposed, are very broad, and the exemptions very limited. An important result of proposing such broad definitions is that the breadth of the proposed swap dealer definition will result in most entities being captured as swap dealers and not as major swap participants. In fact, in his Congressional testimony last week, Chairman Gensler testified that only a handful of entities likely would be major swap participants.
The proposed CFTC rule defining swap dealer identifies certain characteristics to be considered when determining whether an entity is a swap dealer. Those characteristics include a recognition that:
• dealers tend to accommodate demand for swaps from other parties;
• dealers are generally available to enter into swaps to facilitate other parties’ interest in entering into those instruments;
• dealers tend not to request that other parties propose the terms of swaps; rather, dealers tend to enter into those instruments on their own standard terms or on terms they arrange in response to other parties’ interest; and
• dealers tend to be able to arrange customized terms for swaps upon request, or to create new types of swaps at the dealer’s own initiative.
Commenters have stated that these criteria are somewhat vague, are potentially subject to a broad interpretation, and do not provide specific enough notice to market participants to determine whether they should register as a swap dealer. I agree.
Moreover, while Congress directed the CFTC to promulgate rules establishing a “de minimis exemption,” the CFTC’s proposal is so limited I doubt market participants will be able to avail themselves of it as Congress intended. Under the proposed rule, an entity will not be entitled to the exemption if:
• the aggregate effective notional amount of its swaps entered into over the prior 12 months in connection with its dealing activities exceeds $100 million;
• the aggregate effective notional amount of swaps entered into with a “special entity” over the prior 12 months exceeds $25 million;
• the entity entered into swaps as a dealer with more than 15 counterparties, other than security-based swap dealers, over the prior 12 months; or .
• the entity entered into more than 20 swaps as a dealer during the prior 12 months.
This de minimis exemption, as proposed by the Commission, is so narrow that it will likely have little impact on market participants. I favor substantially expanding this exemption so that it can actually be utilized as Congress intended.
Because registration as a swap dealer is mandatory, an entity may err on the side of registration to eliminate the risk of an enforcement action where it is unsure whether its activities are captured. I do not believe it is good policy to propose a rule that, if finalized, would create such uncertainty. The regulatory burdens of being a swap dealer or a major swap participant are substantial. The CFTC should not seek to impose them lightly. Nor should we expend our scarce resources overseeing activity that is not systemically important.
Aside from basic definitional issues that have arisen as we work through the process of implementing Dodd-Frank, I would like to raise an issue that has been of concern to me for over two years -the issue of position limits for all physical commodity derivatives. As you know, the Dodd-Frank Act gave the Commission the authority 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 of this year, the Commission issued its second proposal establishing position limits on physical commodity derivatives. We proposed 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 European Commission (EC) is, for the first time, considering the use of position limits, there are fundamental differences from the CFTC’s approach.
The Commission has also departed from Europe in our 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.”
I believe that harmonizing our rules to the greatest extent possible with our foreign regulatory counterparts is necessary for ensuring that we accomplish the overall objectives of reducing systemic risk and limiting opportunities for regulatory arbitrage.
This goal only highlights the importance of an appropriate regulatory framework for cross-border swaps activities. As you know, 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 the CFTC should not be directly involved in regulating transactions that are international in scope but only tangentially related to U.S. markets.
There is no settled opinion on how jurisdictions will split supervisory responsibility for swap entities and swaps transactions that span multiple jurisdictions. I am hopeful that our 20 + year experience with mutual recognition of comparable regulatory structures will be helpful in structuring a rational regulatory regime for global swaps markets.
Since the passage of Dodd-Frank, Commission staff has been in constant contact with our counterparts in London, the European Union and elsewhere. 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.
As I mentioned in a speech I gave last month in Washington, implementing trade execution requirements for standardized swaps is another area where I believe we are moving out of step in time, substance or both with the SEC and the rest of the world. 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 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 SEC’s proposed rule is also different and 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.
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. I believe we may need to re-propose a SEF rule that adopts a more flexible approach that would be consistent with the SEC and other regulators around the world.
Before I close I would like to address the timing and order of the Commission’s regulatory proposals, and the implementation of final rules, an area I encourage the public to comment on. The aggressive deadlines Congress gave us for promulgating the Dodd-Frank rules have 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, I would like to touch on the importance of a meaningful and thorough 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. 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.
And because independent agencies are not covered by the President’s recent Executive Order on “Improving Regulation and Regulatory Review”, we can add layer upon layer of rules, regulations, restrictions and new duties without attempting to quantify the costs of what we are proposing. I believe we should at least 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. 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.
I want to thank Kevin Hesselbirg for inviting me here to speak today. I really appreciate the opportunity to address this group and am happy to answer any questions.
Last Updated: April 7, 2011