April 26, 2011
Good afternoon. Thank you for the opportunity to discuss the new regulatory regime for swaps transactions under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank or Act) and the ongoing process for implementation by the CFTC. I see from the schedule that a number of our staff members are participating today and tomorrow. Hopefully we will learn some things from you during the course of the conference and you will learn some things from us. We’ve made a lot of progress in proposing rules, but we have a long way to go before a final regulatory structure is in place. Collaboration through the public comment process and conferences such as this one is essential to building a structure that achieves the goals of Dodd-Frank and is workable in practice, and so again I appreciate this opportunity.
Tomorrow, the Commission has scheduled our fourteenth public meeting. One of the four items on the agenda is a fundamental element of the new architecture – a proposal further defining the terms “swap,” and “security-based swap.” This is a joint proposal with the Securities and Exchange Commission (SEC), and it will also address security-based swap agreements and mixed swaps. I know this proposal is of particular interest to many in the energy markets, especially as it relates to the continued validity of the Commission’s Brent Oil forward contract interpretation, book outs and transmission rights. There is no doubt that the teams at both the CFTC and SEC have had a substantial amount of work on their plate drafting this rule over the past several months because of the complicated nature of swap transactions, not to mention the jurisdictional issues involved. The statutory definitions for a swap and a security based swap are fairly straightforward. The proposal seeks to clarify any ambiguity regarding what transactions should not be regulated as swaps or security based swaps under Title VII. As I have publically stated many times during this rulemaking process, my concerns lie generally with any regulatory over-reach and my concerns with this proposal are no different.
Another proposal we will be voting on tomorrow addresses capital requirements for swap dealers and major swap participants. Two weeks ago we issued proposed rules on margin for uncleared swaps, which go hand-in-hand with the capital rules. One of the most anticipated aspects of the proposal was whether commercial end-users would be required to post margin. While the Act clearly exempts commercial end-users from mandatory clearing, it is somewhat ambiguous on whether margin could be required. I have objected to various aspects of a number of the Commission’s proposed rules, but this is one area where I think we got it right. The proposed rule does not require swap dealers or major swap participants to pay or collect initial or variation margin from commercial end-users. The only requirement is that the parties enter into privately negotiated credit support agreements, which may be supported by non-cash collateral. Our proposal gives commercial end-users the flexibility to continue to do business as they did before Dodd-Frank. This is appropriate in my view. The hedging activities of commercial end-users did not contribute to the financial crisis. Requiring them to divert scarce capital to margin would likely increase risk, rather than reduce it, by making hedging more expensive and thus less likely to occur.
While the capital and margin proposals will hopefully introduce some much needed clarity, much remains to be finalized, such as who will be a swap dealer or a major swap participant. The statute defines a swap dealer as an entity that holds itself out as a swap dealer, makes a market in swaps, regularly enters into swaps 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. The criteria laid out in the statute are very broad, but there are three 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 term swap dealer does not include a person that enters into swaps for its own account when doing so is not a part of a regular business. Third, 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.
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,” “major security-based swap participant,” and “eligible contract participant.” The comment period closed on February 22, 2011. As of last week there were 196 postings to the comment file reflecting comment letters and meetings between market participants and Commission personnel.
Generally speaking, the comments filed by electricity providers point out that they are in the market to hedge price risk and ask the Commission to provide clear guidance on how to distinguish between dealing and hedging. The comments filed by energy firms in the oil space focus primarily on the distinction between dealing and trading. Most of the commenters ask for greater clarity on what it means to engage in swaps as part of a regular business. Virtually all commenters argue that the thresholds proposed for the de minimis exemption are far too low. Under the proposal, a dealer would not be eligible for the exemption if, during the prior 12 months, the swaps it enters into in connection with its dealing activity: (1) exceed $100 million in notional value; (2) exceed $25 million in notional value with counterparties that are “special entities”; (3) are with more than 15 counterparties, other than security-based swap dealers; or (4) total more than 20 swaps. Many argue that the thresholds based on the number of swaps or counterparties should be eliminated, and that a notional amount test, if adopted, should take into account the percentage of the entire market that the swap dealer’s positions represent. By contrast, most commenters largely agree with the proposed tests for determining who is a major swap participant.
At a hearing last month before the House Agriculture Committee regarding the proposed rules relating to entity and product definitions, Committee Chairman Frank Lucas noted that he believed the Commission had 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 that could be subject to a new and sweeping regulatory regime far exceeds the risks that 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 did.
I agree with Chairman Lucas. The definitions, as we proposed, are very broad and the exemptions are very limited. While only a handful of entities will likely be classified as major swap participants, the breadth of the proposed swap dealer definition will capture many participants that in my opinion should not be considered dealers. Moreover, the de minimus exemption is so narrow that it is unlikely to have much utility. I favor substantially expanding this exemption so that it can actually be used as Congress intended.
Because it will be illegal to engage in swap dealing activity unless registered as a swap dealer, 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.
Finalizing the definitions of the entities and products that are covered by Dodd-Frank should have been step one in this process of building a new regulatory structure. Only then can entities begin to prepare to come into compliance with vast assortment of new requirements that will apply to swap dealers and major swap participants. Unfortunately, we are not on track to get this done by this coming July, the deadline we were given by the Act. While we do have the authority to extend the dates for coming into compliance, the exclusions and exemptions contained in Sections 2(d), (e), (g), and (h) of the Commodity Exchange Act that were established by the Commodity Futures Modernization Act of 2000 (CFMA) to provide legal certainty for the over-the-counter (OTC) swaps market will be stricken effective July 16, 2011, as will the provisions governing derivatives transaction execution facilities (DTEFs) and exempt boards of trade (EBOTs). The fact that DTEFs will no longer be allowed is not a problem because no DTEFs exist. The same cannot be said for markets operating as EBOTs or under the exclusions and exemptions contained in Section 2.
Recognizing that it may take certain market participants a significant amount of time to comply with the new structure after the new rules are finalized, Congress provided the Commission with the authority to grandfather all Section 2(h) markets and EBOTs for a period of up to one year after the current provisions governing those markets are extinguished. Last September the Commission announced that it would consider applications for grandfather relief from EBOTs and Section 2(h)(3) exempt commercial markets, but stated that it may not be necessary to do so for bilateral exempt markets operating under Section 2(h)(1). The hope at that time was that the new rules would be in place and those market participants would be able to make the transition by the statutory deadline. It is now crystal clear that deadlines will not be met and that the extension of grandfather relief to Section 2(h)(1) markets will be necessary. July is fast approaching. I believe it is imperative that the Commission publicly announce as soon as possible how it intends to address the legal uncertainty that will be reintroduced into the OTC derivatives markets, both excluded and exempt, once the certainty provided by the CFMA goes away. Specific guidance issued by the Commission on this issue, I believe, would go a long way to address the uncertainty and give market participants clarity regarding what happens on Monday, July 18 when none of the definitions have been finalized and not a single swap execution facility is operating.
Another area of looming uncertainty is the extraterritorial application of Dodd-Frank. As you know, the swaps business is global. 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 yet 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. I am hopeful that our 20-plus years of 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.
Commission staff has been in constant contact with our counterparts in London, the European Union and elsewhere. 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. 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.
I would like to close with a few words on position limits, an issue that I know is important to the energy markets and has long been a concern of mine. High gasoline prices are back and with them renewed calls for the Commission to impose position limits to eliminate or prevent excessive speculation.
As you are familiar, 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 for 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 is, for the first time, considering the use of position limits, there are fundamental differences from the CFTC’s approach.
Last Thursday U.S. Attorney General Eric Holder announced the formation of an inter-agency working group to investigate whether the rise in oil and gasoline prices is in any way connected to collusion, fraud, or misrepresentations at the retail or wholesale levels. The working group, which will include representatives from the Department of Justice, the National Association of Attorneys General, the CFTC, the Federal Trade Commission, the Treasury Department, the Federal Reserve Board, the SEC, and the Departments of Agriculture and Energy, will also evaluate developments in the commodity markets and will examine investor practices, supply and demand factors, and the role of speculators and index traders in the futures markets.
You may recall that a similar interagency task force was formed in 2008. The CFTC also conducted its own study of swap dealers and index traders in 2008 to determine whether their activity was affecting prices in the crude oil and certain agricultural markets, which were also dramatically rising. Neither the interagency task force nor the CFTC study found a connection between speculative trading and rising prices in 2008. These markets warrant continuous study, however. I welcome the formation of the new interagency group and look forward to its findings.
The implementation of the Dodd/Frank Act is enormously important. I am very proud of the staff at the CFTC for their continuous hard-work and dedication to getting all of these rules right. And after eight months of non-stop rule writing, the difficult task of finalizing the proposals is still ahead of us. With that in mind, I believe we must not lose sight of our global objectives as we address the challenges in front of us:
Thank you to Mark Young and Skadden Arps for inviting me to speak today. I am happy to answer any questions.
Last Updated: April 26, 2011