October 19, 2011
Good afternoon. Thank you for inviting me here today to discuss my perspective on the role of the CFTC in commodity futures and options markets, and more recently our role in the oversight and regulation of swap markets. Much of what the Commission has focused on over the last year has been directly related to implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. It has been a very complex process involving a great deal of coordination with other U.S. and foreign regulators. The further along we get in the implementation process, the more complex it is has become. To date, the Commission has held 20 public meetings to vote on various Dodd-Frank matters and has issued nearly 60 proposed rules, notices, or other requests seeking public comment, and 22 final rules, interim final rules, and exemptions.
Before addressing the details of the new regime for the previously unregulated over-the-counter swaps markets, I think it would be helpful to talk a little bit about the CFTC’s history and the markets we regulate today.
The Commission was created by Congress as an independent agency in 1974, replacing the Commodity Exchange Administration within USDA. At that time, most futures contracts were on agricultural commodities. In 1975, the CFTC approved the first financial futures contract on Ginnie Mae’s at the Chicago Board of Trade and within months a 90-day Treasury bill contract at the Chicago Mercantile Exchange. The beginning of financial futures would forever change the industry.
The CFTC currently regulates 17 designated contracts markets (DCMs), 14 derivatives clearing organizations (DCOs) and 127 futures commission merchants (FCMs) or intermediaries. There are currently 2,466 actively traded futures contracts listed on the exchanges we regulate.
The Futures Industry Association reports that in 2010 the total volume in U.S. futures and options markets was 3.222 billion contracts, and last year the total number of contracts traded on derivatives exchanges around the world reached a new all-time record of 22.3 billion.
When I arrived at the CFTC in August of 2007, we employed approximately 440 FTEs. The CFTC’s 2011 spending plan accommodates 720 FTEs. This is an increase of 280 FTEs in 4 years - a 64% increase in staffing levels. Yet our annualized operating budget under the current continuing resolution is only $199,230,000.
Before Dodd-Frank, the CFTC was largely a principles-based regulator. That is, futures markets and market participants had flexibility in the manner in which they complied with the Commodity Exchange Act as long as they complied with specific core principles. During this period, the markets the Commission regulates flourished and experienced unprecedented levels of expansion and innovation. Moreover, the exchanges, clearinghouses, and market participants subject to the CFTC’s oversight performed very well during the financial crisis. No customers lost money and no futures firms had to be bailed out.
With passage of the Dodd-Frank Act, the CFTC was given broad authority to regulate swap transactions, swap markets and swap market participants. In granting the Commission this new authority Congress expressly preserved the core principles model for exchanges and clearinghouses that intend to list or clear swaps, but it also gave the Commission the authority, if it so chooses, to issue prescriptive rules. Unfortunately, the proposals and final rules the Commission has issued to date reflect that the CFTC is choosing to exercise this authority to abandon its principles-based regulatory approach in favor of a more prescriptive, one-size-fits-all rules-based regime, which in my view, is a mistake.
As we move further and further away from our successful principles-based regulatory approach, I have found myself asking why we would choose this path. It appears that this shift is being driven largely by a perception that swaps are inherently riskier than futures and options and thus require a more prescriptive regulatory oversight regime.
To that I say, futures and options are, and always have, been risky. But the CFTC’s principles-based regulatory regime, with its underpinnings of clearing, margin, capital and transparency prevented the futures and option markets from posing any systemic risk to the economy at large. The futures and option markets performed just fine and did not contribute to the financial meltdown. To the extent that the swaps markets did contribute to the crisis, the problem was not a lack of prescriptive regulation; it was a lack of any regulation. In the unregulated environment that existed prior to Dodd-Frank, with a few exceptions swaps were not transparent to regulators or the public; they were not cleared; they were not appropriately margined; and there was no requirement that sufficient net capital be maintained to support them. In short, there was no way to determine when leverage had reached unacceptable levels between interconnected counterparties. Clearly, that was a recipe for disaster, a disaster that should not be repeated because such unregulated swap markets will no longer exist. Transparency, clearing, margin, and capital will soon be routine in swap markets, not mere exceptions.
What does all this mean? With the underpinnings of transparency, clearing, margin, and capital supporting swap markets (as they have supported futures and option markets), a principles-based regulatory umbrella would address systemic risk and allow these markets to continue to serve their intended purposes. By taking a prescriptive, one-size-fits-all approach we run the risk of needlessly stifling these markets for no apparent benefit. The more prescriptive the regulatory approach, the more onerous and duplicative the rules, regulations, and restrictions, the less likely it is that these markets will flourish and adapt to changing conditions. Nonetheless, that is the direction in which the Commission is headed, and in the process we are dismantling principles-base regulatory oversight of futures and option markets as well.
The Dodd-Frank regulatory agenda before the Commission is daunting. Yesterday the Commission held its 20th public meeting to consider Dodd-Frank rules and voted on speculative position limits and compliance obligations for DCOs. Combined, the rules and associated documents the Commission considered yesterday totaled nearly 700 pages, and there is much, much more to come.
I voted against both final rules yesterday, with the vote on each rule being three in favor and two opposed. A few points illustrate why I voted against both rules and why elements of each rule just do not make sense.
On the clearinghouse or DCO rules, one of the issues raised was whether a market participant could post a letter of credit from a bank as initial margin. In futures markets, letters of credit have been an acceptable form of margin for decades, and I know of no instance where an issuing bank failed to provide necessary funds when required. Colored by the perception that swaps are inherently riskier than futures and options, however, the Commission banned the use of letters of credit to support swaps, but will continue to allow them for futures and options given their problem-free history in those markets. At the same time, the Commission voted to allow letters of credit to meet certain other financial resource requirements on a case-by-case basis, and banned them for purposes of guaranty fund obligations.
These distinctions, in my opinion, are not legally or factually justifiable. We should treat letters of credit the same way unless there is a compelling reason not to. This is especially true given the fact that banning their use as initial margin for swaps will have the perverse, unintended consequence of disincentivizing voluntary clearing by commercial end-users who support their positions in these markets with letters of credit.
Voluntary clearing is a good thing and should be encouraged. Now that letters of credit are prohibited for swaps, those who have been relying on them to support their voluntary clearing will have two choices: they can incur the additional expense of posting some other form of acceptable collateral and either absorb the cost or pass it on to their customers; or they can choose not to clear their swaps. One of the goals of Dodd-Frank is to protect consumers. Another goal is to move as many swaps as possible into a cleared environment to mitigate the risk associated with a default. It is ironic that given the goals of Dodd-Frank, a regulation promulgated pursuant to Dodd-Frank may lead to increased prices for consumers or a decrease in clearing.
The position limits rules the Commission voted on yesterday also have the potential to lead to increased prices for consumers. Dodd-Frank required the Commission to set limits on the size of positions that speculators can take in futures, options, and swaps. I am sure all of you have heard the arguments dating back to 2007 that speculators are driving up the prices of energy, food, and metals, and if their trading activity was limited, prices would surely drop.
I do not believe position limits will control prices or market volatility and I fear that the Commission is destined for failure because this final rule will not result in lower food and energy costs. I am disappointed at this unfortunate circumstance because, although the CFTC’s mission is to protect market users and the public from fraud, manipulation, abusive practices and systemic risk related to derivatives that are subject to the Commodity Exchange Act, and to foster open, competitive, and financially sound markets, nowhere does it state that our mission is to control prices.
When Congress directed the Commission to set speculative position limits, it also directed that position limits would not apply to producers, purchasers, sellers, middlemen, and users of a commodity or a product derived from a commodity, who are commonly referred to as bona-fide hedgers. Congress’s directive specifically allows bona-fide hedgers to hedge their legitimate anticipated business needs irrespective of whether their hedging transactions exceed speculative position limits. Congress recognized that appropriate hedging reduces the risk associated with exposing a bona-fide hedger’s business operations to commodity price fluctuations.
The Commission has historically imposed position limits on nine agricultural commodities and had rules in place to allow bona-fide hedgers to hedge their price risk. The rules the Commission promulgated yesterday narrow the circumstances under which bona-fide hedgers can hedge their price risk, make it more inefficient for them to hedge in certain circumstances, and increase the reporting burdens of hedging. As a result, the likelihood exists that bona-fide hedgers will incur increased costs. Increased costs for bona-fide hedgers will probably lead to increased costs for consumers - a result that is at complete odds with the stated goals of Dodd-Frank.
It is my hope that when the Commission is finished implementing Dodd-Frank, there is not a long list of examples like the two I just mentioned where the results seem to make no sense.
Before I finish I would like to mention a few issues surrounding domestic and international cooperation. Harmonizing our rules to the greatest extent possible with the SEC, other U.S. regulators and our foreign 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 and elsewhere.
In addition, the CFTC co-chairs the International Organization of Securities Commissions Task Force on OTC Derivatives, along with the SEC, the UK FSA, and the Securities and Exchange Board of India. The task force is tackling issues such as analyzing the benefits, costs, and challenges associated with transitioning standardized derivatives products onto exchanges and electronic trading platforms, along with data reporting and aggregation, and international standards. These issues are very complex, and the possibility of divergent views among international regulators is very real. The challenge lies in building a consistent philosophy for how the regulatory frameworks of many nations fit together to ensure cross-border swap activities are not disrupted.
I chair the Commission’s Global Markets Advisory Committee and am particularly sensitive to international regulatory issues. Last year the U.S.
Supreme Court reaffirmed the longstanding principle of American law that unless Congress clearly expresses an affirmative intention to give a statute effect outside the United States, “we must presume it is primarily concerned with domestic conditions.” Morrison v. National Australia Bank, Ltd., 130 S.Ct. 2869, 2877 (2010).
In Dodd-Frank, Congress expressed intent for the statute to apply to activities abroad in certain circumstances, but was not crystal clear on the parameters. 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. Because setting the precise scope of Dodd-Frank with respect to the cross-border activities of foreign entities is crucial to preserving the continuity of global business operations and the risk management tools that swaps provide, I expect the Commission to issue guidance on this issue in the coming months. In addition, I know many foreign entities and foreign governments are very interested in how far the CFTC intends to reach into the operations of entities located overseas.
There are a number of ways cross-border swap markets currently operate, ranging from foreign banks that deal directly with U.S. customers, to transactions between foreign entities that have a U.S. parent. 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. If we interpret “direct and significant impact or effect” in an overly broad way, we will inevitably risk intruding into regulatory activities appropriately left to our foreign counterparts and could damage the CFTC’s long history of international cooperation and recognition and respect for comparable foreign regulatory regimes. This will be a delicate issue, so stay tuned.
It was a pleasure to be here today. A special thank you to Congressman Bentsen and Bradely Edgell for inviting me. I am happy to take questions.
Last Updated: October 19, 2011