Good afternoon. It is such a pleasure to be here again with you all today and a special thanks to Sally Miller for the invitation to discuss my perspective on the role of the CFTC 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 US and foreign regulators. The further along we get in the implementation process, the more difficult it is has become. I would like to touch on a few developments and give my thoughts on the current state of derivatives regulation both here in the US and abroad. Since September of 2010, the Commission has held 24 public meetings to vote on various Dodd-Frank matters and has issued nearly 60 proposed rules, notices, or other requests seeking public comment, and has completed 28 final rules, interim final rules, and exemptions. I think we are about at the half-way mark with at least twenty more rules to go, including the most significant rules like definitions of a swap dealer and swap. We have one meeting scheduled for March and four more meetings scheduled for April and May.
When it comes to the rulemaking process, I believe a reasonable, measured approach is critical. Swap markets developed without our involvement, and we have little experience with these markets. The truth is we don’t know what the full impact of our rules will be, and we don’t know whether the assumptions we operate under are valid. Given this knowledge gap, it makes sense to start with a broader, more flexible approach, and become narrower and more restrictive only as necessary and after we have sufficient experience and data to make these decisions. Unfortunately the Commission has not taken this sensible approach.
By way of example, last month the Commission held an open meeting to consider a final rule related to business conduct standards and a proposed rule related to block trading. Dodd-Frank mandates that the Commission specify the criteria for determining what constitutes a large notional swap transaction—or block trade— for particular markets and contracts. In determining appropriate block trade sizes, Congress has directed that the Commission take into account whether public disclosure of transactions will reduce market liquidity.
This requires a balancing act—if the block threshold is set too low, there will be reduced transparency in the market. If the block threshold is set too high, there will be reduced liquidity in the market. Setting block sizes for swaps is not an easy task, and absent robust data, comprehensive analysis, and the benefit of market experience, we could severely harm liquidity at this critical regulatory juncture where we seek to bring more swaps onto swap execution facilities.
The proposal, which passed by a 3-2 vote, recommends utilizing a formula to determine block size whereby only the largest 6% of all interest rate swaps and credit default swaps would be block trades. This proposal ignores Congress’ mandate that we take into account the impact of public disclosure on liquidity. We now run the risk of sacrificing liquidity at the altar of transparency.
More troubling, the rule writing team only had access to 3 months’ worth of transaction data, and that transaction data dates back to the summer of 2010. In writing these rules we are relying on stale data, and far too little of it. This is just one instance where we have proposed rules without sufficient data, robust analysis, and complete knowledge of their impact.
I am guessing that the issue first and foremost on many of your minds is extraterritoriality. As everyone in this room knows, the swaps market is a global market. Harmonizing our rules to the greatest extent possible with the SEC, other US regulators and our foreign counterparts is absolutely crucial for ensuring that we accomplish the overall global 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 Asia.
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.
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. While the statute gives us some direction, the Commission is considering how broadly or narrowly it intends to interpret the scope of this limitation. Setting the precise scope of Dodd-Frank with respect to the cross-border activities of foreign entities is necessary to preserve the continuity of global business operations and the risk management tools that swaps provide. To that end, I expect the Commission to issue proposed guidance on this issue in the coming weeks; however, it is my understanding the scope of the guidance will only speak to who will be required to register as a US swap dealer or major swap participant. The Commission intends to tackle other issues such as clearing and market infrastructure in subsequent guidance. I am deeply concerned that there has not been adequate coordination with the SEC and the international regulatory community. Of even greater concern to me is that the Commission appears to be considering a piecemeal approach to issues of extraterritoriality by proposing guidance in stages rather than by proposing one comprehensive rule that will give market participants some degree of certainty and the entire framework we are considering. I cannot imagine the global consequences of an inconsistent approach to these issues by the SEC and CFTC. I have spoken to many foreign entities and foreign regulators who are very interested in how far the CFTC intends to reach into the operations of entities located overseas. I believe this is one of the single most important issues the Commission will address during the implementation of Dodd/Frank. There has been an enormous amount of congressional interest and if we do not get this one right, I am confident Congress will step in. I would like to see the CFTC propose a joint rule or at the least a coordinated rule with the SEC. The CFTC has a long history of international cooperation and recognition for comparable foreign regulatory regimes. This is not the time for us to abandon policies that have worked well for us over decades of international practice.
I am also going to guess that the other important issue on your mind is the much discussed “Volcker rule”. The CFTC waited until January of this year to put out its Volcker proposal, notwithstanding the fact that other US regulators put out their version of Volcker last October. The proposal is lengthy and extremely complex and I do not think we spent sufficient time to fully consider all of its implications. I am troubled that this is the path the Commission has chosen. Given that we waited until January to propose our version of Volcker, well after other regulators issued proposals and received comments, we had a unique opportunity to take into consideration the comments filed with those other agencies. Unfortunately, even with the lag time and the benefit of comment letters we proposed a rule that is virtually identical to the other agencies’ proposed Volcker rule. I had concerns about what the CFTC would do if other agencies re-propose their rules. I hope we will be prepared to withdraw our proposal and join a re-proposed Volcker Rule with the other agencies. Otherwise, it seems as if we have put ourselves on a separate track, which I fear will needlessly complicate an already convoluted and likely unworkable set of rules.
Central bankers and regulators from around the world have expressed concern that the rule, which as proposed would apply to the US operations of foreign banks, may also extend to a firms’ operations outside the US. Many countries in Europe and Asia have weighed in, and many industry bodies such as yours have filed helpful comment letters too. In fact, the CFTC, Treasury and other regulators received over 17,000 comment letters. We have seen these concerns voiced by high ranking officials, such as Bank of Canada Governor Mark Carney, EU Financial Services Commissioner Michel Barnier, and FSA chairman Lord Adair Turner.
For example, the UK and Japanese finance ministers weighed in saying that, without an exemption from the rule, their governments’ borrowing costs would rise. Japan and Britain have called on the US to rewrite the Volcker rule given concerns that it could reduce liquidity in sovereign debt markets at a crucial moment for some European governments. Japanese Finance Minister Jun Azumi and his British counterpart George Osborne pointed out that Volcker may be the "wrong prescription," with unintended consequences.
Of particular concern to other nations is the fact that, while the new rule may adversely impact market liquidity in stocks and corporate and government bonds, there is an exemption that allows the banks to buy US government securities -- but not other sovereign debt instruments.
As a consequence, explained Azumi and Osborne, "it could reduce liquidity in non-US sovereign markets, making it more difficult, costlier and riskier for countries to issue and distribute debt." Government debt and related obligations are a major part of the banking sector’s liquid assets. I believe that we need to really consider, especially at this troubled time in the sovereign debt markets, whether this exclusion should be applied in a broad manner that allows banks, especially those outside the US, to engage in liquidity management using assets accepted as liquid reserves such as foreign sovereign debt.
Second, after reviewing the many critical comments we should re-evaluate the foreign banking entities exemption. I do not believe this exemption should be narrower than is required by Dodd-Frank. At a minimum, we could clarify that use of US financial infrastructure (e.g. clearing, settlement, and trade facilitation) would not make the transaction subject to the rule. It is critical for US regulators to come together and form a reasonable approach to the many difficult issues included in the prohibitions and restrictions on proprietary trading. The implications of this rule will most definitely be felt around the globe.
As you know, I chair the Commission’s Global Markets Advisory Committee and have participated for the last three years in the Technical Committee meetings of IOSCO and so am particularly sensitive to international regulatory issues. As a quick recap on other jurisdictions, we continue to monitor the progress of the European Market Infrastructure Regulation (EMIR), the Markets in Financial Instruments Directive (MIFID) and the related Markets in Financial Instruments Regulation (MIFIR), as well as the proposed revisions to the Market Abuse Directive (MAD) and the Basel Committee on Banking Supervision and IOSCO joint working group on margin requirements for uncleared derivatives.
A political agreement on EMIR was reached last month; however, an official version has yet to be released publicly. Based on conversations with our European Commission (EC) counterparts, EMIR will come into force on January 1, 2013, but will not be applied until later in 2013. More specifically, authorization of CCPs will not occur until mid-2013 and we do not have an estimated date for when trade repositories will enter into force.
With regard to MiFID and MiFIR, we expect that the European Parliament will consider them at some point this summer.
All three of these proposals are the EU’s responses to the commitments made by G-20 leaders in 2009 to address less regulated parts of the financial system, such as OTC derivatives, and to improve the oversight and transparency of commodity derivative markets.
MAD/MAR: The European Commission has also proposed regulations to increase the number of commodity derivatives and OTC derivatives that are covered by the market abuse regime. The proposals extend the market manipulation prohibition to instruments whose value relates to exchange traded instruments. So for instance, an OTC derivative referenced to a contract traded on ICE Futures Europe would fall within the new Directive. These updated regulations now include prohibitions against attempted manipulation, where the old rules only covered actual manipulation. I should also point out that the new regulation gives the member states more enforcement tools and criminalizes certain insider trading and market manipulation offenses. We expect these proposals will also be taken up by the European Parliament this summer.
The IOSCO Task Force on OTC derivatives (TF) has been busy. Here’s a sense of where various work is in the pipeline:
The last report left for the task force to take up, the report on OTC Derivatives Market Intermediaries’ oversight, is nearly finished and likely to be approved at the May IOSCO Annual meeting in Beijing.
Lastly, on the international front, I would like to report that the Basel Committee on Banking Supervision and IOSCO has established a joint working group on margin requirements for uncleared derivatives. The group includes representatives from more than twenty regulatory authorities, including the CFTC, and has held two in-person meetings and numerous conference calls. The topics discussed have included:
The group is working toward issuing a consultative paper mid-year. US regulators will coordinate with the international effort, and my hope is that US regulators will not take up the final rulemaking on margin requirements for uncleared derivatives until after the international standards have been settled.
Finally, I will turn to recent developments in Asia.
The Japanese legislature passed the Amendment to the Financial Instruments and Exchange Act (“FIEA”) in May 2010. This amendment gave the Japanese financial regulator, the JFSA, the authority to regulate OTC derivatives. The JFSA expects the implementing cabinet ordinance and other measures to be finalized by November 2012.
The Hong Kong Monetary Authority (“HKMA”) and Hong Kong Securities and Futures Commission (“SFC”, together with the HKMA, the “Hong Kong Authorities”) released a consultation paper on their proposed OTC regulatory regime in October 2011. The Hong Kong Authorities propose amending the Securities and Futures Ordinance to set out a general framework for the regulation of the OTC derivatives market, which includes providing relevant rulemaking powers to the HKMA and SFC. Hong Kong is working to adopt these regulations by the end of 2012.
On February 13, 2012 the Monetary Authority of Singapore (“MAS”) published a consultation paper with proposals to meet the G20 mandate on the trading, clearing and reporting of OTC derivatives. To implement the recommendations of the international standard setting bodies, MAS proposed to expand the scope of the Securities and Futures Act (“SFA”) to mandate central clearing and reporting of OTC derivatives contracts, as well as regulate market operators, clearing facilities, trade repositories and market intermediaries for OTC derivatives contracts.
Generally there is a fair amount of consistency between jurisdictions. Of course there are some areas where coordination and cooperation are essential. I know the concept of indemnity in the context of swap data repositories is an issue, as well as the desire by some for a central bank exemption from the registration, public reporting and clearing requirements of Dodd-Frank. There is also a conflict regarding the open access to CCP’s rules which we finalized in October of last year. The rules prohibit a DCO from setting a minimum adjusted net capital requirement of more than $50million for any person that seeks to become a clearing member in order to clear swaps. This very low number has generated concern from other authorities.
As you all know very well, market regulators around the globe are working diligently to respond to the commitments made at the G-20 level. Considering the scope of the work for all of these jurisdictions, I think the progress made up to this point has been remarkable. We will continue our efforts at the Commission coordinating with our global counterparts and will probably be working to establish appropriate rules and regulations for many years to come.
In closing, I would like to convey my persistent grief regarding the process the Commission is using to finalize these very important rules. I believe we should be crafting all of our regulations in a way that will allow them to stand the test of time and to not favor one market segment over another. I believe that it is crucial for the marketplace and for market participants that we get these rules right and that we finalize them in a way that is reasonable and to not politicize them. It would not be a good outcome if we are re-writing most of these rules in the next couple of years because the rules do not reflect the useful input we have received from the market. We consistently reject reasoned comments from industry professionals with little justification in our cost benefit analysis to support those rejections. I have been hopeful for the past year that things would change when we started finalizing rules, and especially the rules that are so integral to the new regulatory framework, but things have not changed. I am no longer optimistic; I do not believe that these rules have a chance of withstanding the test of time but instead believe that this Commission will be consumed over the next few years using our valuable resources to rewrite rules that we knew or should have known would not work when we issued them.
I have very strong views with regard to these issues and will continue to work toward resolving the challenges we face. Our staff at the CFTC has been enormously helpful to us throughout this process and I encourage all of you to stay engaged. Thank you again for the kind invitation to join you today. I am happy to take questions.
Last Updated: March 7, 2012