October 11, 2012
Good afternoon. It is such a pleasure to be here with you all today in Houston and a special thanks to Cadwalader for the invitation to discuss my perspective on the energy markets and the role of the CFTC in the oversight and regulation of swap markets.
I am sure many of you have been observing the Commission’s implementation of the Dodd-Frank Act over the past two years. It has been a difficult and challenging process. While it is easy at this point to look back with 20/20 vision, there were many of us throughout this process who would have preferred to follow a logical path of “smart regulation,” first implementing definitions of swap and swap dealer, and then the remaining framework for mandatory clearing and reporting requirements, followed by execution rules.
Unfortunately, I stand here on October 11, 2012, the day before the definition of swap becomes effective and compliance rules for swap dealers and MSPs kick in, and I know that if we don’t grant dozens of requests for relief we may damage the market or irreparably harm market participants.
I cannot express how disheartened I am by the number of people who have reached out to me with the same message: “We want to comply, we just need clarity.” It is our job as regulators to set out clear rules of the road. But in an effort to close every conceivable loophole, real or imagined, rather than to regulate for the general markets, we have finalized rules that are vague and subject to legal challenge. Moreover these rules are having real, unintended, and very costly consequences. Certainly this audience knows better than I do the confusion and uncertainty our rules have introduced. They are costing market participants untold time and expense. Someone recently described it to me as death by a thousand cuts … and I believe that to be an accurate depiction of the effect our rules are having.
As you know, the Commission has traditionally taken a principles-based approach to regulation, one that has served the futures markets well for many years. When Congress passed Dodd-Frank it 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 chooses, to issue prescriptive rules. The proposals and final rules the Commission has issued to date reflect that the CFTC has chosen to exercise this authority to abandon its principles-based regulatory approach in favor of a prescriptive one-size-fits-all regime, which in my view is a mistake. While prescriptive rules, if done correctly, can bring the benefit of clarity to the regulatory landscape, regulating for the potential loophole has led to a morass of confusion and uncertainty. Instead of providing clarity to the market we have said we will address industry requests for guidance on a case-by-case basis, which in turn has led to inconsistent answers and a market left trying to figure out how to comply with convoluted rules.
Even if providing guidance on a case-by-case basis was the right course of action, our staff does not have the bandwidth to address all of the one-off requests for guidance and relief we have received—requests which could have been avoided if we had provided the market with clarity up front. This is not “smart regulation.” And while I can understand the desire to prevent a bad actor from taking advantage of a loophole to circumvent our requirements, Dodd-Frank contains specific anti-evasion provisions for that very purpose. 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.
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 the exception.
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 the Commission has taken.
As all of you know, our rules have led to a litany of requests for relief, no-action letters, interpretive guidance and the like. This is because we have not finalized these rules in a way that makes sense. And I am told that market participants seeking guidance from staff often get conflicting interpretations. Of course, I do not blame staff for this lack of direction. Given the way we have proceeded it is no wonder that the divisions find it challenging to coordinate various rules, one-off requests for relief and interpretive guidance.
We knew that achieving these reforms would be complicated and that changing the regulatory landscape in such a short time period would not be easy. I have spoken in the past of my frustration with the thoroughness of our cost-benefit analysis. The Commodity Exchange Act requires the Commission to consider the costs and benefits associated with each of its regulations and orders. During the proposal phase of these rules, instead of conducting that analysis we asked questions and asked commenters to quantify the costs. At that time I suggested we comply with the President’s Executive Order on Improving Regulation and Regulatory Review. Since then I believe the Commission has made significant improvements to that process; however, now we have a new issue associated with compliance costs and the prescriptive nature of our rules, which involves staff interpreting an even more precise manner for compliance after the Commission has finalized a rule. These after-the-fact clarifications may require market participants to integrate completely new processes into their businesses, all done outside of the rulemaking process and free from a cost-benefit analysis. This practice has deprived the public of the opportunity to comment on either the specific method of compliance or the costs associated with it, which in my view violates the Administrative Procedure Act. Again, this is not “smart regulation.”
I believe the Commission has finalized approximately 40 rules, yet I know there are many issues that are important to you that still need to be addressed. For example:
In addition, there are of course the very important rules regarding the extraterritorial reach of Dodd-Frank.
In May of 2011, I testified in front of a House Subcommittee regarding the harmonization of Global Derivatives Reform and its impact on U.S. Competitiveness and Market Stability. At that time I discussed three concerns: (1) there were substantive differences between derivatives reform in the U.S. and other jurisdictions; (2) other jurisdictions were not as far along in their reform process, which may harm the global competitiveness of U.S. businesses; and (3) our failure to clarify how our rules apply internationally created a great deal of uncertainty, both in the U.S. and abroad. Fast forward seventeen months and my concerns remain the same. The Commission faces numerous challenges with regard to the cross-border application of its swaps regulation.
First, I believe we must make sure we are not acting outside the jurisdictional limits set for us by Congress. The Commission’s jurisdiction under Dodd-Frank is outlined in Section 722(d), which states that the CFTC’s swaps regime shall not apply to activities outside the U.S. unless those activities have a direct and significant connection with activities in, or effect on, commerce of the U.S. However, Chairman Gensler has said that cross-border regulation is appropriate whenever “financial institutions operating outside the United States transmit risks directly into the United States through swap transactions with U.S. persons.” The Chairman has focused all of his attention on the word “direct” while ignoring the word “significant.” I believe it is not enough that a swap transaction merely has a direct connection to the U.S., as the Chairman suggests. Rather, the impact must be direct and significant. I do not think our cross-border reach should go outside the parameters set by Congress.
Second, the lack of clarity regarding the definition of “U.S. person” has caused confusion and uncertainty among many market participants. I believe we should revisit the definition as soon as possible to allow entities to adjust their business models and behaviors accordingly.
Third, we must employ common sense in arriving at final standards for substituted compliance. In addition to being too vague for entities to assess whether or not their compliance regime would be appropriate, the proposed guidance unfortunately seems to hint at a rules-based or hybrid approach for gauging comparability. The Commission should be mindful of the fact that many non-U.S. SDs and MSPs will be subject to home country regulation which seeks to achieve the same regulatory goals as Dodd-Frank. As such, overlapping regulation may create compliance costs without counterbalancing benefits. In order to avoid duplicative compliance regimes, I believe the Commission should stay away from rule-by-rule comparisons for the purpose of comparability determinations.
Finally, we should not make the cross-border guidance more confusing than necessary. For example, the Commission’s guidance creates a three-factor test to determine whether swaps between a non-U.S. counterparty and an affiliated U.S. person would be subject to our regulation. I, like many others, believe that this so-called conduit proposal should be removed from the guidance. Its scope is vague, which will lead to uncertainty as to whether or not an entity is a conduit, and it is unnecessary, since any attempts to evade Commission regulations are already covered by the jurisdiction granted in 722(d).
I am hopeful we will clarify and correct these and other cross-border issues expediently to avoid market disruption or fragmentation.
As I have mentioned in the past, I have concerns that we are finalizing these very important rules in a way that will not allow them to stand the test of time. The position limit rules, which were recently vacated by the U.S. District Court for the District of Columbia, are a case in point. The court found the rules could not stand because the Commission failed to make a finding that they were necessary to diminish, eliminate, or prevent the burden on interstate commerce that excessive speculation can cause. The court found it unnecessary to reach the other objections to the rules raised by the plaintiffs because this error alone was fatal. Even if an appellate court were to overturn the district court’s statutory analysis, it is unlikely the rules would survive judicial scrutiny of the Commission’s deficient cost-benefit analysis. I believe the best course of action for position limits is for the Commission to ask Congress for clarification during the 2013 reauthorization process and go back to the drawing board.
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. Rules that cannot be understood or result in litigation are costly and disruptive and in no one’s interest. Unfortunately, we (or Congress, through reauthorization) will most likely be re-writing many of our Dodd-Frank rules over the next couple of years because they do not reflect the input we have received from the market. To the contrary, we have routinely rejected legitimate comments with little justification to support our analysis.
Regulatory changes to the market are seldom easy. The Commission is fortunate to have a dedicated staff who has worked long hours over weekends and holidays to meet tight deadlines set for them by the Chairman. But it is the responsibility of all five Commissioners to ensure that these rules can stand the test of time and will be implemented in a reasonable fashion, with the overall goal of protecting the markets. As we head into October 12 with very few requests for relief being granted by the Commission, I hope that the five of us will keep that responsibility in mind.
Last Updated: October 15, 2012