November 14, 2014
Thank you, David, for the introduction.
I am honored to be with you today here in the Cumberland Lodge, a location rich in history and the site of many important discussions in the past. In preparing for these remarks, I was struck by the Cumberland Lodge’s mission statement, which in part is to prepare society for future responsibilities. Appropriately, the theme of this conference is: “a new era for financial services.”
Today I would like to share some thoughts about a new era for the derivatives markets, with a particular focus on trade execution, and how a collaborative and deliberative approach to those responsibilities shared by the U.S. and Europe will be instrumental in shaping this new era.
Nearly nine months ago, the CFTC implemented the first trading mandate for cleared interest rate and credit default swaps in the U.S. derivatives market. That mandate followed-through on commitments made by the G20 in 2009, which promised to increase transparency and appropriately regulate the trading of swaps within a few short years.
Before this mandate, swaps were executed in a variety of ways, including by voice and electronically, as they are today. Similarly, many of the platforms now registered with the CFTC as swap execution facilities (“SEFs”), or registered within a different regulatory framework with the Financial Conduct Authority (“FCA”), have been facilitating the execution of swaps for years.
Nevertheless, the G20 commitments promise to usher in a substantially new swap market structure.
In the U.S., this new marketplace is largely in place. Due to recently implemented rules, today firms can impartially access all-to-all markets with pre-trade transparency, pre-execution credit approval, and real-time reporting of trades. This has demanded significant operational investments by trading venues and credit intermediaries. Firms operating within the new market structure have new and significant compliance obligations, too.
In other words, legislative and regulatory policies related to trading have dramatically transformed the ways in which the U.S. markets are structured, leading to equally dramatic changes in how firms operate. The goals of these reforms are sound: greater accessibility to liquidity, greater price transparency, and safer and better surveilled marketplaces.
Of all the G20 commitments, however, the trading mandate presents some of the most novel issues for the CFTC and the global regulatory community. This contrasts, for example, with the clearing mandate. Clearinghouses had regulatory reporting obligations and risk-management requirements under U.S. law for a decade prior to Dodd-Frank. Moreover, by the time the CFTC’s clearing mandate was implemented, a significant portion of the rates and credit space already had migrated into the clearing system.
The financial crisis itself motivated changes to risk management and margin practices long before rules were written to require the clearing of swaps, and expected changes to prudential rules, among other things, further changed behavior.
I do not want to overstate the case. Swap execution was familiar to the marketplace, as well. But it is clear to me that the industry’s reaction to clearing and margin reforms did not compare to its reaction to trading policies. Differing economic incentives surely explain some of this, but I suspect that many saw a more attenuated connection between trade-execution policy and systemic risk.
It perhaps should not be surprising, then, that policymaking around the trading mandate has been controversial, perhaps the most controversial of the CFTC’s reforms. It has been especially so given their international scope, which necessarily involve multiple jurisdictions and regulatory authorities throughout the globe.
It perhaps also should not be surprising, that the CFTC’s trading-related policies might be due for fine tuning at the appropriate time, as other jurisdictions catch up and implement their G20 commitments in light of their own regulatory interests, markets, and policy preferences.
In my view, once the clearinghouse equivalency issues presently being addressed by the European Commission and the CFTC are resolved, the next area for continued but intensified, trans-Atlantic collaboration and policymaking should be related to the trading mandate.
There are a number of steps that the CFTC should take toward that end as soon as practicable:
1. Amending the no-action letter on qualifying multilateral trading facilities (“Q-MTFs”) to impose its conditions only on swaps involving at least one U.S. person, and not on all trading done through the platform;
2. Accelerating the CFTC’s consideration of a foreign SEF rulemaking along the lines approved for foreign futures exchanges, and expediting approval of the 25 outstanding applications from foreign-boards-of-trade (“FBOTs”);
3. Proposing a clarifying interpretation concerning the so-called “de-guaranteeing” of trades;
4. Bringing to an end “name give up” occurring in the context of anonymous trading protocols on SEFs;
5. Seeking public comment on the registration of multilateral swap-trading venues facilitating the execution of swaps that are not subject to the trading mandate; and
6. Revisiting the existing made-available-to-trade (“MATT”) process currently done via rule filing.
I will discuss each of these briefly. First, though, I would like to discuss the most immediate consequence of failing to harmonize the trading mandate globally: Market Fragmentation.
Liquidity Fragmentation in the Global Swaps Markets
The CFTC is facing multiple types of fragmentation in the swaps marketplace today. There is international regulatory fragmentation; meaning today, many trading decisions are being made to comply with or avoid rules and mandates imposed by law, and are no longer driven solely by the liquidity profile of, or expertise in, a given marketplace. Consequently, separate pools of liquidity are forming in distinct parts of the world largely based upon the legal status of counterparties.
To be sure, differences in the timing and content of global reforms are part of the reason. Although much progress has been made to implement reforms in the United States and Europe, I am concerned that these differences will continue to encourage, and perhaps create, “regulatory fragmentation.”
There is fragmentation within the U.S. swap marketplace as well. For example, certain swaps, and not others, must be cleared through and traded on regulated platforms.
And then there is fragmentation even within the SEF-trading space. According to a recent research report, “upwards of 40% of activity for rates” and “over 90% of credit volume” is transacted though the dealer-to-client SEFs, evidencing a division of liquidity between different parts of the CFTC-registered marketplace.
It is generally good public policy to minimize fragmentation for several reasons. First, consolidated liquidity pools translate to reduced bid-ask spreads and result in improvements to other market-quality factors. Market participants can more efficiently and affordably unwind, reestablish, and adjust their risk profiles, because more participants are available to interact in the marketplace and to compete on pricing for a given exposure.
Second, centralized liquidity not only increases transparency for the broadest cross-section of price-takers, but reduces informational and trading advantages that accrue only to those able to navigate the complexities of a fragmented market structure.
Third, from a systemic-risk standpoint, fragmentation is very likely risk-enhancing. It can lead to increased operational risks as entities react to and structure around the rules. Regulators must do what they can to avoid incentivizing complex corporate structures and inter-affiliate relationships that will only make global financial firms more difficult to understand, manage, and unwind during a period of market distress.
Fortunately, the market fragmentation occurring around the globe largely has been a creature of the law. It is therefore within the power of lawmakers to minimize the negative consequences associated with it.
It’s important to note here that the data shows some reversal of a trend toward cross-border fragmentation since the CFTC’s trading mandate went into effect, presumably as comfort with SEF trading has increased with time. One dealer-to-client platform operator has characterized the increase of non-U.S. participation on its SEF as “substantial.”
To me, this development serves as a reminder that deliberation and some level of patience is always appropriate in policymaking. It does not mean, however, that the CFTC should not take steps to improve the U.S. and global market structures even further.
How the CFTC and its European Partners Should Minimize Fragmentation
The CFTC Must Continue to Embrace Substituted Compliance
In response to regulatory fragmentation, the CFTC as a general matter should continue embracing substituted compliance. I continue to believe that mutual recognition and appropriate deference to the interests of foreign supervisors and home country regulators—under a strict, outcomes-based conception of substituted compliance—is a readily available policy prescription for driving the markets away from fragmentation.
This cannot mean blanket recognition of policy determinations elsewhere in the world. But a properly conceived, global framework based on substituted compliance can best ensure that jurisdictions compete on an equal playing field, and do not have hold-out incentives that could impede progress on the G20 commitments.
The CFTC, of course, already laid out a substituted-compliance framework through its cross-border guidance, and has issued substituted-compliance determinations for many aspects of its rules. This includes determinations for all six jurisdictions with regulatory interests over CFTC-registered swap dealers. Indeed, the CFTC’s guidance and its implementation were motivated by concerns that fragmentation would be the inevitable result of implementing its reforms first. But more can and should be done.
Four Actions to Reduce Fragmentation and Promote Cooperation on the G20 Trading Commitments
I will now turn to the specific actions the CFTC should take up related to trade execution in order to minimize fragmentation.
The CFTC Must Consider Revising the Q-MTF Letter to Provide Transaction-by-Transaction Relief
To give the CFTC time to implement a foreign SEF regime – which I will speak to next – the CFTC should clarify that a transaction-by-transaction approach for Q-MTFs is permissible and consistent with the policy objectives underlying the trading mandate in the United States, and do so in a timely manner. In the end, the CFTC’s Q-MTF letter issued in the spring was too vague on this point, which dampened interest in the relief.
Substituted compliance was at the heart of the CFTC’s Q-MTF efforts, which was the product of considerable work and collaboration with European colleagues and demonstrated concrete progress on trading reforms. The CFTC has a responsibility to protect the integrity of the swap markets where trading involves U.S. persons. And accordingly, it must regulate the means by which swap trading venues provide access to U.S. persons and monitor trading activities for compliance with U.S. law.
But the CFTC’s regulatory interest is lesser where trades are facilitated solely between foreign persons. The CFTC should defer to home country regulators in those instances where foreign trading venues choose to facilitate trades solely between foreign persons. This should be the case even if other trades are executed through the platform with U.S. persons and would be subject to conditions under U.S. law.
The CFTC Must Develop a Foreign SEF Regime and Approve Pending FBOT Applications
Next, the CFTC should formalize a regulatory regime for foreign SEFs. Congress provided explicit authority for the CFTC to recognize foreign trading venues and exempt them from registration if they can demonstrate that they are subject to “comparable, comprehensive” regulation in their home countries. Tellingly, Congress also provided that, in appropriate cases, trades executed through foreign SEFs could satisfy the trading mandate.
The embrace of a foreign SEF regime would be a useful step toward implementing the CFTC’s cross-border framework. It would also help prevent the unnecessary fragmentation of liquidity and risk that an outright rejection, or unreasonably strict conception of, substituted compliance would invite.
Additionally, the CFTC should move ahead as quickly as possible with registration of foreign exchanges facilitating trades for U.S. persons—especially those exchanges that have relied upon no-action relief for FBOTs for many years.
The CFTC Should Clarify Its Policy on Unguaranteed Trades
The media has reported on the CFTC’s information gathering concerning efforts by registered swap dealers to revise swap master agreements to eliminate the performance guarantees provided by U.S. affiliates. It has been reported, for example, that some foreign swap dealers eliminated these and other forms of financial support from U.S. parent companies in order to avoid U.S. transaction-level requirements.
The CFTC should provide clarity on its analytical approach for determining how guarantees affect the cross-border application of CFTC transaction rules.
I should note that one result of dealers eliminating these financial supports could be that the U.S. financial system is better insulated from external shocks from foreign swap dealing activities. Regardless, the guidance was drafted to capture residual risks from dealing in foreign swap jurisdictions through the entity-level capital rule, which ultimately should require capital buffers that correspond directly to the unsecured exposures created by such foreign-facing activities.
And while I cannot speak on behalf of other U.S. prudential regulators, perhaps most importantly of all, I understand that their policy approach to U.S. bank holding companies does not change depending on whether performance guarantees are provided by affiliated, U.S.-based entities.
Lastly, one final note on the CFTC’s cross-border guidance – while the CFTC should clarify its policy regarding financial supports provided by affiliates, the CFTC’s cross-border guidance should not be otherwise scratched and a cross-border rulemaking effort started anew. Adjustments within the context of the guidance might be appropriate, but the costs and disruptions that would be created by a new rulemaking would overwhelm any potential benefits of such an effort.
The CFTC Should Bring to an End "Name Give Up"
The CFTC also should take a careful look at the alleged information leakage resulting from post-trade affirmation services employed by SEFs. It’s difficult to rationalize trading protocols that reveal the identities of counterparties on an anonymous, central limit order book.
The CFTC Should Reconsider Its SEF Registration Policy More Generally
The CFTC at some point also should reconsider its statutory interpretation and registration policy for SEFs more generally. The Commission could and probably should have interpreted the registration provisions of the Commodity Exchange Act (“CEA”) to require the registration only of those platforms facilitating trading in swaps subject to the trading mandate. This would have addressed in a bright-line manner uncertainties around which entities must register as SEFs.
I am confident that Congress did not intend to require uncleared swap trading activity, without exception, to occur on SEFs and DCMs. To do so would render unnecessary the separate and more limited trade-execution mandate.
Congress understood and intended that other swap markets would continue to exist alongside the new SEF marketplaces.
Nevertheless, the CFTC’s final rule has required multilateral trading platforms, even for uncleared or illiquid swaps, to build systems and provide trading protocols that are intended to apply to, and are really only appropriate for, cleared and relatively liquid swaps. Moreover, the CFTC’s approach has required potential registrants to make subjective judgments about whether a particular structure or multilateral functionality is consistent with the multiple-to-multiple language in the SEF definition. Such judgments, by their nature, are not susceptible to bright-line analysis and have required the CFTC and platform operators to make difficult and potentially conflicting legal determinations.
There was flexibility regarding trading protocols intentionally built in to the CFTC's SEF rule for mandated swap trades. For swaps subject to the trading mandate, the SEF rule sets forth an acceptable RFQ protocol, and permits voice execution through that protocol, for example, and it even establishes acceptable default crossing rules and workup mechanisms for trades within the permitted modes of execution. I have heard no specific complaints that the protocols themselves have constrained the ability of traders to complete their trades on SEFs, but the CFTC should be open to providing further guidance that would simplify operations and compliance for SEFs.
The CFTC Should Revise the MATT Process and Determine Swaps Subject to the Trading Mandate
At the appropriate time, the CFTC also should seek comment on whether the trading mandate should be a CFTC determination, superseding the existing MATT process via SEF or DCM rule filing. This could be a CFTC determination that is specific to the trading mandate, or it could be folded into the existing clearing mandate process, with a special emphasis on the “trading liquidity” factor in the statute.
The existing policy is based on the assumption that SEFs and DCMs are best positioned to evaluate whether a swap is liquid enough to support a trading mandate. But independent regulatory agencies should not leave policymaking of this sort to the very commercial entities that stand to benefit most from the trading policies in question.
By making MATT determinations itself, the Commission would be able to address uncertainty that results from multiple entities submitting different, but overlapping, MATT determinations. And the Commission would be able to inform the markets how certain packaged trades are to be treated, determine the level of specificity that applies to any MATT determination, and publish for the marketplace a standardized list of swaps that have been made available to trade as well.
This more orderly approach would provide the needed objectivity and certainty to the marketplace and, again, reduce the intra and inter-market fragmentation that the MATT process may exacerbate over time. It would also allow the CFTC to better coordinate future trading mandates with other global regulators, which would further minimize cross-border fragmentation.
To conclude, there is regulatory fragmentation today, and those of us responsible for overseeing the derivatives markets should not be satisfied with it. It does appear to be largely rooted in the fact that there is currently more comprehensive regulation of the derivatives markets in certain locales, particularly the U.S., as other jurisdictions continue implementing G20 reforms.
And I, for one, appreciate the greater procedural complexity related to legislating and rule-writing in the European Union, with twenty-eight member states – I have always believed this best explains the timing mismatch in implementation, not an absence of mutual will.
Some cross-border fragmentation already has diminished with time, evidenced by the increase of trading on SEFs by non-U.S. entities. The actions by the CFTC I’ve suggested today would diminish it further.
As we move forward together implementing a new market structure for swaps, further coordinated regulation by the G20 would minimize market fragmentation even more. Global parity must be achieved through agreement on policy objectives and outcomes, and perhaps even means to those outcomes where necessary, to protect the integrity of the markets and the formation of liquidity globally. These should be, and I believe will be, the defining hallmarks of the new era for derivatives markets.
Last Updated: November 18, 2014