June 25, 2013
In 2009, G20 leaders gathered in Pittsburgh and agreed to fundamentally reform the structure and operation of the global derivatives markets. The U.S. followed through on that commitment with the adoption of the Dodd-Frank Act. The Commodity Futures Trading Commission (“CFTC”), for its part, will nearly finalize its implementation of that legislation over the coming weeks.
With more than seventy swap dealers registered with the CFTC—some of whom call the United Kingdom home—regulatory reporting required for market participants, clearing mandates in place for a broad swath of the interest rate and credit space, and swap execution rules to promote pre-trade transparency and usher in real-time public reporting, almost all of the critical components of the agreed-upon reforms have become a reality in the U.S.
One of the remaining and critical components, however, is the CFTC’s cross-border guidance, which will set forth an interpretation of the reach of U.S. law and clarify the circumstances under which Dodd-Frank rules have effect beyond U.S. borders. Discussions inside the agency have been underway for many months and we have made significant progress in recent weeks towards a workable cross-border framework. In many respects, the final guidance involves the most consequential and complicated policy judgments that the agency must make under the Dodd-Frank Act. As a result, carefulness and indeed humility must guide us in this process.
In my judgment, three objectives must be achieved through our cross-border guidance and related relief. First, it must protect U.S. taxpayers and the U.S. financial system. Second, it must embrace a substituted compliance approach that (1) avoids creating un-even playing fields for U.S. financial institutions vis-a-vis each other and foreign competitors and (2) supports an efficient and sound derivatives market structure. Finally, as a mechanical matter, the final cross-border guidance must be clear and workable. By “clear,” I mean that the CFTC’s ultimate approach must contain as little ambiguity as possible concerning the scope and application of U.S. regulatory requirements. By “workable,” I mean it must be implemented over a reasonable period of time, which, in my view, necessarily requires a formal and adequate phase-in period for compliance.
The remainder of my remarks will discuss each of these objectives in more detail.
The CFTC’s Cross-Border Policy Must Protect the U.S. Taxpayer and Financial System.
The G20 commitments were a reaction to a global financial crisis. Although the causes of that crisis are not as clear as messaging often suggests, few would disagree that liquidity constraints at certain firms were at least exacerbated by exposures to derivatives.
The plain truth is that risk associated with derivatives is mobile and can migrate rapidly across borders in modern financial markets. An equally plain truth is that any efforts to monitor and manage global systemic risk therefore must be global in nature. Yet another plain truth is that prudential regulation has taken into account the foregoing for decades. It alone has not always prevented risk-management failures and the resulting threats to the stability of the financial system.
Risk mobility means that regulators in the U.S. and abroad do not have the luxury of limiting their oversight to financial activities occurring solely within their borders. Financial activities abroad may be confined to local markets in some cases, but the financial crisis, and recent events, make clear that the rights and responsibilities that flow from these activities often are not.
Perhaps as important, Congress reacted to the financial crisis by authorizing the CFTC to oversee activities conducted beyond its borders in appropriate cases. It could have limited the CFTC’s oversight to only those entities and activities located or occurring within our shores, but it did not.
In fact, Congress recognized in Dodd-Frank that even when activities do not obviously implicate U.S. interests—as might be the case when an affiliate of a U.S. financial firm deals to a “true” foreign person—they can still create less obvious but legally-binding obligations that are significant and directly relevant to the health of a U.S. firm; and which in the aggregate could have a material impact on the U.S. financial system as a whole.
So it is clear to me that the CFTC must adopt cross-border guidance that accounts for the varied ways that risk can be imported into the U.S. At the same time, it is paramount that the CFTC approaches that task in a manner that respects the limits of U.S. law and the resource constraints of U.S. and global regulators. We should remain mindful, in addition, that the final guidance will have consequences not only for market participants but also our own efforts to promote international harmonization.
The CFTC Must Protect the U.S. Financial System but Avoid Fragmenting Liquidity and Creating Unfair Competitive Advantages for Some Firms and Markets.
In accounting for these concerns, the CFTC’s cross border policy can protect the U.S. financial system and, at the same time, avoid creating needless and arbitrary advantages for certain markets and firms, or their legacy business structures. Properly emphasizing risk importation in fact provides the CFTC a principled basis to permit substituted compliance with foreign regulations, which the Dodd-Frank Act implicitly recognized as a means to further global derivatives reforms.
Indeed, both the CFTC’s cross-border guidance and certain Dodd-Frank provisions contemplate that market participants should be permitted to comply in appropriate cases with “comparable and comprehensive” foreign regimes, which has given life to a necessary debate surrounding the meaning and mechanics of the substituted-compliance concept. There remain important and unresolved questions, however, about the scope and granularity of the CFTC’s substituted-compliance approach, particularly as it relates to transaction-level requirements such as clearing, reporting, and execution.
With regard to scope, I am confident that the CFTC could make rational legal and policy arguments for applying U.S. law in all cases to trades involving at least one U.S. person, properly defined. But there are legitimate counterarguments to that policy, including the rather obvious one that if U.S. interests are directly implicated by having a single U.S. person in a trade, then non-U.S. interests would seem to be logically implicated by having a single non-U.S. person in the trade as well. We must be prepared, moreover, to address the following policy question: if substituted compliance can protect U.S. taxpayers and the financial system in some instances, why not in others as well?
Liquidity and Risk Fragmentation. A more compelling reason to consider substituted compliance for a trade between a U.S. and non-U.S. person is that it is good policy. Indeed, it might be necessary to avoid liquidity fragmentation, for example, which itself can be risk-enhancing. Fragmented liquidity, and the regulatory and financial arbitrage that both drives and follows it, can lead to increased operational costs and risks as entities structure around the rules in primary swap markets. Even if firms are able to navigate the conflicts and complexities of differing regulatory regimes, regulators here and abroad 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.
This policy judgment, moreover, will likely spur an equal and opposite reaction by global regulators. Mutual recognition is a two-way street: permitting a U.S. person to comply in appropriate cases with “equivalent” European laws, for example, means also that an E.U.-based firm might be permitted to substitute compliance with U.S. law as well. Economically, this translates to open, competitive derivatives markets. It means efficient and liquid markets. A global regime is the best means to avoid balkanization of risk and risk management that, though politically palatable to some, in reality benefits no one. In fact, the fragmentation and regionalization of markets may expose the U.S. financial system over time to risks that are unnecessary, needlessly complex, and difficult to predict and contain.
To be sure, in seeking an efficient and sound market structure, the CFTC should take care not to go too far and inadvertently incentivize liquidity formation outside of the U.S. I am confident that substituted compliance, properly conceived, will neither harm our country’s competitive standing nor undermine the systemic-risk objectives of Dodd-Frank.
Unlevel Playing Fields. Of course, substituted compliance is not, in itself, a sufficient means to ensure equal treatment and access to global derivatives markets. I am especially concerned that the CFTC’s guidance in other areas might inadvertently create unfair advantages for certain firms over others, or for certain legacy business structures over others. If this is not avoided, the likely result will be the further balkanization of risk and the adoption of rules by foreign regulators that have the intended effect of closing entire markets to U.S. firms.
U.S. and non-U.S. market participants deserve equal and impartial access to global markets unless there is a rational reason to prevent it. If the activities of and risks presented by these firms or business structures are not materially different, the CFTC should not treat such firms or business structures differently.
The issue of the appropriate granularity of substituted-compliance determinations presents difficult conceptual and diplomatic issues for the CFTC as well. The consensus view at this time is that substituted compliance will be a category-by-category determination, within an “outcomes-based” framework, and I am working with others at the Commission to clarify what the CFTC means by that. Responsible policymaking requires the CFTC to clarify both the process and standards for finding a foreign regulatory regime comparable to U.S. law.
We have to decide, for example, whether the wholesale adoption of the language of the Dodd-Frank Act would be sufficient to qualify a jurisdiction for substituted compliance or whether the Commission intends to go the extra-mile and require adoption of certain implementing regulations as well.
As a more general matter, I am convinced that practicality also has to inform our thinking on cross-border issues. Surely, the CFTC cannot expect another regime to follow U.S. law to the letter and comma. To give fair and workable meaning to an outcomes-based framework, the CFTC’s policy must not confuse concerns about risk importation with the means for limiting it.
For example, Congress provided explicit authority for the CFTC to exempt certain clearinghouses and trading venues from registration, provided the entities seeking these exemptions demonstrate that they are subject to “comparable, comprehensive” regulation in their home countries. Tellingly, Congress also provided that trades cleared and executed through exempt clearinghouses and exempt swap execution facilities could satisfy the clearing and trade-execution mandates, respectively, under the Dodd-Frank Act.
These provisions contemplate a limited-recognition regime that is not unlike the equivalence framework in the E.U. This recognition-through-exemption approach does not, however, address all clearing, reporting, and trading complexities incident to denying substituted compliance for transaction-level requirements more broadly, where a U.S. and non-U.S. person seek to execute a trade. Nevertheless, the CFTC’s embrace of these provisions might be a useful step towards developing a workable cross-border framework for clearing and executing trades on global registered entities. It may in fact incentivize that kind of regulated activity, and it certainly would do more to prevent the unnecessary fragmentation of liquidity and risk than an outright rejection of substituted compliance.
In summary, before settling on a final substituted-compliance approach that addresses fragmentation and competition concerns, the CFTC must ensure that it has fully explored its options, including even more substantial adjustments to the substituted compliance framework (e.g., whether it would be good policy to exclude some or all trade execution requirements from the analysis). Effectuating a policy that permits the use of exempt clearing houses and trading platforms, though, could conceivably release some of the pressure to extend substituted compliance beyond this limited subset of transaction-level requirements.
The CFTC Must Adopt a Cross-Border Policy that is Clear and Workable, Which Requires an Orderly Transition Period.
Clarity. In any event, the CFTC should not delay these policy judgments much longer. Title VII is live in the U.S. and global market participants deserve regulatory certainty to the extent possible through final guidance. Moreover, U.S. regulators simply cannot and should not indefinitely delay financial reform in order to accommodate the procedural hurdles to such reforms overseas. Based upon the significant progress of global reform efforts underway in Europe and elsewhere, however, the CFTC and other financial regulators must be willing to revisit their cross-border frameworks and remain open to course correction as developments in the global and domestic derivatives markets dictate.
Clarity and certainty are paramount. For markets to operate efficiently, competitively, transparently, and safely, market participants must know whether U.S. law applies, whether U.S. law conflicts with the laws of foreign jurisdictions, and whether they are doing what the law requires. Incidentally, ambiguity means uncertainty. It also means opportunities to avoid not only Dodd-Frank but derivatives regulation in general.
We must acknowledge, moreover, that the markets are adjusting quickly to the U.S. push towards a regulated marketplace. The Dodd-Frank Act is in certain areas so transformative that it is unreasonable to expect fundamental changes to the existing market structure to be implemented overnight. Forcing changes too quickly presents operational risks and operates counter to systemic-risk objectives.
Responsible policymaking therefore requires that U.S. regulators provide an orderly transition from the over-the-counter markets to the new, Dodd-Frank marketplace. Financial reforms will not be evaded or avoided during this period if we are measured and deliberative. So provided interim measures do not expose the U.S. and global financial systems to undue risk, we in the global regulatory community must recognize the complexities and practical challenges market participants face as they bring themselves into compliance with our rules.
In addition, as the CFTC reacts to global developments and revisits its policy judgments in the weeks and months ahead, it should consider whether the means for delivering these policy judgments needs to be adjusted. We should consider this, however, only after the staff and market participants have on-the-ground experience overseeing and implementing the final guidance. Given the complexity of the policy questions and compliance challenges, the interim flexibility provided by mere guidance is in some ways useful and preferable to more formal CFTC action under the circumstances.
Finally, U.S. regulators must acknowledge that a global market requires global coordination to protect against systemic risk. We must consider carefully whether stepping in front of the regulatory process discourages the very financial reforms that we are trying to implement, which could in turn needlessly complicate the Commission’s efforts to contain systemic risk and protect the U.S. taxpayer.
Indeed, for these reasons and others, I believe the CFTC should adopt interim final guidance in the coming weeks and seek additional comment on an interim approach that provides the legal certainty needed for the markets in the short term. Of course, that will also facilitate continued coordination with domestic and international regulators.
Workable. It is also absolutely essential that our interim final guidance be coupled with formal relief that provides sufficient adjustment time for the marketplace, and appropriate incentives for foreign regulators, to bring their regimes in line with Dodd-Frank. If the CFTC neither finalizes guidance nor extends the current exemptive order that expires on July 12th, market participants will be left to construe the statute in a manner that is reasonable and consistent with their commercial interests.
It is conceivable that each firm will fear that its competitors will construe the statute to benefit their clients and therefore be incentivized to construe it more narrowly than otherwise would be the case under the exemptive order. In some cases, such a narrow construction could pose risks to the U.S. financial system that would not exist with an extension of the exemptive order.
All of us here today have important work to do in the coming weeks and months to help realize the G20 commitments. I will end by expressing my gratitude to the FIA and FOA for their constructive role in that process, and by wishing those organizations the very best in their new affiliation. I look forward to continued engagement with the newly formed organization.
Last Updated: June 25, 2013