February 23, 2012
Thank you Mr. Chairman and thanks to all of the staff who has put a tremendous amount of time and effort into formulating the final business conduct rules and the proposal for establishing appropriate minimum block sizes for swaps that we are voting on today. The challenges we face in implementing the Dodd-Frank Act are ongoing, and I cannot emphasize enough how proud I am to be part of an organization filled with such dedicated public servants.
While I appreciate the hard work that has gone into finalizing the business conduct rules, I unfortunately cannot support the final product. There are too many provisions in the final rules that don’t make sense, or portend disturbing trends. I’ll point out just a few examples.
During the course of the comment period the Commission received requests to allow substituted compliance for entities subject to comparable regulation by a prudential regulator. This makes perfect sense to me from both resource and policy perspectives. If a registrant is subject to comparable regulation, why do we need to layer on additional regulation? And, given our owned strained resources and the additional burdens that duplicative regulation places on registrants, shouldn’t we be looking for ways to rely on our fellow regulators whenever we can? Instead, the Commission “has determined that its interests in ensuring that all registrants are subject to consistent regulation outweighs any burden that may be placed on registrants that are subject to regulation by a prudential regulator.” This is a form over substance, cookie cutter approach that we can ill afford at a time when our resources have been stretched as never before. It also does not bode well for how the Commission may be approaching extraterritoriality issues. While we have been hearing for months that staff has been developing guidance on the application of Dodd-Frank to activities outside the U.S., nothing of substance has been shared with my office to date. Given the Commission’s unwillingness to rely on comparable regulation by a U.S. prudential regulator, I am left wondering whether we will be abandoning our long standing policy of recognizing and relying on comparable foreign regulators. I hope the answer to that question is no.
Another provision of the final rules that baffles me is the requirement that swap dealers (SDs) and major swap participants (MSPs) diligently investigate the adequacy of the financial resources and risk management procedures of any central counterparty (CCP) through which the registrant clears. Given the extensive, detailed regulations the Commission recently finalized for derivatives clearing organizations (DCOs) on financial resources and risk management procedures, any DCO that accepts a swap for clearing presumably will not do so unless it has the proper resources and risk management procedures in place. The preamble to the rules states, however, that a determination that a DCO is in compliance with the Commission’s core principles and regulations is no “substitute for the due diligence of registrants who must evaluate the use of a central counterparty in light of their own circumstances.” This begs the question – what is a registrant supposed to do to independently satisfy itself that a DCO has sufficient resources and procedures to clear a particular swap that it accepts for clearing? Can a registrant refuse to clear a swap the Commission has determined must be cleared because the registrant has determined that no DCO that accepts the swap for clearing is truly up to the task given the registrant’s particular circumstances? The preamble also states that SDs and MSPs may voluntarily elect to clear swaps that are not required to be cleared through CCPs that are not registered with the Commission, and in those instances some sort of due diligence prior to submitting a swap for clearing would be part of a prudent risk management program. While this makes slightly more sense, I am again left wondering whether we are signaling something about the extraterritorial application of our rules. Do we contemplate allowing U.S. swap dealers to voluntarily clear through foreign CCPs? If so, under what circumstances will that be allowed?
I am most disturbed, however, by the walls we are erecting on communications between the trading and clearing units of swap dealers and affiliated FCMs. The only exception we allow is for communications necessary to manage a default. The statute requires SDs to establish safeguards to ensure that interactions between trading and clearing personnel do not contravene the provisions of the Act requiring open access to clearing. In typical fashion, our rules go far beyond the intent of the statute and prevent any communication between a swap dealer and an affiliated FCM that would incentivize or encourage the use of an affiliated FCM for clearing. We seem to be worried that a customer’s clearing choices will be narrowed if a multi-service financial institution offers options based on bundled or non-bundled services. The end effect of the rules, however, is to restrict a customer’s access to information upon which to make an informed choice. Rather than protecting customers, I fear the rules will increase their costs and create needless inefficiencies for those looking for full service options.
With regard to the block trading proposal, I really appreciate the hard work the team has put into trying to come up with a practicable solution to a very challenging problem. Dodd-Frank mandates that the Commission specify the criteria for determining what constitutes a large notional swap transaction (blocks) for particular markets and contracts. In determining appropriate block sizes, Congress has directed that we 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. It is no small task to come up with a solution to this complex problem. I believe it is worth noting that we have been grappling with the concept of appropriate block size and market transparency in the futures markets for years. In July 2004 we proposed guidance on, among other things, DCM block trading rules. We re-proposed again in 2008, and again in 2010. 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 SEFs.
Under the current proposal which recommends utilizing a 67% notional amount calculation, only the largest 6% of all IRS and CDS would be block trades. This proposal ignores Congress’ mandate that we take into account the impact of public disclosure on liquidity. We are effectively sacrificing liquidity at the altar of transparency.
While I applaud the rule team’s efforts to analyze available data in the Interest Rate Swap and Credit asset classes, the team only had access to 3 months’ worth of transaction data, and that transaction data dates back to the summer of 2010. We are relying on stale data, and far too little of it. Absent further transaction data it is hard to say if the 6% relationship would even hold true over a larger transaction data set. Of greater concern to me is the one size fits all approach in which we blindly apply the 67% formula across asset classes. I do not believe this is prudent given the potential variations in liquidity among the asset classes.
The one ray of light that I do see in this proposal is that this team has gone to great lengths to pose numerous questions and to put out myriad alternative approaches for comment. If we are going to get this right in the final rule, we need to be willing to consider all of the comments from industry.
Working to finalize the rules which will implement Dodd-Frank is the most important role I have played as a Commissioner at the CFTC. 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 will give these rules the ability to stand the test of time. The rules should not only reflect input from the majority, but from the Commission as a whole and these rules do not do that. We consistently reject reasoned comments from industry professionals with little justification in our cost benefit analysis to support those rejections. I have been hopeful over 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, and 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.
Last Updated: February 23, 2012