December 5, 2011
Thank you Mr. Chairman. I too would like to welcome Commissioner Wetjen to his first CFTC Dodd-Frank open meeting. And, as always, I thank the teams who have worked so diligently on the two final rules and the proposal we are considering today. The longs hours you have committed to the documents before us today are very much appreciated.
Today we are considering the final rule creating a registration system for Foreign Boards of Trade (FBOTs) that make their products available to U.S. customers by providing them with direct access to their electronic trading system. This rule will replace the existing process of staff-issued no action relief letters. The CFTC has a long history of recognizing regimes with comparable regulatory objectives. Currently we have over 20 Foreign Boards of Trade operating under no-action relief. It is very important to me for us to retain the type of regulatory cooperation we have with other jurisdictions. I believe that global markets benefit from international support and collaboration among supervisors. It is my hope that under this new registration regime, the CFTC will continue to be a global leader in recognizing and granting access to FBOT’s with comprehensive and comparable oversight from their home country regulator.
In September of this year the Commission voted on a proposed compliance and implementation schedule for the clearing and trade execution requirements of Section 2(h) of the Act. I reluctantly supported the proposal because it provided some degree of certainty regarding implementation deadlines. I was discouraged; however, that the Commission had failed to provide any certainty with respect to what would trigger the trade execution requirement. I urged the Commission at our September meeting to define what it means to “make a swap available to trade.” The proposal before us today represents some progress in that direction. Unfortunately, I think we’ve taken a wrong turn.
The proposal provides that DCMs and SEFs, rather than the Commission, will make the determination of when a swap has been made available to trade by considering seven enumerated factors, or any other factor that the DCM or SEF may view as relevant. The DCM or SEF may base its determination on any combination of the factors, or on a single factor. The rules provide that the DCM or SEF may either certify the determination or seek approval under the Commission’s part 40 rules. Although the Commission could theoretically overturn such a determination through its rule certification or approval review, the lack of any parameters on how these factors should be considered will make it very difficult, if not impossible, for the Commission to reverse a determination. Once such a determination is final, all other DCMs and SEFs are obligated to determine whether they list or offer the same, or an economically equivalent swap, and if so, they must treat the swap or economically equivalent swap as having been made available to trade within the meaning of Section 2(h)(8). And although the proposal is silent on the matter, all over-the-counter (OTC) participants will also have to determine whether a swap they trade or would like to trade is the same or economically equivalent because, if the Commission has determined that the swap must be cleared, OTC trading must cease.
This approach is deeply flawed and I cannot support putting it out for comment, even recognizing that it is just a proposal. This proposal, if finalized, would allow a single DCM or SEF to bind the entire marketplace to a trade execution requirement through an ill-defined analysis that the Commission will be unable to reject unless it finds that the determination is inconsistent with the Act or Commission regulations. Given the lack of any mandatory, objective criteria contained in the rules, it is difficult to envision how the Commission could find a made-available-for-trading determination to be inconsistent with the Act or regulations. For example, the proposed rules would allow a DCM or SEF to declare a swap made available to trade based solely on a finding that there are ready and willing buyers and sellers. Will a swap that trades once or twice a year qualify under this test? Could the Commission find a determination based on one or two trades a year to be inconsistent with the rule? I don’t know.
The definition of “economically equivalent” set forth in the proposal is also problematic. It directs DCMs and SEFs to determine whether a swap is economically equivalent with another swap after considering each swap’s “material pricing terms.” I’m not sure what that means and expect that market participants will not be sure either.
The proposal, in effect, would delegate implementation of the trade execution requirement of Section 2(h)(8) of the Act to DCMs and SEFs. The fact that Congress did not explicitly direct the Commission to make the made-available-for-trading determinations does not mean that we should turn this critical responsibility over to DCMs and SEFs. I strongly disagree with the statement in the preamble to the proposed rules that this is a balanced approach. In my view, going down this path amounts to an abdication of our responsibility as market regulators to provide clear rules of the road. We’ve given no legitimate reason for taking this approach and I do not believe that Congress intended for us to allow a single DCM or SEF to make determinations that will have profound market-wide implications.
Revisions to the list of permitted investments under Rule 1.25 is an issue the Commission has been grappling with for quite some time, beginning with a survey conducted in 2007 to gather information on how futures commission merchants (FCMs) and derivatives clearing organizations (DCOs) were investing customer funds. In May 2009 the Commission solicited comments through an advanced notice of proposed rulemaking, and we issued a proposed rulemaking in October 2010. In July of this year staff circulated to the Commission a proposed final rule. I supported most of the provisions contained in the July version of the rule, but believed some of the revisions needed further vetting, primarily the ban on in-house transactions. The preamble to the version of the rule we are voting on today clarifies the scope of the ban and distinguishes in-house transactions from in-house sales of permitted investments and in-house exchanges of collateral to convert customer funds into collateral that will be accepted by a DCO or foreign board of trade as margin. I support the ban on in-house transactions with this clarification. I also support the harmonization of Rule 30.7 with the investment limitations of Rule 1.25 and the concentration limits on various investments to promote portfolio diversification.
I have lingering questions, however, regarding investment in foreign sovereign debt. A number of different recommendations on this issue have been presented to the Commission in recent days. The version before us today bans investment in foreign sovereign debt, but invites FCMs and DCOs that seek to invest customer funds in foreign sovereign debt to petition the Commission for exemptive relief pursuant to Section 4(c) of the Act. I believe that investment in foreign sovereign debt, to the extent that an FCM or DCO has balances in segregated accounts denominated in that country’s currency, should be permitted to hedge foreign currency fluctuation risk so long as the foreign sovereign debt qualifies under the overarching objectives of preserving principal and maintaining liquidity. I look forward to discussing how this will handled under Section 4(c).
I would like to close with an observation on the dearth of information we have regarding how FCMs and DCOs are actually investing customer funds. The cost-benefit analysis states that FCMs currently hold over $170 billion in segregated customer funds and $40 billion in Rule 30.7 funds. Throughout the cost-benefit analysis we acknowledge that the new restrictions on investments may cause some forced sales or administrative costs to convert unacceptable investments into permitted investments, but we have no way of calculating these costs because we are not in a position to know the composition of customer fund portfolios. We should know. The last time the Commission attempted to collect this information was in 2007. As the last four years have demonstrated, we are living in volatile times. Financial instruments that are safe today can quickly devolve into risky propositions. The Commission should make a concerted effort, through either a reporting regime or regular surveys, to collect information on the investment of customer funds on at least a yearly basis. We should also think about ways to regularly review and update the list of permitted investments under Rule 1.25.
Last Updated: December 5, 2011