January 11, 2012
Thank you, Chairman Gensler. Thank you also to the professional staff for your hard work on the recommendations before us today. I appreciate your dedication to getting these regulations right and that you have remained open to public input and feedback from my office and others.
Protection of Cleared Swaps Customer Collateral
Clearing is a critical component of the Dodd-Frank Act’s regulatory regime for swaps and one of its primary means of reducing systemic risk in the financial markets. Today, we are considering final regulations that will take important first steps to ensure that customer collateral is appropriately protected throughout the swaps clearing process.
The Commission previously requested comment on a number of clearing models, each with certain customer protections and operational costs. After considering these models and engaging in detailed discussions with the public, I am confident that, at present, the legal segregation with operational commingling model (“LSOC”)—or the “complete legal segregation model” as it has been re-termed in the final—sets forth the most cost effective framework to protect customer collateral for swap transactions.
The LSOC model substantially reduces fellow customer risk. Derivatives clearing organizations (“DCOs”) will be prohibited from accessing non-defaulting customer collateral in the event of a double default of a customer and its FCM clearing member. In the event of such a default, moreover, LSOC facilitates the movement of positions and related collateral. Each DCO will have customer information on a customer-by-customer basis and thus will be less reliant upon the defaulting FCM for that information.
To be clear, certain risks remain under the LSOC model. First, although fellow customer risk is significantly reduced, it is not eliminated. In the event of a double default, customers continue to face the risk that substantial variation margin will not be credited and ported immediately with non-defaulting customer collateral due to payment netting practices. Second, excess collateral in the FCM’s customer account is always exposed to operational risks, including risks of fraud or misappropriation.
But no regulation—indeed, no segregation model in itself—will in every case prevent the willful misappropriation of customer funds. That is why I have asked the staff to consider whether additional or other collateral protections could further reduce risks to customer collateral.
For instance, I am eager to further discuss the merits of a “guaranteed clearing participant relationship” that would permit a customer to hold its collateral in a third party custodial account, with a guarantee from its FCM clearing member. In the meantime, today’s final regulations take the initial step of clarifying that customer collateral may be deposited, at the election of the FCM and its customers, in a “third-party safekeeping account.”
The staff is planning two roundtables to seek public input concerning other potential measures to provide further protections for customer collateral. I look forward to working with the staff on these important ongoing initiatives. One of the issues we need to explore is whether similar protections for customer collateral in the futures markets would be appropriate. This should not, however, prevent us from taking important first steps to protect swaps customer collateral now.
I therefore will be supporting the staff’s recommendations.
External Business Conduct Standards
We are also considering final regulations to establish external business conduct standards, which require a delicate balance. If our rules prove unworkable, or raise unacceptable legal risks, then swap dealers and major swap participants may choose not to do business with some swap counterparties—especially “Special Entities,” as defined by Dodd-Frank. This could deprive swap market participants of the liquidity they need to manage their risks.
I commend the staff for their diligent efforts and thoughtful consideration of the strong views expressed by those on all sides of this debate. The staff has fairly considered conflicting viewpoints in crafting a rule that, in their professional judgment, protect counterparties from abusive practices.
I support the staff’s recommendations because, in my judgment as well, they take a reasoned approach consistent with the statute. On the one hand, the rules implement a robust investor protection regime, as directed by Congress, especially with respect to Special Entities that the public depends on for stewardship of retirement benefits, public funds, and endowments. On the other hand, the rules set standards that are reasonably tailored to the manner in which the swap markets operate, and thus market participants should be able to comply without undue regulatory risks and costs.
I appreciate the willingness of the staff to accommodate changes throughout the rulemaking process. These changes have improved the final regulations. For example, the revisions made to develop safe harbors with respect to ERISA plans, supported by my office and others, reflect sound public policy in light of the established regulatory structure under ERISA and the high fiduciary standards already imposed.
I also support the shift in the final rules from the proposed requirement that swap dealers provide a scenario analysis for high-risk, complex swaps. Rather than leaving difficult determinations as to what constitutes “high risk” or “complex” to the dealer, the final rules permit a counterparty to “opt-in” by requesting a scenario analysis for any swap, together with disclosure of the material assumptions and limitations of the analysis. Where, however, a counterparty performs its own analysis and does not elect to obtain one from the dealer, we will not prescriptively mandate that one be provided anyway.
The final rule will build strong, new investor protections into the swap marketplace. It includes robust disclosure requirements that ensure counterparties receive information sufficient to assess the nature and extent of the material risks of a swap.
And the final rules contain a strong independence test to ensure that where a Special Entity has a Qualified Independent Representative to act in its best interests, that Representative is truly independent of the swap dealer or major swap participant on the other side of the transaction.
Finally, while I support this rule, our work in this area will not end here. The staff continues to work with the SEC, the Department of Labor, the National Futures Association (NFA), and the Municipal Securities Rulemaking Board (MSRB) to harmonize, where appropriate, our respective rules. Equally important, some commenters have suggested that a registration and testing regime for independent representatives be created. The staff is exploring whether such a regime is feasible.
Registration of Swap Dealers and Major Swap Participants
The registration-process rules leverage the Commission’s existing framework by delegating to the National Futures Association full registration authority. The NFA will be responsible for reviewing applications and confirming initial compliance with Commission rules.
Importantly, the Commission will maintain the authority to review the NFA’s performance and conduct on-site examinations of swap dealers and major swap participants. I will be supporting these rules because they establish an appropriate process for provisional registration while the new regulatory framework comes into effect.
The “Volcker Rule”
Finally, we are also considering a proposal to implement what is commonly known as the “Volcker Rule.” Among other things, the Volcker Rule generally prohibits banking entities from engaging in short-term proprietary trading for their own accounts and from owning or sponsoring hedge funds or private equity funds.
The Commission’s proposal includes questions concerning the applicability of certain provisions to CFTC-regulated entities, including FCMs, DCOs, swap dealers, and major swap participants.
This proposal is an important step towards finalizing the Volcker Rule and providing much-needed regulatory certainty to the public and the banking community. The Commission’s issuance of this proposal, together with the recent extension of the comment period by the other financial regulatory agencies, will afford the public an appropriate opportunity to review and comment on each agency’s Volcker Rule.
I would like to thank the staff for their hard work and coordination with other financial regulators. I will be supporting this proposal and I look forward to the comments.
I again want to thank the staff for its hard work on the proposed and final rules before us today.
Last Updated: January 11, 2012