SPEECHES & TESTIMONY

Dissenting Statement of Commissioner Dan M. Berkovitz on the Supplemental Proposal for Exemption from Derivatives Clearing Organization Registration

July 11, 2019

I dissent from the proposal to exempt certain foreign clearinghouses from the derivatives clearing organization (“DCO”) registration requirements.  The proposal would jeopardize U.S. customers, create systemic risks to the U.S. financial system, promote the use of foreign intermediaries at the expense of U.S. firms, and exceed this agency’s limited exemptive authority.[1]

The Commodity Futures Trading Commission (“Commission”) previously has permitted the clearing of proprietary swap positions at a limited number of foreign clearinghouses that it has exempted from the DCO registration requirement.[2]  The proposed rule before us today (“Exempt DCO Proposal” or “Proposal”) would permit, for the first time, exempt DCOs to clear positions of U.S. customers.[3]  To accomplish this, the Proposal disregards key protections for U.S. customers and the U.S. financial system provided by the U.S. Bankruptcy Code, the CEA, and CFTC regulations.

The Exempt DCO Proposal would permit U.S. customers to clear swaps at exempt non-U.S. DCOs without the protections afforded to swap customers under the Bankruptcy Code or CFTC regulations.  It would enable U.S. customers to trade at these exempt DCOs through non-registered foreign intermediaries who would not be covered by the U.S. Bankruptcy Code or subject to the CFTC’s customer protection requirements.  Enabling U.S. customers to trade swaps and amass large positions in non-U.S. markets without these protections not only poses risks to those customers, but also presents systemic risks to the U.S. financial system.

The Exempt DCO Proposal also would prohibit U.S. FCMs that are registered with the CFTC from providing clearing services at exempt DCOs.  The Exempt DCO Proposal thus requires that which the CEA prohibits (clearing by a non-registered intermediary), and prohibits that which the CEA requires (clearing by a registered FCM).  The Proposal creates a Bizarro World[4] for U.S. swaps customers in which the CFTC does not regulate derivative clearing organizations, only unregistered foreign firms are allowed to serve U.S. customers, and U.S. customers get none of the protections provided by U.S. law.

The CFTC does not have the superpowers to fashion its own de-regulatory planet.  It must stay within the orbit of the laws prescribed by the Congress.  It cannot bypass any provision of the CEA that it considers an impediment to a global swaps market.  Congress has not provided the CFTC’s with unlimited exemptive authority.  In particular, the CFTC’s limited exemptive authority under CEA section 4(c) does not extend to instruments that are not subject to the exchange-trading requirement of section 4(a), such as non-U.S. swaps traded in markets located outside the United States.[5]  By seeking to exempt non-U.S. intermediaries who provide clearing services to U.S. swap customers in overseas markets from the registration requirement for FCMs,[6] the Proposal exceeds the Commission’s authority.

No Customer Protections

The Exempt DCO Proposal would eliminate the important protections afforded to U.S. swaps customers provided by Congress and the CFTC’s regulations.[7]  Many of these protections result from the provisions in the Bankruptcy Code applicable to FCMs and the regulatory requirements imposed on the FCMs regarding the handling of customer funds.  Section 4d(f) of the Act, which was added by the Dodd-Frank Act, provides that only registered FCMs may accept customer monies to margin cleared swaps.  It also requires FCMs to segregate customer cleared swaps funds, and prohibits the comingling of customer and proprietary funds.[8]  In addition, all FCMs must implement systems and procedures to address conflicts of interest, and they must each designate a chief compliance officer to fulfill specified duties and responsibilities.

In the event that a registered FCM becomes insolvent, swaps customers are protected if their funds reside in segregated accounts as required by the Act and Commission regulations,[9] are carried by an FCM, and are deposited with a registered DCO.  Segregation helps to ensure that swaps customer funds are not comingled with an FCM’s proprietary funds, while registration helps ensure that they meet applicable definitions in the Bankruptcy Code to fall under its protections.

Customer protections under the Bankruptcy Code include safe harbors for certain derivatives contracts that allow non-defaulting counterparties in a bankruptcy proceeding to quickly terminate and net their swaps.  The safe harbors override the Bankruptcy Code’s automatic stays that would otherwise foreclose any action to liquidate collateral and collect debts from a defaulting party.[10]  Swap customer funds are given priority treatment and not included in the bankruptcy estate that is subject to other creditors of the bankrupt firm.  These protections facilitate the prompt transfer of customer positions away from an insolvent FCM, which can avoid a forced liquidation at potentially depressed valuations.  In the event that an FCM becomes insolvent, the Bankruptcy Code also entitles the FCM’s customers to a pro rata distribution of customer assets ahead of any other creditors of the FCM.

The Exempt DCO Proposal would circumvent these fundamental swaps customer protections by permitting foreign intermediaries to accept U.S. customer funds to margin cleared swaps at exempt DCOs without registering as an FCM.  It would free foreign intermediaries from all of the regulatory requirements that apply to U.S. FCMs, including requirements providing for the protection of customer funds, financial safeguards, and operational soundness.  At the same time, it would prohibit CFTC-registered FCMs—the entities which are subject to these customer protection requirements—from acting as FCMs for U.S. customers at exempt DCOs.  The Proposal thus legally ensures that U.S. customers will not receive the customer protections required by the CEA, CFTC regulations for swap transactions, and the Bankruptcy Code.

Absent these protections, U.S. swaps customers potentially face a range of financial and market risks.  U.S. customers may find that foreign bankruptcy laws fail to provide priority treatment for derivatives and could include their funds in the general bankruptcy estate for all creditors of the insolvent firm.  Uncertainty over the treatment of customer funds held at an exempt DCO or a foreign intermediary, as well as over the portability of open positions at the DCO could also lead counterparties to quickly terminate their swaps.  The cascading effects on market prices, liquidity, the value of open positions, and perceived counterparty credit risk could quickly become a systemic event.

Systemic Risks

In the U.S., the segregation requirements for margin funds held at an FCM protect the funds of the customer in the event that the FCM becomes insolvent.  If there are no similar segregation requirements, then the failure of the clearing intermediary could result in significant losses to the intermediary’s customers.  These losses could impair one or more customers’ ability to maintain its trades with its other counterparties, not just those at the affected non-U.S. DCO.  Such other counterparties may seek to terminate their trades with the affected U.S. persons to avoid potential losses that could arise in these circumstances.  The losses of one or more U.S. entities due to the bankruptcy of another entity or intermediary in a non-U.S. jurisdiction without equivalent bankruptcy laws thus could rapidly escalate into a more widespread market event involving numerous other persons within the U.S.[11]

The Proposal contains no discussion or analysis of the potential systemic consequences if a foreign intermediary holding significant assets from large U.S. swaps customers were to fail.  Similarly, it fails to examine the impact to the U.S. financial system if the overseas assets of large U.S. swaps customers were to become entangled – or potentially entangled – in foreign bankruptcy proceedings.

Exclusion of U.S. FCMs

The Exempt DCO Proposal would prohibit U.S. FCMs from providing clearing services to U.S. swaps customers at exempt DCOs.[12]  By itself, this prohibition would not be problematic, as it is consistent with the Commission’s interpretation of the CEA and longstanding policy.  The Proposal veers off course by coupling this prohibition with permitting non-registered foreign intermediaries to provide those same services without any protections for U.S. customers.

In last year’s initial proposal to establish a framework for exempt DCOs, the Commission proposed to prohibit FCMs from clearing customer swaps at exempt DCOs.  At that time, the Commission explained:

Section 4d(f)(1) of the CEA makes it unlawful for any person to accept money, securities, or property (i.e., funds) from a swaps customer to margin a swap cleared through a DCO unless the person is registered as an FCM.  Any swaps customer funds held by a DCO are also subject to the segregation requirements of section 4df(2) of the CEA, and in order for a customer to receive protection under this regime, particularly in an insolvency context, its funds must be carried by an FCM, and deposited with a registered DCO.  Absent that chain of registration, the swaps customer’s funds may not be treated as customer property under the U.S. Bankruptcy Code and the Commission’s regulations.  Because of this, it has been the Commission’s policy to allow exempt DCOs to clear only proprietary positions of U.S. persons and FCMs.[13]

In its zeal to enable U.S. customers to access non-U.S. swap markets, the Commission seeks to sidestep these issues with the Bankruptcy Code by jettisoning the entire bankruptcy regime as it applies to U.S. swaps.  It would accomplish this by permitting non-registered, non-U.S. intermediaries to clear swaps through exempt DCOs.  But this approach leaves U.S. customers without any bankruptcy protection and competitively disadvantages U.S. FCMs with respect to clearing in non-U.S. swaps markets.  In the cost/benefit considerations, the Commission acknowledges, “FCMs may . . . face a competitive disadvantage as a result of this proposal, as they would not be permitted to clear customer trades at an exempt DCO.  To the extent that their customers shift their clearing activity at registered DCOs to exempt DCOs, or otherwise reduce their clearing activity at registered DCOs as a result of this proposal, FCMs would lose business.”[14]

Not only would the Proposal place FCMs at a competitive disadvantage, the Proposal recognizes that this also would place registered DCOs at a competitive disadvantage.  The Commission states in the cost/benefit considerations that it “anticipates that some non-U.S. clearing organizations that are currently registered DCOs, or that would otherwise apply to register in the future, may choose to apply to become exempt an DCO, thus lowering their ongoing compliance costs.”[15]

A better approach would be to prohibit exempt DCOs from providing clearing services to U.S. customers—as the Commission proposed last year—and permit customer clearing only at registered DCOs, through registered FCMs.   This would preserve the competitiveness of U.S. FCMs in the global swaps markets and maintain the bankruptcy and other protections for U.S. customers.  Today’s companion proposed rule, providing for registration with alternative compliance for DCOs that would be eligible for an exemption, would provide a second mechanism—in addition to full DCO registration—for non-U.S. DCOs to provide for clearing services to U.S. customers.  The Commission does not explain why either the existing option for full registration, or the proposed alternative compliance mechanism, are insufficient to enable U.S. customers to access clearing services as non-U.S. DCOs.[16]

The Commission asserts that by expanding the pool of available intermediaries and clearinghouses to include unregistered or exempt non-U.S. entities, the Proposal may “reduc[e] the concentration of U.S. customer funds in a small number of FCMs,”[17] and may also “reduc[e] the concentration risk among registered and exempt DCOs.”[18]  The exclusion of registered FCMs from non-U.S. swap markets, however, will in no way reduce the currently high levels of concentration amongst registered FCMs at registered DCOs serving the U.S. market.  It is the high levels of concentration of registered FCMs at registered DCOs that pose potentially systemic risks to the U.S. financial system.  The Commission should be working to enable greater FCM competition in U.S. swap markets, not precluding U.S. FCMs from competing in non-U.S. markets.

I strongly support efforts to increase competition and reduce concentration amongst registered, U.S. FCMs in the U.S. swaps markets.  It is a topsy-turvy argument that this is best accomplished by prohibiting U.S. FCMs from participating in non-U.S. markets and enabling non-registered non-U.S. FCMs to take this business away from those U.S. FCMs.

Absence of Exemptive Authority

The Proposal relies on CEA Section 4(c) for authority to exempt non-U.S. intermediaries that provide customer clearing at exempt DCOs from the FCM registration requirement and the regulations applicable to registered FCMs.[19]  Section 4(c), however, provides the Commission with limited exemptive authority, applicable to specified classes of instruments and markets.  It does not provide the Commission with the ability to waive any provision of the CEA that it deems inconvenient.[20]  The Commission’s limited authority does not extend to the non-U.S. cleared swaps markets that are the subject of this rulemaking.

Section 4(c) provides that the Commission may exempt any agreement, contract, or transaction from the requirements of section 4(a) (which requires that contracts for future delivery be traded on a designated contract market) or any other provision of the Act if such agreement, contract, or transaction is, in the first instance, subject to section 4(a).[21]  Notably, however, section 4(a) does not apply to contracts “made on or subject to the rules of a board of trade, exchange, or market located outside the United States . . .”[22]

Swaps traded on a non-U.S. trading facility and cleared at a non-U.S. DCO appear to fall into the category of contracts “made on or subject to the rules of a board of trade, exchange, or market located outside the United States.”  The Commission provides no justification or analysis for asserting that section 4(c) provides exemptive authority for transactions in non-U.S. markets involving these contracts.

Conclusion

The Exempt DCO Proposal deprives U.S. customers of bankruptcy protection under U.S. law, creates systemic risks for the U.S. financial system, and promotes the use of foreign intermediaries at the expense of U.S. FCMs.  It also exceeds the Commission’s exemptive authority under section 4(c) of the Act.  If the Commission desires to facilitate greater access by U.S. persons to foreign cleared swaps markets, it should do so within the framework of registered DCOs, registered FCMs, and the customer protections provided by the U.S. bankruptcy laws and CFTC regulations.  It should not do so at the expense of protections for U.S. customers and the U.S. financial system.  Accordingly, I dissent.

 

[1] See Commodity Exchange Act (“CEA”) § 4(c), 7 U.S.C. § 6(c) (2018).

[2] Id. § 5b(h), 7 U.S.C. § 7a-1(h), which permits the Commission to exempt a DCO from registration if the Commission determines that it is subject to “comparable, comprehensive supervision and regulation” by its home country regulator.  The Exempt DCO Proposal would add an additional requirement that the DCO not pose a “substantial risk to the U.S. financial system.”  See Exempt DCO Proposal, section III.A.  To date, the Commission has exempted four foreign clearinghouses from the requirement to register as DCOs for the clearing of proprietary swap positions.

[3] See Exempt DCO Proposal, section III.C.

[4]In popular culture, ‘Bizarro World’ has come to mean a situation or setting which is weirdly inverted or opposite to expectations.”  See Bizarro World, Wikipedia (July 10, 2019), https://en.wikipedia.org/wiki/Bizarro_World.

[5] See Commodity Exchange Act § 4(c), 7 U.S.C. § 6(c).

[6] The FCM registration requirement is at Commodity Exchange Act § 4d(f), 7 U.S.C. §6d(f).

[7] In lieu of the Act’s and Commission regulation’s extensive customer protection provisions, the Exempt DCO Proposal would require that each foreign intermediary provide its U.S. customers with notice that the intermediary is not an FCM, that the clearinghouse is not a registered DCO, and that the protections of the U.S Bankruptcy Code do not apply.  See Exempt DCO Proposal, § 39.6(b)(2).

[8] See Commodity Exchange Act § 4d(f)(1)–(2), 7 U.S.C. § 6d(f)(1)–(2).

[9] Id. § 4d(f)(2), 7 U.S.C. § 6d(f)(2); 17 C.F.R. § 22 (2019).

[10] See Stephen Adams, Derivatives Safe Harbors in Bankruptcy and Dodd-Frank: A Structural Analysis (Apr. 30, 2013), http://nrs.harvard.edu/urn-3:HUL.InstRepos:10985175.

[11] The Report of the President’s Working Group on Financial Markets on Hedge Funds, Leverage, and the Long-Term Capital Management (1999), which followed the near collapse and industry bailout of the Long-Term Capital Management (LTCM) hedge fund, identifies the benefits to market stability of the provisions of the U.S. bankruptcy code and highlights the systemic issues that may arise when significant transactions of U.S. entities are subject to non-U.S. regulatory regimes that do not provide equivalent protections.  LTCM was a large, U.S.-based hedge fund that at one point had gross notional amounts of over $500 billion in futures, more than $750 billion in swaps, and over $150 billion in options and other derivatives in multiple jurisdictions around the world.  The LTCM Report described how the application of bankruptcy laws in these other jurisdictions to LTCM would present “substantial uncertainty . . . for counterparties and other creditors of the Fund because bankruptcy proceedings may very well have been initiated both in the U.S. and abroad and involved resolution of complicated and novel international bankruptcy issues.”  Dept. of the Treasury, Bd. of Governors of the Federal Reserve System, Securities and Exchange Commission, Commodity Futures Trading Commission, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, Report of the President’s Working Group on Financial Markets (Apr. 1999), at E-1.  The LTCM Report cautioned, “While cross-border insolvencies have been characterized by growing cooperation, reliance on a case-by-case judicial approach can create unpredictability—particularly in emergency situations.”  Id. at E-3. Much of the discussion around LTCM occurred in the context of bilateral, OTC swaps rather than the cleared swaps that are the subject of this Proposal.  However, LTCM’s lessons on the protections offered by the Bankruptcy Code, and on the importance of legal certainty regarding how derivatives will be treated in an insolvency proceeding, remain current to this day.

[12] See Exempt DCO Proposal at § 39.6(b)(1)(i).

[13] Exemption from Derivatives Clearing Organization Registration, 83 Fed. Reg. 39,923, 39,926 (proposed Aug. 13, 2018).

[14] Exempt DCO Proposal, section VI.C.2.b.

[15] Id.

[16] To the extent that U.S. customers are not able to access clearing at non-U.S. registered DCOs due to the absence of U.S.-registered FCM services at such DCOs, the Commission should work with such non-U.S. DCOs and FCMs to identify the impediments to the provision of such FCM services.

[17] Id.

[18] Id.

[19] The Proposal also relies on Section 4(c) to exempt these foreign intermediaries from the CTA registration requirements.

[20] The Conference Report for the Futures Trading Practices Act of 1992, which codified section 4(c), stated the conferees expectation that “the Commission generally use this [4(c)] authority sparingly . . . .”  The conferees further explained that “[t]he goal of providing the Commission with broad exemptive powers is not to prompt a wide-scale deregulation of markets falling within the ambit of the Act.  See H.R. Conf. Rep. 102-978, 102d Cong. (2d Sess. 1992).

[21] Commodity Exchange Act § 4(c), 7 U.S.C. § 6(c).

[22] Id. § 4(a), 7 U.S.C. § 6(a) (emphasis added).