Speech of Commissioner Sharon Y. Bowen before the CFTC Annual Symposium for International Market Authorities
September 23, 2016
Thank you for that wonderful introduction. I am very pleased to be here among so many of my fellow regulators from around the world. In fact, considering how far I know many of you have traveled to be here today, I want to talk to you about a topic that I believe goes to the heart of how financial regulation operates these days, namely, the need for cross-border transparency and cooperation among regulators. First, though, I want to brief you on what we at the CFTC have been working on and what you can expect to see from us in the not too distant future. Next, I will discuss the need for greater coordination and collaboration among our community of financial regulators. Finally, I’d like to briefly address recent international developments affecting our markets, developments that I believe underscore the need for cooperation. As always the opinions I am about to discuss are my own and do not reflect the opinions of the Commission or CFTC staff.
In passing the Dodd-Frank Act, Congress understood that the swaps market is global, and as such, provided for the extraterritorial application of the CFTC’s swaps regulatory regime. Specifically, the Dodd-Frank Act holds that the CFTC’s regulatory authority over swaps “shall not apply to activities outside of the [U.S.] unless those activities – have a direct and significant connection with activities in, or effect on, commerce of the [U.S. or]; or contravene such rules or regulations the [CFTC] may prescribe or promulgate as are necessary or appropriate to prevent the evasion of any provision … that was enacted by the [Dodd-Frank Act].”1 Now, that’s a lot of text to unpack, but the core of that provision is this: we at the CFTC are not empowered to regulate all activities in the futures and swaps markets that occur around the globe. We are instead tasked with regulating only those activities which have a notable and clear impact on U.S. markets or seek to flout our rules. That’s a broad mandate, but it’s not limitless. For those transactions that do not have a significant impact on our markets, we are bound by our laws not to attempt to regulate those transactions. Instead, we rely on you, our fellow regulators, to ensure that your markets are properly regulated just as you rely on us regarding our markets. That sense of shared duty and comity undergirds our global financial system.
Anyway, as a means of implementing our new Dodd-Frank regulatory regime in our domestic markets, Congress directed the CFTC to issue regulations. Pursuant to our Congressional mandate, the CFTC has completed 86% of the rulemaking requirements, from establishing swap execution facilities to placing new recordkeeping requirements on a variety of market participants.2
Forthcoming Dodd-Frank Required Rulemakings
Yet, a few key rulemakings remain uncompleted, in particular three rules that I care a great deal about: position limits, capital, and governance. In addition to these three rulemakings, there are also two other rulemakings that I strongly believe in, but which are not required by Dodd-Frank: our proposed regulations on automatic trading and our proposed regulation regarding cybersecurity. I believe that these non-required rulemakings are just as imperative to fostering confidence and security within the market as the required ones. I will speak briefly about each of these to give you an idea of some of the work the CFTC will be doing during the coming year.
We are in the process of finalizing a rule on position limits which is designed to quell excessive speculation within our commodity futures markets.3 I believe that a strong position limits rule would not only work to reduce excessive speculation, which can be a major source of systematic risk, but would also make it more difficult for certain market participants to engage in market manipulation successfully. I do, however, recognize the reduced risk and increase in confidence brought to the market by the practice of responsible hedging. It is for this reason that I am pleased that CFTC staff included within the proposed rule various enumerated hedge exceptions, as well as a process and standard for exchanges to provide market participants the ability to hedge in certain situations. It is my sincere and I think even reasonable hope that this rule will be finalized in the next few months.
I also hope we can take steps to propose a rule on capital for swap dealers and major swap participants4 before the end of the year. I believe that a robust capital rule for these entities would significantly strengthen the market and may be one of the major keys to preventing the next market crash. By requiring that swap entities are well capitalized with liquid capital, we will be taking steps to ensure that adequate money will actually held by these entities and will be available for use in a crisis. As someone who spent her career as a lawyer on Wall Street, I believe that one of the best plans any entity can have for dealing with a crisis is simply committing to keep some level of liquid capital available for unforeseen events. In fact, I think this idea goes beyond just being a reasonable regulation; it’s pure common sense.
Now, I know that there have been vigorous debates about the right level of capital that should be required in a regulation. I’m sympathetic to some of these concerns – requiring a swap dealer extremely high level of capital to be held, such as 35% or even 50% of a portfolio, would inhibit trading and could slow economic growth. But I also believe that the level of capital required needs to be more than a token amount. Requiring a firm to hold a few million dollars in capital against a multi-billion dollar trading book isn’t a regulation that will actually reduce systemic risk and protect firms from imploding. Instead, that kind of de minimis requirement is just a fig leaf.
Although a number of people have expressed concern about this rule, I believe that is a concern about the nature of the rule and not about whether we should have capital regulations. It is my belief that swap dealers and major swap participants predominantly want to be well capitalized. Undercapitalized firms can, in the short term, potentially outperform responsible firms by holding less net capital while contributing to systematic risk. A strong capital rule will help ensure that responsible capitalization is not undermined by being seen as underperforming.
This brings us to governance; I believe that the prioritization within corporate culture of short term gains at the expense of long term prosperity, which has been dubbed by some as “quarterly capitalism,” is one of the main roots of systematic risk and market inefficiencies.5 It is no secret that I am a proponent of crafting a governance rule that is as robust as possible. I am aware of the notion that generally within markets, rational individuals doing what they believe is in their best interest leads to positive outcomes. In fact, I count myself as a supporter of that belief. Capital markets are one of the great innovations of the last millennium, and they have allowed for the creation of wealth and sustained prosperity the likes of which were never before seen in human history. But I also recognize that markets are not perfect, and without reasonable regulation, markets can do a bad job of allocating resources in some instances, crash, or even help cause financial crises.
Now, I believe that the disconnect between those who would like to see less market regulation and myself is founded on my belief that too often are the people who are meant to act on behalf of a corporation influenced by the reality that their well-being is more connected to the short-term profits of a corporation than its long-term health. This is not something that should astonish us. For decades now, corporations have stressed that their number one goal is providing value to shareholders. It is therefore unsurprising that corporations should sometimes focus on short-term profits over long-term profits in interest of maximizing value to shareholders. Some observers might point out that focusing on short-term gain over long-term gain is irrational, and I think there is some truth to that point of view. But rather than debate what qualifies as rational or irrational thought, I’d rather actually address this problem head on by changing the incentives that lead to this kind of short-term focused decision-making.
And that is what a strong governance rule can do. Perhaps more so than any other rule, a governance rule targets the incentives that encourage of quarterly capitalism rather than simply trying to mitigate the effects of it. In other words, a strong governance rule doesn’t just tinker around the edges of our financial system. Instead, it nudges the entities that comprise our financial system to improve their own decision-making to focus more on long-term gain over short-term gain and following the rules instead of trying to evade them. If you’re looking for a way to improve just about every aspect of your domestic financial systems, I strongly believe crafting a robust corporate governance rule is the best available medicine.
The basis for a robust corporate governance rules starts with the imposition of well-crafted qualitative and quantitative standards for the board of directors. It is my hope that these standards have at their base the establishment of appropriate fitness standards for boards. These standards should include, for example, requirements that directors have a base of understand for the matters under their review. Additionally, I believe that the tenure of independent members of Audit and Compensation Committees should be limited to a set yet meaningful number of years. Such a rule would not bar any member from holding membership on such committees for a prolonged period, but would bar them from holding membership indefinitely while still being considered independent.6 I am also a firm believer in the positive effects of a diverse company makeup which starts at the top. As such, a requirement that firms make public the level of diversity on their boards would be a great step forward and would provide much needed transparency. These common sense governance reforms, along with a few more, would not only allow the CFTC to better protect markets from the source of systematic risk, but would also allow the CFTC to be a leader in implementing governance reform that I believe is needed both domestically and abroad.
Finally, I am pleased to be able to talk about the CFTC undertaking two rulemakings which though not required by Dodd-Frank, are absolutely necessary given the technological advancement that has taken shape within our markets. These rulemakings address the continuing emergence of algorithmic trading as well as the seemingly ever increasing threat of cyber breaches. It is my hope that they are both finalized in the near future.
While Regulation AT addresses many dangers to market integrity posed by algorithmic trading, I am particularly proud of how the rule addresses the massive dangers posed by faulty code within algorithmic trading systems. Algorithmic trading can coordinate and execute the trading of millions of dollars’ worth of assets within mere minutes or even seconds. As such it is not hard to image the resulting determinate to the market caused by an algorithmic trading system that does work as intended. To ensure that traders can avoid inadvertently causing market events and are able understand the likely results of their algorithmic trading, the CFTC’s proposed requirement will impose stringent testing requirements on algorithmic trading. This includes requiring AT persons to conduct tests prior to the implementation of new code as well as to conduct regular back testing using historical data.7 In an effort to facilitate compliance with this rule, DCMs will be required to provide testing environments for AT persons to test their code on.8 I believe that these requirements along with the rest of regulation AT are an important first step in ensuring the continued functioning of our market.
Cybersecurity Testing and Improvement
Unfortunately, cyber breaches have become non-rare occurrences as it seems like every month a new cyber breach is reported. To combat this threat our rulemaking on cybersecurity works to enhance the established cyber safeguards in place for many of our registrants.9 DCOs, DCMs, SEFs and SDRs will have to comply with five types of cybersecurity testing requirements. The testing requirements are vulnerability testing, penetration testing, controls testing, security incident response plan testing and enterprise technology risk assessments.10 These tests will have to be conducted quarterly, bi-annually or once a year depending on entity, with SEFs having the ability to determine testing frequency via their own risk analysis.11 These rules sound complex, and some of the procedures that have to be undertaken to comply with them are, but they are based on common sense. I hope and expect that most well-versed persons in charge of cybersecurity at our registrants will welcome them if they are not already conducting such tests.
The Importance of Cooperation between Regulators
Of course, as I alluded to earlier, it is not enough for the CFTC just to promulgate rules for our market participants and trust that they will be effective. Instead, we have to work hand-in-hand with other international regulators to ensure that there are robust, relatively consistent standards worldwide. In our truly global financial system, no country is an island when it comes to financial regulation, even those countries which are technically islands. If one country tries to regulate in a way that is adamantly opposed by all foreign regulators, that regulatory push will be troubled at best and may be doomed to failure at worst. Conversely, if numerous countries seek to craft new standards of regulation on a particular area of finance but fail to convince a few key countries to adopt those new standards, the new standards may become regulations in name only. They may technically on the books, but if the industry can easily work around them by trading in non-participating countries, those standards might as well not exist.
Now I do not believe that regulators should always drop to the lowest common denominator when it comes to regulation. That way lies lax regulation and a new financial crisis. Individual regulators should fight to craft regulations and international standards that are workable but provide robust protections to the financial system and to investors. Sometimes that may lead to moments of tension with other regulators, and needless to say, that is unfortunate. Yet, considering the pressures we all frequently face to reduce regulation and to give the industry latitude, the alternative is for regulation to consistently trend weaker. Consensus is important, but a desire for consensus cannot and should not outweigh the need for strong but appropriate regulations on the financial system.
However, just as we should resist the desire to accept weak international standards, all regulators should be mindful that we are in this together. A failure to reach a comprehensive international set of financial standards will lead to a weak regulatory regime, unnecessary risk to the financial system and investors, and an increased chance of a new financial crisis. Ultimately, we have to ensure that we hit a very difficult mark. Regulations and international financial standards need to be broadly aligned, but also be strong enough to ward off undue systemic risk and flexible enough to allow for growth. Needless to say, that’s not an easy task. But I know that many of us revel in the difficult problems because the solutions are so rewarding. And successfully crafting robust, reasonable, universal global financial standards would certainly qualify as a rewarding accomplishment.
To that end, I would hope that many of you here today have been intrigued by the rules I discussed earlier and are considering adopting similar rules if you haven’t already. And nothing would make me happier than that. As I said earlier, we rely on you just as you rely on us. If we adopt rules that are completely unique and not similar to anywhere else in the world, our rules will not be as effective as they could be. In fact, such a situation could easily lead to some financial entities simply pulling financial activity out of our markets to avoid having to comply with our rules. The result would be reduced trading and prosperity here in America without a lessening of systemic risk; in other words, the worst case scenario. Ultimately, we’re all in this together, and I’d rather have an excellent regulation that is widely adopted across the globe to a perfect regulation that is only adopted here in America. Additionally, if you have thoughts or comments on ways that we can improve the rules I’ve discussed, I would love to discuss the matter with you.
Recent International Events
Before I conclude, I want to take a moment to discuss current events. I am sure all of you are well versed in the major events during the last year, including Brexit. Both the European Commission’s decision to delay the implementation of their rule for initial margins12 and especially Brexit took many of us by surprise. I do not want to spend too much time talking about these events. I do, however, want to commend the level of communication and interaction between regulators and the industry during the immediate aftermath of Brexit. Here at the Commission, I was impressed by not only the frequency of interactions with foreign regulators, but how willing people were to thoughtfully engage about how to best deal with a fast-moving, unpredictable market event. While it goes too far to say Brexit was the next financial crisis, I do think it was a good road test of how well we can work together in a market event; and I certainly was happy with the results.
I believe that the turmoil of the last few months shows that our relationships with foreign regulators are strong and even that the reforms we have put in place following the crisis are working to reduce systemic risk. But I also think these events show why we need strong international cooperation. If we lacked trust in our community, I do not think we would have performed quite as well during the week of Brexit, and that would have had very real consequences for our markets and our financial systems. As a result, we need to do what we can to ensure that these relationships, forged slowly across years and many different market events, grow stronger over time. After all, in both life and financial regulation, you really can never have too much communication. With continued focus on communication, transparency and cooperation amongst our community of regulators, I believe that we can make our markets even more secure against the next crisis, wherever and whenever it comes.
Thank you for your time and I hope you enjoy your time in Washington D.C.
1 7 U.S.C. § 2(i).
2 See Davis Polk, Dodd-Frank Progress Report: Six-Year Anniversary (Jul. 19, 2016), available at: https://www.davispolk.com/sites/default/files/2016-dodd-frank-six-year-anniversary-report.pdf.
3 Position Limits for Derivatives and Aggregation of Positions, 80 Fed. Reg. 30762 (Proposed May 29, 2014).
4 See 7 U.S.C. 1 § 6s(e)(1)(B).
5 See Neil King, Jr., Hillary Clinton Is Not the Only Critic of ‘Quarterly Capitalism’, Wall St. J. (Jul. 31, 2015, 7:19 AM), http://blogs.wsj.com/washwire/2015/07/31/hillary-clinton-joins-al-gore-prince-charles-and-etsy-in-criticizing-quarterly-capitalism/.
6 See generally Yaron Nili, The ‘New Insiders’: Rethinking Independent Directors’ Tenure, 67 Hastings L. J., (forthcoming 2016), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2728413.
7 Regulation Automated Trading, 80 Fed. Reg. 78824 (Proposed Dec. 17, 2015) (to be codified at 17 C.F.R. pt. 1.81(a)(1)).
8 Regulation Automated Trading, 80 Fed. Reg. 78824 (Proposed Dec. 17, 2015) (to be codified at 17 C.F.R. pt. 40.21).
9 System Safeguards Testing Requirements for Derivatives Clearing Organizations, 80 Fed. Reg. 80114 (Proposed December 23, 2015) and System Safeguards Testing Requirements. 80 Fed. Reg. 80140 (Proposed December 23, 2015)
10 Covington & Burling LLP, Cybersecurity: CFTC Proposes New Cybersecurity Testing Rules for Derivatives Market Infrastructure (Jan. 12, 2016), available at https://www.cov.com/~/media/files/corporate/publications/2016/01/cftc_cybersecurity_proposed_rules.pdf
12 Tom Osborn & Peter Madigan, Europe set to delay variation margin regime, Risk.net (Jun. 10, 2016), available at http://www.risk.net/risk-magazine/news/2461208/europe-set-to-delay-variation-margin-regime
Last Updated: September 23, 2016