Keynote Address of CFTC Commissioner J. Christopher Giancarlo before the ISDA’s Trade Execution Legal Forum
Looking Ahead: 2017 and Beyond
December 9, 2016
Good morning, ladies and gentlemen. Thank you for your kind welcome.
Before I begin, let me say that my remarks reflect my own views and are not necessarily the views of the Commodity Futures Trading Commission (CFTC or Commission), my fellow CFTC commissioners or the CFTC staff.
I want to start with a word about ISDA. ISDA has been and remains a vital supporter of strong and vibrant swaps markets around the globe. Long before Dodd-Frank and MiFID, ISDA played an important role in the derivatives marketplace, from crafting standard documentation and developing a consistent international reporting framework to publishing important research to better inform market participants. More recently, ISDA has been central to the implementation of margin requirements for non-cleared derivatives, including the development of a standard initial margin model. That project was made all the more challenging given the short implementation timeframe imposed by regulators. Since the 2008 financial crisis, it has been a busy and challenging time for regulatory reform, so, I would like to acknowledge ISDA for its perseverance and its service in support of safe, efficient derivatives markets.
And, I would like to say something about the upcoming March 1st variation margin deadline for uncleared swaps. I echo Scott’s recent comments that this deadline will pose a massive challenge for market participants.1 Derivatives users must now be working to modify their existing collateral agreements or draft new ones.2 Unfortunately, regulators imposed an unrealistic deadline on the marketplace and seem intent on sticking to that deadline regardless of the effect on the health of the market and market participants.3 As the variation margin deadline approaches, I call on my fellow regulators to determine the market’s readiness and help ease the transition as much as possible to ensure the orderly functioning of the marketplace.
Now, I would like to turn to today’s topic.
I have been calling for a more forward-looking agenda since arriving at the CFTC two and a half years ago. In January of 2015, I published a white paper that reconsidered the CFTC’s swaps trading rules.4 In October of last year, I addressed market liquidity concerns, automated trading and cybersecurity at ISDA’s annual Asia Pacific conference.5 And, last December, I gave a lecture at Harvard Law School about several major challenges for capital and risk-hedging markets in the 21st century.6 In that lecture, I laid out six mega-trends that are transforming global financial markets today.
1. Cyber Threats;
2. Technological Disruption;
3. Central Bank Intervention;
4. Changing Market Liquidity;
5. Participant Concentration; and
6. Global Fragmentation.
Today, I would like to speak about three of these trends:
1. Technological Disruption,
2. Changing Market Liquidity; and
3. Global Fragmentation.
I would like to give you my thoughts about how regulators should be responding to these challenges in the new year.
1. Disruptive Technology
The first challenge comes from exponential digital technologies that are rapidly changing the very nature of human identity, work, leisure and society. These breaking digital innovations include automated algorithmic trading that has transformed trading markets, distributed ledger technology, more commonly known as blockchain,7 “big data” capability for sophisticated data analysis and interpretation,8 artificial intelligence guiding highly dynamic trade execution9 and “smart” contracts that value themselves and calculate payments in real-time.10 Today, I want to discuss automated electronic trading, distributed ledger technology and digital data analysis.
A. Automated Electronic Trading
Automated trading has brought many benefits and challenges to financial markets. Automated trading can lower transaction costs while increasing trader productivity through greater transaction speed, precision and sophistication.11 For many markets, automated trading brings trading liquidity, broader market access, enhanced transparency and greater competition.12 Such features are all the more beneficial in the wake of departing bank liquidity.13
At the same time, automated trading may bring an increased risk of sudden spikes in market volatility and “phantom” liquidity arising from the sheer speed of execution,14 flawed algorithms15 and position crowding.16 It also includes the risk of data misinterpretation by computerized analysis and mathematical models that increasingly replace human thought and deliberation.17
Undoubtedly, we must understand the full implications of digital trading markets. We should determine the existing rules that need to be updated to enhance trading markets and the participants they serve. We should figure out how to effectively repurpose the CFTC’s regulations for the challenges of 21st century digital markets.
Last year, the CFTC adopted a proposed rule (Reg. AT) to tackle some of the challenges of automated trading and last month, issued a supplemental proposal.18 I raised a number of concerns with both.19 Most notably, I objected to the prospect of the CFTC obtaining trading system source code without a subpoena. For me, this provision remains a non-starter.
Otherwise, the proposal includes some prescriptive risk controls and development, testing and reporting requirements. Some of these provisions do not reflect current industry best practices. They may require costly changes to existing business practices with no material market benefit.
Although I voted against the current proposal, I maintain an open mind to a number of its elements. It is certainly time to formulate and establish well-considered policy responses to the digitization of contemporary markets and then take action in a deliberate and thorough manner to enhance market liquidity, safety and soundness. I look forward to reviewing the public’s comments on the proposal.
B. Distributed Ledger Technology
I have been speaking a lot about distributed ledger technology (DLT) this past year because I believe in its promising benefits for the financial marketplace and financial regulators.20 I also believe that, in order for this technology to flourish, regulators must take a “do no harm” approach. Earlier this year, I outlined five practical steps that the CFTC and other financial regulators should take to promote DLT and other financial technology or “FinTech:”
1. Put Our Best Foot Forward: Financial regulators should designate dedicated, technology savvy teams to work collaboratively with FinTech companies – both new and established – to address issues of how existing regulatory frameworks apply to new, digital products, services and business models derived from innovative technologies, including DLT;
2. Allow “Breathing Room”: Financial regulators should foster a regulatory environment that spurs innovation similar to the Financial Conduct Authority’s (FCA) sandbox, where FinTech businesses, working collaboratively with regulators, have appropriate “space to breath” to develop and test innovative solutions without fear of enforcement action and regulatory fines;
3. Get Involved: Financial regulators should participate directly in FinTech proof of concepts to advance regulatory understanding of technological innovation and determine how new innovations may help regulators do their jobs more efficiently and effectively;21
4. Listen and Learn: Financial regulators should work closely with FinTech innovators to determine how rules and regulations should be adapted to enable 21st century technologies and business models; and
5. Collaborate Globally: Financial regulators should provide a dedicated team to help FinTech firms navigate through the various state, federal and foreign regulators and regimes across domestic and international jurisdictions.
On this last step, financial regulators must address how to prevent death from a thousand cuts by numerous state, federal and foreign regulators for FinTech firms that look to provide services across various financial market regulatory jurisdictions. Because emerging technology, such as DLT, has the potential to provide many benefits that transcend regulatory boundaries, financial regulators must start with an agreement on general principles in order to avoid stifling innovation.
The CFTC and other U.S. financial regulators are falling behind foreign jurisdictions in promoting FinTech. As you know, here in the U.K. the FCA has already created an Innovation Hub that allows FinTech firms to introduce innovative financial products and services to the market and test new ideas through its Regulatory Sandbox.22 Several other jurisdictions are following the FCA’s lead.
It is now time for U.S. financial regulators to take the affirmative steps I have laid out to further FinTech innovation and development for the betterment of U.S. and foreign markets and market participants.
C. Digital Data Analysis
Let me now turn to market data analysis. At the heart of the 2008 financial crisis was the inability of regulators to assess and quantify the counterparty credit risk of large banks and swap dealers.23 The legislative solution was to build swap data repositories (SDRs) under the Dodd-Frank Act.24 Although much hard work and effort has gone into establishing SDRs and supplying them with swaps data, eight years after the financial crisis the SDRs still cannot provide regulators with a full and accurate picture of bank counterparty credit risk in global markets.25 In part, it is because international regulators have not yet harmonized global reporting protocols and data fields across international jurisdictions.26
Of all the many mandates to emerge from the financial crisis, visibility into counterparty credit risk of major financial institutions was perhaps the most pressing. The failure to accomplish it is certainly the most disappointing, especially as the emerging science of financial network cartography is so promising.27 Global regulators working by themselves have failed to achieve the objective of full counterparty credit risk transparency.
What is needed is a concerted and cooperative effort by regulators, academics and the private sector to make greater use of emerging digital technologies and network science of financial markets. It is well past time for regulators to draw on the technological and other resources of the private sector to make it happen.
2. Changing Market Liquidity
The second broad challenge is the changing nature of liquidity in global trading markets.
Just two months ago, the British Pound suddenly crashed six percent against the U.S. dollar in volatile trading. The abrupt “flash crash” of the world’s fourth-most-traded currency was exacerbated by a lack of market liquidity.28
In fact, there have been at least twelve major flash crashes since the passage of the Dodd-Frank Act.29 The growing incidence of these events shakes confidence in world financial markets.
It has been almost two years since I sounded the alarm about heightened market liquidity risk in the global financial system.30 I am concerned that the increased risk is in part due to untested capital requirements, leverage ratios and other regulations imposed on traditional dealers by U.S. and overseas bank regulators under the Dodd-Frank Act and similar laws.31
As this audience knows, large global money center banks traditionally served as market liquidity makers drawing from inventories of securities and other financial instruments. This role as inventory-based securities dealers had the effect of reducing episodes of market volatility because dealers would buy and sell reserves of trading instruments to take advantage of short-term anomalies in market prices.32 Their balance sheets served as market “shock absorbers” in times of market turbulence.
Now, market “shock absorbers” seem to be a thing of the past. In many of these recent sharp volatility episodes, banks appear to have been unable or unwilling to step in aggressively to provide additional trading liquidity.33 Banks’ role as inventory-based liquidity providers appears diminished.
As dealers retreat from their traditional role in trading markets, the provision of liquidity is being made up by proprietary trading firms that do not operate on an inventory-based model and are not subject to regulatory capital constraints. Rather, they use high precision automated trading algorithms that source and provide liquidity from the market itself rather than from proprietary holdings of tradable assets. The goal of these liquidity providers is to carry as little overnight inventory as possible. Hence, they are more likely to discontinue than expand trading in episodes of pronounced market liquidity.
It appears that one effect of regulatory capital constraints has been to reduce the diversity of liquidity in trading markets by hampering inventory-based liquidity while unburdening proprietary, trading-based liquidity. It should therefore be no surprise that the nature of today’s trading liquidity is structurally different. It is shorter-dated and more flighty34 - and apparently more shock prone - than before the capital constraints were put in place.
I am not suggesting that prudential restrictions on bank capital are the singular cause of today’s sudden market volatility shocks. Other causes likely include the CFTC’s flawed and restrictive swaps trading rules, the evolution of some trading markets from dealer to agency models and the impact of U.S. and European monetary policy, which has led market participants to enter crowded, one-way trading postures and asset holdings in anticipation of changes in the outsized government debt inventories of central banks.35
Yet, whatever the exact mix of causes, the fact of more episodic trading liquidity and sharper volatility has enormous implications for 21st century markets. It raises the prospect that a future market crisis may be exacerbated by the sudden disappearance of trading liquidity.
I find it disconcerting that, rather than acknowledging and carefully studying the causes of changing market liquidity, U.S. and foreign regulators continue plowing ahead with capital constraining regulations. The Financial Stability Oversight Council has been particularly delinquent in its duty to measure the cumulative effect of dozens of new federal and overseas regulations on trading liquidity in U.S. financial markets.
We can no longer continue to avoid the question of whether the amount of capital that bank regulators have caused traditional dealers to take out of trading markets is at all calibrated to the amount of capital needed to be kept in global markets to support the health and durability of the global financial system.
If the next financial crisis is not to be a crisis of market liquidity, then the time has come for both market and bank prudential regulators to devote full attention and concern to the changed nature of trading liquidity.
3. Global Market Fragmentation
Let me now turn to the last of these broad challenges, the continuing fragmentation of global financial markets.
In January 2015, I issued an extensive White Paper analyzing the mismatch between the CFTC’s swaps trading regulatory framework and the distinct liquidity and trading dynamics of the global swaps markets.36 This mismatch – and the application of this framework worldwide – has caused numerous harms, foremost of which is driving global market participants away from transacting with entities subject to CFTC swaps regulation.
Traditionally, users of swaps products chose to do business with global financial institutions based on factors such as quality of service, product expertise, financial resources and professional relationship. Now, those criteria are secondary to the question of the institution’s regulatory profile. Overseas market participants avoid financial firms bearing the scarlet letters of “U.S. person” in certain swaps products to steer clear of the CFTC’s problematic regulations. As a result, non-U.S. market participants’ efforts to escape the CFTC’s flawed swaps trading rules are fragmenting global swaps trading and driving global capital away from U.S. markets.
Since the start of the CFTC’s SEF regime in October 2013 and accelerating with mandatory SEF trading in February 2014, global swaps markets have divided into separate trading and liquidity pools: those in which U.S. persons are able to participate and those in which U.S. persons are shunned.37 Liquidity has been fractured between an on-SEF, U.S. person market on one side and an off-SEF, non-U.S. person market on the other.
Fragmentation has exacerbated the already inherent challenge in swaps trading – adequate liquidity – and is increasing market fragility as a result.38 Fragmentation has led to smaller, disconnected liquidity pools and less efficient and more volatile pricing. Divided markets are more brittle, with shallower liquidity, posing a risk of failure in times of economic stress or crisis. Fragmentation has increased firms’ operational risks as they structure themselves to avoid U.S. rules and manage multiple liquidity pools in different jurisdictions (e.g., through different affiliates). As structural complexity has grown, operational efficiency has been reduced.
The current fragmentation of global financial markets may be likened to habitat fragmentation in the natural world, in which large, continuous biological habitats are divided into a greater number of smaller eco-systems, isolated from each other by a matrix of dissimilar habitats, leading inexorably to broad ecosystem decay.39
In a similar way, trading market fragmentation caused by ill-designed rules and burdensome regulations – and the application of those rules abroad – is harming market liquidity and market safety and soundness, increasing the systemic risk that the Dodd-Frank Act was predicated on reducing. Amidst the current tide of de-globalization and slowing world economic growth, market regulators cannot continue to ignore the growing systemic risk caused by market fragmentation.
The time has come for the CFTC to revisit its flawed swaps trading rules to better align them to market dynamics, allow U.S. swap intermediaries to fairly compete in world markets and reverse the tide of global market fragmentation.
As we enter the new year and, perhaps, a new regulatory environment, I believe regulators and others with responsibility for financial markets must do the following to address the challenges I described today:
- foster best practices for new trading technologies and harness them for the benefit of market participants and regulators alike;
- acknowledge and address the diminishing liquidity in trading markets; and
- review and reduce poorly designed rules and regulations that are causing service-provider concentration and market fragmentation.
Only with clear-eyed attention to the true challenges facing contemporary markets can we ever restore the market vitality that will be necessary for broad-based economic prosperity.
Flourishing capital markets are the answer to U.S. and global economic woes, not diminished trading and risk transfer. We must foster safe, sound and vibrant global markets for investment and risk management if we are ever to escape the “new mediocre” of prolonged economic stagnation.40
I pledge to do my part in the years to come to tackle these challenges to enhance market health, vibrancy and durability.
Thank you for your time and attention.
1 Peter Madigan, O’Malia: Renegotiate VM Docs Now to Avoid March Mayhem, Risk.net, Nov. 9, 2016.
3 Louie Woodall, Regulators Deaf to Variation Margin Concerns, Say Dealers, Risk.net, Nov. 17, 2016.
4 CFTC Commissioner J. Christopher Giancarlo, Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank, White Paper, Jan. 29, 2015 (White Paper).
5 Keynote Address of CFTC Commissioner J. Christopher Giancarlo before the 2015 ISDA Annual Asia Pacific Conference, Oct. 26, 2015.
6 Guest Lecture of Commissioner J. Christopher Giancarlo, Harvard Law School, Fidelity Guest Lecture Series on International Finance, Dec. 1, 2015.
7 Keynote Address of Commissioner J. Christopher Giancarlo before the Markit Group, 2016 Annual Customer Conference, May 10, 2016; see also Oscar Williams-Grut, WEF: Blockchain Will Become the ‘Beating Heart’ of Finance, Business Insider, Aug. 12, 2016; see generally William Mougayar, The Business Blockchain: Promise, Practice, and Application of the Next Internet Technology (Wiley 2016).
9 Tom Upchurch, Technology: AI and the Spectre of Automation, Euromoney, Aug. 2016.
10 Nigel Farmer, Making Contracts Smarter, TabbForum, May 3, 2016; Jay Cassano, What Are Smart Contracts? Cryptocurrency’s Killer App, Fast Company, Sept. 17, 2014.
11 Futures Industry Association, Comment Letter on Concept Release on Risk Controls and System Safeguards for Automated Trading Environments, at 2 (Dec. 11, 2013); see also CME Group, Comment Letter on Concept Release on Risk Controls and System Safeguards for Automated Trading Environments, at 2-3 (Dec. 11, 2013).
13 See infra Part 2.
14 Tom C.W. Lin, The New Investor, 60 UCLA L. Rev. 678, 692, 703 (2013) (explaining that “[d]uring periods of high uncertainty . . . high-frequency trading can exacerbate volatility and hurt liquidity by removing significant trading positions from the markets at warp speeds” and that “[t]he enhanced speed and interconnectedness of cyborg finance makes it more endogenously vulnerable to volatile crashes . . . .”); Katy Burne, The New Bond Market: Algorithms Trump Humans, Wall Street Journal, Sept. 24, 2015.
15 Yesha Yadav, How Algorithmic Trading Undermines Efficiency in Capital Markets, 68 Vand. L. Rev. 1607 (2015).
16 See Lin, supra note 14, at 716.
17 Id. at 712; Yadav, supra note 15, at 1613-14.
18 Regulation Automated Trading, 80 Fed. Reg. 78824 (Dec. 17, 2015); Regulation Automated Trading 81 Fed. Reg. 85334 (Nov. 25, 2016).
19 80 Fed. Reg. at 78945-48; 81 Fed. Reg. at 85396-99.
20 See, e.g., Keynote Address of Commissioner J. Christopher Giancarlo before the Markit Group, 2016 Annual Customer Conference New York May 10, 2016; Special Address of CFTC Commissioner J. Christopher Giancarlo Before the Depository Trust & Clearing Corporation 2016 Blockchain Symposium, Mar. 29, 2016.
21 Technology Advisory Committee Meeting Transcript, at 226-227, Feb. 23, 2016 (citing Brad Levy of Markit describing regulators as a node on the network).
22 FCA Innovation Hub & Project Innovate, https://innovate.fca.org.uk.
23 Financial Crisis Inquiry Commission, Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States 298–300, 329, 363, 386 (2011).
24 7 U.S.C. § 24a, Commodity Exchange Act § 21.
25 Silla Brush, Dodd-Frank Swap Data Fails to Catch JPMorgan Whale, O’Malia Says, Bloomberg, Mar. 19, 2013.
26 Neil Roland, IOSCO’s Wright Faults Authorities’ Coordination on Derivatives Trade Reporting, MLex FS Core, Nov. 18, 2015.
27 Network science is an interdisciplinary scientific field that enhances human understanding of the networks that make up the natural and scientific world, from biological to technological systems. Financial network science was pioneered by academics in the 1990s and continues to be advanced in leading university financial research departments. The continued development of interactive financial network maps allows analysts to explore and diagnose systemic fragilities and mitigate critical vulnerabilities and escalating risk patterns. Systemic risk maps can also serve as mass collaboration platforms to harness network intelligence. Drawing upon newly evolving peer-to-peer methodologies, real-time financial cartography may allow organizations and regulators to proactively address emergent systemic market risk.
28 Lananh Nguyen and Andrea Wong, Liquidity Illusion Burns Traders Blindsided by Pound’s Crash, Bloomberg, Oct. 9, 2016.
29 Id. and Max Colchester and Alistair MacDonald, A Short History of Sudden Market Moves, The Wall Street Journal, Oct. 7, 2016.
30 White Paper, supra note 4, at 52-54.
31 Id. and Michael S. Piwowar and J. Christopher Giancarlo, Banking Regulators Heighten Financial Market Risk, Reuters, Jul. 12, 2015.
32 See Justin Baer, James Sterngold & Gregory Zuckerman, Large Banks Retreat from Trading Frenzy, Wall Street Journal, at C1-C2, Sept. 3, 2015. See also Anthony J. Perrotta, Jr., An E-Trading Treasury Market “Flash Crash?” Not So Fast, Tabb Forum, Nov. 24, 2014.
33 See, e.g., Baer, Sterngold & Zuckerman, supra note 32.
34 See Stella Farrington, ‘Wrong Type of Liquidity’ Spells Trouble for Energy Hedges, Risk.net, Dec. 2, 2016.
35 See Nouriel Roubini, The Liquidity Time Bomb, Project Syndicate, May 31, 2015.
36 White Paper, supra note 4.
37 See ISDA, Cross-Border Fragmentation of Global Interest Rate Derivatives: Second Half 2015 Update 1–3 (2016); see also Philip Stafford, US Swaps Trading Rules Have “Split Market,” Financial Times, Jan. 21, 2014.
38 Referring to the manifest liquidity split between London and New York, Dexter Senft, Morgan Stanley’s co-head of fixed income electronic markets, said, “I liken [SEF liquidity] to a canary in a coal mine. It’s not dead yet, but it’s lying on its side.” Kim Hunter, Growing Pains, Markit Magazine, at 30, 31, Winter 2014.
39 See Raphael K. Didham, The University of Western Australia & CSIRO Ecosystem Sciences, Ecological Consequences of Habitat Fragmentation 1–2 (2010).
40 Christine Lagarde, the Managing Director of the IMF, has dubbed current economic conditions as the “new mediocre.” Editorial, The “New Mediocre,” Wall Street Journal, Oct. 16, 2014.
Last Updated: December 20, 2017