Remarks of Acting Chairman J. Christopher Giancarlo before International Swaps and Derivatives Association 32nd Annual Meeting, Lisbon, Portugal
“Changing Swaps Trading Liquidity, Market Fragmentation and Regulatory Comity in Post-Reform Global Swaps Markets”
May 10, 2017
As Prepared for Delivery
Good morning. It is great to be here in Lisbon speaking before all of you at this great conference. It is an honor to speak alongside my esteemed international colleagues, Steven Maijoor, Chair of ESMA, and Svein Andresen, Secretary General of the FSB.
My thanks also to ISDA for inviting me to speak. ISDA provides a critical service to an array of participants in the swaps markets. I commend Scott O’Malia for his leadership. Scott and I overlapped but a few months at the Commodity Futures Trading Commission (CFTC or Commission), and I am grateful for his service and commitment to shared principles about the derivatives markets. I’d also like to thank ISDA’s Chairman, Eric Litvack, and its Board of Directors for their hospitality here.
As you know, in January I was sworn in as Acting Chair of the CFTC. In March, President Trump indicated that I was his choice to lead the agency. I look forward to the US Senate’s consideration of my nomination. This process will provide me the opportunity to state, on the record, my long-standing support for swaps market reform and some of the current and long-term challenges facing trading markets.
This morning I’d like to talk about the changing nature of the global swaps market. It’s been almost a decade since the onset of the financial crisis. It will be seven years next month since passage of the main legislation – the Dodd Frank Act of 2010 – that laid the groundwork for the post-crisis world. Mandatory clearing for swaps under Title VII of Dodd-Frank has now been in effect for four years. So we have a statistically significant sample size, if not a long period of history, to evaluate the effects of these reforms and their implementation.
As part of the President’s executive order on Core Principles for Regulating the United States Financial System,1, I recently completed a review of the impact of existing regulation on the financial system. From that review, I have come away with three main imperatives:
1) Market liquidity must be enhanced.
2) Global trading markets must be preserved.
3) Regulatory comity must be deepened.
Let me address each of the three issues in depth.
I. Changing Trading Liquidity
As this audience well knows, trading liquidity can be defined as the degree to which financial assets may be easily bought or sold with minimal price disturbance by ready and willing buyers and sellers. Market liquidity is therefore a critical quality for risk transfer. The ability of market-makers and end-users such as retailers, farmers, ranchers, and energy suppliers to lay off risk is dependent on the depth and resiliency of liquidity. Unfortunately, since the financial crisis of 2008 and the Dodd-Frank Act of 2010, markets have signaled warnings that liquidity has been significantly curtailed.
Indicators include no fewer than a dozen major flash events since the passage of the Dodd-Frank Act2 and at least several dozen minor ones.3 The growing incidence of these events shakes confidence in world financial markets. They are alarm bells warning about heightened market liquidity risk in the global financial system.4
Multiple studies by the official sector, as well as by academics, have examined potential causes of some of these events.5 One of the most important ones was the Joint Study on the Treasury Markets that the CFTC co-authored with the Securities and Exchange Commission, the Federal Reserve Board, the Federal Reserve Bank of New York and the Treasury.6 The focus of these studies has been on market structure issues, mainly the expansion of automated trading in markets. But from these studies, it is not clear that market structure factors are the primary contributors to these events. Instead, these studies point to a confluence of factors. Those include changes in regulations and the role of traditional dealers.
On the structural level, bank-dealer firms have shifted significantly from the principal model to the agency model of securities dealing. Therefore traditional market-makers no longer hold such ability to support trading liquidity by risking capital and holding inventory. Rather than buying or selling financial instruments to hold on their own account until counterparties are found, dealers increasingly prefer matching customer orders, thereby avoiding the need for overnight capital or exposure to cash flow risk from margin calls. Depth and immediacy – two key features of liquidity – have been affected by these changes.
Today, banks have been prompted to significantly increase their regulatory capital and leverage ratios by raising more equity in relation to their total assets. These measures prioritize bank capital reserves over investment capital, balance sheet surplus over market-making and bank solvency over economic growth and opportunity. The result is a market in which traditional dealers can support little risk, a situation that, in itself, nurtures another type of system-wide risk: liquidity risk – a first order concern for market regulators like the CFTC.
As bank-dealers have stepped away from liquidity provisioning, other firms have stepped in, providing important trading liquidity, but with different liquidity characteristics. Given these firms’ low levels of capitalization, their liquidity provisioning role is qualitatively different from that of the traditional dealers. As these firms typically do not carry positions overnight, the changing roles have likely caused gaps in the liquidity profile of our markets, rendering them more vulnerable to stress conditions.
I do not subscribe to the view that recurring liquidity flash events are a fair price to pay for enhanced bank stability. Global efforts at swaps market reforms – reforms that I support – have so far failed to adequately address the question of whether the amount of capital that bank regulators have caused financial institutions to take out of trading markets is at all calibrated to the amount of capital needed to be kept in global markets to support overall market health and durability.
In the US, the President was elected on the premise of furthering robust, broad-based economic growth. Capital and risk transfer markets must be placed in service to that objective. I would expect that the European imperative for economic growth would be much the same. The time has come for regulators on both sides of the Atlantic to recalibrate bank capital requirements to better balance systemic risk concerns with healthy economic growth and prosperity.
Supplementary Leverage Ratio
Other regulatory changes have further impacted liquidity in the markets. They include: overly restrictive application of the Volcker Rule and one-size-fits-all transparency requirements for trade reporting. They also include the CFTC’s flawed US swaps trading rules and the supplemental leverage ratio (SLR), both of which I will take a moment to discuss.
The SLR is a global capital requirement for banks. By design, it is size-based rather than risk-based. It requires large US banks to set aside roughly five percent of assets for loss absorption. This is intended to supplement risk-based capital requirements like the Common Equity Tier 1 Ratio. Banks that hold clearing customer client margin in the form of cash through their affiliate future commission merchant (FCM) clearing services must also set aside the requisite five percent SLR.
The SLR is a bank-based capital charge. It was designed to reduce the risk of bank balance sheet activity (namely lending). Yet it is being applied to an entirely different activity – swaps clearing – designed itself to steer risk away from bank balance sheets.
Applying the SLR to clearing customer margin reflects a flawed understanding of central counterparty (CCP) clearing. Swaps clearing was adopted in the 2009 Pittsburgh Accords7 and Dodd-Frank Act8 to move customer margin off the balance sheets of bank FCMs and into CCPs. Yet applying a capital charge against that customer margin continues to treat FCMs as having retained the exposure.
The SLR also reduces the already-narrow profit margins of bank-owned FCMs. Its impact on segregated customer margin payments passed on to CCPs for clearing is causing many of the largest banking institutions to reduce their willingness be in the FCM business.
In addition, the current implementation of the SLR does not take into account the fact that outstanding derivative contracts in a portfolio can offset each other and thus reduce the potential risk exposure. These rules also treat the notional size of a derivative contract as representative of the total potential risk of that contract. This failure ignores the exposure-reducing effect of margin for clearing firms.
My predecessor at the CFTC, Chairman Massad, was both consistent and correct in explaining how the SLR has impaired the ability of derivative end-users to hedge risk and reduce volatility. His arguments now seem quite prescient as we witness diminishing market access for smaller market participants, who will have a much tougher time laying off risk during stressed market conditions.
The FCM marketplace has declined from 100 CFTC-registered entities in 2002 to 55 at the beginning of 2017. Of these 55, just 19 were holding customer funds for swaps clearing. Many large banks have exited the business, including State Street, Bank of New York-Mellon, Nomura, RBS and Deutsche Bank.
A consolidated FCM industry could pose difficulties in transferring customer positions and margin to other FCMs in times of stress or an FCM default. In certain exchange-traded derivatives markets, three to four firms clear nearly half of the trades cleared. Such concentration can potentially impact market functioning and be a source of systemic risk.
Another concern is the disadvantage clearing customers, such as pension plans and other retail investment funds, would face in such circumstances. They lack the legal authority or market sophistication to become clearing members themselves. They are reliant on the intermediation of an FCM in our mandated clearing world.
Given the low profit margins of the FCM business, it is unlikely that this business has a viable second home outside the banking system. Fixing the misapplication of the SLR is key to ensuring the structure of the critical FCM link in the mandatory clearing model.
The following two steps would provide relief from the misguided application of the SLR toward swaps clearing:
1. Exclude customer cash collateral held at the CCP from the bank’s leverage calculation.
2. Take customer collateral held at the CCP into account in computing potential future exposure in a manner consistent with the Basel Committee on Bank Supervision’s standardized approach to counterparty credit risk.
The suggested SLR rule changes will significantly reduce capital costs for clearing members. By CFTC estimates, this potential reduction in capital costs for these clearing members could be as high as 70 percent; but these will translate into a small one percent capital reduction at the bank holding company level. Assuming these savings are fully passed on to their customers, these reductions could translate into a three-fold increase in trading activity, especially hedge positions that are carried overnight. This dramatic reduction in costs on a service imperative to managing systemic risk in swaps is entirely worth the trade-off of a miniscule reduction in balance sheet protection. The financial system will be safer and more stable for it.
II. Market Fragmentation
I now will take a moment and talk about swaps market fragmentation. I believe that the CFTC’s own swaps trading rules have driven a wedge between US and European markets. This is not helpful for trading counterparties on either side of the Atlantic.
It is the basis for some degree of national pride to recognize that US risk-transfer markets are the world’s largest, longest developed and most comprehensively regulated. They ably serve the world’s largest economy and largest agricultural exporter. It is undoubtedly in America’s vital national interest to assure that its derivatives markets remain highly attractive and accessible to the world so that the businesses and customers who utilize them can obtain the best possible terms of trade and that economic growth can be bolstered.
Swaps Trading Rules
Unfortunately, the flawed swaps trading rules imposed by the CFTC in 2013 have put America at a disadvantage globally. These rules are highly over-engineered, disproportionately modeled on the US futures market and biased against both human discretion and technological innovation. They are fundamentally mismatched to the distinct liquidity, trading and market structure characteristics of the global swaps market.
The CFTC’s flawed swaps trading rules have driven global market participants away from transacting with entities subject to CFTC swaps regulation. They have contributed to the continuing fragmentation of global markets into a series of distinct liquidity pools that are less resilient to market shocks and less supportive of global economic growth.
The CFTC must move forward with a better regulatory framework for swaps trading.9 It must allow market participants to choose the manner of trade execution best suited to their swaps trading and liquidity needs and not have it chosen for them by the federal government. Our regulatory framework must help to attract, rather than repel, global capital to US trading markets. It must better align regulatory oversight with inherent swaps market dynamics. Most importantly, it must facilitate risk transfer in support of increased commercial lending and broad-based economic revival.
Our goal is to oversee markets that are neither the least nor the most prescriptively regulated – but the BEST regulated – balancing market oversight, health and vitality.
III. Regulatory Comity
I will now turn to the critical importance of cross-border regulatory coordination.
As part of his Executive Order on Core Principles for Regulating the United States Financial System, President Trump also called upon US government agencies to advance national interests in international financial regulatory negotiations and meetings. The CFTC seeks to fully embrace that Core Principle in President Trump’s executive order.
By their very nature, swaps instruments trade in global markets. They allow American agriculture producers, industrial manufacturers and financial service providers to transfer or bear exposure to the risk of variable commodity prices, foreign exchange, rate of interest or counterparty credit default in marketplaces around the world.
Without robust and orderly global derivative markets, American firms would bear greater risk in their international commercial activities. As a result, they would either curtail operations or be less competitive than their overseas counterparts. That would mean fewer jobs at home and diminished US economic activity.
Instead, we must ensure that global markets are salutatory and suitable for the risk transfer needs of American agriculture producers, industrial manufacturers and financial service providers. To do so, the CFTC must be an active participant in international bodies, like the International Organization of Securities Commissions (IOSCO), where it may pursue policies to enhance the health, durability and vitality of global markets suitable for American trading and risk transfer.
As our regulatory counterparts continue to implement swaps reforms in their markets, it is critical that we make sure our rules do not conflict and fragment the global marketplace. That is why the CFTC should operate on the basis of comity, not uniformity, with overseas regulators. The CFTC should move to a flexible, outcomes-based approach for cross-border equivalence and substituted compliance.
In all of its international engagements with fellow financial regulators and related regulatory bodies, the CFTC should act in a forthright and candid manner, displaying leadership when appropriate and respect and due consideration at all times. The CFTC aims to be considered a trusted and worthy counterpart by its overseas regulatory associates.
I am committed to making regulatory comity work. I will do everything I can to see that the CFTC works positively with our regulatory counterparts from around the world. As I am here in Lisbon, I particularly want to emphasize the importance I hold for the relationship between the CFTC and European Commission (EC) and the European Securities and Markets Authority (ESMA). I want to build on the success we have had working with the EC and ESMA – chaired by Steven Maijoor – on CCP equivalence. I look forward to positive equivalence decisions by the EC on trading platforms and margin requirements. It is critical that we achieve these results and make them enduring and provide market certainty.
Let me briefly comment on an issue that has been the subject of much discussion of late here in Europe: the location of euro-denominated derivatives clearing. I am respectful of the fact that this is an important regulatory policy decision that needs to be made with care by European officials. I do not presume to tell those in Europe what they should do or what should be the outcome of important discussions between representatives on both sides of the Channel. I do not envy the choice that European officials will have to make between the perceived additional benefits of re-location to facilitate central bank support against the higher costs to the European financial system associated with loss of netting of euro-denominated risk exposures.
I would note, as has my thoughtful colleague, CFTC Commissioner Sharon Bowen, that the CFTC has much experience and expertise in the supervision of CCPs both in the US and abroad. We welcome the opportunity to discuss the CFTC’s experience with officials in Europe.
To date, the US has not deemed a body of water – even as large as the Atlantic Ocean – as an impediment to effective CCP supervision and examination. Given the closeness of the US and European derivatives markets, what Europe chooses to do on the supervision of CCPs undoubtedly will inform the evolution of US regulatory policy for cross-border swaps clearing.
Getting the International Reforms Right and Efficient Regulation
The President’s order to have US regulators review the impact of our recent regulation on the financial system10 has proven to be an invaluable opportunity. I believe a similar effort should be done on a global scale.
Recently, my CFTC colleagues and I had the pleasure of hosting, along with Svein Andresen and his colleagues at the Financial Stability Board (FSB), a roundtable to discuss the market impact of the G-20 derivatives reforms. Scott O’Malia represented ISDA at the roundtable. I think Scott would agree that it was first-of-its-kind in bringing together the various heads of international standard setting bodies and senior leaders of the financial industry to have a concrete dialogue about the effects of the G-20 reforms.
Participants in the roundtable generally agreed that the reforms have made the global financial system more resilient by enhancing capital reserves of banks and other financial institutions. But one key message that came through was that we need a better understanding of how the various reforms work together.
Since 2009 when the G-20 Leaders outlined the basic components of the reforms, international bodies like the Basel Committee, the FSB (whose dedicated Secretary General Svein Andresen is with us today), the Committee on Payments and Market Infrastructures (CPMI), and IOSCO, produced reports on capital, margin, central clearing, and other reforms, all with the goal of making the global financial system more resilient. And many of these reforms have been implemented into law in the US, Europe, Japan and other major market jurisdictions.
But not enough has been done to examine how these reforms interact with each other and whether the reforms – when applied in the aggregate – have made the financial system as effective as possible in supporting economic growth. FSB Chair Mark Carney describes this challenge as one of achieving “efficient resiliency.” As I said earlier, I believe that some of these reforms, like the SLR, have over-weighted balance sheet safety at the expense of trading liquidity resiliency.
It is critical that international bodies make it their top priority to take up this challenge of looking across reforms to see if we have this balance right. We risk causing irreparable harm to the global markets if we do not do this. Some of the issues I have noted, like SLR, have their origins in these international discussions. And SLR is a perfect example where regulators, who focused narrowly on the goal of increasing bank capital, failed to appreciate the impact on another important risk buffer, central clearing. This has undermined the resiliency and efficiency of the financial markets.
So, in conclusion, let us again be reminded of the essential role of global derivatives markets: to help moderate price, supply and other commercial risks – shifting risk to those who can best bear it from those who cannot. Thus, well-functioning global derivatives markets free up capital for business lending and investment necessary for economic growth – economic growth that still remains far too meager on both sides of the Atlantic.
Flourishing capital markets are the answer to global economic woes, not diminished trading and risk transfer. We must foster safe, sound and vibrant global markets for investment and risk management to stimulate greater job creation and broad-based prosperity.
The time has come to take stock of global swaps market reforms to better enhance trading market liquidity, reverse market fragmentation and reestablish regulatory comity.
I intend to do my part – as I may have the honor to serve – to oversee vibrant and durable markets for risk transfer in the twenty-first century, global economy.
I thank you for your time.
1 Presidential Executive Order on Core Principles for Regulating the United States Financial System (Feb. 3, 2017), available at https://www.whitehouse.gov/the-press-office/2017/02/03/presidential-executive-order-core-principles-regulating-united-states
2 Id.; see also Max Colchester & Alistair MacDonald, A Short History of Sudden Market Moves, Wall St. J. (Oct. 7, 2016), http://www.wsj.com/articles/a-short-history-of-sudden-currency-moves-1475837735.
3 Chairman Timothy Massad, U.S. Commodity Futures Trading Comm’n, Remarks Before the Conference on the Evolving Structure of the U.S. Treasury Market (Oct. 21, 2015), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-30.
4 Michael S. Piwowar & J. Christopher Giancarlo, Banking Regulators Heighten Financial Market Risk, Reuters (July 12, 2015, 6:59 PM EST), http://www.reuters.com/article/2015/07/12/column-seccftc-idUSL1N0ZP29520150712.
5 Max Colchester & Alistair MacDonald, A Short History of Sudden Market Moves, Wall St. J. (Oct. 7, 2016), http://www.wsj.com/articles/a-short-history-of-sudden-currency-moves-1475837735.
6 Joint Staff Report: The U.S. Treasury Market on October 15, 2014. Available at https://www.treasury.gov/press-center/press-releases/Documents/Joint_Staff_Report_Treasury_10-15-2015.pdf
7 G20 Leaders Statement: The Pittsburgh Summit. (September 24-25, 2009). Available at http://www.g20.utoronto.ca/2009/2009communique0925.html
8 Dodd-Frank Wall Street Reform and Consumer Protection Act. Available at http://www.cftc.gov/idc/groups/public/@swaps/documents/file/hr4173_enrolledbill.pdf
9 Id.; see also Commissioner J. Christopher Giancarlo, U.S. Commodity Futures Trading Comm’n, Reconsidering the Dodd-Frank Swaps Trading Regulatory Framework, in Reframing Financial Regulation: Enhancing Stability and Protecting Consumers (Hester Peirce & Benjamin Klutsey eds., 2016) (publishing a condensed version of the White Paper).
10 See Presidential Executive Order on Enforcing the Regulatory Reform Agenda (Feb. 24, 2017), available at https://www.whitehouse.gov/the-press-office/2017/02/24/presidential-executive-order-enforcing-regulatory-reform-agenda
Last Updated: December 20, 2017