Remarks of Chairman Timothy Massad Before the American Gas Association 9th Annual Energy Market Regulation Conference
December 8, 2016
Thank you very much for that warm welcome. It’s a pleasure to be here today.
Throughout my tenure as Chairman, it’s been a great pleasure to meet with groups like yours that represent commercial users of the derivatives markets. One of the best parts of this job is learning about different businesses and how they use these markets.
I came to this post after serving five years at the Treasury Department, overseeing the Troubled Asset Relief Program, or TARP. There, I dealt firsthand with the consequences of excessive risk related to swaps. It is still beyond comprehension that the U.S. government had to commit $182 billion to prevent the collapse of AIG, largely due to excessive swap risk. But the government had little choice because at that time, in those circumstances, its failure probably would have caused our economy to fall into a great depression. We did recover all that money, plus a profit, but the need to act so dramatically underscored the depths and the seriousness of the global financial crisis.
The financial crisis taught us all that we needed regulatory oversight of the over-the-counter swap market, just as we have a framework for the futures market, the securities market, and many other financial sectors. We at the CFTC have spent the last few years working to implement that framework.
I came to this post with another perspective as well. And that was following a twenty-five year career as a private sector corporate attorney, where I helped write the original master agreements for swaps and advised companies on derivatives transactions. So I appreciate the importance of the derivatives markets, especially to the types of companies represented here today. You know better than anyone how critical these markets are in enabling companies to hedge risk. That’s true whether it’s natural gas or oil, corn or soybeans, gold or platinum. It’s also true for interest rates, currencies, and equity prices. These markets have helped our economy grow and prosper. And that is in large part because they have served the needs of commercial end-users very well.
One of the commitments I made during the confirmation process was to focus on the concerns of commercial end-users. We needed to make sure the reforms we are implementing do not create undue burdens on these businesses. Commercial end-users were not the cause of the crisis, and we must make sure they can continue to use these markets efficiently and effectively as part of their day-to-day business operations. And during my time in office, I have followed through on that commitment.
When I and my fellow Commissioners, Sharon Bowen and Chris Giancarlo, joined the CFTC together in June of 2014, it already had written most of the rules required by the Dodd-Frank Act. However, there were many criticisms and concerns. We inherited the task of finishing and improving this framework.
We have achieved a lot since then, and predominantly on a bipartisan basis. We addressed many end-user concerns, which I will discuss in a moment. We worked to keep the focus of regulation on those who create the most risk, and made rules less prescriptive in some areas. And we have worked to strengthen relationships with international regulators and harmonize regulations across borders. I thank Commissioners Bowen and Giancarlo for their willingness to work constructively and collaboratively.
Exactly one month ago, this country had an election. There will be a new president in a matter of weeks. So, I thought I would use this time to review some of the things we have accomplished for end-users during my term, discuss some of the items that remain on our agenda, and mention a few of the issues that it is important the Commission continue to make a priority in the future.
Continuing to Support Commercial End-Users
Let me begin with some of the actions we have taken on behalf of commercial end-users.
Margin for Uncleared Swaps. First, the Commission exempted commercial end-users from our rule on margin for uncleared swaps, which went into effect earlier this year. Swap dealers are not required to collect margin from commercial end-user counterparties. This distinction was appropriate because the requirements are focused on those who create the most risk, which are large financial institutions.
Volumetric Optionality. The Commission clarified when certain agreements that include volumetric optionality provisions are forward contracts, rather than swaps. We recognized how important it was to not have these commonly-used contracts subject to swap rules.
Trade Options. We also addressed concerns related to Trade Options. We eliminated certain reporting and recordkeeping obligations for commercial users, including Form TO, and we stated our intention to not apply position limits to trade options.
Customer Protection/Margin Collection. In addition, we removed a provision that would have automatically changed the deadline for futures commission merchants to post “residual interest.” The provision could have resulted in customers facing an earlier deadline to post collateral.
Simplifying Recordkeeping Requirements. We have also taken action to reduce recordkeeping obligations for commercial end-users, particularly regarding pre-trade communications, text messages, and records of final transactions. More detailed recordkeeping is appropriate for intermediaries handling customer funds, but not for end-users.
Reporting Requirements for Contracts in Illiquid Markets. CFTC staff took action so that real-time swap reporting requirements do not make it more difficult to hedge, by granting delayed reporting for certain less liquid, long-dated swap contracts related to the hedging of jet fuel.
Public Utility Companies. We also amended our swap dealer rules so that local, publicly-owned utility companies can continue to effectively hedge their risks in the energy swaps market.
Regional Transmission Organizations. Further, we have exempted certain transactions in the regional transmission organization (RTO) and independent system operator (ISO) markets from most provisions of our rules, other than our authority to pursue fraud and manipulation in those markets.
Relief for Small Banks and CDFIs. CFTC staff also addressed a concern of our community development financial institutions and small banks, by making clear that they may choose not to clear a swap subject to the CFTC’s clearing requirement, similar to the exception provided to end-users.
Treasury Affiliates. The Commission staff has also taken action to make sure that end-users can use the Congressional exemptions given to them regarding clearing and swap trading even if they enter into swaps through a treasury affiliate.
These are just some of the actions we have taken during my tenure to make sure these markets work for commercial end-users. I appreciate the input that many end-users have given us, and encourage you to continue to do so.
Let me turn now to a couple of major issues we’re working on that I know are of interest to you.
Position Limits. Of course, top of mind for many of you is our rule on position limits. You may know that earlier this week, the Commission unanimously acted to repropose this rule. We also unanimously finalized a separate but related rule on aggregation of positions.
Our reproposal makes many changes to the 2013 proposal I and my fellow Commissioners inherited when we took office. Certain aspects of our reproposal have been previously proposed in separate pieces, and we felt the public would benefit from seeing the proposal in its entirety, to better understand how the various changes work together. We also felt it was appropriate to repropose the rule given that we are in a period of transition.
Our staff has done a tremendous amount of work to devise a position limits rule that meets the requirements of the law and balances the various concerns at stake. Commissioners Bowen, Giancarlo, and I have also spent substantial time on this issue.
We have revised the proposed limits themselves in light of substantial work our staff has done to make sure they are based on the latest and best information as to estimated deliverable supply. For some contracts, the proposed limits for the spot month are higher than the exchange-set limits today. In other cases, we have accepted recommendations of the exchanges to set federal limits that are actually lower than 25 percent of deliverable supply, because we determined that the requested lower limit was consistent with the overall policy goals and would not compromise market liquidity.
We have proposed further adjustments to the bona fide hedging position definition, to eliminate certain requirements that we have decided are unnecessary, and to address other concerns raised by market participants. And we have included a proposal we first made this summer to allow the exchanges to grant non-enumerated hedge exemptions—subject to our oversight.
The Commission has a responsibility to implement a balanced rule that achieves the objectives Congress has established. I believe this reproposal does so and I hope that it can be finalized in the near future.
Capital Requirements for Swap Dealers and Major Swap Participants. Let me now turn to another important rule: capital requirements for swap dealers and major swap participants. The Commission unanimously approved a reproposal of this rule last week. These requirements are among the most important reforms of the over-the-counter swap market agreed to by the leaders of the G20 nations in 2009. And they serve as a strong complement to margin requirements for uncleared swaps. While margin is the front line defense against a default, adequate capital is critical to the ability of swap dealers to absorb uncollateralized losses.
Our original proposal was issued at a time when margin requirements for uncleared swaps had not yet been established and bank capital rules were still being finalized. Now that those are in place, one of my key goals has been to move forward with the rule and harmonize our capital requirements with those that already exist. We did not want to simply add another requirement where there are already capital standards. We also recognize that there are different types of firms that act as swap dealers: bank affiliates, broker-dealers, and others primarily engaged in non-financial activities. Requiring all firms to follow one approach could favor one business model over another, and cause even greater concentration in the industry.
Our proposal supports competition as well as safety and soundness, by providing three different approaches. First, for swap dealers that are affiliates of regulated banking entities, the proposal permits them to use a method based on that of our banking regulators. Swap dealers that are also broker-dealers can use an approach that is based on the Securities and Exchange Commission’s net liquid assets approach. And for those dealers that are engaged primarily in non-financial activities, we have proposed a third approach based on net worth. And we have harmonized these requirements, where appropriate, with the capital rules of our prudential regulators and the SEC.
De Minimis Threshold. We’re also working to address what is known as the de minimis threshold for swap dealing. This determines when an entity’s swap dealing activity requires registration with the CFTC, which triggers margin and capital requirements, as well as other oversight and business conduct rules. This fall, the Commission took action to delay by one year—until December 2018—the automatic drop in the threshold from $8 billion dollars in notional amount of swap dealing activity over the course of a year to $3 billion dollars.
Here again, I think we must set the threshold so as to achieve the goal of addressing potential excessive risk while still ensuring that we have robust, competitive markets.
Our decision was informed by a staff study that estimated lowering the threshold would not increase significantly the percentage of interest rate swaps (IRS) and credit default swaps (CDS) covered by swap dealer regulation, but it would require many additional firms to register. This might include some smaller banks whose swap activity is related to their commercial lending business. So lowering the threshold might reduce some beneficial activity, or increase costs, without a commensurate benefit. It might also lead to the largest dealers, who are affiliated with the largest banks, having even greater market shares and thus a more concentrated market.
These are some of the reasons why we acted to delay. We now have time to review the issue and decide the proper level.
I think this may also be a good opportunity for the Commission to consider other issues related to the threshold. For example, do we need to modify rules that pertain to the concerns of smaller banks that do not pose systemic risk, such as the rules on hedging exemptions?
I think it is also worth reviewing the various requirements that are triggered by swap dealer registration and considering whether some distinctions are warranted. That is, perhaps certain basic requirements, such as prohibitions on fraud or disclosure requirements, should apply broadly to swap transactions, and more detailed compliance and reporting requirements can then be focused on the largest dealers.
Modernizing Recordkeeping Requirements. We must also be mindful of the obligations our recordkeeping requirements place on market participants. As I mentioned earlier, we have made some changes to reduce obligations on commercial end-users. I believe we must also ensure our rules are up-to-date in light of technological changes, as outdated rules can create unnecessary burdens. To this end, CFTC staff is working on a proposal to modernize our recordkeeping and storage requirements, to make these rules technology neutral.
New Challenges in our Markets
Finally, I want to discuss some of the new challenges we face in our markets that have been priorities of mine, and that I believe we must continue to address. These issues are extremely important to all users of these markets. They fundamentally affect whether our markets continue to be robust, dynamic, and serve all those that rely on them.
Cybersecurity. First is cybersecurity. The risk of cyberattack likely represents the single most important threat to financial stability today. Recently, the Commission unanimously finalized rules that would bolster protections against cyberattacks and other types of operational risk in our markets. They require the core market infrastructure to regularly evaluate cyber risks and test their cybersecurity and operational risk defenses. These are principles-based standards, which rely on best practices. We are also continuing to make cybersecurity a priority in our examinations. There needs to be a continued focus on this. That does not mean the adoption of additional rules. Rather, one of the most important activities is to continue the work we have been doing to bring industry and government together to tackle this problem.
Today, there is much greater sharing of information between government and businesses on potential cyber threats and preparations to prevent attacks. A lot of work has occurred across the federal government over the last couple years in this regard. For example, last month the CFTC hosted an exercise involving participants from several government agencies—including law enforcement agencies and Homeland Security—as well as CME, ICE, clearing firms, and trading firms—to discuss what would happen if derivatives trading platforms were hit by a cyberattack. The scenario was hypothetical, but the discussion was real—and very useful for all of us. I think it will help all of us in our planning and in our understanding of how such an attack could unfold.
Automated Trading and the Changing Nature of Liquidity. A second set of concerns is related to automated trading and its consequences. Automated trading has brought benefits in terms of narrower spreads and speed of execution. But it raises concerns and issues as well.
First, we need to make sure that market participants can handle the speed and complexity of our markets today. The Commission has issued a proposal to minimize the risk of disruption and other problems that can be caused by automated trading—and to make sure we have the tools to deal with those problems should they occur.
The proposal requires reasonable risk controls, using a principles-based approach that would codify many industry best practices. It requires testing and monitoring of algorithms. It requires the preservation of source code and other records — the equivalent of the records that those trading at human speed have preserved for years. And it ensures that we would have the right to review such records when necessary, just as for years we have had the right to review the records of traders at human speed.
A second but related issue is examining more broadly the nature of market liquidity today—and making sure that liquidity, as well as access to these markets, remains robust. Because liquidity is the product of many different factors—and has different definitions—this is a challenging issue to examine, and time does not permit me to discuss all its facets. But my general view is that the issue we face today is not a decline in liquidity, but rather a change in its character. For example, some have been saying that regulation has hurt liquidity, particularly in stressful situations. I would say first, there is always a reduction in liquidity in stressful situations—look at what happened in the crisis, well before Dodd-Frank was signed into law. There was plenty of liquidity if you wanted to buy, but not if you wanted to sell. Our staff has studied liquidity in the most stressful moment we have faced since—the aftermath of the Brexit vote—and liquidity was very good.
In my view, the real issue is the changing nature of liquidity. As one example, consider that proprietary trading firms today represent 50 to 60 percent of the volume in many key contracts. But they represent a far lower percentage of the open interest, often only 5 percent. As another example, any analysis of order book data will show how rapidly and frequently bids and offers change—by the microsecond. I hear a lot of complaints from end-users, particularly those operating at human speed, who feel some algorithmic traders simply pick off the bids and offers of the slower participants. We have also witnessed moments of volatility that sometimes occur for no apparent reason. Some would say automated trading contributes to this, though that is very hard to test this claim. Finally, we need to make sure we continue to have a robust clearing member industry, so that smaller customers do not get shut out.
All these concerns and issues deserve attention. They are not easy to analyze, but it’s critical that the Commission continue to focus on them and engage with market participants.
Clearinghouse Resilience. Finally, during my tenure the CFTC has been very focused on the issue of clearinghouse resiliency. Clearinghouses play a critical role in the global financial system – one that has only become more prominent since the enactment of Dodd-Frank. Their strength and resiliency is critical. We have overhauled our regulations, enhanced our oversight, strengthened customer protection measures, bolstered our examination, compliance, and risk surveillance programs, and taken a number of actions to enhance overall clearinghouse strength and resilience. Today, are working to ensure our major clearinghouses complete the implementation of their recovery and wind down plans and rules this year. We are also working with domestic regulators on clearinghouse resolution planning.
We want a system in which neither recovery or resolution is ever necessary, of course. And to that end, our staff recently released a report detailing the results of a series of supervisory stress tests we performed on the five largest clearinghouses under our jurisdiction, located in the U.S. and the United Kingdom. These tests assessed the impact of stressful market scenarios across these clearinghouses and across the largest clearing members. The results showed that the clearinghouses had ample resources to withstand extremely stressful market scenarios on the test date. And they further showed that risk was diversified across clearing members — a clearing member that had a loss at one clearinghouse might actually have gains at other clearinghouses. These results are good news, and illustrate how far we’ve come in terms of transparency and oversight. But they are also just one test; we will continue these types of reviews in the future.
We are also helping to lead a major effort involving regulators from around the world to look at clearinghouse resilience and recovery planning. This includes examining issues such as stress-testing standards, margin methodologies, capital, liquidity and adequacy of resources in a default.
Clearinghouse resilience also depends on having a robust clearing member industry, and we have been very focused on that issue as well.
It is critical for the Commission to continue to prioritize these issues.
There is much more going on at the Commission. But let me conclude by saying what a privilege it is to chair this agency and work with groups like this one. The United States has the strongest financial markets in the world, and I believe a critical component of that is sensible regulation. I appreciate your input into the work of the CFTC.
Thank you very much for your time today. I’d be pleased to answer any questions you may have.
Last Updated: December 8, 2016