“Smart Regulatory Reform and the Perils of High-Frequency Regulation”
Remarks by Commissioner Scott D. O’Malia at MarkitSERV’s 2012 Outlook for OTC Markets, New York City, New York
May 31, 2012
Good afternoon and thank you Armins for the warm introduction and for the opportunity to speak at MarkitSERV’s 2012 Outlook for OTC Markets event. In light of the significant regulatory reform efforts that are currently underway at the Commodity Futures Trading Commission (the “CFTC” or the “Commission”) and elsewhere, events like this one are essential for market participants seeking clarity and guidance in navigating the array of new financial regulations that are coming down the pike while continuing to grow and innovate.
As a technology company, MarkitSERV provides critical solutions to its customers in connection with their over-the-counter (“OTC”) derivative transactions in order to streamline workflows and simplify tasks. Technology has always been near and dear to my heart, and I understand the challenges of integrating the newest and best products without having to put the brakes on.
As chairman of the Commission’s Technology Advisory Committee (“TAC”), I similarly have pushed the Commission to upgrade its technology infrastructure for the purpose of automating and expanding the Commission’s market surveillance and oversight of both the futures and swaps markets while fostering innovation. I also have utilized the TAC to inform the Commission as to the costs and impacts of its regulatory and policy decisions, as well as to provide a context for future choices.
Most recently, I established the TAC Subcommittee on Automated and High Frequency Trading. This subcommittee’s only focus is developing consensus regarding the definition of high-frequency trading (“HFT”) in the context of the larger universe of automated trading. The definition of HFT will serve as an initial step towards assessing the impact of HFT in the CFTC’s regulated markets. We will use this definition in considering appropriate regulatory responses.
While it is tempting to rush to regulate automated trading and HF—especially in light of its proliferation in our markets and the reality of events like the Flash Crash of 2010—I realized at the outset that there is currently no consensus among market regulators or even market participants as to the definition of HFT. Every debate begins by clearly defining the issue, and that is what I am doing right now.
Today, my remarks cover what I call “smart regulatory reform” and the benefits of avoiding that temptation to engage in rapid regulatory leaps before clearly defining the issues and, more importantly, the objectives. I will focus on three topics. First, I plan to discuss the process by which the Commission is implementing its final rules. The pace has been frenetic. We have not spent enough time thinking through all of the potential issues. The Commission is engaged in its version of “high-frequency regulation.” Similar to high-frequency trading, the market is unfamiliar with the exact goals and objectives of the Commission’s rulemaking and can only react. Without a schedule of rules and clear compliance dates, the market is left guessing as to whom the rules apply, when they must comply and what venue they must connect.
Second, I plan to discuss the extraterritorial application of the Dodd-Frank Act and our rules. Defining our own jurisdiction should have been one of our first steps down this regulatory rabbit hole. It is now almost two years since the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) passed and I have not even seen or reviewed our draft guidance.1
Third and finally, I want to provide a general update on the Commission’s upcoming rules, customer reforms and technology.
Before touching on the three topics of my speech, I would like to start today by providing a little background and context.
Financial Markets in Crisis
As you all know, the 2008-2009 global financial crisis resulted in the collapse of large financial institutions and significant government intervention in the form of bailouts. In response, Congress passed the Dodd-Frank Act, which was directed at reducing risk, increasing transparency and promoting market integrity. In particular, Title VII of the Dodd-Frank Act significantly transformed the Commodity Exchange Act (the “CEA”) and required the Commission to prescribe over 50 final rules within 360 days after the date of enactment of the Dodd-Frank Act.
The Perils of High-Frequency Regulation
For those of you who are unfamiliar with the typical Washington rulemaking process, it is generally a long and all-consuming one. Before the enactment of the Dodd-Frank Act, the Commission issued three or four rules a year at best. My friend and former Commissioner Mike Dunn would always say that most of the Commission’s rules normally take anywhere from 15 to 18 months to finalize. In order to complete the Herculean task of finalizing over 50 rules, the Commission also has established over 30 multi-disciplinary, rule-writing teams. Essentially, we are engaging in what amounts to high-frequency regulation.
Notwithstanding the Commission’s tighter timeframes and staff restructuring, the Commission is charged with understanding and overseeing markets with which it does not have prior expertise. Swaps and futures markets are different. I believe that the Commission must spend an appropriate amount of time understanding swaps markets and the ramifications of these rules, including the cost and benefits of each and every rule before they are finalized, not after.
Some of you may know that I have been very critical of the Commission’s cost-benefit analyses. The Commission previously minimized the role of performing complete cost-benefit analyses by turning the process into an administrative, check-the-box exercise. The good news is the Commission has reversed course and the chairman recently signed a Memorandum of Understanding with the Office of Information and Regulatory Affairs (“OIRA”) within the White House to provide technical expertise2 in order to develop a more thorough process for conducting the Commission’s cost-benefit analyses during the implementation of the Dodd-Frank Act.
In my view, there are three critical areas where the Commission can and must improve its cost-benefit analysis. First, the Commission should develop a realistic and status quo ante baseline. Second, the Commission should develop replicable quantitative analysis, which will allow it to make informed decisions about the market. Finally, the Commission should develop a range of policy alternatives for consideration. All three of these standards are best practices recommended in the Office of Management and Budget Circular A-4, Regulatory Analysis.3
As a result of our high-frequency regulatory approach, several of our final rules have created significant regulatory uncertainty and unnecessary angst; much like the uncertainty and angst surrounding the HFT activity during the Flash Crash of 2010. As you peel back the layers of some of these final rules, the problems of our high-frequency regulatory approach becomes apparent. I will briefly highlight several examples.
The poster-child for high-frequency regulation is the recently finalized swap dealer definition rule.4 This final rule includes an overly complex definition that would require several commercial firms and cooperative banks to register as swap dealers if it were not for a generous and temporary de minimis threshold for swap dealing activities at set $8 billion. Due to the complexity of this 600+ page final rule, some commercial firms will be confused as to whether they will be considered a swap dealer or not. The final rule also adds two new definitions of the term “bona fide hedging” to our existing two definitions (Regulation 1.3(z) and Position Limits Rule). As a result, the Commission is now up to four separate definitions and counting.
Another example of high-frequency regulation can be seen in the inconsistencies among the Commission’s various reporting rulemakings.5 For instance, since final passage of the large trader reporting rules,6 the Commission has been forced to delay implementation and issue a 160+ page guidebook on compliance reporting.7
The license approval process for swap data repositories (“SDRs”) and swap execution facilities (“SEFs”) has also been problematic. Thus far, the Commission has received four SDR applications, but has approved none. Since no two SDRs will be the same, the Commission is challenged with approving different models within the same regulatory framework. This problem will only be compounded when we receive dozens of SEF applications. Due to the compressed schedule, we do not have the luxury of delaying license approvals to make sure that they meet a one-size-fits-all standard. The delayed license approval process makes a strong case for preserving the principles-based regulation the Commission was known for versus the more specific rule-based regulation the Commission has adopted since the passage of the Dodd-Frank Act.
The Elements of Smart Regulatory Reform
To avoid the perils of high-frequency regulation, the Commission needs to engage in what I call “smart regulatory reform.” Right now, you may be asking yourself, “What does he mean by ‘smart regulatory reform?’” In my view, smart regulatory reform consists of three key elements. First, smart regulatory reform is based on facts that are uncovered through comprehensive research and robust and frequent discussions with industry. Second, smart regulatory reform reflects thorough economic analysis. Put differently, the Commission cannot ignore the importance of its cost-benefit analyses when prescribing regulations. Finally, smart regulatory reform should provide market participants and other affected persons with regulatory certainty. Our rules should not be unnecessarily complex, confusing, and in some cases redundant.
The Commission’s primary objective in implementing the Dodd-Frank Act should be to encourage compliance—not to increase its enforcement docket. Firms utilizing swaps and futures markets to mitigate and manage commercial risks should be focused on just that and not on the risk that they will take a misstep into a regulatory trap. Ultimately, I believe that smart regulatory reform will reduce systemic and counterparty risk, encourage liquidity formation, promote price discovery, and enhance market efficiency and competition in our financial markets. Enforcement is one of the Commission’s many functions. It is not the Commission’s only function.
The Swaps Market Is Global
In September 2010, the G-20 leaders met in Pittsburgh, Pennsylvania and agreed to implement comprehensive financial reform and the clearing of OTC derivative contracts by no later than 2012.8 Based on the work completed thus far, I believe it is possible for Commission to implement clearing in the fourth quarter of 2012 for major banks. I believe that the Commission will not require managed money and end users to clear until early-to-mid2013.
What I cannot predict is when Europe will require their registrants and market participants to meet a similar deadline. I am not confident based on recent press accounts that European OTC derivatives rules will be ready until sometime next year.
Although the futures and swaps markets developed as parallel markets, the swaps market is a more globalized market. It is very typical that swaps market participants are domiciled inside and outside of the United States and engage in a variety of cross-border swap activities such as marketing to foreign customers and making OTC markets in foreign jurisdictions. These activities could be subject to both U.S. and non-U.S. regulatory oversight. J.P. Morgan’s recent trading loss highlights the global nature of this business and the importance of a coordinated global regulatory approach.
The Commission’s Cross-Border Proposed Interpretative Guidance
When I accepted this speaking engagement, I expected the Commission would have released guidance on the extraterritorial application of the Dodd-Frank Act and its rules. That has not happened and I have not even reviewed a draft. However, let me share with you what I expect to see and the principles that I hope will be included in the guidance.
I expect the Commission will propose: (1) which foreign persons will have to register as swap dealers and major swap participants (“MSPs”); (2) what Dodd-Frank Act requirements will apply to those swap dealers and MSPs; (3) when the Commission will defer to comparable foreign regulatory regimes and permit swap dealers and MSPs to satisfy their requirements under the Dodd-Frank Act through substituted compliance; and (4) how the clearing mandate, trade execution, and certain reporting provisions will apply to cross-border swap transactions involving non-swap dealer and non-MSP counterparties. The Commission’s cross-border guidance will turn on a small provision that quietly made its way into the CEA through the Dodd-Frank Act—new Section 2(i) of the CEA.
Many people are unfamiliar with new Section 2(i). This section contains only 101 words—enough words that could fit into a Twitter feed. Specifically, Section 2(i) provides that the Commission’s swap authority shall not apply to foreign activities unless those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States . . . .”9 The important thing for you all to remember is that this language gives the Commission broad authority over the swaps market that goes well beyond other areas of law.10 For that reason, I believe that the Commission’s cross-border guidance, once issued, should take into account the following four principles and considerations.
First, the CFTC’s cross-border guidance should be based on principles of international comity. In other words, the guidance should not overreach or step on the toes of sovereign nations. We would not want these nations to retaliate by re-characterizing as foreign, market participants who we typically think of as “U.S. persons.”
Second, and in some way related to the first point, the CFTC’s guidance should be based on principles of international harmonization. That is, the CFTC needs to coordinate its efforts with the Securities and Exchange Commission (the “SEC”), as well as the efforts of foreign regulators. As far as I am aware, the CFTC and SEC will release separate extraterritorial guidance, which can only create inconsistency and added compliance challenges and costs. Additionally, our cross-border guidance needs an appropriate phase-in to match global regulatory efforts relating to swaps.
Third, I believe that the Commission’s guidance should in some way demonstrate the costs and benefits of setting its jurisdiction too broadly. The CEA only requires the Commission to consider the costs and benefits of its regulations and orders. It does not require that the Commission consider the costs and benefits of interpretative guidance, which the Commission will propose. In my view, however, the Commission should do the right thing and conduct a thorough analysis of the costs and benefits of its guidance. That way, the Commission will be able to adequately understand the implications of its guidance and make an informed decision regarding policy alternatives.
Finally, the Commission should ensure that its registrants and registered entities remain competitive in global financial markets. Understandably, U.S. registrants and registered entities would be subject to all of the provisions of the Dodd-Frank Act. Nevertheless, the Commission’s policies should not put them at a disadvantage vis-à-vis their foreign competitors.
Without a doubt, the Commission will be busy this summer. I estimate that the next handful of Commission rules and guidance to be issued will include: (1) the definition of “swap;” (2) the Commission’s cross-border guidance; (3) mandatory clearing determinations; and (4) the Commission’s final implementation timetable for clearing. In July, I believe that the Commission will vote on rules regarding trade execution, including the final rules for SEFs, as well as Core Principle 9 for Designated Contract Markets. These are my best guesses.
There are also a number of significant developments at the Commission on the customer protection front. These developments are very important to me. The failure of MF Global exposed material gaps in our regulatory oversight. Our reporting methods and disclosure timetables enabled MF Global to move customer money without detection. On Tuesday of this week, the National Futures Association (“NFA”)—working with the Commission—made several important rule changes to improve transparency and promote further protections for customer funds.11
Another action taken by NFA in coordination with the Commission has been dubbed the “Corzine Rule.”12 This rule will require CEOs and CFOs to sign-off before a futures commission merchant (“FCM”) can transfer or otherwise move customer funds. I support this rule as well as other rule improvements in FCM transparency—something I call “know-your-FCM rules.” The Commission and the NFA plan to work together on the know-your-FCM rules this summer. These rules will help customers make informed decisions about the safety and security of their FCM. Our challenge is to improve FCM disclosures in such a way to make them useful and relevant.
Broadly, deterrence, transparency, and technology are the three key elements to improving the Commission’s oversight over not only FCMs, but over all CFTC registrants and registered entities. Deterrence speaks for itself. Transparency offers market participants and regulators a window into business transactions and operations, in addition to exposing possible risks. Lastly, technology provides the Commission with the ability to catch risks and nefarious behavior before it is too late.
Brave New World of Technology: Swaps Market Infrastructure
When I became a commissioner two-and-a-half years ago, I was aware of the modern trading and matching engines used to trade equities and futures and the explosion in trade volumes across the globe. However, I was amazed by the lack of sophistication of the Commission’s surveillance and automation capabilities. In my view, the Commission was not organized to appropriately oversee the futures and swaps markets. I have made correcting this problem among my top priorities while at the Commission. The good news is that we have addressed this problem by creating a new office of data and technology. This new office is deploying state-of-the-art technologies to expand the Commission’s oversight functionality.
I appreciate the opportunity to speak with you all today and hope that you have found my insights to be useful. The Commission’s reform efforts must not only provide the needed guidance to ensure that swaps markets are transparent and promote integrity. Our regulatory reform efforts must also be smart, make sense in terms of their sequencing and implementation, and most importantly not employ a high-frequency regulatory approach.
Again, I would like to thank you all for your participation today. I would also like to thank MarkitSERV for organizing such a timely and constructive event.
1 See Pub. L. 111-203, 124 Stat. 1376 (2010).
2 The Commission entered into the Memorandum of Understanding with OIRA in May 2012.
3 See OMB Circular A-4 (Sept. 17, 2003), available at http://www.whitehouse.gov/sites/default/files/omb/assets/regulatory_matters_pdf/a-4.pdf.
4 See Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 77 Fed. Reg. 30596 (May 23, 2012).
5 See Swap Data Recordkeeping and Reporting Requirements, 77 Fed. Reg. 2136 (Jan. 13, 2012); Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, ___ Fed. Reg. ___ (Not Yet Published), available at: http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister051812.pdf; Real-Time Public Reporting of Swap Transaction Data, 77 Fed. Reg. 1182 (Jan. 9, 2012); Swap Data Repositories: Registration Standards, Duties and Core Principles, 76 Fed. Reg. 54538 (Sept. 1, 2011).
6 See Large Trader Reporting for Physical Commodity Swaps, 76 Fed. Reg. 43851 (July 22, 2011).
7 See Large Trader Reporting for Physical Commodity Swaps: Division of Market Oversight Guidebook for Part 20 Reports (Nov. 11, 2011), available at: http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/ltrguidebook120711.pdf.
8 See Pittsburgh G20 Leaders’ Summit Communiqué (Sept 24-25, 2012) at p.9.
9 7 U.S.C. 2(i) (2012).
10 For example, the closest analogue in the law is the Federal Trade Antitrust Improvements Act of 1982, 15 U.S.C. § 6a (2012) (“FTAIA”). The FTAIA amended the Sherman Act, 15 U.S.C. §§ 1 et seq., by removing from the Sherman Act’s reach conduct involving all trade or commerce with foreign nations except for conduct involving import trade or import commerce unless such conduct has a direct, substantial, and reasonably foreseeable effect (A) on trade or commerce which is not trade or commerce with foreign nations, or on import trade or import commerce with foreign nations; or (B) on export trade or export commerce with foreign nations, of a person engaged in such trade or commerce in the United States. This language is arguably less broad than the language in CEA Section 2(i).
11 See May 29, 2012 Letter to the Commission from NFA re: Protection of Customer Funds – Proposed Amendment to NFA Financial Requirements Section 4 and Adoption of NFA Financial Requirements Section 16 and its Related Interpretive Notice Regarding FCM Financial Practices and Excess Segregated Funds/Secured Amount Disbursements, available at: http://www.nfa.futures.org/news/PDF/CFTC/FR_Sec_16_ProtectionCustomerFunds_IntNotc_0517.pdf.
12 See Id.
Last Updated: December 20, 2017