Derivatives Reform: Assessing and Improving the Change
Keynote Address by Commissioner Scott D. O’Malia, TabbForum, Fixed Income 2013: Liquidity, Products, Platforms
January 30, 2013
Thank you very much for that kind introduction, Larry. It’s always great to be here in New York City and I’m particularly pleased to be speaking at a forum being hosted by TABB Group. TABB Group is widely respected, deservedly so, for its fine research and analysis and for stimulating debate about the big issues facing the financial markets today. This timely event on fixed income products – the largest component of the swaps market – is another example of how Larry and his colleagues are advancing discussion of these issues.
I am particularly honored to have the opportunity to speak at this conference for a second time. My first was two years ago almost to the day, when the Dodd-Frank rulemaking process was just taking shape. In my appropriately titled speech “Derivatives Reform: Preparing for Change,”1 I provided some insight as to how the Commission was going to implement the rulemaking process. At that time, the Commission had produced 33 proposed rules, two interim rules and four advance notices of proposed rulemaking.
In the span of two years, we have finalized 43 rules and proposed a total of 64. We have also issued a total of 73 exemptions, interpretations, Q&As, and no-action relief letters – 63 of them since October alone. We have been sued three times – won one,2 lost one,3 and one has been withdrawn for the moment – and I wouldn’t be surprised to see more lawsuits. The lawsuits and the ad-hoc barrage of exemptions point to a flawed rulemaking process that prioritized getting the rules done fast over getting them done right.
So much has changed from a regulatory standpoint in these two years. We are now just beginning to see the consequences of our rulemakings manifest themselves in the markets. Today, the final framework of derivatives regulation is largely in place and we can see participants making decisions based on the new regulations.
I would like to discuss three main topics with you today. First, I would like to address technology, and specifically to focus on customer protection measures and the supervision of automated and high-frequency trading. Second, I would like to discuss the phenomenon known as the “futurization” of the swaps markets. And third, I would like to talk about the Commission’s upcoming rules governing swap execution facilities (SEFs).
Technology: Customer Protection Solutions Becoming a Reality
So let’s get started with technology.
Tomorrow is a significant day on the CFTC calendar, as a federal district court in Iowa will hold a sentencing hearing for Russ Wassendorf Sr., who “made-off” with $215 million in customer funds over a twenty year period as CEO of Peregrine Financial Group. Due to the lack of technology that had been deployed in the oversight of customer funds, Mr. Wassendorf was able to conceal his theft with Photoshop and a fax machine.
Unfortunately, the Peregrine fraud was not the only black eye recently suffered by futures customers. I believe everyone recalls the Halloween 2011 bankruptcy of MF Global, the eighth largest in U.S. history. MF Global management tricked customers when it used over $1.6B in customer funds for house trading activities. This exposed another area where the automated oversight of segregated accounts could have prevented MF Global management from illegally tapping customer funds.
The industry recognized that the one-two punch of MF Global and Peregrine, if not quickly addressed, would decimate customer confidence. To their credit, the leading self-regulatory organizations, the National Futures Association (NFA) and the CME Group, established a plan to automate oversight of customer segregated funds – to be done at the expense of the industry, with no taxpayer funds used. This plan was announced at the Commission’s Technology Advisory Committee (TAC) meeting on July 26, 2012.4
Under this plan, an automated system collects account balances directly from depository banks and reconciles those values with the account balances claimed by futures commission merchants (FCMs), thus providing daily confirmation of customer account balances and allowing us to move away from sole reliance on the statements provided by the FCMs themselves. Any discrepancy between the two values can be immediately investigated.
The industry committed to launching this system by January 1, 2013. Already, they have connected the majority of futures customer cash accounts to this customer verification system. This is a great start, but we need to keep progressing so that we are able to receive information on 100% of all types of customer accounts by later this year.
These tools will give us alerts when accounts deviate more than 1% from expected levels. Criminals will no longer have a three-day head start, let alone a 20-year run, to use customer funds without the Commission knowing about it.
HFT: Identifying the Gaps and Implementing Effective Controls to Ensure Well-Functioning Markets
The second technology issue I would like to address is the oversight of automated trading strategies (ATS), including the high-speed strategies known as high-frequency trading (HFT). I recognize that we can’t put the genie back in the bottle and hope that HFT traders will magically disappear from our market. They provide an enormous amount of liquidity and they are here to stay. At the same time, we should develop a better understanding of their trading methodologies and develop market structures to prevent a liquidity crisis or runaway markets similar to the Flash Crash of May 6, 2010.
As the Chairman of the Technology Advisory Committee, I am working to define, study and measure HFT and ATS involvement in our markets. I have also worked to identify the baseline controls that traders, FCMs and exchanges deploy to ensure trades that are submitted to the market are properly checked to prevent misfires or rogue behavior.
The Commission is currently considering a draft concept release to apply testing and supervision requirements to traders and exchanges as well. Unfortunately, the current draft simply looks at gaps in the federal rules and proposes to “federalize” some of the existing market-based solutions.
We need to develop solutions that are more thoughtful and more cognizant of existing developments in the market. I remain hopeful that a revised draft of the document will conduct a complete review of existing market and regulatory controls, identify where there are gaps in the marketplace and where market-based solutions are ineffective, and based on that gap analysis proceed to determining what federal action is warranted.
Next Technology Advisory Committee Meeting
I have scheduled the next TAC meeting for April 30 in Washington D.C. I hope the revised testing and supervision proposal will be released before that date, so that the experts of the TAC can provide their input and discuss its relation to existing and recommended market controls.5
CFTC Must Adopt a Disruptive Attitude toward Technology
Before I move on to my next topic, I would like to say a word about the Commission and technology more generally. From the beginning of my term, I have been focused on automating every aspect of the surveillance and oversight of markets under our jurisdiction.
Why such a focus on technology? Because I believe it is important for the Commission to keep pace with the technological developments of traders in the market and to ensure customers that our markets are safe and fair. We must develop new surveillance capabilities to watch not only the futures and options markets but the swaps markets as well.
People often talk about disruptive innovation: innovation that forces a paradigm shift from existing, but inadequate and often obsolete, technologies in favor of new, more effective technology solutions. I believe the Commission needs to adopt this innovative mindset and approach in order to develop and deploy new, better automated surveillance responsibilities and, in doing so, make our existing capabilities obsolete. We can’t assure the markets that we are fully prepared to carry out our oversight responsibilities if we are only looking at transaction data for a single trader in a single market.
To be effective, we must see the big picture, and to do that we must access and analyze other pieces of the puzzle – for example, order data to understand how automated trading schemes drive market behavior and to be able to see a trader’s behavior across platforms. We need to develop new tools, new techniques and new concepts to watch for a new brand of electronic fraud.
Unfortunately, the current CFTC vision for investing in new technology is anything but innovative. Technology is a second-order priority when it comes to allocating scarce resources. The focus on our budget should be to develop a forward-thinking technology plan, with specific objectives and plans for each division, and then to build the people around that based on the available resources.
Futurization: A Still Unfolding Story
Now to my second topic: futurization.
“Futurize”: verb, to take a derivative product and trade it as a future. While it may not become as ubiquitous as the expression "google it" has, there’s no doubt it is showing up in the trading lexicon. This is a new, fresh term that was developed to describe the wholesale shift in the energy market on the day the Commission’s new swap regulatory regime became effective: October 15, 2012.
On that date, the energy swaps market was “futurized” and began trading as exchange-traded futures. Customers fled the confusing and increasingly costly swaps regulatory regime in favor of a well-defined, smoothly functioning futures market that has been a global model for decades and was in fact the model for the swaps market under Dodd-Frank.
I first discussed futurization in a speech on November 136 and soon thereafter I specifically called for a Commission hearing to discuss futurization, its causes and its effects.7 I’m pleased that Commission staff has taken up my call and will be hosting a public roundtable tomorrow.
In my opinion, the move to futures is logical and, in some financial products like rates and credit, a more cost-efficient solution. Some have even opined that the shift to futures is a move to a less regulated environment. While I disagree with the characterization that the futures market is less regulated, I couldn't agree more with the argument that the futures market is well understood and that its rules are clear and provide market participants with regulatory certainty. In comparison, the swaps rules are vague, poorly understood, and now riddled with temporary exemptions and no-action relief – in other words, a confounding mess that only an outside counsel could love.
However, the current state of affairs is not necessarily the end of the story. The transition to futures in the energy market has been facilitated by the exchanges establishing extremely low threshold sizes for block trades in the futures contracts. These thresholds are unlikely to stay at these levels. The question is: if they are raised, what impact will this have on traders? Will our rule changes discourage traders from using futures markets and clearing trades? I thought the whole point of financial reform was to encourage exchange trading and clearing. This is a significant issue that needs to be sufficiently thought through by both the Commission and market participants, and it is the reason that I called for tomorrow’s futurization roundtable.
Futurization: is it bad, or is it good, or is it simply inevitable? I can already imagine what certain special interests might say: “this is a great opportunity to increase regulation on the futures market,” or “let’s repeal Dodd-Frank.” Neither is the right answer. With the election behind us, we can lower the rhetoric and look objectively at the relationship between the markets and the products. We must look at both U.S. markets and foreign markets to understand the costs and regulatory incentives embedded in their rules. We must always be thinking about risk management. We must also refrain from jumping to conclusions as we haven’t yet completely defined the costs associated with over-the-counter trades.
Impact of OTC Margin Rules
That brings me to a big issue looming on the horizon: margin and capital rules for uncleared products. There’s no doubt that the cost of OTC trading is rising, but by how much? How will this higher cost affect trading in the markets?
It’s important to note that the effort to establish a margining regime for uncleared swaps is not a solo effort by the Commission. Rather, it is a global effort, as it should be, and coordinated through the Working Group on Margin Requirements, which was established in October 2011 by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO). This working group issued an initial report in July 2012 and requested comment from the public.
The working group has prepared a revised report, which is currently under review by regulators. There seems to be general agreement on the basic elements: variation margin as well as two-way initial margin.
One estimate of initial margin requirements, put forth by the International Swaps and Derivatives Association (ISDA), is $1.7 trillion in global assets,8 a number that Janet Yellen, Vice Chair of the Board of Governors of the Federal Reserve System, characterized in a speech earlier this month as “eye opening, to say the least.”9 And that number is based on firms being permitted to use internal models to calculate initial margin; assuming the use of standardized schedules instead of internal models, ISDA’s estimate rises to $10.2 trillion.
These figures are indeed eye-opening, and may explain why there are now reports that the working group may yet launch a second period of public consultation on the margin document. At the least, the figures drive home the point that efforts to reduce systemic risk are not without significant liquidity costs. Stay tuned.
SEFs: Flexible Final Rule, Clear Registration Process
Let me move now to my third main topic: SEFs and other transaction-related rules.
The Commission is currently considering this suite of rules to determine how swaps will transact on exchange. These rules consist of: the requirements for SEFs, the SEF block rules, the “made available to trade” determination and Core Principle 9, which effectively sets the minimum trading threshold for futures exchanges. Hopefully, the Commission will finalize these rules in a way that creates a level playing field, from a regulatory perspective, between swaps and futures, allowing market participants to decide whether to gravitate more toward one or the other.
I’d like to focus specifically for a bit on the topic of SEFs. It appears the SEF final rules may be voted on by the Commission as early as mid-February. That’s right in time for Valentine’s Day, and nothing says “Valentine, I care” like a SEF final rulemaking.
The Commission published the proposed SEF rules in January 2011. The proposal was a decent start, but a broad range of market participants – from buy-side asset managers and commercial end users to sell-side dealers and even prospective SEFs – expressed concern that it did not provide the necessary flexibility for less liquid swaps to be executed on the SEF platforms.
I have developed a little four-part checklist for the SEF final rule.
Rule 1: Allow for flexible methods of execution including request for quote systems (RFQs) and limited voice-based systems. While I am supportive of the overarching objective of promoting pre-trade price transparency, let’s make sure that everybody, whether buy-side, sell-side or commercial firm, can find what they want and in the size and price they want on a SEF.
Rule 2: Do not copy the rules for designated contract markets (DCMs). Congress specifically stated that a SEF is not a DCM, and we shouldn’t attempt to adopt and implement identical rules. The Commission must implement flexible rules under the SEF core principles and take into account the fact that unlike DCMs, SEFs can only allow sophisticated entities called eligible contract participants (ECPs) to trade on their platforms.
Rule 3: Adhere to and explain the statute, or risk litigation and delay. Dodd-Frank’s definition of a SEF explicitly allows for swap transactions to be executed “by any means of interstate commerce.” The process of interpreting these six words has been a challenge for the Commission. Our proposal failed to provide a clear role for the execution of swap transactions over the telephone, a common mode of execution for swap transactions prior to the enactment of Dodd-Frank. At a minimum, the final SEF rules must provide some way for telephone and electronic systems to work together. I’ll admit, integrating a phone-based system into the SEF framework is not an easy task and it certainly presents new regulatory challenges with respect to Commission oversight and auditing of these systems.
Rule 4: Develop a clear pathway for timely approval of temporary SEF licenses. Without a clear, transparent baseline for all SEFs to develop their licensing applications, we are doomed to repeat the failures of the registration process for swap data repositories (SDRs). The SDR final rule was approved in September 2011. Since then, we have only provisionally registered three SDRs and our review process has been so inefficient and inconsistent that we were sued in district court by a prospective SDR.
This experience does not bode well for the application process for SEFs. Over the course of the past two years I have met with prospective SEF applicants, each anticipating a trading platform different in level of complexity, trading protocol, and technology employed. This variety found in the SEF universe makes a one-size-fits-all approach to SEF registration impossible.
This reality was brought into focus by Chairman Gensler at a House hearing in December, when he expressed the view that even carrier pigeons could potentially qualify as a SEF platform. Now, carrier pigeons may not have the necessary start-up capital. But the central point remains: SEFs can be incredibly varied. So the question is: how will Commission staff review and evaluate applications for such a variety of entities? How long will it take to receive approval if your SEF doesn’t comport with the “interpretations” of staff that were never specified in the rules?
I believe the Commission must develop a uniform, consistent and efficient application process, instead of the ad-hoc, inconsistent and sometimes contradictory approaches it took in the SDR realm. To that end, it is crucial for the Commission to issue clear written guidance to the public that explains the path forward to temporary SEF registration. And it must issue this guidance before applicants begin the process, not after the process has begun.
Our job isn’t to pick winners and losers five years from now – the market will take care of that. Our job is to ensure the fundamental responsibility of market oversight and enforcement is in place with a chief compliance officer, appropriate interconnections to clearing and reporting and a rulebook that provides for fair and open access for qualified participants.
I want a robust competitive market that will bring transparency to trading derivative products and I want it to happen now, not a year from now.
Commissioner Jill Sommers’s Departure
I know I promised you earlier that I had three topics, but I would be remiss if I didn’t say a few words today about my colleague Jill Sommers, who announced last week that she will be stepping down from the Commission following five years of distinguished service. She brought to the Commission a wealth of industry knowledge and experience, and she utilized that experience in providing a clear and consistent voice for thoughtful, balanced regulation. Jill did all this with grace that earned her the respect of her fellow commissioners, the Commission staff and Congress alike. So, while I am sad to see her go, I am very proud to have had the opportunity to serve with her and I wish her all the best in her future endeavors.
I began today by referring to my talk at this forum two years ago, so I thought maybe it would be appropriate to conclude with a thought about what I will say here two years from now – assuming Larry invites me back.
I hope in two years I can look back and say that the Commission fully embraced technology to stand up a first-class oversight program – one that provides thorough and cost-effective customer protection. I hope we will have developed rules to facilitate competitive swaps and futures exchanges that trade relative to one another, rather than at the expense of one another, and provide for a range of innovative, transparent derivative products. I hope we will provide more clarity with respect to all the exemptions and no-action relief we have provided in recent months. And I hope we will revisit several of our rules, both to reduce the confusion within each rule and to improve the consistency among all the rules, in order to ensure cost-effective and safe derivatives markets.
Thank you very much for your time.
1 “Derivatives Reform: Preparing for Change.” Remarks by Commissioner Scott D. O’Malia, January 25, 2011. http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-3.
2 Investment Company Institute and Chamber of Commerce of the United States of America v. United States Commodity Futures Trading Commission. The decision is available at: https://ecf.dcd.uscourts.gov/cgi-bin/show_public_doc?2012cv0612-42.
3 International Swaps and Derivatives Association, et al. v. United States Commodity Futures Trading Commission. The decision is available at: https://ecf.dcd.uscourts.gov/cgi-bin/show_public_doc?2011cv2146-69.
4 Testimony by Chris Hehmeyer, CEO, HTG Capital Partners and Chairman of the Board of Directors of the NFA, available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/tac_072612_transcript.pdf.
5 TAC reference document available at: http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/tac103012_reference.pdf.
6 “A Better Regulatory Path: Applying Good Government to Dodd-Frank Implementation.” Remarks by Commissioner Scott D. O’Malia, November 13, 2012. http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-19.
7 “The Dodd-Frank Holiday Season.” Remarks by Commissioner Scott D. O’Malia, November 30, 2012. http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-20.
Last Updated: January 30, 2013