Derivatives Reform: Preparing for Change
Keynote Address by Commissioner Scott D. O’Malia, Title VII of the Dodd-Frank Act: 732 Pages and Counting
January 25, 2011
I would like to thank Larry Tabb and his organization for providing this opportunity to join you today.
This is actually a Home-and-Home series. I agreed to speak to the TABB Group here in New York, if Larry would agree to testify before the Commission’s Technology Advisory Committee (TAC) on Thursday in Washington. I certainly hope that we are able to get this kind of attendance.
As you know, I have reconvened the TAC to bring industry and academia together to advise the Commission on technology issues. Technology is going to be the cornerstone of the new market structures, and I am happy to lead the groundbreaking.
Since arriving at the Commission, I have been amazed by the challenges and opportunities that technology presents. On the one hand, it is a challenge is to keep up with the pace of business and the markets—and the markets have a significant head start. On the other hand, it is an opportunity for the CFTC to take a huge leap into the 21st Century and finally begin to use technology to our advantage to carry out the heightened surveillance and oversight responsibilities mandated by the Dodd-Frank Act.
We can no longer achieve our mission and goals by throwing people at them. We need to leverage our investment in automated surveillance systems, eliminate human intervention in data collection and at a minimum, ensure that all forms filed with the Commission can be filed electronically and retire the fax machine. While this is not a reality today, everyone should have a dream.
I have enjoyed the discussions here today and found them to be very insightful. I would like to share with you my impressions of the Dodd-Frank rulemaking process and touch on other issues that the Commission is wrestling with. I will cover my approach to implementing these regulations and identify both consequences we should be aware of and self-imposed budget limitations that will compromise the Commission’s ability to deploy state-of-the-art technology that is necessary to fulfill the requirements of the Dodd-Frank Act. I’ll close by responding to some of your questions and concerns.
Since August of last year, the Commission has published in the Federal Register four Advance Notices of Proposed Rulemaking, 33 Notices of Proposed Rulemaking, two interim rules, one order, one notice, and two requests for comment pursuant to the Dodd-Frank Act. That equates to 732 Federal Register pages (and you know how dense those tri-column, 9-point font pages are)—and we’re still counting. We have more than a few in the hopper, including the position limits proposal. If you were to lay those pages end-to-end lengthwise, they would stretch for 671 feet. That is more than twice the height of the Statue of Liberty from its base to the tip of the torch, and more than half the height of the Empire State Building. And with comment periods ranging from 30 to 60 days, if you took those comment periods consecutively, you’d end up with 2,154 days or just short of 6 years. I’m not even going to get into how many hours it takes to review and respond to these releases or the costs associated with hiring a top-notch attorney to take it on at a modest rate of up to $1000 bucks an hour.
I understand the challenges involved for market participants and other stakeholders to review the several hundred pages of piecemeal rules released and respond to the hundreds of questions, all within the next several months. Frankly, the schedule set by Congress for the Commission to implement the Dodd-Frank Act is unrealistic. I am aware of four statutory deadlines the Commission has missed to date.
Dodd-Frank gave the CFTC primary oversight over the majority of the swaps market based in part on the fact that our regulatory framework for the futures market has proved largely successful in preventing the meltdowns that crippled so many other financial sectors. However, we cannot lose sight of the fact that the futures and swaps markets developed as parallel markets.
The tight one-year implementation time frame for Dodd-Frank may encourage some to ignore the fundamental preferences of swaps market participants and do a regulatory cut-and-paste job. But we can’t simply force a one-size-fits-all solution because we have to respect the way the markets work. The bilateral swaps market evolved in response to the inability of the futures market to address certain industry needs. In our rulemaking proposals, we must not forget that those fundamental market preferences gave rise to the swaps market in the first place.
My Approach to Rulemaking
Making Rules More Sensible and Cost-Effective
I would like to now share my approach to the rulemaking process. But first, I must thank the President for his thoughtful Wall Street Journal opinion piece1 and the signing of an Executive Order, “To Improve Regulation and Regulatory Review.” His directive to government to seek affordable and less intrusive means to achieve our goals echoes my own objectives to promote predictability and reduce uncertainty and ensure that regulations are accessible, consistent, written in plain language, guided by empirical data, and are easily understood. With each piecemeal rulemaking, we risk creating redundancies and inconsistencies that result in costs—both opportunity costs and economic costs—without corresponding benefits.
As I initially read through the Order, I found myself agreeing wholeheartedly with all of it, right up to the point when I found out that it doesn’t apply to independent agencies like the CFTC.
Since day one, I’ve been saying that we need to regulate better and more effectively, and it’s time for us to put the President’s words into action. The CFTC should adopt this Executive Order as policy and seek to include its high standards into each of our pending and future rulemakings.
Making the Intersection of Main Street and Wall Street Safer
I believe our challenge at the Commission is one of balance. We must develop regulations and market structures that achieve the primary goal of Dodd-Frank to reduce systemic risk within the financial system by improving transparency, competition, and open access, while still respecting the unique characteristics and preferences of the swaps market at the same time.
Picture a traffic intersection. At the center of the intersection is a traffic cop whose responsibility is to ensure that traffic continues to flow in all directions and, more importantly, that everyone—whether on foot or in an SUV—gets through safely and without incident. We are not here to stand in the middle of the intersection between Main Street and Wall Street and block it, because that would stop traffic—the flow of commerce in our markets—altogether. Rather, we must balance the needs of commercial end users and speculators, as well as the buy-side and sell-side, to make sure that everyone’s interests are protected and our markets continue to work properly to hedge risk and enhance price discovery.
This metaphor can also be applied to SEFs. SEFs will be the major intersections in the swaps market. In order to reach its overarching goal of maximum trading on SEFs, Dodd-Frank requires that multiple participants trade with one another on this facility to ensure that traffic flows without incident. It also requires both pre- and post-trade price transparency, so that everyone can watch where they are going and know where the best routes are. Our challenge is to make sure that our rules of the road create a trading environment that will attract liquidity and facilitate product standardization so that we can meet the goals of the Dodd-Frank Act and the needs of the industry. Failure to recognize important variables and the difference between types of asset classes and participants by trying to create a one-size-fits-all solution will set us up for just more failure.
For example, let me tell you about a recent proposed rulemaking where extensive negotiations among the Commissioners resulted in a significantly improved swap execution facility (SEF) proposal that achieved both my and the President’s objectives for affordable and less intrusive regulation. The Commission was originally expected to vote on the proposal on December 9th. This initial SEF proposal ignored the alternatives and comments from those who are most likely to be affected by the rule, and instead had a proposed rule that required market participants to either use a limit order book or submit firm bids and offers that would be shared with the entire market. If this approach had been adopted, it would not only have been overly restrictive for the industry as a whole, but was certain to detract from the goal of Dodd-Frank to promote the trading of swaps on SEFs.
I was prepared to offer an alternative proposal at our rulemaking on December 9th. However, the rule was pulled to allow for more negotiations. In the end, while not perfect, we negotiated a proposed rule that offers far more flexibility to traders, allowing them to transact in illiquid markets and in large volume without fear of telling the whole market their strategy. This compromise solution does not mandate a limit order book, but will instead allow participants to use a variety of trading systems and platforms, including order books, request for quote systems, and voice-based systems. But, it does require that SEFs maintain an electronic screen that displays all firm and indicative quotes to market participants and so in that way satisfies pre-trade transparency requirements. By talking through the proposal and its alternatives and comments, we were able to come up with a rule that better served the markets and our statutory goals.
Facing the Consequences: “Too Costly to Clear”
I have serious concerns about the cost of clearing. I believe everyone recognizes that the Dodd-Frank Act mandates the clearing of swaps, and that as a result, we are concentrating market risk in clearinghouses to mitigate risk in other parts of the financial system. I said this back in October, and unfortunately, I have not been proven wrong yet. Our challenge in implementing these new clearing rules is in not making it “too costly to clear.” Regardless of what the new market structures ultimately look like, hedging commercial risk and operating in general will become more expensive as costs increase across the board, from trading and clearing, to compliance and reporting.
In the short time I have been involved in this rulemaking process, I have seen a distinct but consistent pattern. There seems to be a strong correlation between risk reduction and cash. Any time the clearing rulemaking team discusses increasing risk reduction, it is followed by a conversation regarding the cost of compliance and how much more cash is required.
For example, there are several changes to our existing rules that will contribute to increased costs, including more stringent standards for those clearinghouses deemed to be systemically significant. The Commission staff has also recommended establishing a new margining regime for the swaps market that is different from the futures market model because it requires individual segregation of customer collateral. I am told this will increase costs to the customer and create moral hazard by reducing the incentive of futures commission merchants to appropriately identify and manage customer risk. In the spirit of the Executive Order, we must ask ourselves: Are we creating an environment that makes it too costly to clear and puts risk management out of reach?
Technology: Caught in a Game of Budgetary Chicken
Last week, Chairman Gensler publicly stated that he is cutting the technology budget in order to comply with the continuing resolution passed by Congress during a lame duck session. In my opinion, the Chairman is playing a game of “chicken” with Congress over the CFTC technology budget—and that is not a game where anyone wins.
To understand the Commission’s dilemma, I need to provide a little background on how we got here. First, the Commission’s budget is set at $168.8 million, the same level we had during fiscal year 2010. Second, despite receiving no net increase in funding, the Commission has added people to the payroll and has grown from 605 full-time equivalent employees in FY2010, to 682 employees as of January of this year. In dollar terms, that is a $15 million increase in payroll and an additional $1 million increase in leasing costs. To offset a portion of this increase, over $11 million was cut from the technology budget.
Under the Chairman’s budget, no funding will be provided for technology upgrades to meet our supervisory burdens under the Dodd-Frank Act. Drastic cutbacks in technology will reduce our investment in data storage to the point where the Commission is estimated to run out of data storage by October of this year. The decision has also been made to slow down the development of our automated trade surveillance system and automation of all forms, which is long overdue.
Because the CFTC continued to hire new staff, even during the continuing resolution, we now find ourselves in this position. Putting people ahead of technology will not ensure our compliance with Dodd-Frank, and it will certainly not ensure that we do so in the most cost-effective manner.
I think we should work with Congress to find a more balanced solution that allows the Commission to move forward and still comply with the funding limitations that all government agencies are faced with.
Technology is going to be the cornerstone of new market structures. Therefore, notwithstanding our budgetary situation, this is the opportunity to reorganize the Commission to lay a solid foundation from the ground up to address technology challenges. We must establish a new Office of Market Data Collection and Analysis that will make collection and dissemination of data to the various agency divisions its top priority. It will also give the markets a one-stop shop to coordinate the technology investments mandated by Dodd-Frank and ensure cost-effective compliance. This Office should be led by a capable, forward-thinking chief data officer who will be responsible for developing and articulating a strategic vision for the mission-critical functions associated with data management administration, and a budget that doesn’t include laptops, blackberry support, and toner cartridges.
As I noted in the beginning of my speech, the Technology Advisory Committee will hold its third meeting this Thursday. Our first two meetings focused on appropriate risk management tools and best practices for high frequency and algorithmic trading strategies, the events of May 6, 2010 (the “Flash Crash”), and achieving the statutory goals and regulatory objectives of Dodd-Frank.
On Thursday, we will focus on the issues being discussed here today. There are a lot of important questions to be answered about how the technology infrastructure will look in the Dodd-Frank world for not only the industry and markets, but also here at the Commission. For example, we’ve already received several comments that the Commission has drastically underestimated the cost of implementing technology required under our proposed rulemakings. We will explore answers to these questions at Thursday’s meeting through presentations and discussions of costs and technology challenges in implementing the trade execution, processing, and records management requirements of Dodd-Frank.
Before I close, I want to respond to a couple of questions I’ve heard from some of the participants during today’s session.
I greatly appreciate the opportunity to address you all. I benefited from the discussions today and appreciate the hospitality of the TABB Group.
I am pleased to host Larry Tabb and other industry and academic experts in Washington, D.C. at the third meeting of the Technology Advisory Committee on Thursday. I hope you will all attend or at least log onto the webcast.
I would also strongly encourage you and your staff to continue to pore through the nearly 800 pages in rulemakings to provide useful comments for the over 40 proposed rules and other agency publications. We need your advice, your recommendations, and your counsel so that we can set out the new rules of the swaps market and make sure that they facilitate the commercial hedging that is the heart of these markets.
1 Barack Obama, Toward a 21st-Century Regulatory System, Wall St. J., Jan. 18, 2011, at A17.
Last Updated: January 25, 2011