FIA Clearing 2011: A Derivatives Forum
Speech of Commissioner Scott D. O’Malia
April 13, 2011
Thank you for inviting me to participate in this forum. It’s great to get out of the office and meet with the people who are impacted the most by the Commission’s actions in implementing the Dodd-Frank Act. I want to hear about what keeps you up late at night, and I want to understand exactly where we have strayed off course. But, I also realize you are here to listen to me explain where the Commission is—at this moment—heading on the over 50 rulemakings, and when we expect to reach the end of our rulemaking odyssey.
I’ll make you a deal. I’ll give you an overview of our current plan along with some thoughtful remarks about my priorities and concerns related to the rulemakings, and the future of the Commission as a whole. Then it will be my turn to hear from you. I’ll take questions, comments, ideas, and anything else you want to share that will give me greater insight into your priorities and concerns.
Is that a deal?
Preparing for Change
There is no doubt in my mind that the changes in store for the futures and swaps markets are monumental. I recognize that the changes will force many to radically change their business models, and in most if not all cases, spend an enormous amount of time and money to comply with the new requirements, the most of significant of which is the clearing mandate.
Amidst this great upheaval, I find myself impressed with the creative ideas that have quickly emerged. They have come in various forms, and are sure to test new business models and commercial alliances while bringing innovative technology to bear in the market.
Two weeks ago, I hosted a SEF Showcase at the CFTC headquarters in Washington, DC. I offered any SEF platform the opportunity to show off its technology and outline how it would comply with the proposed SEF rules. I had 16 SEF platforms present from all asset classes.
It was clear that SEFs are prepared to move quickly to meet the new mandates, and they are doing so in a manner that will raise the bar in terms of transparency and competition.
It was, however, a process for many SEFs. The product on the screen often represented version 2.0, 3.0 and so on. What came out of the process, we were reminded by participants, is that while the CFTC is dictating the outcome, the rules need to provide flexibility. I believe this is code for: don’t apply a futures exchange model and expect it to be equally successful in the swaps market. The swaps market is a less liquid and more customized market. SEF’s will provide greater price transparency, but we must protect the market’s ability to transact sufficient size without penalty.
At the end of the day, we can’t claim success if we create a market structure that fractures liquidity and creates an incentive to utilize dark pools. Based on all the negative responses to the Commission’s proposed block trading rule, I think we should consider introducing more flexibility into the block trading rules to allow the SEF’s to set the block size or allow them to be phased in. My goal is to bring more trades on exchange and make the use of block trades a rare occurrence. I believe this is entirely consistent with that of Congress.
Let me turn to the Commission’s implementation schedule.
Everyone is very concerned about the Commission’s rulemaking schedule and the much talked about, but yet to be released, proposal for phased implementation. Rightly so. The rulemaking process has consumed the Commission, and staff members at all levels are working extraordinarily hard to harness their collective knowledge and experience to develop and propose rules consistent with the legislative mandates. To date, the Commission has held eight public roundtables, thirteen Commission meetings and issued more than 50 proposed rules, notices or other requests seeking comment on Dodd-Frank related issues. If we lined up the Federal Register pages end to end, it would stretch over 921 feet. With just a handful of proposed rules to go, by the end of May we will very likely have enough Federal Register pages to reach the 86th-floor observation deck of the Empire State Building.
The fact I find most amazing, is that if we allowed the comment period for each rule to run consecutively, its total running time would last over seven-and-a-half years. Yet, you have less than one year to meaningfully respond to all of the proposed rules, which as we are all aware, were not rolled out in a coherent order.
During the past several months, I have encouraged the Commission to consider input from the public on the order in which final rules should be considered and a phasing of implementation. We are beginning to receive responses, which have been enormously helpful. I commend the Chairman for being responsive to the market and taking input from the market on implementing rules along an early-middle-late timeline, and for working with the SEC to hold a two-day joint public roundtable on May 2nd and 3rd to discuss the schedule for implementing final rules and provide the public with the opportunity to comment on what factors ought to direct the phasing of implementation.
In the interest of ensuring that this process is fully transparent, and that all affected persons and entities are given a full opportunity to provide their views, I have requested that the Commission, based on the comments received before and as a result of the roundtable, develop an order of sequencing and schedule of implementation for all of its final rules and regulations under the Dodd-Frank Act for publication in the Federal Register for notice and comment for a period of no less than sixty (60) days.
The reality is that we will miss the congressionally mandated implementation date of July 2011. We will miss the unreasonable statutory deadline, and we shouldn’t feel compelled to set any new, arbitrary dates only to be readjusted in the future. We don’t need deadlines to demonstrate our conviction to the mission at hand. I can certainly testify that the entire Commission is working as hard as possible. And in this time of budget deficits, the taxpayers can be relieved to know that on an hourly basis, the CFTC is the best bang for buck.
The Data Made Me Do It
I’ve shared my thoughts on implementation, so while you think about how you’d like to react to those statements, I’ll move on to my top priorities: technology and data. Since I first arrived at the Commission, I knew technology was going to be an issue to take ownership of. As I work through the mandates of Dodd-Frank, our rulemakings, the budget, and the issues presented today at this conference, it is clear to me that data in all its forms and expressions should be the Commission’s top priority as we evolve.
I am repeatedly struck by the lack of technological capacity at the agency. Our forms and filings are not required to be filed electronically, and those that are don’t automatically populate our trade surveillance data bases. We have only a few automated surveillance alerts, and none of those monitor real-time trading. It took us far too long to reconstruct and analyze the CME order book for our ultimate response to the May 6, 2010 Flash Crash.
We have massive new responsibilities under the Dodd-Frank Act that will require a heightened focus on technology investment and data management and analysis. If we are to establish a credible surveillance and oversight program of both the futures and swaps markets, that investment needs to start yesterday. I am committed to doing something about it.
Within months of my arrival, I reconvened the Technology Advisory Committee (TAC) and brought together experts to look at a range of compelling technology questions, including the impact high frequency trading has on markets and the scope and scale of technology investment required by the Dodd-Frank Act for both the industry and the Commission.
Pre-Trade Controls for High Frequency Traders (HFTs)
To evolve on the technological front, we first need to get up to speed. The influx of high frequency traders in the futures markets certainly left us in the dust even before Dodd-Frank was signed into law. To address the concerns that high frequency traders are a ticking time bomb in our markets, I convened a TAC subcommittee to provide the Commission with recommendations for establishing and implementing standards by which all traders—whether they are trading on an exchange or a SEF—must comply. The full Technology Advisory Committee received the recommendations1 from our subcommittee last month, and it is my expectation that these new standards will be integrated into proposed Commission guidance and possibly a rulemaking to ensure that higher and uniform standards for high frequency traders are implemented.
Rather than trying to understand, evaluate, and monitor in real-time each and every algorithm that trades in our markets, I believe we ought to set a testing standard for HFT programs prior to deployment and a requirement that such programs be monitored once deployed. Computer trading strategies are not infallible, and sometimes the markets behave unpredictably. The Commission must be vigilant as it develops and enforces new principles and rules to put the appropriate trade controls in place.
Data Standardization: We Need to Speak the Same Language
Data is the foundation of the Commission’s surveillance programs and the new swap data repositories are where all of the data will come together. Under Dodd-Frank, the Commission is charged with collecting, aggregating, monitoring, screening, and analyzing data across swaps and futures markets for many purposes including enhanced surveillance capabilities aimed at identifying potential market disruptions and violations of the Commodity Exchange Act. Our current information systems are largely dependent upon the analytical capabilities and advanced computer –driven surveillance technology currently provided by the exchanges and self-regulatory organizations. This is unacceptable. We must develop our own analytical capabilities and ensure that the data that comes into to the Commission is of the highest quality. This is especially critical as this data may ultimately be disseminated to the public.
While it seems easy enough to collect trade data, as necessitated by many of our proposed rules, understanding the ownership and control of each account and the relationship of bespoke swaps to standard futures contracts is easier said than done. We must finish the revisions to the Ownership and Control Rulemaking, which we started over a year ago.
My compliments to the FIA members and staff for organizing a market working group to advise the Commission and find a cost effective middle ground that will ensure the Commission gets the data it needs, without breaking the bank. In my opinion, we should withdraw our current rule and go back to the drawing boards to work with industry on a new rule.
We are dealing with the complex intersection of data, finance, and law. There are clearly technical aspects of data collection and utilization that must be resolved to ensure standardization and universal system compatibility. Legally, we are challenged to ensure documents and standards are binding. Financially, these elements must serve a complex and continually evolving market. Solving these complex questions is beyond the Commission’s current capabilities and we must seek input from the markets and innovators in the private sector that have experience with management of large complex data sets.
Subcommittee on Data Standardization
I am proposing to establish another subcommittee of the Technology Advisory Committee to focus on developing a standardized reference data depository representing the universe of legal and financial terms utilized in describing, defining, and valuing the various derivatives and other financial instruments which are presently and in the future may be traded both on and off of regulated exchanges. The creation of standardized reference points and data terms will most certainly aid in the development of universal entity, product, and/or instrument identifiers and provide greater consistency in the collection, reporting, and management of individual transactions. We already have a foundation for discussion based on report required by Section 719 (b) of the Dodd-Frank Act, which is the culmination of a joint CFTC/SEC study to determine whether we could establish data standards for the derivatives market. That study was released last Friday, and you can find it on the Commission’s website. 2
Time to Reorganize the Commission
Like I said earlier, implementing Dodd-Frank is a major initiative for all of us, and I have a plan that is a tectonic shift for this little agency: the creation of an entirely new division. As the Commission evolves into a multiple-market regulator, it should reorganize its current and new functions around data collection and analysis. Such a change demands that we react with the creation of an entirely new Division of Market Data Collection and Analysis. With the acquisition and use of data-related technology as a primary mission, this Division should focus on securing and managing all of the Commission’s trade and surveillance data, working with all other Divisions to monitor the futures and swaps markets, performing broad risk analysis for the Commission. This Division can drive the automation of cross market surveillance programs including the development of our own algorithms, enabling the Commission to keep pace with new computer-generated trading styles as well as nefarious activities.
Budget - Technology Should be our Top Priority
I can’t stress enough the relationship between data and technology and the fact that we have so much ground to make up. We need to make technology our top financial priority. We can’t hire enough people to keep pace with the rapid increase in the volume and speed of trading today.
I commend the Appropriations Committee for supporting the Commission by providing additional resources with a greater focus on technology. The Conferees have come to recognize the importance of advancing technology by providing a floor of $37.2 million specifically earmarked for “the highest priority information technology activities of the Commission.” Where do I take my list? I am grateful to have a budget agreement in place that will provide the budgetary certainty we need to fulfill our mandates.
We Had a Deal
I think my ten minutes is up. I’ve given you an overview of our current plan and shared my priorities and concerns. Now it’s time for me to listen and respond.
1 Report of the Pre-Trade Functionality Subcommittee of the Technology Advisory Committee, Recommendations on Pre-Trade Practices for Trading Firms, Clearing Firms and Exchanges Involved in Direct Market Access (Mar. 1, 2011), available at http://www.cftc.gov/idc/groups/public/@swaps/documents/dfsubmission/tacpresentation030111_ptfs2.pdf
2 Joint Study on the Feasibility of Mandating Algorithmic Descriptions for Derivatives, A Study by the Staff of the Securities and Exchange Commission and the Commodity Futures Trading Commission as Required by Section 719(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (April 7, 2011), available at http://www.cftc.gov/idc/groups/public/@swaps/documents/file/dfstudy_algo_040711.pdf
Last Updated: April 13, 2011