Statement of Commissioner Mark P. Wetjen before the Open Meeting of the Commodity Futures Trading Commission
September 17, 2014
Thank you, Chairman. Let me start by saying that it is a pleasure to be here today on the dais with you, Chairman Massad, and Commissioners Bowen and Giancarlo. This is our first open meeting together as commissioners, and it has been a real honor to work with each of you over these last few months. It also is a pleasure to meet you in this setting as a commission. Before turning to my remarks, I want to commend Chairman Massad for his focus on the unfinished work implementing Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), as well as his openness to appropriate fine-tuning of previous rulemakings, as reflected by the inclusion of the final rule relating to special-entities in today’s agenda.
The CFTC’s staff has been coordinating with international and domestic regulators for many months on the new margin proposal, and it should be commended as well for completing that work in a way that positions the Commodity Futures Trading Commission (“CFTC” or “Commission”)—along with the prudential regulators—to seek meaningful public comment on a new approach to margin requirements. With respect to the utility special-entities release, finalizing this rule today shows the Commission’s continuing commitment to course correction where necessary. These commercial end-users found competition waning in certain parts of the swap market and therefore faced the prospect of increased hedging costs due to the impact of the sub-threshold in the final swap-dealer-definition. Today’s release appropriately remedies this issue in a manner that respects congressional intent.
I. Margin For Uncleared Swaps
The new margin proposal before the Commission today establishes initial and variation margin requirements for uncleared swaps between swap dealers, and others, and certain financial entities with material swap exposures. It also contains important risk-management and documentation provisions for swap dealers and major swap participants. I am supporting today’s release to facilitate an ongoing dialogue on the appropriate means for ensuring the safety and soundness of these critical intermediaries. I do, however, have a number of questions about, and indeed concerns with, the proposal.
Today’s release has been largely harmonized with the proposal issued by the prudential regulators two weeks ago, as well as the September 2013 policy framework for margin requirements published by the Basel Committee on Banking Supervision, the Board of the International Organization of Securities Commissions, and the Bank for International Settlements (“Global Margin Framework”). There remain, however, some important differences, and public comments will be especially critical in these areas.
Cross-Border Application of Margin Rules and the Nexus to Capital Rules
I am most eager to review, for example, public comments relating to the alternatives proposed for the cross-border application of the margin rules. Unlike previous drafts, and as a result of many discussions between commissioners in recent days, the preamble now seeks public comment on three approaches to applying margin rules in a cross-border context. Importantly, one option proposes that the margin rule be applied as a transaction-level requirement under the Commission’s cross-border guidance, which at this moment I am confident is the best option. I commend Chairman Massad for his openness to this approach in addition to the two other alternatives set forth in the newest draft of the proposal.
One of these two additional approaches would mirror the margin proposal issued by the prudential regulators two weeks ago. That proposal effectively—and perhaps not surprisingly given the purposes of the prudential regulatory regimes—would apply the margin rule as an entity-level rule (“Prudential Approach”) with certain exclusions for foreign swap activities. It would do so, moreover, under definitions that potentially bring many foreign entities and transactions under the purview of U.S. law. Many non-U.S. swap dealers as a consequence may need to comply with U.S. law for a broader array of transactions than was contemplated by the Commission’s guidance last year, though this general statement is complicated by the fact that the Prudential Approach also permits substituted compliance for transactions involving U.S. persons.
The Prudential Approach is founded on the legitimate policy rationale that entities having sufficient U.S. contacts or counterparties pose sufficient safety and soundness concerns that it is necessary, through the margin rule, to impose regulatory limits on the unsecured credit exposures arising from all swap activities of these firms. I agree that regulatory limits on unsecured credit exposures are appropriate. However, the Commission should carefully consider whether the transaction-level approach taken in its cross-border guidance struck at least an equally agreeable balance in achieving that policy objective and perhaps better ensured an equal playing field for swap dealers operating in the global marketplace.
Ensuring fair competition in the global swaps marketplace does not mean that the Commission should not regulate risks arising from foreign-facing swap activities. In fact, the cross-border guidance recognized that capital rules interact with the margin rules to the extent additional capital is required when trades are not fully margined. It is worth noting, therefore, that the credit risks addressed by the Prudential Approach in the present proposal may be addressed, at least in large part, both by indirect capital requirements at the holding company level and direct capital requirements at the registrant level. Moreover, to the extent any foreign swap dealer were to fail and expose U.S. financial entities to losses from uncleared swaps, the Commission’s cross-border guidance requires those trades to be fully-collateralized consistent with CFTC margin rules. These losses would be mitigated as they relate to financial entities by the custodial provisions, among other things, which are intended to safeguard U.S. collateral posted in connection with such trades.
To be clear, I do not intend to suggest that the cross-border guidance is the sole means to address risk importation concerns or to account for all cross-border considerations. I mean to suggest only that the Commission should be judicious when applying its margin rule abroad knowing that covered swap entities are complying with U.S. capital rules, or capital rules in foreign jurisdictions recognized as equally comparable and comprehensive, and will have collateralized their exposures with U.S. financial firms. In addition, there may be fewer complications in operationalizing substituted compliance for the Commission’s capital rule—as an entity-level rule—than for today’s margin proposal, given the latter’s requirement that initial margin be passed between counterparties on a bilateral basis.
It is important to remember as well that many operational and compliance decisions have been made with significant costs incurred by firms under the Commission’s jurisdiction pursuant to the cross-border guidance, and we should not depart from the policy driving those decisions without a compelling reason to do so. Finally, the Commission should avoid adding further complexity to its regulatory regime under the Commodity Exchange Act, particular though rules departing from the Commission’s own pronouncements only a short time ago. In other words, the Commission should not knowingly make our rules unnecessarily complex, even in the face of a statutory mandate that we coordinate with the prudential regulators to the maximum extent practicable.
In any event, the Commission should consider implementing its capital rules in the near future and re-open the comment period for its margin proposal at that time. Only by fully considering the margin rule alongside the capital rule can the Commission make the best policy judgments about how to protect against the risks posed by covered swap entities.
Materiality Thresholds for Financial End-Users
In addition to the cross-border application of the margin rule, I also have a number of questions concerning the proposed materiality threshold for financial end-users, which departs substantially from the Global Margin Framework but hews closely to the Prudential Approach.
1. $3 billion Materiality Threshold for Financial End-Users
First, the release proposes lowering the $11 billion threshold in the Global Margin Framework to $3 billion, which means more and smaller financial end-users may be required to post initial margin. Considered by itself, the rationale for departing from the Global Margin Framework may be sound, but I worry that the lower threshold may complicate recognition of foreign margin rules and perhaps negatively impact global harmonization incentives. In the context of risk-management rules for clearinghouses, for example, the Commission closely followed the international standards set forth in the Principles for Financial Markets Infrastructure (“PFMIs”). Nevertheless, global regulators struggled at times to find comparability when their regimes differed in what could be viewed by some as seemingly insignificant ways. Moreover, it is unclear how many, and what types of, additional financial end-users may be subject to the final rules under the lower threshold. It is difficult for regulators to assess at this time, therefore, whether the proposed $3 billion threshold is the appropriate risk measure for purposes of satisfying congressional intent and reducing credit risk in the marketplace.
There are ambiguities concerning the calculation of the materiality threshold under the rule as well. First, I presume that financial end-users would be required to calculate, at a particular time for each business day, aggregate notional amounts for the affiliated groups, and to use those amounts to determine the average aggregate figure over the specified period. We should be clearer and more specific on the timing of the calculations to provide certainty to the marketplace and ensure uniform application of our rules. Second, the proposal also does not specify the treatment for multi-legged swaps, like basis swaps, which potentially could greatly affect the calculations. Third, the proposal does not indicate whether calculations should be netted to account for inverse correlations among the swap book of the consolidated group. Finally, the release proposes a “material swaps exposure” level for any entity and its affiliates that have an average daily aggregate notional amount of uncleared activity over a three-month period in the previous year. I look forward to comments on the specified three-month period for measurement in this respect.
I look forward to public comments as well on whether it is appropriate to include exposures from the outstanding swaps of non-financial entities in the $3 billion threshold calculation.
2. $65 Million Threshold for Initial Margin Calculations
I also have questions about reductions to the initial margin calculations available under the proposal. More specifically, I look forward to public comment on the appropriateness of, and the methodology for, determining the $65 million initial margin threshold amount applicable to an entity’s counterparty-specific credit exposures, which includes the entity’s credit exposures to affiliates of counterparties as well. I will be interested in public comments on whether that figure is appropriately calibrated to leverage the credit-management expertise of swap dealers, for example, while limiting the unsecured exposure of these entities to an appropriate degree in the event counterparties do not promptly meet variation margin obligations.
The $65 million threshold, in effect, rightly incentivizes counterparty diversification by requiring initial margin to be posted in connection with significant exposures to specific corporate groups. The proposed rule may present, however, operational challenges for registrants operating in, or trading with, counterparties in consolidated corporate groups with swap activities in dozens of affiliates. To complicate matters further, the affiliate definition applicable to this aspect of the proposal appears to be modeled on a definition from the Bank Holding Company Act, which is somewhat different than the definitions discussed or defined elsewhere in the CFTC’s own rulemakings.
I look forward to reviewing public comment on each of these issues.
Segregation of Margin
In another area that departs from the Global Margin Framework, the release today proposes an outright prohibition on rehypothecation of required initial margin. For trading relationships where initial margin is not required, and for excess initial margin, rehypothecation of collateral would be permitted. The release also proposes that all required initial margin collateral be held at independent custodians to better ensure the timely receipt of collateral for safety and soundness reasons.
Such arrangements, though, require the negotiation of relatively complex account documentation, which means many firms will nearly simultaneously rush to establish accounts conforming to our rules at only a handful of custodial banks. In addition, the proposal would require registrants to repaper with clients to provide for various other aspects of these proposed rules. In connection with revisions to relationship documentation, many firms will be required to conduct legal analyses concerning foreign laws applicable to collateral segregation, among other things.
In short, this process will undoubtedly require significant lead time for full compliance. Public comment on the proposed implementation framework for this rule is therefore very important. I also wonder whether following the broad parameters of the implementation schedule for the Commission’s clearing mandate would be a better approach.
There also is an open question as to whether the statute mandates a requirement that swap dealers, and others, establish third-party custodial arrangements in all cases. It is an important question to resolve because mandating custodial arrangements will likely increase funding costs and the costs of inventorying risks on behalf of counterparties. If funding costs increase substantially, for example, firms may pass these costs on to their counterparties or simply withdraw from less liquid swap markets. I look forward to public comments on the potential liquidity effects of all aspects of the proposal but importantly, the proposed custodial account structure that would be newly required for much of the marketplace.
From my conversations with the staff, I also understand that the proposal may permit an omnibus segregated account structure, consistent with the individual opt-in approach recommended in the Global Margin Framework. This omnibus account structure may present U.S. bankruptcy law questions for financial end-users posting initial margin with third-party custodians, however. I look forward to robust legal analysis on the bankruptcy protections that the omnibus segregated account scheme might provide, or perhaps not provide, to financial end-users with material swap exposures. Interestingly, there is a tension with the final rule governing the protection of collateral for uncleared swaps, which requires initial margin segregated pursuant to a counterparty election to be held in an account “segregated for and on behalf of the counterparty, and designated as such.”
Margin Models, Collateral, and Documentation
Finally, I want to quickly highlight a number of relatively technical issues in the proposal. First, I favor federal oversight of margin methodologies used by covered swap entities, but there are limits to what the commission staff can pragmatically accomplish toward that end. I look forward to public comments, therefore, concerning whether margin methodologies should be self-executing filings akin to rule certifications under Part 40 of the CFTC’s regulations, at least during the pendency of staff review, and whether such self-executing filings should be limited to models approved by the Securities and Exchange Commission, the prudential regulators, and certain foreign regulators.
Second, I will be interested in public comment on two aspects of the proposed standardized haircut schedule: the specified haircut percentages for the specified asset classes permitted under the proposal; and whether and how the standardized haircut schedule should be updated in light of market developments. I would be interested, for example, in the market’s preferred process for updating the schedule—perhaps through periodic orders.
Third, although the Global Margin Framework does not contemplate cash collateral standards but rather a principles-based standard for “highly liquid” assets, today’s release would require cash collateral for variation margin. I look forward to public comments on the availability of, and cost of posting, cash collateral for variation margin obligations and, further, whether the cash-only requirement may incentivize the use of more permissive margining regimes abroad.
Fourth, today’s recommendation proposes to require covered entities to determine whether each foreign counterparty would fall within a new definition, “financial end-user,” if the foreign entity were hypothetically subject to U.S. law. The proposal, therefore, would require covered swap entities to analyze in detail each counterparty’s business lines and arrive at legal conclusions concerning the activities of these foreign counterparties under a broad array of complex, U.S. regulatory requirements. I look forward to comments on whether the final rule could permit foreign counterparties to represent that they have an informed basis to conclude that their activities would not bring them within the definition of “financial entity” if these entities were hypothetically subject to U.S. law. I also look forward to comments on whether a representation requirement of this sort would be practical for the foreign firms themselves.
Fifth and finally, with respect to collateral treatment, today’s proposal sets forth documentation requirements that could be read to go somewhat beyond those required in the final internal business conduct standards rulemaking. That final rule did not require disclosure of initial margin methodologies but rather focused on the importance of timely initiation and resolution of valuation disputes in the interest of meeting daily variation margin obligations. In fact, the swap trading relationship documentation preamble and provisions focus on “the process . . . for determining the value of each swap at any time from the execution to termination, maturity, or expiration of the swap for purposes of complying with the margin requirements . . .” and state that “[a] swap dealer is not required to disclose to the counterparty confidential, proprietary information about any model it uses to value a swap.”
This presents some tension with the proposal before us, which appears to require that “[t]he margin documentation . . . specify . . . [t]he methodology and data sources . . . used to value uncleared swaps and collateral to calculate initial margin for uncleared swaps” and “to value positions and to calculate variation margin for uncleared swaps” between those parties. I look forward to comments on whether, and if so, suggestions on how, these rules might be aligned in manner that provides sufficient disclosures as balanced against publication of needlessly complex, and perhaps proprietary, methodologies and inputs concerning margining, and intrinsically valuation, methodologies.
Defining “Uncleared Swap” and Margining for Interaffiliate Swaps
The proposal defines an “uncleared swap” as one that is not cleared by a registered derivatives clearing organization or a clearinghouse eligible to rely upon no-action relief issued by the CFTC’s staff or a Commission exemption. However, only two years ago, the CFTC passed final rules permitting the clearing of swaps by foreign boards of trade and in that rule, provided that such swaps may be cleared by any clearinghouse complying with the PFMIs.
Accordingly, I look forward to public comment on whether the Commission should recognize as cleared, for purposes of the margin rules, all swaps cleared by clearinghouses complying with the PFMIs. One implication of the current formulation is that clearinghouses potentially would be subject to margin obligations in various locales around the world, meaning they could have margin collection and posting obligations, and perhaps new custodial obligations with respect to collateral held in support of positions, under U.S. law.
In addition, in April 2013, the Commission exempted certain inter-affiliate swaps from the clearing mandate, noting that “inter-affiliate swaps offer certain risk-mitigating, hedging, and netting benefits” and finding such exemption to be in the public interest. The inter-affiliate clearing exemption was subject to a number of conditions “designed to increase the likelihood that affiliates will take into account their mutual interests when entering into, and fulfilling, their inter-affiliate swap obligations.” Notably, the Commission did not require affiliated entities availing themselves of the exemption in all cases to exchange variation margin or initial margin. The release before us today proposes to reverse this judgment. It would impose both variation margin and initial margin requirements on uncleared swaps between affiliated entities. I look forward to public comments on whether requiring margin, in particular initial margin, for inter-affiliate swaps would stifle their use and potentially balkanize risk management at systemically relevant registrants.
II. Special Entity De Minimis
Turning to the other release before us today, I once again applaud Chairman Massad’s focus on fine-tuning existing Dodd-Frank rulemakings that especially impact the end-user community. The de minimis exception in the swap dealer definition for Special Entities—defined in the Dodd Frank Act to include federal, state, and municipal entities—made it difficult for government-owned electric utilities to hedge key operational risks. Several months ago, the Commission’s staff convened a roundtable focusing on end-user concerns related to this exception and other matters, and electric utilities from across the country discussed the challenges the swap-dealer-definition rule imposes on their ability to appropriately manage their market risk.
Today’s rule would amend the Commission’s swap dealer definition to permit a person dealing in “utility operations-related swaps” with “utility special entities” to exclude those swaps in determining whether that person has exceeded the de minimis threshold specific to dealing with special entities. The final rule includes beneficial modifications to the original proposal, including striking the notice requirement for market participants who rely on the exclusion provided by the rule. Likewise, I support removing redundant recordkeeping requirements for swaps with utility special entities and instead relying on current Part 45 requirements and representations from utility special entities that the swap entered into qualifies for the exclusion. I look forward to staff recommendations regarding how our Part 45 rules might be amended to further account for swaps with utility operations-related swaps.
Thank you again to the staff and my fellow commissioners for their hard work on the rules before us today. I look forward to asking a few clarifying questions in a few minutes.
Last Updated: September 17, 2014