This spring, when we proposed the first comprehensive revision to the Commodity Futures Trading Commission’s (CFTC or Commission) bankruptcy regime in 37 years, I noted the tremendous teamwork that drove that endeavor.  As I said then, I have long believed that one attribute distinguishing our agency and the industry we regulate is the level of engagement and spirit of cooperation between derivatives market participants and the CFTC.  The proposal to amend Part 190 of our regulations, itself a product of constructive external engagement, as well as this final rule which accounts for the comments we received in response to that proposal—including the concerns raised regarding the potential for undermining the qualified master netting agreement status of derivatives clearing organization (DCO) rulebooks and the supplemental proposal that followed—are all exemplary products of that engagement and cooperation. 

The updates to our bankruptcy regulations that we are finalizing today recognize technological advancements over the past 37 years, incorporate lessons learned from futures commission merchant bankruptcies during that time, and recognize the necessity of providing more clarity regarding how a DCO would be treated in bankruptcy.  I believe it is prudent that we are not finalizing the provisions in the original proposal or the concept in the supplemental proposal that attempted to provide an opportunity for the Federal Deposit Insurance Corporation to conduct an effective resolution if it stepped in as the receiver of a DCO pursuant to Title II of the Dodd-Frank Act after the DCO entered bankruptcy.  I believe that any perceived problem and any contemplated solution both need further discussion amongst industry participants, the Commission, and perhaps even other regulators.  I look forward to continued engagement on the topic. 

I thank Bob Wasserman, his team in the Division of Clearing and Risk, and all those who commented for offering their expertise and insights into this complex and technical undertaking. 

I support the final rule amending the Commission’s part 190 bankruptcy regulations.  The amendments comprehensively update these regulations to address the increased size and speed of our markets and incorporate “lessons learned” from futures commission merchant (FCM) bankruptcies that occurred since the regulations were first adopted in 1983.  The new derivatives clearing organization (DCO) bankruptcy regulations provide a framework to help market participants be prepared for such an event.  While FCM bankruptcies are infrequent, and a registered DCO has never gone bankrupt, any such event could have significant financial impacts on many market participants, which, in turn, could have systemic implications.  Improving the overall effectiveness and efficiency of the bankruptcy process fosters systemic stability and helps to better protect, preserve, and quickly return customer assets.

The Bankruptcy Code provides express preferences for positions and property of customers of an FCM or DCO debtor so that the customers and their counterparties can be assured that those positions and property will not be included in the debtor’s general assets or clawed back post-filing.  As a result, those positions and property (e.g., customer margin) can be transferred to another FCM or liquidated for value quickly and returned to customers following the filing of the bankruptcy.  In this way, an FCM bankruptcy can be resolved expeditiously, greatly reducing any uncertainty as to the treatment of positions and property held in the name of the debtor.[1]  The protection of customer assets and positions furthers market stability by reducing the need for customers to rush to liquidate or transfer the positions themselves prior to the bankruptcy to avoid such assets being entangled in the debtor’s general assets.  I am voting for the final rule because it significantly improves the likelihood of achieving these objectives.

As a general matter, commenters agreed that, overall, the final rule is a significant improvement.  As described in the final rule release and my statement on the proposed rule, the revised regulations further solidify and implement important principles such as the preference for public customers, pro rata distributions within account classes, and prompt return of assets.  The final rule does this not only through general statements, but also in specific procedures established in the rule.

Commenters raised a number of specific concerns regarding the final rule.  As would be expected, these concerns were often (though not always) grouped by the specific interests of different types of market participants in the event of a bankruptcy of an FCM or DCO.  

Bankruptcy occurs because there are not enough assets to cover a debtor’s liabilities.  In resolving the claims on the debtor’s assets during a bankruptcy proceeding, the allocation of the shortfall must entail a balancing of equities that, unfortunately, most often leaves one or more creditors and other interested parties (e.g., shareholders) with less than they expected to have if a bankruptcy had not occurred.  As such, different creditor groups may have competing interests in the preferences and processes established in the Commission’s bankruptcy regulations.

This reality is reflected in the thoughtful comments we received in response to the proposed rule.  The final rule release addresses these comments in turn, discussing the pros and cons of the changes requested.  In a number of instances, the final rule has been modified to address concerns raised where such modifications better achieve the stated principles of the regulations.  For other concerns raised, as explained in the release, the balancing of the equities meant that the overall outcome of the bankruptcy proceeding would be better served by maintaining the rule as proposed.  Particularly with respect to the bankruptcy rules, the fact that nobody gets everything they want likely means that the rule, for the most part, is well-balanced.

I would like to take this opportunity to address two particular areas of comments.  Entities that represent certain “public customers” expressed concern regarding the greater “reasonable” discretion provided to bankruptcy trustees, which is intended to facilitate a speedier resolution and return of value to customers generally.  These commenters are concerned that some customers could receive less than they could otherwise if the trustee makes poor choices when exercising its discretion or does not implement specific customer instructions.  This concern is partially addressed with the addition of subsection 190.00(c)(3)(i)(C) to clarify how a trustee shall exercise its discretion to “best achieve the overarching goal of protecting public customers as a class by enhancing recoveries for, and mitigating disruptions to, public customers as a class.”  Otherwise, as explained in the preamble, the discretion granted to the trustee is appropriate when weighing the benefits of prompt resolution of the bankruptcy with the other goals of the regulations.

The Commission also received numerous comments on the proposed DCO bankruptcy regulations.  This is not surprising given that these regulations create, for the first time, a regulatory scheme for DCO bankruptcies.  Many commenters expressed concerns regarding the direction in section 190.15 to the trustee to, within reasonable discretion, follow the debtor DCO’s recovery and wind-down plans.  The final rule, while largely leaving the proposed provision in place, did modify the rule text to emphasize that the trustee must act in a manner “consistent with the protection of customers.”  In addition, the preamble notes that some of the concerns raised in this context are part of a broader discussion in the derivatives industry regarding the involvement of DCO members and customers in the governance, rulemaking, and structuring of the DCOs, and that the Commission continues to review these matters.  I look forward to engaging in further discussions on these issues.

I commend the Commission staff, particularly Bob Wasserman, for the thoughtful effort that has clearly been put into the final rule release.  The Commission staff has done an exemplary job of reviewing the comments received, addressing those concerns, and drafting the preamble in very understandable language.  I also appreciate Commission staff’s engagement with my office on a number of areas in the final rule.

The final rule modernizes the Commission’s bankruptcy regulations and furthers the general principles these regulations serve.  Public customers and markets will be better protected in the event of an FCM or DCO bankruptcy.  For these reasons, I support the final rule.

[1] The bankruptcy trustee is directed to “return promptly to a customer any specifically identifiable security, property, or commodity contract to which such customer is entitled, or shall transfer, on such customer’s behalf, such security, property, or commodity contract to a commodity broker that is not a debtor” subject to CFTC regulations.  11 U.S.C. 766(c).  Section 764(a) of the Bankruptcy Code provides that “any transfer by the debtor of property that, but for such transfer, would have been customer property, may be avoided by the [bankruptcy] trustee . . . .”  11 U.S.C. 764(a).

Overview

As a former legislative staffer with a front row seat during the development of the Dodd-Frank Act,[1] I observed that the bulk of the debate was devoted to the complicated task of how the clearing mandate would be applied to swaps that previously traded in the over-the-counter market and which types of market participants would need to migrate positions into a cleared environment.  By contrast, the operational aspects of trade execution were left to be finalized near the end of the process, and unfortunately received less attention due to a push for quick completion of the legislation – this is probably evident from the verbiage, or lack thereof, that appears in the statute on this topic.

I have said it before – building an entirely new regulatory regime for an equally new market structure is quite a challenge, especially so for tools, such as swaps, where legacy markets existed long prior to the structure Congress directed us to develop.  No one assumed it was going to be easy, and I admit to a sense of personal relief that I was not at the Commission when it undertook the enormous endeavor of establishing a new framework governing swap execution facilities (SEFs).  It has been over seven years since the Commission adopted its SEF Rules,[2] and I also admit to a sense of admiration for what was achieved in such a short timeframe.  That said, it is not surprising that varying statutory interpretations emerged among Commissioners at that time, with resulting confusion surrounding how best to implement Congress’ goals for SEF trading.  The challenges in implementing the SEF Rules have proven vast, questions have persisted, and uncertainty has reigned.  As a result, Staff of the Commission has issued numerous no-action letters to address shortcomings.

Today, our Commission has a different task derived from the often-overlooked component of the Leaders’ Statement from the 2009 Group of 20 (G-20) Summit in Pittsburgh, which stipulates that regulators should “assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.”[3]  It is noteworthy that in 2009, in the midst of responding to the financial crisis, the G-20 Leaders recognized that, as individual jurisdictions implemented these monumental principles, a look-back would be needed to ensure the objectives were being met.    

In conducting this look-back, we have the benefit of time and experience.  The way SEFs approached the new regulatory framework, while once novel and uncertain, has matured into more established market practice.  While the Commission, SEFs, and swap trading counterparties were once unsure of how the new regime would develop, we are now informed about how these practices have evolved.  And the passage of time also affords us the chance to observe how Staff no-action relief has operated in real-time.  Our role today is to heed the lessons learned and leverage our knowledge from observing these markets in action. 

In fulfilling that role, we are adopting two rulemakings that both arise out of a set of reforms to the SEF Rules proposed in 2018 (the “2018 SEF Proposal”), and that make changes to the Commission’s rules in 5 areas relating to SEFs and the trade execution mandate.  By recognizing the current reality of how SEFs, and those utilizing these venues, have applied our regulations and built their infrastructure and systems, these rulemakings improve upon the original iteration of the SEF Rules.  In some instances, they codify previous Staff action, thereby providing legal certainty and fostering prudent oversight over these swap markets.  Significantly, the Commission did not receive any comment letters voicing substantive opposition to the changes we are adopting in these two rulemakings. 

Rules Relating to SEFs: Part 37 

First, we are amending the Commission’s Part 37 rules for SEFs in 3 areas, concerning a SEF’s:  1) audit trail data; 2) financial resources; and 3) chief compliance officer (CCO) and annual compliance reports (ACRs).   More specifically, among other things, this rulemaking—   

Audit Trail: 

• Requires a SEF to capture and retain in its audit trail information through the execution of a trade on the SEF, but not post-execution allocation information as under the current rules since SEFs do not have access to this type of information.

Financial Resources: 

• Adjusts the liquid assets that a SEF is required to maintain, in order to tailor this requirement to the projected costs needed to wind down the SEF’s operations;
• Provides that a SEF’s calculation of its projected operating costs need include only the costs of activities necessary to comply with the SEF Core Principles under the CEA and the Commission’s rules;
• Requires that the quarterly financial statements that a SEF submits to the Commission be those of the SEF itself, rather than its parent company as currently permitted;
• Extends the time for submitting fourth-quarter financial reports to the Commission in recognition of staffing challenges and timing constraints associated with the regulatory requirements applicable to SEFs at year-end; and
• Requires SEFs to notify the Commission of noncompliance with financial resource requirements within 48 hours after the SEF knows or reasonably should know of its noncompliance. 

CCOs and ACRs: 

• Provides a SEF’s senior officer with the same day-to-day oversight authority over the CCO as the board of directors in recognition that in many instances, the senior officer may be better positioned to exercise these responsibilities;
• Incorporates reasonableness and materiality standards into the duties of the CCO, and the ACR certification responsibility of the CCO, in order to avoid imposing standards of conduct that are impossible for a CCO to meet;
• Enhances the overall quality of ACRs by eliminating requirements that do not provide useful information to the Commission in evaluating SEF compliance; and
• Extends the time for submitting the ACR to the Commission in conformity with the timeline for submitting a SEF’s fiscal year-end financial reports.

These are common-sense amendments that are based on our experience in implementing the SEF Rules, as opposed to drawing assumptions based upon unknowns as constrained previous Commissions.  On balance, the amendments to Part 37 that we are adopting appropriately streamline requirements imposed on SEFs and their CCOs, and make our SEF Rules workable in practice.  As I have stated before, no matter how well-intentioned a rule may be, if it is not workable, it cannot deliver on its intended purpose.[4]  Based on our oversight of these markets and monitoring of no-action relief issued by our Staff, I believe these refinements to the SEF Rules will enhance compliance without adversely affecting our ability to fulfill the Commission’s responsibilities under the CEA. 

Exemptions from the Trade Execution Mandate: Part 36

Second, we are amending the Commission’s Part 36 rules to provide 2 exemptions from the CEA’s trade execution mandate for swaps that:  1) qualify for an exemption to, or exception from, the CEA’s clearing mandate under the Commission’s rules; or 2) are entered into by affiliated counterparties that qualify for the Commission’s inter-affiliate exemption from the clearing mandate, but that the affiliated counterparties elect to clear voluntarily. 

More specifically, the first exemption from the requirement that a swap be traded on a SEF[5] applies to swaps that the Commission has either exempted from, or determined are not subject to, the clearing mandate.  This currently includes, among others, and subject to applicable conditions—

• Swaps entered into by cooperatives;
• Swaps that qualify for the inter-affiliate exemption; and
• Swaps entered into by banks and bank holding companies, savings associations and savings and loan holding companies, farm credit system institutions, credit unions, central banks, sovereign entities, certain international financial institutions, and certain swaps entered into by community development financial institutions.

The Dodd-Frank Act amended the CEA to establish a trade execution mandate for “swaps subject to the clearing requirement.”[6]  Thus, Congress intended that swaps that are not subject to a clearing mandate should not be subject to a trade execution mandate, either.  The exemption to the trade execution mandate that we are adopting for swaps that the Commission has exempted, or found to be excepted, from the clearing mandate is consistent with this Congressional intent.

The second exemption from the requirement that a swap be traded on a SEF applies to swaps that qualify for the Commission’s clearing exemption for swaps between affiliates – but that the affiliated counterparties voluntarily elect to clear anyway.  As discussed in the release, inter-affiliate swaps offer significant benefits to corporate groups from a risk management perspective; and, since these swaps are not arm’s length, market-facing, or competitively executed, they do not contribute to price discovery if executed on a SEF.  This exemption also advances the objective of the G-20 Leaders’ Statement and the Dodd-Frank Act to promote central clearing of swaps.  Accordingly, this is a prudent exemption to the trade execution mandate. 

Withdrawal of Unadopted Portions of 2018 Proposal

With respect to the remainder of the 2018 SEF Proposal, I commend former Chairman Giancarlo for his thought leadership in putting forward a principled proposal for public consideration.  Commenters, however, expressed substantial concerns about the expansive nature of some of the structural reforms for SEFs that were included in that proposal.  In light of this public feedback, I concur in the decision to adopt the targeted rule changes regarding SEF operations and the trade execution mandate discussed above, and to withdraw the broader market reforms contained in the 2018 SEF Proposal.

Conclusion

In closing, let me say how pleased I am at the work the Commission has done this year to enhance our SEF Rules.  These two rulemakings follow on our recent rulemakings addressing other pressing SEF-related issues such as package transactions, error trades, and block trades.[7]  Through these actions, we have made the SEF Rules more workable in practice, answered fundamental questions that have been lingering for awhile, and provided the legal certainty that comes from policymaking by rulemaking rather than Staff relief. 

But that is not to say that our work regarding SEFs is necessarily complete.  Some staff relief remains outstanding, such as Letter No. 17-17 regarding SEF confirmation and recordkeeping requirements,[8] that might also be appropriate for a transition into formal regulations.  And I suspect that market participants have additional thoughts about areas for constructive changes in our SEF Rules.  I would like to reiterate my view that we need an ongoing review of our rules implementing the Dodd-Frank Act that builds upon the efforts of this agency in the aftermath of the financial crisis.[9] 

I would like to express my thanks and sincere gratitude to the Staff who diligently worked to prepare the rulemakings that we are adopting, and who worked patiently with my Office to answer our questions and address our comments.  I also want to commend those Staff members, particularly in the Division of Market Oversight, who have been thoughtfully considering ways to improve the Commission’s regulatory framework for SEFs for quite some time, and who worked on the 2018 SEF Proposal (including those portions that we are withdrawing).  Those efforts predated my arrival at the Commission, but helped to highlight issues that are of importance to me, and I appreciate your excellent work in that regard.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, Title VII, 124 Stat. 1376 (2010) (Dodd-Frank Act). 

[2] See Core Principles and Other Requirements for Swap Execution Facilities, 78 Fed. Reg. 33476 (June 4, 2013).  As used in this Statement, references to the “SEF Rules” encompass rules governing SEFs themselves, as well as rules regarding the trade execution mandate set forth in Section 2(h)(8), 7 U.S.C. 2(h)(8), of the Commodity Exchange Act (CEA).

[3] See Leaders’ Statement from the 2009 G-20 Summit in Pittsburgh, Pa. at 9 (September 24-25, 2009), available at https://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.

[4] Statement of Commissioner Dawn D. Stump Regarding Final Rule:  Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to Swap Dealers and Major Swap Participants (July 23, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/stumpstatement072320.

[5] Swaps that are subject to the CEA’s trade execution mandate may be traded on a designated contract market in lieu of a SEF.

[6] CEA Section 2(h)(8)(A), 7 U.S.C. 2(h)(8)(A).

[7] See Swap Execution Facility Requirements (adopted November 18, 2020, publication in Federal Register pending) (package transactions, error trades), available at https://www.cftc.gov/PressRoom/PressReleases/8313-20; Real-Time Public Reporting Requirements, 85 Fed. Reg. 75422 (November 25, 2020) (block trades).

[8] CFTC Letter No. 17-17, Extension of No-Action Relief for Swap Execution Facility Confirmation and Recordkeeping Requirements under Commodity Futures Trading Commission Regulations 37.6(b), 37.1000, 37.1001, 45.2, and 45.3(a) (March 24, 2017), available at https://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/17-17.pdf.

[9] As I have said before, “[i]t is simply good government to re-visit our rules and assess whether certain rules need to be updated, evaluate whether rules are achieving their objectives, and identify rules that are falling short and should be withdrawn or improved.”  Statement of Commissioner Dawn D. Stump for CFTC Open Meeting on:  1) Final Rule on Position Limits and Position Accountability for Security Futures Products; and 2) Proposed Rule on Public Rulemaking Procedures (Part 13 Amendments) (September 16, 2019), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/stumpstatement091619.

As I observed when we proposed these risk principles last summer, it is a simple fact that the markets we regulate have become increasingly electronic (much like everything else in our modern lives).  The rulemaking that we are now adopting appropriately recognizes that market infrastructure providers have already implemented a host of measures pursuant to our existing regulations and their own self-regulatory responsibilities to account for the associated risks that inherently come with the development of electronic trading.  I do not want our adoption of additional Commission risk principles regarding electronic trading on DCMs to be taken as an indication that adequate attention is not being paid – or that insufficient resources are being invested – by the exchanges to address the lessons that have already been learned and applied as electronic trading has become more prevalent in these markets.

I also want to stress the significance of the often-overlooked direction we have received from Congress in Section 3 of the Commodity Exchange Act (CEA).[1]  Section 3(a) sets out Congress’s finding that the transactions subject to the CEA are affected with a national public interest.  Then, in Section 3(b), Congress stated that it is the purpose of the CEA to serve this public interest “through a system of effective self-regulation of trading facilities, clearing systems, market participants and market professionals under the oversight of the Commission.” 

I support adopting these electronic trading risk principles as an appropriate exercise of the Commission’s oversight that Congress expects from us, as stated in Section 3(b) of the CEA.  While, as noted, I do not question the exchanges’ diligence in addressing the risks in electronic trading on their platforms, I am comfortable incorporating these principles into our existing rule set in order to make clear that DCMs must continue to monitor these risks as they evolve along with the markets, and make reasonable modifications as appropriate. 

Importantly, though, I also support the principles-based approach of this rulemaking.  This approach recognizes that the front-line responsibility for preventing, detecting, and mitigating material risks posed by electronic trading rests with the exchanges themselves.  The exchanges are best positioned to execute this responsibility because they have the best knowledge of the trading that occurs on their own markets.  At the same time, this approach serves the public interest through a system of effective self-regulation of trading facilities – precisely as Congress directed in its statement of purpose in Section 3(b) of the CEA.

I thank and commend the Staff for the time and energy they have put into the preparation of this rulemaking.
 

[1] CEA Section 3, 7 U.S.C. 5.

I support today’s two final rules that make tailored amendments to the CFTC’s Margin Rule.[1]  The Margin Rule requires swap dealers (SDs) and major swap participants (MSPs) for which there is no prudential regulator to post and collect, each business day, initial and variation margin for uncleared swap transactions with each counterparty that is an SD, MSP, or a financial end user with material swaps exposure (MSE). [2]  The Margin Rule is a lynchpin of the Dodd-Frank reforms for swaps markets, and critical to mitigating risks in the financial system that might otherwise arise from uncleared swaps.[3]  I support the final rules because they provide targeted, operational improvements to the Margin Rule; include backstops to deter any potential abuse; and are unlikely to increase risk to the U.S. financial system.

The two final rules address: (1) the definition of MSE and an alternative method for calculating initial margin (MSE and Initial Margin Final Rule); and (2) the application of the minimum transfer amount (MTA) for initial and variation margin (MTA Final Rule).  The final rules align Commission requirements with international frameworks developed by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS/IOSCO),[4] and incorporate recommendations made to the CFTC’s Global Markets Advisory Committee.[5]  The final rules also build off existing CFTC staff no-action letters that in some cases have been in place since 2017, and that have operated with no apparent detrimental effects. 

MSE and Initial Margin Final Rule

The MSE and Initial Margin Final Rule amends the definition of MSE to align it with the BCBS/IOSCO framework, including the method for calculating the average daily aggregate notional amount (AANA) of swaps.  The final rule provides for calculations based on the average of the last business day in each month of a three-month period.  The Commission previously raised concerns that this method of AANA calculation could potentially become less representative of an entity’s true AANA and swaps exposure, potentially through the use of “window dressing” to artificially reduce AANA during the measurement period.[6] 

The MSE and Initial Margin Final Rule includes an important new provision to address this issue.  The final rule explicitly prohibits any “[a]ctivities not carried out in the regular course of business and willfully designed to circumvent calculation at month-end to evade meeting the definition of material swaps exposure . . . .”[7]  The addition of this language to the final rule’s regulatory text will help ensure that CFTC efforts at international harmonization will not come at the expense of the safety and soundness of the U.S. financial system.[8]   I thank the Chairman and the CFTC staff for working with my office to include this provision.        

The MSE and Initial Margin Final Rule will also allow SDs and MSPs for which there is no prudential regulator (Covered Swap Entities or CSEs) to rely on the initial margin calculations of the more sophisticated counterparties with whom they transact swaps to manage their risks.  This flexibility is limited to circumstances where a CSE enters into uncleared swaps with an SD, MSP, or swap entity to hedge its customer-facing swaps.  This amendment to the Commission’s existing rules could help promote liquidity and competition in swaps markets by increasing choice for end-users that are CSE customers. 

The MSE and Initial Margin Final Rule provides helpful direction regarding the scope of hedging swaps for purposes of relying on a CSE counterparty’s initial margin calculations.  As set forth in the preamble to the final rule, a hedging swap must be consistent (although not identical) with the statutory definition of “bona fide hedging transaction or position” in CEA section 4a(c)(2)(B).[9]  The final rule also makes clear that existing Commission regulations require a CSE that relies on its counterparty’s initial margin calculations to also take steps to “monitor, identify, and address potential shortfalls in the amounts of [initial margin] generated by the counterparty on whose [initial margin] model the CSE is relying.”[10]

MTA Final Rule

To reduce operational burdens associated with de minimis margin transfers, the Margin Rule provides that a CSE is not required to collect or post margin until the combined amount of initial margin and variation margin that is required to be collected or posted and that has not been collected or posted with respect to the counterparty exceeds $500,000—the MTA.[11]  This MTA level, in part, helps limit the amount of a counterparty’s uncollateralized, uncleared swaps exposure and mitigate any systemic risk arising from such swaps. 

The MTA Final Rule addresses the application of the $500,000 MTA level to a counterparty’s “separately managed accounts,” as well as the use of separate MTAs for initial and variation margin.[12]  The MTA Final Rule codifies separate treatment for separately managed accounts and permits an MTA of $50,000 for each such account of a counterparty.  This approach responds to practical limits on the ability of asset managers, for example, to aggregate initial and variation margin obligations across multiple separately managed accounts owned by the same counterparty.  The MTA Final Rule also provides that if certain entities agree to separate MTAs for initial margin and variation margin, the respective amounts of MTA must be reflected in their required margin documentation.

These new provisions balance concerns over operational inefficiencies and practical challenges in the Commission’s MTA rules against concerns that they may result in the exchange of less total margin than would be the case under the Commission’s current requirements.  Comments in response to the proposed rule noted the difficulties that would be associated with creating numerous separately managed accounts solely to evade the comparatively low $50,000 MTA for separately managed accounts.  The MTA Final Rule also defines separately managed account so that the swaps of such account are not subject to a netting of initial or variation margin obligations.  This potentially provides further disincentive to create separately managed accounts solely for the purpose of evading the $50,000 MTA level for such accounts.  

Conclusion

Mitigating systemic risk to the U.S. financial system was a primary objective of the Dodd-Frank Act in 2010, and of subsequent Commission rulemakings to implement Dodd-Frank, including the Margin Rule adopted in 2016.  The Commission must remain committed to the Margin Rule and vigilant for any large pool of uncollateralized, uncleared swaps exposure.  Today’s targeted final rules, which codify existing practices, include embedded backstops, and provide tailored operational enhancements to the Margin Rule, are unlikely to present systemic risks.  

I thank staff of the Market Participants Division for their work on these final rules.
 

[1] Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 81 FR 636 (Jan. 6, 2016) (Margin Rule).

[2] Although addressed in the final rules, there are currently no registered MSPs.

[3] Section 4s(e) of the Commodity Exchange Act (CEA), as amended by the Dodd-Frank Act, requires the Commission to adopt rules for minimum initial and variation margin for uncleared swaps entered into by SDs and MSPs for which there is no prudential regulator.

[4] BCBS/IOSCO, Margin requirements for non-centrally cleared derivatives (July 2019), available at https://www.bis.org/bcbs/publ/d475.pdf.  The BCBS/IOSCO framework was originally promulgated in 2013 and later revised in 2015.

[5] Recommendations to Improve Scoping and Implementation of Initial Margin Requirements for Non-Cleared Swaps, Report to the CFTC’s Global Markets Advisory Committee by the Subcommittee on Margin Requirements for Non-Cleared Swaps (Apr. 2020), available at https://www.cftc.gov/media/3886/GMAC_051920MarginSubcommitteeReport/download.

[6] See Margin Rule, 81 FR at 645.

[7] MSE and Initial Margin Final Rule at new § 23.151 (defining “Material Swaps Exposure”).

[8] The preamble to the MSE and Initial Margin Final Rule also notes an analysis by the CFTC’s Office of the Chief Economist indicating that the new month-end AANA calculation method captures substantially the same entities and total number of entities as the Commission’s previous daily AANA calculation method.  As with any rulemaking, the Commission is free in the future to periodically review its data and confirm that the new AANA calculation method is performing as expected.   

[9] 7 U.S.C. 6a(c)(2).

[10] MSE and Initial Margin Final Rule at section II(B).

[11] 17 CFR 23.151

[12] Both aspects of the MTA Final Rule were the subject of CFTC staff no-action letters issued in 2017 and 2019, respectively.

I support today’s final rule on Electronic Trading Risk Principles (Final Rule).  The Final Rule addresses market disruptions associated with electronic trading through limited requirements applicable directly to designated contract markets (DCMs) and indirectly to DCM market participants.  It is an incremental step that can enhance the safety and soundness of electronic trading on U.S. exchanges.  I look forward to the continuing evolution of trading in our markets, and to the Commission’s steady engagement with the technology and risk controls of modern trading to determine whether more may be needed in the future.

I am able to support the Final Rule because it recognizes the role of both DCMs and market participants in preventing and mitigating market disruptions, as well as the ultimate responsibility and authority of the Commission to oversee the actions of our market infrastructures and market participants.  The Final Rule codifies three “Risk Principles,” including new requirements in Risk Principle 1 that DCMs implement rules governing their market participants to prevent, detect, and mitigate market disruptions and system anomalies.[1]  This provision, codified in Commission regulation 38.251(e), speaks directly to new risk-reducing practices and may be the most helpful of the three Risk Principles. 

Market participants originate, place, and manage orders on DCMs though an array of systems that vary in sophistication and automation.  Experience teaches that errors in the design, testing, implementation, operation, or supervision of such systems by a single market participant can lead to cascading effects that disrupt an entire market and the ability of all market participants to engage in price discovery and risk mitigation.  Accordingly, it is crucial that market participants, DCMs, and the Commission implement and enforce the Risk Principles in meaningful ways going forward.[2]

The Commission’s efforts in this regard may be aided by Risk Principle 3, which requires DCMs to “promptly notify Commission staff of any significant market disruptions” and “provide timely information on the causes and remediation.”[3]  I support Commission efforts to remain up-to-date as technologies evolve, new potential sources of market disruptions arise, and best practices for safeguarding markets are developed.  Information provided to the Commission through Risk Principle 3 will strengthen the Commission’s daily oversight of DCMs, and help educate the Commission and its staff as to the most effective risk-reducing measures.

I am also able to support the Final Rule because it recognizes and preserves the Commission’s authority to interpret and enforce the standards in the Risk Principles, and because it clarifies that Risk Principles 1 and 2 are intended to address any type of market disruption arising from market participants or electronic orders that materially affects electronic trading.  I thank the Chairman for working with my office to achieve these enhancements to the Final Rule.

The Final Rule includes Acceptable Practices in Appendix B to part 38 providing that a DCM can comply with Risk Principles 1 and 2 through rules and pre-trade risk controls that are “reasonably designed” to prevent, detect, and mitigate market disruptions and system anomalies.  While legitimate concerns have been raised that these terms could lend themselves to excessive disputes over interpretation, the Final Rule makes clear that they are subject to an objective standard and Commission oversight.  It notes specifically that “[t]he Commission will oversee and enforce the Risk Principles in accordance with an objective reasonableness standard[,]” and that the Risk Principles are “enforceable regulations.”[4]  I am pleased that the Final Rule clearly articulates the seriousness with which the Commission will monitor and enforce the Risk Principles.

The Final Rule also makes clear that while Risk Principle 3 addresses “significant” market disruptions, Risk Principles 1 and 2 include the broader set of “material” disruptions.  As stated in the Final Rule, “the standard for a significant market disruption under Risk Principle 3 is higher than the standard for a market disruption under Risk Principles 1 and 2.”  Markets and market participants will benefit from the Commission’s decision to resolve this potential ambiguity in the proposed rule and to implement a rigorous standard for Risk Principles 1 and 2.

Today’s Final Rule addresses an issue that has remained open in the Commission’s books for far too long.  Electronic trading is no longer a new technology in Commission-regulated markets, and it has not been new for many years.  The Risk Principles are a circumscribed but important first step in ensuring that the Commission’s rules keep pace with technological changes underlying derivatives trading.  The Commission must now proceed to full, effective implementation of the Risk Principles and to oversight of DCMs’ own implementations.  I support these efforts, combined with continued vigilance to determine whether additional steps may be needed in the future.

In the preamble to the Final Rule, the Commission stresses the potential benefits of the principles-based approach embodied in the Risk Principles.  My support for the principles-based approach in this particular rulemaking, however, should not be interpreted as an endorsement of such a broad principles-based approach in other circumstances, or foreclose my support for more prescriptive measures should they become necessary with respect to risk controls.  Although the markets overseen by the Commission have benefitted from the flexibility of a principles-based approach in a number of areas, in other circumstances a more prescriptive approach has provided the market with needed clarity and certainty.  The appropriate choice or balance between prescriptive regulations and principles-based regulations will depend upon the circumstances being addressed by those regulations.

Whether this rulemaking will fully accomplish its objectives will depend to a large extent upon the diligence and commitment to its implementation by DCMs and market participants.  If DCMs and market participants comprehensively adopt and maintain industry best practices to prevent, detect, and mitigate market disruptions and system anomalies, as well as develop and implement measures to address emerging issues as they arise, then further prescriptive action by the Commission may not be necessary.

I thank the staff of the Division of Market Oversight for their work to address a number of my concerns with the Final Rule, as well as their overall work on the Final Rule.

[1] In addition, Risk Principle 2 requires DCMs to subject all electronic orders to exchange-based pre-trade risk controls to prevent, detect, and mitigate market disruptions or system anomalies associated with electronic trading.  Risk Principle 2 overlaps with existing Commission regulations, including § 38.255, which requires DCMs to “establish and maintain risk control mechanisms to prevent and reduce the potential risk of price distortions and market disruptions.”  DCMs should help drive an effective implementation of Risk Principle 2 by carefully examining their existing pre-trade risk controls and ensuring that such controls are fit for the types of market participants, technologies, and trading practices prevalent on their markets. 

[2] I appreciate the concerns raised by some commenters that the Risk Principles may be imprecise, difficult to enforce, or provide too much deference to DCMs.  As discussed below, the Final Rule helps mitigate some of these concerns by emphasizing that the Risk Principles are an objective standard and enforceable rules subject to Commission oversight.  The Commission will be able to monitor DCMs’ compliance with the Risk Principles through its DCM rule enforcement review program, as well as other oversight activities including review of new rule certifications, review of market disruption notifications received pursuant to Risk Principle 3, market surveillance, and other oversight tools.  

[3] Risk Principle 3 is codified in new Commission regulation 38.251(g).

[4] As I articulated in my statement when the Risk Principles were first proposed, the Dodd-Frank Act amended the Commodity Exchange Act to make clear that a DCM’s discretion with respect to core principle compliance is circumscribed by any rule or regulation that the Commission might adopt pursuant to a core principle.  In today’s Final Rule, the Commission is requiring DCMs to adopt and implement rules and pre-trade risk controls that are “reasonably designed to prevent, detect, and mitigate market disruptions or system anomalies associated with electronic trading.

I vote in favor of today’s final rule that first, amends a key definition used to determine whether a financial end-user must comply with the Commission’s uncleared swap margin regulations when trading with a swap dealer,[1] and second, codifies no-action relief providing additional flexibility for swap dealers to use the risk-based calculation of initial margin.[2]  With regard to the adjustment to the definition of material swap exposure, I support the fact that the rulemaking further aligns the Commission’s rules to the framework agreed upon by the international framework established by BCBS-IOSCO.  However, I continue to take issue with the reliance on notional value as the defining metric for determining whether a firm should be subject to the uncleared margin regulations.  The philosophy behind such a framework is that firms with small levels of swaps can have outsized impacts on the financial system.  Further, the fact that we, as an agency and as international regulators, continue to embrace a metric as useless, biased, and arbitrary as notional value is something I have long opposed, and I have never, not once, heard an acceptable or even rationale defense for doing so. 

[1] Definition of material swap exposure under reg. 23.151(a).

[2] CFTC Letter 19-29.

I support the Commission’s decision to withdraw its 2018 proposal to overhaul the regulation of swap execution facilities (SEFs)[1] (2018 SEF NPRM) and proceed instead with targeted adjustments to our SEF rules (Final Rules).  The two Final Rules approved today will make minor changes to SEF requirements while retaining the progress we have made in moving standardized swaps onto electronic trading platforms, which has enhanced the stability, transparency, and competitiveness of our swaps markets.[2]

When the Commission issued the 2018 SEF NPRM, I proposed that we enhance the existing swaps trading system instead of dismantling it.  For example, I urged the Commission to clarify the floor trader exception to the swap dealer registration requirement and abolish the practice of post-trade name give-up for cleared swaps.  I am pleased that the Commission already has acted favorably on both of those matters.  Today’s rulemaking represents a further positive step in this targeted approach. 

Many commenters to the 2018 SEF NPRM supported this incremental approach, advocating discrete amendments rather than wholesale changes.  Today, the Commission is adopting two Final Rules that codify tailored amendments that received general support from commenters.  The first rule—Swap Execution Facilities—amends part 37 to address certain operational challenges that SEFs face in complying with current requirements, some of which are currently the subject of no-action relief or other Commission guidance.  The second rule—Exemptions from Swap Trade Execution Requirement—exempts two categories of swaps from the trade execution requirement, both of which are linked to exceptions to or exemptions from the swap clearing requirement.

Swap Execution Facilities: Audit Trail Data, Financial Resources and Reporting, and Requirements for Chief Compliance Officers

Commission regulations require a SEF to capture and retain all audit trail data necessary to detect, investigate, and prevent customer and market abuses, which currently includes identification of each account to which fills are ultimately allocated.[3]  Following the adoption of these regulations, SEFs represented that they are unable to capture post-execution allocation data because the allocations occur away from the SEF, prompting CFTC staff to issue no-action relief.  Other parties, including DCOs and account managers, must capture and retain post-execution allocation information and produce it to the CFTC upon request, and SEFs are required to establish rules that allow them obtain this allocation information from market participants as necessary to fulfill their self-regulatory responsibilities.  Given that staff is not aware of any regulatory gaps that have resulted from SEFs’ reliance on the no-action letter, codifying this alternative compliance framework is appropriate.

This Swap Execution Facility final rule also will amend part 37 to tie a SEF’s financial resource requirements more closely to the cost of its operations, whether in complying with core principles and Commission regulations or winding down its operations.  Based on its experience implementing the SEF regulatory regime, the Commission believes that these amended resource requirements—some of which simply reflect current practice—will be sufficient to ensure that a SEF is financially stable while avoiding the imposition of unnecessary costs.  Additional amendments to part 37, including requirements that a SEF must prepare its financial statements in accordance with U.S. GAAP standards, identify costs that it has excluded in determining its projected operated costs, and notify the Commission within 48 hours if it is unable to comply with its financial resource requirements, will further enhance the Commission’s ability to exercise it oversight responsibilities.

Finally, this rule makes limited changes to the Chief Compliance Officer (CCO) requirements.  As a general matter, I agree that the Commission should clarify certain CCO duties and streamline CCO reporting requirements where information is duplicative or not useful to the Commission.  Although the CCO requirements diverge somewhat from those for futures commission merchants and swap dealers, the role of SEFs is different and therefore, standardization is not always necessary or appropriate.  I expect that the staff will continue to monitor the effects of all of the changes adopted today and inform the Commission if it believes further changes to our rules are needed.

Exemptions from Swap Trade Execution Requirement

Commodity Exchange Act (CEA) section 2(h)(8) specifies that a swap that is excepted from the clearing requirement pursuant to CEA section 2(h)(7) is not subject to the requirement to trade the swap on a SEF.  Accordingly, swaps that fall into the statutory swap clearing exceptions (e.g., commercial end-users and small banks) are also excepted from the trading mandate.  However, the Commission has also exempted from mandatory clearing swaps entered into by certain entities (e.g., cooperatives, central banks, and swaps between affiliates) using different exemptive authorities from section 2(h)(7). 

The Exemptions from Swap Trade Execution Requirement final rule affirms the link between the clearing mandate and the trading mandate for swaps that are exempted from the clearing mandate under authorities other than CEA section 2(h)(7).  The additional clearing exemptions are typically provided by the Commission to limited types of market participants, such as cooperatives or central banks that use swaps for commercial hedging or have financial structures or purposes that greatly reduce the need for mandatory clearing and SEF trading.  In addition, limited data provided in the release indicates that, at least up to this point in time, these exempted swaps represent a small percentage of the notional amount of swaps traded.

This final rule also exempts inter-affiliate swaps from the trade execution requirement.  These swaps are exempted from the clearing requirement primarily because the risks on both sides of the swap are, at least in some respects, held within the same corporate enterprise.  As described in the final rule release, these swaps may not be traded at arms-length and serve primarily to move risk from one affiliate to another within the same enterprise.  Neither market transparency nor price discovery would be enhanced by including these transactions within the trade execution mandate.  For these reasons, I am approving the Exemptions from Swap Trade Execution Requirement final rule as a sensible exemption consistent with the relevant sections of the CEA.

Conclusion

These two Final Rules provide targeted changes to the SEF regulations based on experience from several years of implementing them.  These limited changes, together with the withdrawal of the remainder of the 2018 SEF NPRM, effectively leave in place the basic framework of the SEF rules as originally adopted by the Commission.  This framework has enhanced market transparency, improved competition, lowered transaction costs, and resulted in better swap prices for end users.  While it may be appropriate to make other incremental changes going forward, it is important that we affirm the established regulatory program for SEFs to maintain these benefits and facilitate further expansion of this framework.

I thank the staff of the Division of Market Oversight for their work on these two rules and their helpful engagement with my office.

[1] Swap Execution Facilities and Trade Execution Requirement, 83 FR 61946 (Nov. 30, 2018).

[2] Dissenting Statement of Commissioner Dan M. Berkovitz Regarding Proposed Rulemaking on Swap Execution Facilities and Trade Execution Requirement (Nov, 5, 2018), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement110518a. 

[3] 17 CFR 37.205(a), b(2)(iv).

I will vote in favor of withdrawing the unadopted provisions from the Commission’s 2018 proposal comprehensively to amend the regulations applicable to swap execution facilities (SEFs)[1], but only because the Commission has already adopted many of these proposals, including in the areas of SEF financial resources, audit trail data, and exceptions to the trade execution requirement, so that the SEF ruleset becomes more practical for market participants.  I note that many of the finalized provisions are based on longstanding no-action relief that has taken over eight years and a Republican administration to rationalize the inadequate ruleset left by the Commission’s prior leadership. 

I regret significantly, however, that certain aspects of the 2018 proposal have not been acted upon or debated as a Commission since.  In particular, the CEA as amended by Dodd Frank, legally allows SEFs greater flexibility –specifically through “any means of interstate commerce”[2] — in which methods of execution they may offer for swaps subject to the trade execution requirement, than the overly prescriptive and government-knows-best requirement that a SEF may only provide either a RFQ-to-3 or a Central Limit Order Book (CLOB) trading mechanism, as dictated by an existing CFTC rule.[3]  Indeed, such flexibility was recently requested by a wide range of market participants during the period of COVID-inspired market volatility and thin liquidity.[4]  If such trade execution flexibility is necessary to support liquidity in a stressed environment, why would it not benefit the markets more generally in normal environments? Additionally, such flexibility is absolutely consistent with the definition of a SEF set forth in the CEA, that establishes a SEF as a multiple-to-multiple trading system.”[5]
 

[1] SEFs and Trade Execution Requirement, 83 Fed. Reg. 61,946 (Nov. 30, 2018).

[2] Definition of SEF, sec. 1a(50) of the CEA.

[3] CFTC reg. 37.9(a).

[4] Comment letter from ISDA, dated May 22, 2020, in response to the Commission’s February 2020 proposal on SEF and Real-Time Reporting requirements (85 Fed. Reg. 9,407 (Feb. 19, 2020)).

[5] Definition of SEF, sec. 1a(50) of the CEA.

Overview

I am pleased to support the two final rulemakings that the Commission is adopting with respect to margin requirements for uncleared swaps.  These rulemakings address several recommendations that the Commission received from its Global Markets Advisory Committee (GMAC), which I am proud to sponsor, and are based on a comprehensive report prepared by GMAC’s Subcommittee on Margin Requirements for Non-Cleared Swaps (GMAC Margin Subcommittee).[1]  They demonstrate the value added to the Commission’s policymaking by its Advisory Committees, in which market participants and other interested parties come together to provide us with their perspectives and potential solutions to practical problems.

The two rulemakings we are adopting make 4 changes to the Commission’s uncleared margin rules.  The four changes have much to commend them – indeed, we did not receive any comment letters opposing them.  These rule changes further objectives that I have commented on before:

• the need to tailor our rules to assure that they are workable for those required to comply with them;
• the benefits of codifying relief that has been issued by our Staff and re-visiting our rules, where appropriate; and
• the imperative of harmonizing our margin requirements with those of our international colleagues in order to facilitate compliance and coordinated regulatory oversight. 

A Different Universe is Coming into Scope of the Uncleared Margin Rules

The Commission’s uncleared margin rules for swap dealers, like the Framework of the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions (BCBS/IOSCO) on which they are based,[2] were designed primarily to ensure the exchange of margin between the largest, most systemic, and interconnected financial institutions for their uncleared swap transactions with one another.  Today, these institutions and transactions are subject to uncleared margin requirements that have taken effect since the rules were adopted.

Pursuant to the phased implementation schedule of the Commission’s rules and the BCBS/IOSCO Framework, though, a different universe of market participants – presenting unique considerations – will soon be coming into scope of the margin rules.  It is only now, as we enter the final phases of the implementation schedule, that the Commission’s uncleared margin rules will apply to a significant number of financial end-users, and we have a responsibility to make sure they are fit for that purpose.  Accordingly, now is the time we must thoughtfully consider whether the regulatory parameters that we have designed for the largest financial institutions in the earlier phases of margin implementation need to be tailored to account for the practical and operational challenges posed by the exchange of margin when one of the counterparties is a pension plan, endowment, insurance provider, mortgage service provider, or other financial end-user.

The rulemaking regarding the “minimum transfer amount” does exactly that.  The Commission’s uncleared margin rules provide that a swap dealer is not required to collect or post initial margin (IM) or variation margin (VM) with a counterparty until the combined amount of such IM and VM exceeds the minimum transfer amount (MTA) of $500,000.  Yet, the application of the MTA presents a significant operational challenge for institutional investors that typically hire asset managers to exercise investment discretion over portions of their assets in separately managed accounts (SMAs) for purposes of diversification.  As a practical matter, neither the owner of the SMA, the manager of the assets in the SMA, nor the swap dealer that is a counterparty to the SMA is in a position to readily determine when the MTA has been exceeded on an aggregate basis (or to assure that it is not). 

To address this challenge, the Commission is amending the definition of MTA in its margin rules to allow a swap dealer to apply an MTA of up to $50,000 to each SMA owned by a counterparty with which the swap dealer enters into uncleared swaps.  As noted in the release, any potential increase in uncollateralized credit risk as a result would be mitigated both by the conditions set out in the rules we are adopting, as well as existing safeguards in the Commodity Exchange Act (CEA) and the Commission’s regulations.[3]

This is a sensible approach and an appropriate refinement to make the Commission’s uncleared margin rules workable for SMAs given the realities of the modern investment management environment.  As I have stated before, no matter how well-intentioned a rule may be, if it is not workable, it cannot deliver on its intended purpose.[4]   

The Benefits of Codifying Staff Relief and Re-Visiting our Rules

Application of MTA to SMAs:  The rule change that I have discussed above regarding the application of the MTA to SMAs would codify no-action relief in Letter No. 17-12 that our Staff issued in 2017.[5]  The Commission’s Staff often has occasion to issue relief or take other action in the form of no-action letters, interpretative letters, or advisories on various issues and in various circumstances.  This affords the Commission a chance to observe how the Staff action operates in real-time, and to evaluate lessons learned.  With the benefit of this time and experience, the Commission should then consider whether codifying such Staff action into rules is appropriate.[6] 

As I have said before, “[i]t is simply good government to re-visit our rules and assess whether certain rules need to be updated, evaluate whether rules are achieving their objectives, and identify rules that are falling short and should be withdrawn or improved.”[7]  Experience with the Staff no-action relief in Letter No. 17-12 supports our rule change to tailor the application of the MTA under the Commission’s uncleared margin rules in the SMA context. 

Two of the other rule changes that we are adopting similarly would codify existing Staff no-action relief in recognition of market realities:

Separate MTAs for IM and VM:  Our second rule change regarding the MTA, consistent with Staff no-action Letter No. 19-25,[8] would recognize that a swap dealer may apply separate MTAs for IM and VM with each counterparty, provided that the MTAs corresponding to IM and VM are specified in the margin documentation required under the Commission’s regulations, and that the MTAs, on a combined basis, do not exceed the prescribed MTA. 

Staff’s no-action relief, and the Commission’s rule amendments to codify that relief, take into account the separate settlement workflows that swap counterparties maintain to reflect, from an operational perspective, the different regulatory treatment of IM and VM.[9]  And given that the total amount of combined IM and VM exchanged would not exceed the prescribed MTA, separate MTAs for IM and VM would not materially increase the amount of credit risk at a given time.  Under Letter No. 19-25 and this codification, swap dealers and their counterparties can manage MTA in an operationally practicable way that aligns with the market standard. 

Reliance on Counterparty’s Model Calculation of IM:  A third rule change we are adopting codifies a Staff no-action position taken in Letter No. 19-29,[10] providing that a swap dealer may use the risk-based model calculation of IM of a counterparty that is a CFTC-registered swap dealer as the amount of IM that the former must collect from the latter.  The release states the Commission’s expectation that this alternative method of IM collection will be used by swap dealers with a discrete and limited swap business consisting primarily of entering into uncleared customer-facing swaps with end-user counterparties, and then hedging the risk of those swaps with uncleared swaps entered into with a few other swap dealers.   

Simply put, not all swap dealers are created equal.  It is therefore appropriate to tailor our uncleared margin regime accordingly.  Letter No. 19-29 recognized this reality and smoothed the rough edges of our otherwise one-size-fits-all uncleared margin rules, and it is appropriate to codify that result.

Yet, under the rule amendments being adopted, this alternative method is subject to the condition that the uncleared swaps for which a swap dealer uses the risk-based model calculation of IM of its swap dealer counterparty are entered into for the purpose of hedging the former’s own risk from entering into customer-facing swaps with non-swap dealer counterparties.  This is a departure from the GMAC Margin Subcommittee, which did not recommend such a condition.

I am concerned by comments we received suggesting that this condition may cause this rule change to prove unworkable in practice.[11]  I am encouraged that the rulemaking release addresses some of these comments by, among other things, confirming: 1) the flexibility of swap dealers as part of their hedging strategy to match a set of customer-facing swaps with one or more hedging swaps undertaken with other swap dealer counterparties; and 2) that customer-facing swaps entered into through anticipatory hedging or that are subsequently terminated would be deemed hedges for purposes of the alternative method of IM calculation.  Nevertheless, if over time, market participants find that the hedging condition causes this rule change to fail to fulfill its intended purpose, I urge them to alert the Commission so that it can consider appropriate adjustments.

International Harmonization to Enhance Compliance and Coordinated Regulation

The Commission’s fourth and final rule change would revise the calculation method for determining whether financial end-users come within the scope of the IM requirements, and the timing for compliance with the IM requirements after the end of the compliance schedule.  These changes would align certain timing and calculation issues under the Commission’s margin rules with both the BCBS/IOSCO Framework and the manner in which these issues are handled by our regulatory colleagues in all other major market jurisdictions.

Swap dealers must exchange IM with respect to uncleared swaps that they enter into with a financial end-user counterparty that has “material swaps exposure” (MSE).  The Commission’s margin rules currently provide that after the last phase of compliance, MSE is to be determined on January 1, and that an entity has MSE if it has more than $8 billion in average aggregate notional amount (AANA) during June, July, and August of the prior year.  By contrast, under the BCBS/IOSCO Framework and in virtually every other country in the world, an entity is determined to come into scope of the IM requirement on September 1, and an entity has MSE if it has the equivalent of $8 billion in AANA[12] during March, April, and May of that year.

The reason the United States is out-of-step with the rest of the world on these timing and calculation issues is not because of any reasoned policy determination.  Rather, it is the result of a quirk that the U.S. margin rules were adopted based on the BCBS/IOSCO Framework that was in effect at the time – but the BCBS/IOSCO Framework was revised two years later.

In a further disconnect, the Commission’s margin rules look to the daily average AANA during the three-month calculation period for determining MSE, whereas the BCBS/IOSCO Framework and other major market jurisdictions base the AANA calculation on an average of month-end dates during that period.  Yet, as noted in the rulemaking release, the Commission’s Office of the Chief Economist has estimated that calculations based on end-of-month AANA generally would yield similar results as calculations based on the Commission’s current daily AANA approach.  It has been suggested that this rule change theoretically might incentivize a firm to “window dress” its swap exposures as the month-end approaches in order to avoid margin requirements.  But the GMAC Margin Subcommittee observed that it would be neither practicable nor financially desirable for parties to tear-up their positions on a recurring basis prior to the month-end calculation,[13] because doing so would interfere with hedging strategies and cause the firm to incur realized profit and loss.[14]

Accordingly, the Commission is amending these timing and calculation provisions of its uncleared margin rules to harmonize them with the BCBS/IOSCO Framework and the approach followed by our international colleagues.  Given the global nature of the derivatives markets, we should always seek international harmonization of our regulations unless a compelling reason exists not to do so – which is not the case here.

Indeed, in the Dodd-Frank Act, Congress specifically directed the Commission, “[i]n order to promote effective and consistent global regulation of swaps,” to “consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards with respect to the regulation . . . of swaps [and] swap entities . . .”[15]  And when the G-20 leaders met in Pittsburgh in the midst of the financial crisis in 2009, they, too, recognized that a workable solution for global derivatives markets demands coordinated policies and cooperation.[16]

Our rule change regarding MSE is true to the direction of Congress in the Dodd-Frank Act, and honors the commitment of the G-20 leaders at the Pittsburgh summit.  Differences between countries in the detailed timing and calculation requirements with respect to uncleared margin compel participants in these global markets to run multiple compliance calculations – for no particular regulatory reason.  This not only forces market participants to bear unnecessary costs, but actually hinders compliance with margin requirements because of the entirely foreseeable prospect of calculation errors in applying the different rules.

As noted above, now is the time to address this disconnect in MSE timing and calculation requirements because the financial end-users to which the MSE definition applies are coming into scope of the margin rules.  During the unfortunate events of the financial crisis, we learned that coordination among global regulators, working towards a common objective, is essential.  That lesson remains true today, and we are reminded that disregarding this reality has the potential to weaken, rather than strengthen, the effectiveness of our oversight and the resilience of global derivatives markets.

There Remains Unfinished Business

While I am pleased with the steps the Commission is taking, there remains unfinished business in the implementation of uncleared margin requirements.  As an initial matter, U.S. prudential regulators with oversight authority over bank swap dealers have not yet adopted the corresponding rule changes relevant for consistent applications.  As a result, although commenters expressed support for the Commission proceeding with these rule changes even in the absence of parallel action by the U.S. prudential regulators, the operational difficulties confronting market participants that are coming into scope of the margin rules will not be fully addressed when they enter into uncleared swaps with bank swap dealers.  I look forward to continuing the dialogue with our regulatory colleagues at other U.S. agencies to support addressing these challenges.

In addition, the report of the GMAC Margin Subcommittee recommended several actions, beyond those that we are adopting, to address the hurdles associated with the application of uncleared margin requirements to end-users.  Having been present for the development of the Dodd-Frank Act, I recall that the concerns expressed by many lawmakers at the time focused on the application of the new requirements to end-users.  The unique challenges with respect to uncleared margin that caused uneasiness back in 2009-2010 are now much more immediate as the margin requirements are being phased in to apply to these end-users.  As the calendar turns into the new year, I look forward to continuing to work together to address the other recommendations contained in the GMAC Margin Subcommittee’s report regarding applying the uncleared margin rules to financial end-users.  The need to do so will only become more urgent as time marches on.

Conclusion

To be clear, these four changes to the uncleared margin rules are not a “roll-back” of the margin requirements that apply today to the largest financial institutions in their swap transactions with one another.  Rather, they reflect a thoughtful refinement of our rules to align them with the rest of the international regulatory community, and to take account of specific circumstances in which the rules impose substantial practical and operational challenges (i.e., they are not workable) when applied to financial end-users that are now coming within the scope of their mandates.

I am very appreciative of the many people whose efforts have contributed to bringing these rulemakings to fruition.  First, the members of the GMAC, and especially the GMAC Margin Subcommittee, who devoted a tremendous amount of time to provide us with a high-quality report on complex margin issues during the turmoil of the start of the pandemic.  Second, Chairman Tarbert and my fellow Commissioners for working with me on these important issues.  And finally, the Staff of the Market Participants Division, whose tireless efforts have enabled us to advance these initiatives to assure that our uncleared margin rules are workable for all and are in line with international standards, thereby enhancing compliance consistent with our oversight responsibilities under the CEA.

[1] Recommendations to Improve Scoping and Implementation of Initial Margin Requirements for Non-Cleared Swaps, Report to the CFTC’s Global Markets Advisory Committee by the Subcommittee on Margin Requirements for Non-Cleared Swaps (April 2020) (Margin Subcommittee Report), available at https://www.cftc.gov/media/3886/GMAC_051920MarginSubcommitteeReport/download.

[2] See generally BCBS/IOSCO, Margin requirements for non-centrally cleared derivatives (July 2019), available at https://www.bis.org/bcbs/publ/d475.pdf.

[3] Specifically, CEA Section 4s(j)(2), 7 U.S.C. 6s(j)(2), requires swap dealers to adopt a robust risk management system adequate for the management of their swap activities, and CFTC Rule 23.600, 17 CFR 23.600, requires swap dealers to establish a risk management program to monitor and manage risks associated with their swap activities.

[4] Statement of Commissioner Dawn D. Stump Regarding Final Rule:  Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to Swap Dealers and Major Swap Participants (July 23, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/stumpstatement072320.

[5] CFTC Letter No. 17-12, Commission Regulations 23.152(b)(3) and 23.153(c): No-Action Position for Minimum Transfer Amount with respect to Separately Managed Accounts (February 13, 2017), available at https://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/17-12.pdf.

[6] See comments of Commissioner Dawn D. Stump during Open Commission Meeting on January 30, 2020, at 183 (noting that after several years of no-action relief regarding trading on swap execution facilities (SEFs), “we have the benefit of time and experience and it is time to think about codifying some of that relief. .  . . [T]he SEFs, the market participants, and the Commission have benefited from this time and we have an obligation to provide more legal certainty through codifying these provisions into rules.”), available at https://www.cftc.gov/sites/default/files/2020/08/1597339661/openmeeting_013020_Transcript.pdf.

[7] Statement of Commissioner Dawn D. Stump for CFTC Open Meeting on: 1) Final Rule on Position Limits and Position Accountability for Security Futures Products; and 2) Proposed Rule on Public Rulemaking Procedures (Part 13 Amendments) (September 16, 2019), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/stumpstatement091619.

[8] CFTC Letter No. 19-25, Commission Regulations 23.151, 23.152, and 23.153 – Staff Time-Limited No-Action Position Regarding Application of Minimum Transfer Amount under the Uncleared Margin Rules (December 6, 2019), available at https://www.cftc.gov/csl/19-25/download.

[9] Under the Commission’s uncleared margin rules, IM posted or collected by a swap dealer must be held by one or more custodians that are not affiliated with the swap dealer or the counterparty, whereas VM posted or collected by a swap dealer is not required to be segregated with an independent custodian.  See 17 CFR 23.157.

[10] CFTC Letter No. 19-29, Request for No-Action Relief Concerning Calculation of Initial Margin (December 19, 2019), available at https://www.cftc.gov/csl/19-29/download.

[11] See, e.g., Letter from BP Energy Company at 5 (given the uncertainty as to what constitutes hedging, swap dealers may be reluctant to rely on the alternative method of IM calculation) and 6 (limiting relief to hedge transactions may diminish its utility); Letter from Futures Industry Association at 8 (complexity and added risk of hedging condition will make the alternative method of IM calculation impractical as counterparties will shy away from undertaking swaps with swap dealers that rely on the alternative method of calculating IM; also, cost, operational and documentation burdens associated with hedging condition could lead small swap dealers to cease providing risk management services to end-user counterparties, leaving end users with unhedged risks).  Comment letters available at https://comments.cftc.gov/PublicComments/CommentList.aspx?id=4157.

[12] The MSE threshold under the BCBS/IOSCO Framework is stated in euros rather than dollars.

[13] Margin Subcommittee Report at 52.

[14] Commenters made this same point.  See, e.g., Joint Letter from ISDA, SIFMA, and GFXD at 3 (month-end window dressing is not a realistic risk since unwinding and then reestablishing positions on a recurring basis over the three-month period would take considerable effort, interrupt hedging strategies, and require counterparties to absorb the costs of realized profit and loss changes); Letter from SIFMA Asset Management Group at 3 (it would be neither practicable nor financially desirable for parties to tear-up positions on a recurring basis prior to each month end); Letter from Investment Company Institute at 5-6 (for regulated funds, adjusting swap exposures over the course of three periodic dates solely to avoid IM could impose transaction costs and inhibit a fund’s ability to manage its portfolio risk, which may be inconsistent with investment adviser’s fiduciary duty to act in the best interest of its clients).

[15] See section 752(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111–203, Title VII, 124 Stat. 1376 (2010) (Dodd-Frank Act).

[16] See Leaders’ Statement from the 2009 G-20 Summit in Pittsburgh, Pa. at 7 (September 24-25, 2009) (“We are committed to take action at the national and international level to raise standards together so that our national authorities implement global standards consistently in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage”), available at https://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.