I respectfully dissent from the Commodity Futures Trading Commission’s (the “Commission” or “CFTC”) rulemaking today regarding Capital Requirements of Swap Dealers and Major Swap Participants (the “Final Capital Rule”).

Ten Years of Dodd-Frank

Yesterday marked ten years since Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act[1].  Congress passed Dodd-Frank as a targeted legislative response to the 2008 financial crisis and the near obsolescence of the U.S. financial regulatory framework.  The Great Recession wreaked havoc on Main Street Americans and the global economy.  Undercapitalization was at the heart of the 2008 crisis, and the swift response to require financial institutions to hold additional capital mitigated both the blunt economic shock we endured this past March, and the substantial weight we continue to shoulder as a result of the Covid-19 pandemic.

Section 731 of the Dodd-Frank Act[2] requires the CFTC to establish capital rules for all registered Swap Dealers (“SDs”) and Major Swap Participants (“MSPs”) that are not banks, as well as associated financial recordkeeping and reporting requirements.  The capital requirements in Section 731, which established Section 4s(e) of the Commodity Exchange Act (“the Act”), are clear: “…[t]o offset the greater risk to the swap dealer or major swap participant and the financial system arising from the use of swaps that are not cleared,” the Commission’s capital requirements shall “help ensure the safety and soundness of the swap dealer or major swap participant” and “be appropriate to the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.”[3]  There can be no doubt that Congress intended to impose significant new requirements that would contribute to the protection from another financial crisis.

Congress’s 2010 response largely incorporated the international financial reform initiatives for over-the-counter derivatives laid out at the 2009 G20 Pittsburgh Summit aimed at improving transparency, mitigating systemic risk, and protecting against market abuse.[4]  One of the core initiatives in the G20 statement was the imposition of higher capital requirements.  Paragraph 16 of the statement provides the purpose the G20 leaders agreed to aim for:  “To make sure our regulatory system for banks and other financial firms reins in the excesses that led to the crisis.”[5]  Paragraph 17 then lays out what the G20 leaders agreed to do to rein in the excesses, and the first item is this:  “We committed to act together to raise capital standards.”[6]  The G20 leaders said unequivocally that, for over-the-counter derivatives markets, “[n]on-centrally cleared contracts should be subject to higher capital requirements.”[7]  Congress had this same goal in mind when enacting the Dodd-Frank Act a decade ago.[8]

Three and a Half Years of the Capital Proposal

In 2016, the Commission issued a bipartisan proposal to implement capital requirements as directed by Congress through Section 731 of the Dodd-Frank Act.[9]  The Commission now jumps from a proposal issued in 2016 to a significantly different final rule nearly four years later, without any intervening reproposal to provide interested market participants clear proposed capital requirements to meaningfully comment upon.  In so doing, the Commission undermines the spirit of the Dodd-Frank Act and violates the letter of the Administrative Procedure Act (“APA”).[10]

The preamble to the Final Capital Rule asserts that all of the actions taken today are a “logical outgrowth” from the 2016 Proposal.[11]  The preamble even goes a step further, arguing that “modifications described in the 2019 Capital Reopening, including a discussion and specific inclusion of potential rule language, were logical outgrowths” of the 2016 Proposal.[12]  This simply cannot be true if the requirement that a final rule is a logical outgrowth of an agency’s proposed rule is to have any meaning at all.[13] 

The changes in the Final Capital Rule to the amount of capital that a futures commission merchant SD (FCM-SD) must maintain are illustrative of the point.  The 2016 Proposal would have required an FCM-SD to maintain regulatory capital equal to or greater than 8% of the initial margin associated with the FCM-SD’s proprietary cleared and uncleared futures, foreign futures, swap, and security-based swap positions.  In 2019, the Commission reopened the comment period on the 2016 Proposal.[14]  In the Federal Register release announcing the 2019 reopening, the Commission sought additional public input based on an initial review of comments received from the 2016 Proposal on myriad alternatives, seeking comment “on all aspects of the proposed risk margin amount, including comments regarding the possible increase or decrease of the risk margin percentage in coordination with the inclusion or exclusion of certain products in order to establish the most optimal capital requirement.”[15]  This, in many respects, is a blank check.  Not only does it allow for any conceivable percentage of risk margin, it simultaneously opens up multiple combinations of inputs.  The Commission now states that any of the possible outcomes along this sliding scale would have been a logical outgrowth.  It is the equivalent of saying that the Final Capital Rule is a logical outgrowth because it imposes any capital requirements at all, and that simply cannot be the case under the legal intent and plain reading of the principle of logical outgrowth.

A Final Capital Rule (and Five Years of Review)

Where did the Commission end up?  The Commission decides today to set the multiplier for the uncleared swaps of FCM-SDs at 2%, rather than the 8% originally proposed.  The Commission also is modifying the final rule from the proposal to remove security-based swaps, proprietary futures, foreign futures, and cleared swaps from the risk margin amount calculation.  These are significant changes from the 2016 proposal, and they are just one of the possible outcomes suggested in the reopening of the comment period.

I am not sure if 2% is the appropriate landing spot to insulate our markets from outsize risk.  And based on the preamble to this Final Capital Rule, I do not think the Commission is certain either.  The preamble states that the Commission does not have the data to determine whether or not 2% is the optimal or even adequate percentage.[16]  Instead, the Commission chooses 2% with the intent that  “the Commission’s decision to modify the final rule by removing cleared and uncleared security-based swaps, as well as proprietary futures, foreign futures, and cleared swaps positions from the risk margin amount calculation, and to set the multiplier at 2% should mitigate many of the commenters’ concerns that the proposed 8% risk margin amount calculation was over inclusive of the types of positions included in the calculation and was set at a percentage that was too high.”[17]  Due to this lack of data, the Commission will need to conduct a 5-year post implementation review “to assess whether the minimum capital requirements for FCM-SDs are adequately calibrated to ensure their safety and soundness.”[18]  And I applaud the Commission for including this critical regulatory component of the capital regime’s implementation.  However, this information is exactly the type of data that the Commission would have benefited from during the notice and comment process.  By failing to issue a reproposal in 2019, allowing just a few additional months of concrete, data driven deliberation, which could have clearly stated a specific approach, we lost the opportunity to find out whether the minimum capital requirements that we selected are adequately calibrated to ensure safety and soundness.

Because of the lack of clarity in the reopening of the comment period, we again received more general comments that 8% was too high.  In justifying the selection of 2%, the preamble states that “2% should mitigate many of the commenters’ concerns that the proposed 8% risk margin amount calculation was over inclusive of the types of positions included in the calculation and was set at a percentage that was too high.” [19]  Because we did not provide a clear alternative, we again received comments on 8% rather than comments on 2%, or on some alternative.

Ultimately, this lack of information gathering impacts the CFTC and results in a Final Capital Rule that has not benefited from fulsome public comment.  However, the impacts on our market participants are greater.  They have been denied the ability to comment meaningfully.  This is particularly true of the cost benefit analysis.  Broadly asking stakeholders to comment on any variation results in a situation where no one had an opportunity to comment on anything approximating what the Commission has done in its Final Capital Rule.  As a result, this rule ultimately derived from a process that is, in many respects, equivalent to not soliciting comments from the public and market participants at all.[20]

I note that, less than a month ago, the Commission voted to withdraw the Regulation Automated Trading proposal (“Regulation AT”),[21] the most recent iteration of which had been issued in November 2016, a couple of weeks before the 2016 Proposal.[22]  At the same time that Regulation AT was withdrawn, the Commission issued a rebranded Electronic Trading Risk Principles proposal intended to “accomplish a similar goal” to the original Regulation AT.[23]  Following the logic set forth today for the Final Capital Rule, the Commission could have simply issued a final rule for Electronic Trading Risk Principles last month, arguing that it was merely a logical outgrowth of the latest iteration of Regulation AT.  While I disagreed with last month’s policy decision, procedurally the Commission did the right thing under the APA.  We should have followed the same procedure for capital, and issued a reproposal.[24]  If we had done so last December, we could have received meaningful comments from market participants on a clearly stated reproposal, and we could well have been in position to finalize a stronger, more carefully considered Final Capital Rule today that addresses current market conditions in a manner that is more data driven.

Conclusion

Before I conclude, I would like to thank staff from the Division of Swap Dealer and Intermediary Oversight for their excellent work on this highly technical and complex rulemaking, and willingness to answer my questions and take feedback.

While I would have liked to stand with my fellow Commissioners today, I cannot justify it under these circumstances.  I truly wish that I could support today’s Commission action as we mark the tenth anniversary of the Dodd-Frank Act this week.  To reiterate sentiments made in my first speech as a CFTC Commissioner,[25] capital is a cornerstone financial crisis reform[26] that is critical to protecting our financial institutions and our financial system as a whole from systemic risk and contagion. But it is also critical to protection from unintended consequences if capital (and margin) levels are applied and set without due regard to the uniqueness of our financial markets and market participants.

I appreciate that in moving forward, we must fulfill our directive to establish capital standards appropriately, and in consideration of other activities engaged in by SDs and MSPs such that we ensure that we do not penalize commercial end-users who need choices and benefit from competition in our markets.   At the same time, we must heed Congressional intent without any compromise, regardless of what we think is best, remaining cognizant of the impact that capital requirements have on market stability, and follow APA rulemaking requirements when we do so.

Shortly before the Commission voted on the reopening in December, 2019, Chairman Tarbert gave remarks about transparency[27], making many very powerful and important points about the incredible importance of being mindful – as regulators – of “…not only what we do, but how we do it.”[28]  The Chairman ended that particular statement with a wonderful quote from Aristotle.  Among many profound lessons from the Greek philosopher, he is also sometimes credited with the statement that “[p]atience is bitter, but its fruit is sweet.”  In that vein, I simply wish the Commission had devoted a little bit more time to how we fulfill this foundational Dodd-Frank requirement. 

The road has been long, far too long in many respects.  But, unsure of what deadlines we are racing to meet at this point, or targets we are aiming to hit, I feel strongly the Commission and our markets, would have stood on sturdier ground, and perhaps even have landed at the same conclusion voted on today, if we had practiced a little patience.

[1] See The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203), 124 Stat. 1376 (2010) (the “Dodd-Frank Act”).

[2] Id.at § 731(e), 124 Stat. at 1704-6.

[3] Section 4s(e)(3) of the Commodity Exchange Act (“the Act”), 7 U.S.C. § 6s(e)(3). 

[4] G20, Leaders’ Statement, The Pittsburgh Summit (Sept. 24-25, 2009), available at https://www.oecd.org/g20/summits/pittsburgh/.

[5] Id. at 2.

[6] Id.

[7] Id. at 9.

[8] See Statement of Sen. Christopher Dodd, Cong. Rec., Vol. 156, Issue 104, S5828, S5832 (July 14, 2010) (“Derivatives are vitally important if utilized properly in terms of wealth creation and growing an economy.  But what was once a way for companies to hedge against sudden price shocks has become a profit center in and of itself, and it can be a dangerous one as well, when dealers and other large market participants don’t hold enough capital to back up their risky bets and regulators don’t have information about where the risks lie.”).

[9] Capital Requirements of Swap Dealers and Major Swap Participants, 81 FR 91252 (proposed Dec. 16, 2016) (the “2016 Proposal”).

[10] 5 U.S.C. § 551 et seq.

[11] Final Capital Rule at 1.B.

[12] Id.; Capital Requirements for Swap Dealers and Major Swap Participants, 84 FR 69664 (Dec. 19, 2019).

[13] See Small Refiner Lead Phase-Down Task Force v. United States Envtl. Prot. Agency, 705 F.2d 506, 548-49 (D.C. Cir. 1983) (“Agency notice must describe the range of alternatives being considered with reasonable specificity.  Otherwise, interested parties will not know what to comment on, and notice will not lead to better-informed agency decisionmaking.”).

[14] 84 FR 69664.

[15] Id. at 69668. 

[16] Final Capital Rule at II.B.2.b. (“The Commission does not have the benefit of . . . comprehensive data regarding the multiplier for the uncleared swaps risk margin amount at this time.”)

[17] Id.

[18] Id.

[19] Id.

[20] See Texas v. United States EPA, 389 F.Supp. 3d. 497, 505 (S.D. Tex. 2019) (“The APA does not envision requiring interested parties to parse through such vague references like tea leaves to discern an agency’s regulatory intent regarding such significant changes to a final rule”).

[21] Press Release Number 8188-20, CFTC, CFTC Approves Two Final Rules and Two Proposed Rules at June 25 Open Meeting (June 25, 2020), https://www.cftc.gov/PressRoom/PressReleases/8188-20.

[22] Regulation Automated Trading, 81 FR 85333 (proposed Nov. 25, 2016).

[23] Electronic Trading Risk Principles (proposed Jun. 25, 2020), at I.B.

[24] Statement of Dissent of Commissioner Rostin Behnam, Capital Requirements of Swap Dealers and Major Swap Participants (Dec. 10, 2019), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement121019.

[25] See Rostin Behnam, Commissioner, CFTC, The Dodd-Frank Inflection Point: Building on Derivatives Reform, Remarks of CFTC Commissioner Rostin Behnam at the Georgetown Center for Financial Markets and Policy (Nov. 14, 2017), https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam.

[26] G20, Leaders’ Statement, Framework for Strong, Sustainable and Balanced Growth, The Pittsburgh Summit (September 24-25 2009), http://www.g20.utoronto.ca/2009/2009communique0925.html (“We committed to act together to raise capital standards…”). 

[27] Heath P. Tarbert, Chairman, CFTC, Statement of Chairman Heath P. Tarbert Before the December 10, 2019 Open Meeting (Dec. 10, 2019), https://www.cftc.gov/PressRoom/SpeechesTestimony/tarbertstatement121019.

[28] Id.

Today, for the first time, the Commission adopts capital requirements for non-bank swap dealers (“Final Rule”).  This is the last major swap dealer regulation required under the Dodd-Frank Act.  The Dodd-Frank Act specified that the swap dealer capital requirement “shall—(i) help ensure the safety and soundness of the swap dealer or major swap participant; and (ii) be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.”[1]

Unfortunately, there is no rational basis to conclude that the minimum capital requirements in the Final Rule meet those standards and serve their intended purpose.  The Final Rule is not based on quantitative analysis of data or the appropriate level of capital for the risks presented by a swap dealer.  Rather, it appears to be designed with the objective of ensuring that most dealers will not need to raise more capital.  In its consideration of costs and benefits, the Commission concludes that, depending on the type of swap dealer, “the likelihood of . . . needing to raise additional capital due to this rule might be low,” “may not be significant,” or “that their tangible net worth greatly exceeds the Commission’s requirement.”[2]  For this reason, I dissent.

No Rational Basis to Conclude that Minimum Capital Levels are Appropriate

The Final Rule permits swap dealers, depending on their characteristics, to select one of three different approaches to calculate their minimum capital requirements.  The approaches are identified as the: (1) “Net Liquid Assets Capital Approach,” (2) “Bank-Based Capital Approach,” and (3) “Tangible Net Worth Capital Approach.”  The first two approaches are based on existing CFTC, Securities and Exchange Commission (“SEC”), and Federal Reserve capital requirements for futures commission merchants (“FCMs”), securities broker-dealers (“BDs”), and banks.  The third approach is designed to accommodate commercial swap dealers whose capital is normally in the form of physical assets. 

These methods are based on existing holistic, all-enterprise capital approaches that take into account a broad spectrum of risks.  They are not necessarily suited to the swap dealers subject to the CFTC capital requirements, which are mostly stand-alone legal entities for swap dealing.  Accordingly, it is not clear that these methodologies will generate capital requirements that are “appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.”[3]  However, using those precedents has some advantages in that it allows the different types of swap dealers to manage capital using known structures.  While these historical approaches were not specifically designed to be able to meet the statutory standard, it may be possible to achieve the intended outcome using these structures if the specific methods, limits, and other factors had been developed based on the swap dealer specific standard.  Unfortunately, this did not happen.

In December 2016, the Commission issued a re-proposal of the previously proposed capital regulations (“2016 Re-Proposal”)[4] that contained minimum capital requirements in each approach that were largely based on existing levels for FCM capital requirements.  The 2016 Re-Proposal included cleared and uncleared swaps and uncleared security-based swaps in the calculation of the minimum requirements.     

Commenters objected that the 2016 Re-Proposal was too costly and burdensome.  At the end of last year the Commission, by a 3-2 vote, issued a second re-proposal (“2019 Second Re-Proposal”) consisting  of over 140 mostly open-ended questions designed to invite comments supporting reduced minimum capital requirements or otherwise lower the costs for swap dealers to comply.[5]

Not surprisingly, the Final Rule adopts numerous provisions that are weaker than the 2016 Re-Proposal.  The preamble to the Final Rule identifies “lower capital charges,” “harmonization,” and consistency with “historical” precedent as rationales for these provisions. 

While the Commission makes conclusory statements that the rule helps “ensure the safety and soundness” of the swap dealers, there is little or no analysis supporting these assertions.  Similarly, there is no analysis as to how or why these capital levels are “appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.”

The capital requirements for dually-registered FCM/BDs that are also swap dealers illustrate how this approach leads to arbitrary results from a risk-based perspective.  Under the 2016 Re-Proposal, in addition to capital required to be held for non-swap activity, the FCM/BD swap dealer would be required to hold capital equal to a minimum of 8% of initial margin for uncleared swaps, security-based swaps, and certain futures positions of the swap dealer.  As explained in the 2016 Re-Proposal, the 8% multiplier level is drawn from the Commission’s experience with its risk-based capital requirements for FCMs.[6] 

Based on comments received on the prior proposals, and on the desire to “harmonize” with the SEC, the Final Rule lowers the capital add-on multiplier level to 2%, and only applies the multiplier to uncleared swaps initial margin.[7]  Security-based swaps are not included in the calculation based on the rationale that only swaps are within the CFTC’s jurisdiction.  If the entity is also registered with the SEC and the SEC’s capital requirements are greater than the CFTC’s, then the entity can use the SEC’s requirement with no add-on for uncleared swaps.  The Commission makes these changes not based on any analysis of the risk to the registrant, but because this approach “maintains a consistency with the long-standing historical approach that the Commission and SEC have followed with respect to dually-registered FCM/BDs.”[8]

The following example shows how this approach can result in an arbitrary outcome from a risk perspective.  Under the Final Rule, if the amount of uncleared swap margin for an FCM that is not a BD is $1 billion, multiplying that amount by 2% yields a minimum capital add-on of $20 million.  Similarly, under the SEC’s capital rule, for a securities-based swap dealer that is not an FCM with $1 billion of required margin for uncleared security-based swaps, a 2% add-on would be $20 million.[9]  Now, let’s consider the add-on for a dually-registered FCM/BD.  Each of the CFTC and SEC capital rules individually require that the minimum capital requirements include capital based on either the uncleared swap positions or the uncleared security-based swap positions, respectively, but not the aggregate of both types of positions.  A dually-registered firm with the same aggregate risk margin amount of $1 billion, but split half to swaps and half to security-based swaps, would be required to reserve $10 million ($500 million * 2%).   Thus, the dually-registered firm with a total initial margin requirement of $1 billion held for a portfolio split evenly between swaps and security-based swaps would be required to reserve only half the capital required for the same amount of initial margin held for a portfolio that was either all swaps or all security-based swaps.  For such dually-registered firms, the amount of capital required to be held may ultimately be based on irrelevant and arbitrary considerations of “historical precedent” and agency jurisdiction rather than swap risk-based calculations.

Financial Data and Monitoring Capital Sufficiency

The capital requirements for swap dealers are one of the most complex and highly technical areas in our regulations.  The swap dealers subject to the CFTC capital requirements vary significantly and include (i) very large FCMs and/or BDs registered with the CFTC and the SEC; (ii) U.S. and foreign affiliates of banking organizations; (iii) large commercial enterprises and affiliates thereof; and (iv) other financial companies that are not affiliated with banks.  Each grouping has unique capital structures.  Furthermore, there was little available quantitative financial accounting data for the swap activities of these entities to calibrate the appropriate levels of capital.  Given this complex and technical backdrop, the Final Rule notes in several places that the Commission will gather and analyze the new financial reporting data now required under the rule and may reassess components of the rule to determine whether it needs to be amended to be better fit for purpose.  I strongly support that effort and will follow this monitoring and analysis closely.

Substituted Compliance for Capital Requirements

Under the Final Rule, swap dealers organized and domiciled outside of the United States, including many subsidiaries of U.S. firms, can satisfy the capital requirements by complying with the capital requirements of the country of their domicile if the Commission grants substituted compliance.  The methods and standards for such a determination are similar to those to be established in the final cross-border swap regulations scheduled for consideration by the Commission tomorrow.  Unfortunately, those methods and standards are substantively weaker than the standards currently used by the Commission and may result in outsourcing swap dealer capital oversight to other jurisdictions where not appropriate.

Conclusion

Notwithstanding my dissent, I want to once again acknowledge the complexity and highly technical nature of the capital requirements.  Given these difficulties, I would like to recognize the hard-working staff of the CFTC for their efforts in fashioning the Final Rule.  Some of you spent many a late night addressing comments and questions and revising the rule release.  While I cannot support the outcome, I nonetheless appreciate and thank you for the dedication you bring to your work here at the CFTC.

Unfortunately, the rule the Commission will be adopting today is simply an affirmation of the status quo.  This is not what Congress intended when it directed the CFTC to adopt capital requirements “appropriate for the risk” presented by uncleared swap activities of swap dealers.  For this reason, I dissent.

Ten years and one day ago, the Dodd-Frank Act Wall Street Reform and Consumer Protection Act was enacted.  I am proud to vote for today’s final rule which, in my view, is the capstone of the Commodity Futures Trading Commission’s (CFTC or Commission) work to appropriately calibrate the post-crisis reforms.  Capital ensures that firms are able to continue to operate during times of economic and financial stress by providing an adequate cushion to protect them from losses.  Just as important as the safety and soundness of individual firms, capital is designed to give the marketplace confidence that any given firm has a high probability of surviving the next crisis.

But, capital requirements also create important incentives that drive market behavior.  The cost of capital may be the most determinative factor in a firm’s decision to remain, or become, a swap dealer (SD), or to continue to provide clearing services to clients, in the case of a futures commission merchant (FCM).  If capital costs are too expensive, firms will restrict certain business activities, end unprofitable business lines, or, in some cases, exit the swaps or futures markets altogether.  As a result, over time, the swaps and futures markets will become less liquid, less accessible to end users, more heavily concentrated, and less competitive. These are not the hallmarks of a healthy financial system.  This is why I have always regarded the finalization of capital requirements for SDs and FCMs to be the most consequential rulemaking of the post-crisis reforms.

I believe the final capital regulations for SDs and FCMs adopted today establish minimum capital requirements that will ensure the safety and soundness of these firms for years to come, through periods of economic growth and stability and through periods of market contraction and extreme volatility.  They are appropriately calibrated to the true risks posed by an SD’s or FCM’s business and ensure these firms have the capital necessary to support their active participation in the markets and servicing of clients.  They are also largely harmonized with the capital approaches of the prudential regulators and the Securities and Exchange Commission (SEC), which should reduce unnecessary burdens and facilitate compliance.

No rule is perfect.  I expect there will be aspects of this rule that need to be revised or recalibrated in the future–and I specifically discuss some areas below which I would like to see revisited.  Nevertheless, it is a common saying that you cannot build a great house without a solid foundation.  I am confident that today’s capital regulations provide that foundation and will support vibrant, healthy derivatives markets, with future Commissions able to build upon this progress in the years to come.  I would like to highlight a few aspects of the final rule below.

The risk margin amount.  We heard from many commenters that, of all the alternatives, the proposed eight percent risk margin amount would act not as a capital floor as intended, but rather as the primary driver of firms’ capital requirements and as a potential binding constraint on their businesses.  The final rule appropriately recalibrates the scope of products included in this calculation, while also adopting a risk margin amount percentage that is appropriately tailored to the capital approach elected by the firm.  Specifically, the final rule maintains the existing minimum capital requirements for standalone FCMs, with those firms continuing to maintain minimum capital equal to or greater than 8% of the risk margin amount for customer futures and cleared swaps.  For FCM-SDs, the final rule establishes a minimum capital requirement equal to or greater than (i) 8% of the risk margin amount for customer futures and cleared swaps, plus (ii) 2% of the risk margin amount for the FCM-SD’s uncleared swaps.  For non-FCM SDs that elect the Net Liquid Assets Approach, the Final Rule requires the firm to maintain minimum capital equal to or greater than 2% of the SD’s uncleared swap margin.  For non-FCM SDs electing either the Bank-Based Approach or the Tentative Net Worth Approach, the final rule establishes a minimum capital requirement equal to or greater than 8% of the firm’s uncleared swap margin.  For the reasons discussed below, I believe each of these adjustments from the proposal represents an improvement that more precisely tailors the capital requirements of a firm to its particular business and its selected capital approach.

I support the removal of a firm’s cleared and uncleared security-based swaps (SBS) from the risk margin amount calculation.  It is appropriate that the Commission maintain its historical approach and establish minimum capital requirements for registrants that are based upon products within the CFTC’s jurisdiction.  I am also very pleased that proprietary cleared futures and swaps were removed from the risk margin amount.  FCMs, FCM-SDs, and SDs electing the Net Liquid Assets Approach are all subject to rigorous market and credit risk capital charges on these proprietary cleared positions.  I believe these capital charges adequately account for the risk of these positions and there is no reason to account for them yet again in the firm’s minimum capital requirement.  Moreover, for SDs that elect one of the other capital approaches, I also believe it is appropriate to exclude proprietary cleared positions given that the SD’s credit exposure on such positions is limited to either a clearing organization or to the FCM that carries the SD’s account.

Finally, I also support the reduced 2% risk margin multiplier amount on uncleared swap margin for FCMs, FCM-SDs, and SDs electing the Net Liquid Assets Approach, while maintaining the 8% multiplier for other types of standalone SDs.  Under the FCM capital rules and the Net Liquid Assets Capital Approach for standalone SDs, the types of capital that may be used to meet a firm’s minimum capital requirement are significantly more conservative than the types of capital that may be used under the Bank-Based Capital Approach and the Tangible Net Worth Capital Approach.  The Net Liquid Assets Approach is liquidity-focused and generally requires the firm to hold at least one dollar of highly liquid assets for each dollar of the firm’s liabilities. As a result, when computing what qualifies as eligible capital under this approach, firms must subtract all illiquid assets, such as fixed assets and intangible assets.  In contrast, the other capital approaches focus on the solvency of the firm and require the firms to maintain positive balance sheet equity.  Under these approaches, firms are not required to subtract illiquid assets or fixed assets from their balance sheet equity.  Given the significantly more restrictive standard for qualifying eligible capital under the Net Liquid Assets Approach, I think it is appropriate to lower the risk margin multiplier to 2% in order to minimize competitive disparities across the other two capital approaches.

The final rule also expresses the Commission’s ongoing commitment to monitor, and if necessary, adjust, the risk margin percentage.  This should only be done, however, with a wealth of data and a highly robust economic analysis. With the benefit of the financial reporting the Commission will soon receive from SDs, the Commission may be able to further refine this metric to promote consistency across the possible SD capital approaches.

Bank-based capital approach.  In response to commenters, the final rule now permits firms to use a combination of common equity tier 1, additional tier 1, and tier 2 capital to meet its minimum capital requirements under both the 8% of risk-weighted assets and 8% of uncleared swap margin alternatives.  In particular, with respect to the 8% of uncleared swap margin alternative, the rule does not limit the amounts of additional tier 1 or tier 2 capital the firm can use to meet the requirement.  Because of this additional flexibility, the final rule requires firms electing this approach to satisfy all of the four possible minimum capital alternatives.  The Commission will need to closely observe the impact of this change to ensure it does not create any competitive disadvantages for firms electing this approach.  I anticipate that if additional data and analysis shows this outcome creates unintended consequences, the Commission will take action to address them.

Model approval process.  I am also pleased with the model approval process established in the final rule, which allows the Commission to realize the benefits of the NFA’s considerable expertise and resources.  Once the Commission, or the Director of the Division of Swap Dealer and Intermediary Oversight (DSIO) pursuant to delegated authority, makes a determination that the NFA’s model review process is comparable to the Commission’s process, the NFA’s approval of a model will satisfy the Commission’s model approval requirement.  In addition, for a firm utilizing a model that has already been approved by its relevant regulator, the final rule provides a process whereby, upon making certain representations, the firm can continue to use the model pending approval by the Commission or NFA.  These steps help ensure that firms seeking to use models will be able to do so by the rule’s compliance date.

Areas for further improvement.

As I noted above, no rule is perfect.  I would like to briefly highlight three areas not addressed in this final rule that I hope the Commission will address in the future.

Standardized market risk capital charges.  First, this final rule does not adjust any of the standardized market risk charges under Regulation 1.17.  I believe that many of these standardized charges are too high given the liquidity and actual risks of the product.  For example, the final rule applies a 20% notional standardized market risk charge on uncleared foreign exchange non-deliverable forwards.  In contrast, the Commission’s uncleared margin rules apply a 6% notional charge on these products for purposes of the standardized initial margin calculation.  I hope that in the future the Commission can work with the SEC to recalibrate and update these charges to better reflect the risks of the underlying products.

Alternative forms of collateral.  Second, I hope that with the benefit of experience and information received from financial reporting, the Commission will consider modifying its rules to recognize alternative forms of collateral, such as letters of credit or liens, provided by commercial end users that are exempt from clearing and margin requirements when computing credit risk charges.  Alternative collateral arrangements are frequently used by SDs in commodity derivatives transactions with end users to create “right way” risk and can be effective means of managing the credit risk of certain derivatives transactions.  I think it would be beneficial for the Commission’s capital regime to recognize, as appropriate, the risk-reducing nature of these arrangements.

Net liquid assets approach.  Third, I am also interested in continuing to explore commenters’ suggestion that firms electing the Net Liquid Assets Approach be required to maintain tentative net capital in excess of the risk margin amount, as opposed to the current net capital requirement.  I continue to have concerns that in periods of high volatility, the procyclicality of increasing margin requirements may cause unnecessary stress on these firms, as their capital charges for positions increase at the same time as their minimum capital requirement.  I am interested in looking at possible adjustments that could be made to address this issue.

In closing, I believe the capital regime adopted today strikes the necessary balance between capital levels that protect firms from losses on certain products, and levels that allow firms to earn an economic benefit from servicing their customers’ risk management needs through those products.  There is a direct tradeoff between the amount of capital regulators require firms to hold to ensure firms’ resilience and viability, and the amount of available capital firms have to deploy in financial markets to support the market’s ongoing liquidity and health.  The capital standards adopted today protect the safety and soundness of firms, while ensuring they can continue to service their clients and make markets.

I would also like to thank DSIO, in particular Tom Smith, for their thoughtfulness and tireless dedication to getting this rule right.  It has truly been a pleasure to work with and learn from you throughout this process.

Ten years ago yesterday, President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).  Drafted in the midst of the most severe financial crisis and economic recession since the 1930s, the Dodd-Frank Act created a new, comprehensive framework for regulating swap markets.  The absence of swap market regulation and transparency had helped to cause the crisis.  Over the past decade, the CFTC has worked diligently to develop regulations to implement the Dodd-Frank framework.

We have made much progress.  Today, our derivatives markets are stronger and more resilient as a result of the CFTC’s regulations, as well as their effective implementation by many market participants.

Unfortunately, our progress is now threatened.  Today, the Commission is considering the first of three major rules that will address—and in one case, re-address—core Dodd-Frank Act requirements.  These new rules will not provide the protections Congress intended.  Rather, they are designed to either confirm the status quo or cut back existing protections.  There is never a good time to weaken good financial regulations; it is particularly bad timing to do it in the middle of a pandemic that poses clear and present dangers to the economy.

Financial markets are currently facing their greatest challenges since the 2008 crisis.  The Covid-19 pandemic has wreaked havoc on American businesses and households.  Nearly 18 million Americans are unemployed.[1]  Companies in sectors as diverse as restaurants, auto rentals, clothing, dairy, and energy have filed for bankruptcy.  Businesses in many other industries such as travel, transportation, and recreation are severely threatened.  Over the past few months the derivatives markets have experienced unprecedented volatility and price extremes.

Although it would be premature to declare success with respect to the current crisis, so far, despite bankruptcies, volatility, and uncertainty, the derivative markets have continued to perform their essential functions.  American companies have been able to rely on and have confidence in the integrity of derivatives markets to manage the extraordinary risks arising from the pandemic.  During these volatile markets, high levels of swap clearing and reporting have facilitated market confidence and price discovery.

The safeguards that Congress and the CFTC have built into the markets over the past ten years have made our markets stronger today.  Banks are better capitalized due to increased capital requirements.  Swap markets are more robust due to the clearing mandate, margin requirements, and other new rules for uncleared swaps.  The trade execution mandate and real-time public reporting requirements have increased swap market efficiency and transparency for buy-side firms.  Regulatory swap data reporting provides critical data to regulators.  Our cross-border guidance has controlled risk coming into the U.S. from swap activities overseas.

The three new rulemakings that will soon be voted on by the Commission will jeopardize this progress.  Today, the Commission will vote on a final rule claiming to implement the Dodd-Frank Act’s mandate that the CFTC impose capital requirements upon swap dealers and major swap participants that are not subject to a prudential regulator.  Tomorrow, the CFTC will consider a rule governing how the CFTC’s swap regulations apply to cross-border swap activity.  And third, the CFTC staff is working to finalize a new position limits rule covering swaps for the first time, as required by Congress.

In their current form, these three rulemakings suffer from a common deregulatory bias that is inconsistent with Congressional directives in the Dodd-Frank Act.  They reflect an overarching determination to ensure that the CFTC’s rules will impose only minor, if any, costs upon the financial industry, and will not require any significant changes to existing industry practices.  The proposals reflect excessive deference to industry self-regulatory bodies and foreign regulators.  They acquiesce to industry requests to roll back existing requirements.

The final swap dealer capital rules we will consider today are not based upon the risks of uncleared swaps, as the law requires, but rather are based on existing capital requirements for futures commission merchants and banks.  The Commission acknowledges that there will be little or no need for most affected swap dealers to raise new capital under this rule.

The cross-border rules we will consider tomorrow will permit U.S. banks and other swap dealers to avoid the CFTC’s rules by booking their swaps in affiliates overseas, while still negotiating the swaps in the U.S. and placing all the risk at their U.S. parents.  At the same time, these rules will expand the ability of foreign banks to operate in the U.S. and pose risks to U.S. markets while avoiding CFTC regulation of those activities.

The proposed position limits rules would allow much more speculation in our commodity markets, without effective limits.  We have repeatedly seen how speculative activity can destabilize commodity derivatives markets.  The proposed rule would increase current limits, which have worked well over the decades, to accommodate this type of harmful activity.

The desire of the agency’s majority is apparent.  Last week the Financial Times, based on an interview with the Chairman, characterized the Commission’s upcoming agenda as “several new rules that would move the CFTC back from the aggressive regulatory positions staked out by [the Chairman’s] Democratic predecessors under the Obama administration.”[2]  “We’ve pared back our extraterritorial application of our swap dealer regime,” the Chairman is quoted as saying.[3]  The Financial Times also quoted the Chairman as stating that the financial industry has been “yearning for” the regulations the agency will be considering.[4]

A global pandemic is no time to weaken our financial regulations.  Rather, we must work to ensure that our financial markets remain at least as robust and resilient as they have been over the previous decade in order to successfully meet the challenges of tomorrow and the next decade.

Questions and concerns about the COVID-19 virus have rightfully dominated headlines and pervaded our daily conversations dating back to the first weeks of this year when there were still so many unknowns. How severe was it going to be? Why are some people impacted more than others when they are infected? How exactly does it spread? And, of course, when will we be able to resume normal life? What will the new “normal” be? We may not know the precise answers to many of these questions until well after the pandemic has passed.  But, in the meantime, the rapid, exponential spread of the virus seemingly evades a complete understanding of how we can address and mitigate the risk it poses to the population in the near and long term. 

Over the next 24 hours, the CFTC will consider two major rules that target the heart of post-2008 financial crisis reform.  Unlike our limited understanding of the transmission of the COVID-19 virus, we do have the benefit of hindsight in understanding how risk spreads in global swap markets.  The 2008 financial crisis made clear that, in many cases, risk deriving from activities in non-US jurisdictions can seamlessly enter, embed in, and infect U.S. markets.[1] We also understand that undercapitalization greatly increases the impact of economic shocks.  Yesterday marked ten years since Congress passed Wall Street reform,[2] a swift legislative response to the financial crisis and ensuing Great Recession, which wreaked havoc on Main Street America and the global economy in large part because of undercapitalized financial institutions.  We must keep these hard-learned lessons top of mind as we refine the tools we use to prevent another crisis of that magnitude.  Some may suggest that our efforts over the next 24 hours will finally close a decade long chapter on financial reform.  However, we must not forget that although timing matters, substance equally matters: how we do things is as important as when we do things.

This afternoon, the Commission is voting on a final rule that establishes minimum capital requirements for swap dealers (“SDs”) and major swap participants (“MSPs”) who are not subject to a prudential regulator.  Although the rule under consideration this afternoon is the first time the Commission will be voting on a final rule for capital requirements, as clearly prescribed by Dodd-Frank, there have been multiple iterations of a capital rule dating back to 2011.[3] 

Congress’s 2010 response largely incorporated the international financial reform initiatives for over-the-counter derivatives laid out at the 2009 G20 Pittsburgh Summit aimed at improving transparency, mitigating systemic risk, and protecting against market abuse.[4]  One of the major initiatives in the G20 statement was the imposition of higher capital requirements, “To make sure our regulatory system for banks and other financial firms reins in the excesses that led to the crisis.”[5]  To rein in those excesses, the G20 leaders agreed to raise capital standards.[6]  The G20 leaders said unequivocally that, for over-the-counter derivatives markets, “[n]on-centrally cleared contracts should be subject to higher capital requirements.”[7]  There is no question that Congress had this same goal in mind when enacting the Dodd-Frank Act a decade ago.[8] 

Tomorrow morning, the Commission will vote on a separate rule that reduces our ability to exercise jurisdiction over cross-border activities that have a “direct and significant” connection to activities in U.S. markets.  In 2013, the Commission issued interpretive guidance and a policy statement to address the extraterritorial application of the Title VII Rules,[9] which has achieved the goals set out by both Congress and the CFTC.  In the wake of the financial crisis, Congress entrusted the CFTC with overseeing all swap activities that have a direct and significant connection to or effect on U.S. markets, and we must not abdicate this Congressionally-mandated responsibility.

Last December, the Commission voted to propose to discard the existing Guidance -- and the use of agency guidance and non-binding policy statements altogether -- in favor of rules implementing a purely risk-based approach.[10]  Focusing our expertise and resources on those entities which individually may pose systemic risk to U.S. markets means that many other entities that are smaller in relative size, yet able to generate and transmit significant risk, can evade oversight, and may ultimately carry risk into U.S. markets.  Regardless of their size, such entities can individually or in the aggregate affect and negatively impact U.S. financial markets. Just as the least restrictive parts of the country directly impact how rapidly COVID-19 spreads in the rest of the U.S., so too will the jurisdictions with the least regulatory oversight of swap markets directly impact the riskiness of U.S. markets.

As we collectively work to navigate and resolve a global pandemic that has harmed both the U.S. and global economies, it is more important than ever that we, as financial regulators, remember what we learned from the 2008 crisis, and remain steadfast in our support and advocacy for robust reforms; these reforms shielded our markets during the worst of market volatility of the Covid-19 pandemic, and will certainly do the same in the future.  

I am grateful for the work that staff did to prepare these rules, and I look forward to hearing more from the teams.

[1] See Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swaps Regulations, 78 FR 45292, 45293-5 (Jul. 26, 2013) (the “Guidance”); SIFMA v. CFTC, 67 F.Supp.3d 373, 387-88 (D.D.C. 2014)(describing the “several poster children for the 2008 financial crisis” that demonstrate the impact that overseas over-the-counter derivatives swaps trading can have on a U.S. parent corporation).

[2] The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).

[3] See Capital Requirements of Swap Dealers and Major Swap Participants, 76 FR 27802 (proposed May 12, 2011).

[4] G20, Leaders’ Statement, The Pittsburgh Summit (Sept. 24-25, 2009), available at https://www.oecd.org/g20/summits/pittsburgh/.

[5] Id. at 2.

[6] Id.

[7] Id. at 9.

[8] See Statement of Sen. Christopher Dodd, Cong. Rec., Vol. 156, Issue 104, S5828, S5832 (July 14, 2010) (“Derivatives are vitally important if utilized properly in terms of wealth creation and growing an economy.  But what was once a way for companies to hedge against sudden price shocks has become a profit center in and of itself, and it can be a dangerous one as well, when dealers and other large market participants don’t hold enough capital to back up their risky bets and regulators don’t have information about where the risks lie.”).

[9] Guidance, 78 FR at 45297.

[10] Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to Swap Dealers and Major Swap Participants, 85 FR 952 (proposed Jan. 8, 2020).

Thank you Mr. Chairman for bringing the Commission together, albeit remotely, for both today and tomorrow’s open meetings.  I also want to express my gratitude for the hard work and dedication of the staff of the Division of Swap Dealer and Intermediary Oversight (DSIO), Office of General Counsel, and Office of the Chief Economist for the final capital rule before us.

Capital remains the last substantive Dodd-Frank Act rulemaking yet to be finalized by the CFTC.  When we last met on the question of capital in December, I spoke of the importance of regulatory certainty for Swap Dealers.  Today’s action will enable Swap Dealers to more comprehensively ascertain the cost of operating this business.  While I believe that adequate regulatory capital for Swap Dealers is an important component of the post-crisis reforms, the development of capital rules involves difficult questions to be answered and complicated decisions to be made.  Robust capital obligations are reasonably considered to increase the safety and soundness of the system, but we must ensure that such requirements do not deteriorate the availability of counterparties and liquidity required for well-functioning markets.  The benefit of capital requirements must be balanced to prevent disproportionate unfavorable impacts on the very markets we are attempting to protect.

Only time will serve as the judge of our actions today.  The preamble speaks to how the Commission will continually monitor and evaluate the final rule and make fact-based assessments about the efficacy of today’s action.  As I have repeatedly stated, this sort of lookback is prudent because the markets we regulate are dynamic.  Therefore, the rules we adopt will require ongoing review and possible adjustments.

This rule making is by no means simple.  The length of time it took us to get here, breadth and depth of comments received, and hard work by Commission staff is a testament to the difficult path.  Last summer, in what seems to be a lifetime ago, I provided remarks titled “The Law Is Our Authority and Common Sense Our Judge”[1] centered on Thomas Paine’s Common Sense pamphlet.[2] While much has changed since then, I felt a return to the principle of applying common sense when considering how to approach the final version of the rulemaking on capital was appropriate.  Instead of focusing on any imperfections that remain, I prefer to instead target the logical choices below concerning capital that I am happy to support based on common sense.

1. The Commission acted appropriately in re-opening the comment period last year to allow for market participants to update their views based on developments since the 2016 CFTC proposal and improve the end product.  As a result, the Commission considered the actions taken by our fellow regulators, especially the SEC finalizing their capital and financial reporting rules in the interim, concerning capital and adopting their lessons learned and harmonizing where appropriate.  Re-opening the comment period provided us with an opportunity to rethink our approach to capital and allowed us to be more consistent with what other regulators had accomplished.
2.  It is worthwhile to frame today’s capital conversation appropriately by reminding ourselves that we are setting policy for the 55 Swap Dealers that are subject to the Commission’s jurisdiction for capital, 40% of which are non-US financial entities.  The other 57 CFTC-registered Swap Dealers are prudentially regulated when it comes to capital requirements.  It is reasonable to provide three different alternatives for entities to choose from based on their operations and balance sheets rather than a one-size fits all approach.

• First, for the largest swap dealers expected to adopt the Bank Based Approach, based upon the Federal Reserve Board’s capital requirements, the rule will ultimately retain the proposed maintenance of minimum capital equal to or greater than 8% of the initial margin amount associated with uncleared swaps.  In addition, these SDs will also be required to meet an 8% of risk weighted assets component, an amount established by the Registered Futures Association, and a $20 million floor, but each of the components have been adjusted to permit different compositions of capital as defined under banking rules.  The importance of these institutions to the vitality of the financial system makes it understandable to require this robust amount of capital
• Second, for other swap dealers applying the Net Liquid Asset Approach, the Commission is adjusting the requirement to 2% of initial margin to address concerns the approach may over-account for market and credit risk and thereby place these Swap Dealers at a competitive disadvantage.  This approach also better aligns with that required for similarly situated dealers registered with the SEC.  For those Swap Dealers dually registered as FCMs, this 2% multiplier will function as an add-on to already existing requirements for these firms.
• Third, for Swap Dealers that are predominantly engaged in non-financial activities, the rule applies a Tangible Net Worth approach, and allows firms to apply the proposed commercial activity test at the parent level, thus potentially making more commodity firms eligible for this treatment.  It is a measured resolution to facilitate commodity based swap dealers adopting a more tailored and nuanced approach for their activities, commensurate to the key function they serve in providing valuable production and hedging avenues in the real economy, consisting of physical goods and products.

3. The rule also tailors the types of positions included within the margin amount, which is used as a minimum component across each of the elective approaches, to remove all security based swaps, cleared proprietary futures, cleared foreign futures, and cleared swaps since those products are either overseen by fellow regulators or are subject to requirements imposed on central counterparties and their clearing members to decrease bilateral credit risk.
4. The Commission is showing flexibility by deferring the financial reporting to previously existing formats, such as utilizing SEC financial reporting forms or other types of financial reporting already employed by the Swap Dealer, rather than forcing entities to adopt a prescriptive, CFTC-unique reporting schema.  As a result, Swap Dealers will be able to leverage existing financial reporting to meet these obligations rather than incurring more costs and resources to comply.
5. Allowing swap dealers to continue to use models already reviewed and approved for capital by the SEC, a prudential regulator, a foreign regulatory authority in a jurisdiction that the Commission has found to be eligible for substituted compliance, or a foreign regulatory authority whose capital adequacy requirements are consistent with the capital requirements issued by the Basel Committee on Banking Supervision demonstrates recognition of prior work by swap dealers and respects the work of the international regulatory process.  At the same time, it is also logical for a registered futures association to play a role in reviewing and approving models.
6. Equally important is a transparent and reasonable schedule for the implementation of capital requirements.   Businesses need accurate and timely information to make sound decisions and plan for the allocation of resources.  While not providing as much time as some commenters requested, harmonization with the SEC’s implementation schedule to allow for dually-registered entities to prepare more efficiently and not cause a competitive disadvantage or regulatory arbitrage makes sense.

It is these last two topics, model approval and implementation, that I wish to address a bit further as we project the next steps in this process.  Even though I am satisfied as to where this final rule has arrived and pleased to finalize this portion of the CFTC’s post-financial crisis mandate, the work of a regulator is never done.

First, I wish to focus on the model approvals to be conducted by the National Futures Association.  While the final rule makes considerable improvements to better prioritize the approval process for covered Swap Dealer’s internal models, there is a new, related element that warrants mention.  The rule establishes a Commission review process to ascertain the consistency of NFA’s approval process with that of the CFTC’s approval process.  The Commission will subsequently need to issue a determination that NFA approvals may serve as a means of alternative compliance to the CFTC’s own approval process.  Today, the Commission and the NFA are in constant communication to ensure our objectives are aligned and I hope we will be able to leverage that interaction in order for this process review to be done expeditiously.  Then the NFA personnel can focus on the task at hand – reviewing models on an implementation timeline that though improved, remains ambitious.

Second, I previously spoke of my hope that the reopening of the comment period last December would provide insight into properly determining a compliance date with the incorporation of substituted compliance considerations.  While the October 2021 deadline is reasonable and harmonizes with implementation of the SEC’s capital rule, I want to emphasize the importance of attention to substituted compliance determinations as this date is already fast approaching.  Achieving substituted compliance for capital adequacy and financial reporting by operating in a jurisdiction deemed comparable would have a material impact on regulated Swap Dealers, but this must be achieved well in advance of the compliance date.  DSIO has worked tirelessly on this and other significant rules and I hope that they will be able to turn their energy towards reviewing and recommending to the Commission whether it be appropriate to grant such comparability determinations.

Overall, I believe that many of the policy choices concerning capital are appropriate and I am happy to support today’s final rule on capital.  I again want to commend all the staff involved for their hard work to this endeavor.

Today the Division of Swap Dealer and Intermediary Oversight made presentations before the Commission and provided a good basis for subsequent Commission action on specific enhancements to the Uncleared Margin Rules.  I wish to thank the staff and my fellow Commissioners for working with me on those matters, and I hope we can continue to work together to address many of the other recommendations included in the report recently sent to the Commission from the Global Markets Advisory Committee.

I would like to say just a few words about why we need to thoughtfully consider some of the other recommendations from the recent report.  To be clear, I am not advocating for a roll-back of the uncleared margin regulations that are today applied to large financial institutions engaged in swap transactions with one another.  Rather, as these regulations are just now being applied to a new set of financial end users, we have a responsibility to ensure they are fit for that purpose. 

Title VII of the Dodd-Frank Act dealt with many complex provisions and major changes to the swap market structure.  Having been present for the development of the legislation in 2009 and 2010, my recollection is that the vast majority of the concepts debated prior to the passage of Dodd-Frank, at least those applicable to the derivatives markets, were broadly supported, and the bulk of the hand-wringing and consternation was limited to a few provisions, most of which centered on concerns from lawmakers about how the new requirements being necessarily applied to the largest banks would be extended to impact end users and whether that might present practical challenges. 

Here we are, ten years later, and some may be surprised that we continue to struggle with this.  But the reality is that only now are these uncleared margin provisions being phased in to apply to certain end users.  So it really should not come as a surprise that now is the time to thoughtfully consider whether rules designed to ensure the exchange of margin between the largest financial institutions need to be tailored to account for the exchange of margin in which one of the counterparties is an insurance provider, a pension plan manager, a mortgage service provider, or other type of end user.  The Global Markets Advisory Committee report recommends several actions beyond those we are considering today that the Commission should consider to address the unique challenges associated with the application of the uncleared margin regulations to end users – challenges that caused uneasiness in 2010 but are becoming more evident in 2020.

Today marks 10 years and a day since the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was signed into law.  Much has changed during the past decade—our derivatives markets today are faster, increasingly digital, and more deeply connected to the global economy than they were in 2010.  Yet amidst these changes, there has been at least one constant: the absence of capital requirements for swap dealers and major swap participants for which the CFTC is responsible.[1]  As a response to the credit crisis of 2008, Section 731 of the Dodd-Frank Act amended the Commodity Exchange Act (CEA), providing that the CFTC “shall adopt” capital and financial reporting requirements for these entities.[2]  It is high time to fulfill this mandate and close the book on our Dodd-Frank Act responsibilities.[3]  After all, “late” is always better than “too late.” 

There is another compelling reason to finalize a capital rule that is more than a decade in the making[4]: certainty.  One of our strategic goals as an agency is to enhance the regulatory experience for market participants at home and abroad.[5]  Certainty is the bedrock of this goal.  Our swap dealers cannot effectively plan for compliance without clarity from us about what their capital obligations will look like.  Today we lift this cloud of uncertainty by finalizing a capital rule that carefully accounts for the differences among our swap dealers.

The final capital rule is designed to enhance customer protection and reduce systemic risk in the financial system.  Capital requirements are the ultimate backstop, ensuring that customers are protected and the financial system remains sound in the event that all other measures fail.  While our uncleared margin rules have effectively absorbed the shocks of recent pandemic-driven volatility,[6] a capital regime will provide further assurances that our markets and their participants can weather new storms.

Determining Capital

The final capital rule requires swap dealers and major swap participants to maintain a level of minimum capital based on one of three basic approaches.  Each approach incorporates minimum amounts of capital based on various criteria, including a $20 million floor, a level of capital required by the National Futures Association, and the amount of margin on uncleared swap transactions.  The three basic approaches will be the focus of my remarks because they are effectively tailored to the distinctive type of swap dealer involved.

Regulatory Flexibility

Our derivatives markets are vibrant in large part because of the diversity of swap dealers and other market participants.  Of the 108 provisionally registered swap dealers, 56 will be subject to the capital requirements.  Of those, four are futures commission merchants that are dually registered with the SEC as broker-dealers and 12 are non-bank subsidiaries of bank holding companies.  Others are non-banks that deal in financial swaps involving interest rates, foreign currency, credit, and the like; still more are primarily engaged in agricultural and energy businesses; and several are subject to the laws and regulations of other countries. 

The final capital rule applies to entities with a variety of business structures, asset profiles, and risk levels.  For example, a swap dealer primarily involved in the energy business is fundamentally different from a large bank involved in financial swaps.  A “one-size-fits-all” approach would be incompatible with the rich gradations in our derivatives markets.  As a result, the final capital requirements offer regulatory flexibility by accounting for key differences among covered entities.  This flexible approach is designed to enhance the regulatory experience for our market participants[7] while safeguarding the markets, as more fully discussed below.

1. Capital Requirements for FCM Swap Dealers

The CFTC has longstanding capital requirements for Futures Commission Merchants (FCMs) to ensure customer funds are protected in the event of an FCM failure.[8]  The final rule preserves existing FCM capital rules for swap dealers that are also registered as FCMs, but makes a few key adjustments to better address risk and customer protection associated with dealing in swaps.

The final rule requires FCM swap dealers to maintain minimum capital equal to or greater than the sum of: (i) the current FCM risk margin amount of 8% of customer and noncustomer cleared futures, cleared foreign futures, and cleared swaps positions; and (ii) 2% of the total margin amount associated with uncleared swaps.  Security-based swaps are excluded from both margin amounts.  In addition, the final rule increases the $1 million minimum capital “floor” for FCMs to $20 million for FCM swap dealers.

These changes reflect sound policy.  In particular, excluding security-based swaps comports with the CFTC’s longstanding respect for the SEC’s jurisdiction over those products.  Moreover, excluding cleared swaps from the 2% risk margin amount brings our capital requirements in line with the lower credit risk posed by cleared products.  This approach is also consistent with the CFTC’s net capital requirement for Registered Foreign Exchange Dealers,[9] as well as the SEC’s capital rules for broker dealers.[10]

2. Capital Requirements for non-FCM Swap Dealers

Well-crafted rules must account for the differences among our market participants.  For swap dealers that are not FCMs, the final rule provides three methods of determining minimum capital that respond to their different business models, risk profiles, and capital structures.[11]   

a. The Net Liquid Assets Approach

Some swap dealers have responsibility for customer funds, such as those that are dually registered with the SEC as broker dealers.  For these swap dealers, capital requirements can advance customer protection where all else has failed, by providing a “cushion” for orderly liquidation.[12]  An effective cushion requires liquidity, which can be analogized to the readily available cash in one’s wallet.  Consistent with this analogy, swap dealers may select the Net Liquid Assets approach in the final rule—requiring them to maintain 2% of the margin amount associated with uncleared swaps—which we believe is sufficient to protect customer funds in the event of a liquidation.

The Net Liquid Assets approach is not only about customer protection: it also facilitates sensible harmonization with SEC capital requirements for dual registrants.  In doing so, the Net Liquid Assets approach supports the CFTC’s strategic goal of improving the regulatory experience for market participants.[13]

b. The Bank-Based Approach

Banks are the backbone of our financial system, and are subject to a specific statutory regime managed by the Federal Reserve Board and other federal banking regulators.  Banks—and by extension their non-bank swap dealer subsidiaries—naturally raise greater systemic risk concerns than other types of swap dealers.   

While the cash in one’s wallet is the appropriate analogy when thinking about capital as a measure of customer protection, the central role banks play in our financial system requires us to consider a much bigger picture.  For banks, capital must facilitate safety and soundness, ensuring that they act prudently.[14]  The personal finance analogy for assessing bank capital, therefore, is not just cash-in-wallet, but also savings accounts, checking accounts, retirement funds, and other assets.   

This broad view of bank capital as a window into solvency is designed to reduce overall risk in the financial system, advancing a strategic goal of the CFTC.[15]  As stated in the agency’s 2020-2024 Strategic Plan, “[t]aking steps to avoid systemic risk will not only protect market participants, but increase confidence in the soundness of U.S. derivatives markets.”[16]  Our bank-based capital approach is designed to meet this goal. 

Accordingly, swap dealers selecting the Bank-Based Approach may satisfy their capital requirements by retaining (i) 8% of risk-weighted assets (RWA), composed of at least 6.5% of tier 1 common equity (CET1), and (ii) 8% of their uncleared swap margin amount.  Requiring at least 6.5% of a swap dealer’s RWA to be composed of CET1—the highest-quality regulatory capital—addresses potential systemic risk by ensuring that available capital can immediately stem losses, avoiding financial contagion.  Second, the requirement that swap dealers electing the Bank-Based Approach must retain 8% of margin for uncleared swaps reflects the uniquely critical role they play in the financial system. 

c. The Tangible Net Worth Approach

Finally, some swap dealers are not financial entities, but rather commercial businesses engaged in the agriculture and energy sectors.  These swap dealers help American families put food on the table and gas in the car.  Unlike financial entities, their balance sheets often contain significant physical assets, such as oil refineries, grain warehouses, and even railroad rolling stock.  Net worth—inclusive of physical assets—is the appropriate measure to assess minimum capital for these commercial entities.  In extending our analogy, capital for these swap dealers must be inclusive not just of cash or retirement account holdings, but one’s house and car—the assets that could be pledged as collateral in borrowing.   

The final capital rule recognizes that commercial entities are fundamentally different from other swap dealers.  This is reflected in the Tangible Net Worth (TNW) approach, which sets minimum capital at 8% of the margin amount for uncleared swaps.  Eligibility for the TNW approach is determined at the consolidated parent level, which allows a financial subsidiary of a commercial entity that is registered as a swap dealer to elect the approach. 

3. Market and Credit Risk Models

In addition to capital requirements, today’s final rule makes important adjustments to the requirements that swap dealers must satisfy to rely on internal market and credit risk models rather than the standardized models provided in Regulation 1.17.  Like minimum capital requirements, market and credit risk models will be most effective when they reflect a swap dealer’s unique business and risk profile.  In addition, internal models specific to a swap dealer’s portfolio can provide a more nuanced view of risk than standardized models.  

That said, the final rule provides a certification process for swap dealers relying on internal market and credit risk models, ensuring flexibility while retaining oversight through the National Futures Association.  Permitting swap dealers to rely on bespoke models that best account for their particular situations is good governance and enhances the regulatory experience.[17]  At the same time, by subjecting those models to objective validation by the National Futures Association (and potentially other domestic and foreign regulators), there is a check on that flexibility.  Further, this approach makes the CFTC’s model approval process more closely aligned with the SEC and federal banking regulators.[18]   

Allowing swap dealers to rely on internal risk models is also an appropriate instance of principles-based regulation,[19] as prescriptive requirements that do not account for differences among firms simply cannot measure risk as accurately as internal models that account for key differences among swap dealers. 

4. Financial Reporting

Today’s final rule also adopts financial reporting, recordkeeping, and notification requirements for swap dealers and major swap participants.  These requirements include the obligation to provide financial statements and reports to the CFTC and the National Futures Association.  Most importantly, covered entities must alert us when there is undercapitalization, a books and records problem, and/or a specified triggering event, such as the failure to post required margin.  The rule also includes public reporting requirements for those swap dealers not subject to the jurisdiction of a banking regulator.

These reporting requirements should serve as early warning systems for systemic risk, allowing the CFTC to react quickly to emerging threats to financial stability.  At the same time, the reporting requirements are designed to harmonize, as appropriate, with existing financial reporting requirements for FCMs, bank swap dealers, and SEC-registered entities.  The final rule also eliminates weekly position reporting, which does not materially advance our ability to monitor systemic risk.  In short, balance is the touchstone of the financial reporting rules, allowing us to achieve greater insight into potential systemic risk without placing undue burdens on market participants.

5. Substituted Compliance

Last, our final rule today accounts for non-U.S. domiciled swap dealers by allowing them to petition the CFTC for substituted compliance in satisfaction of their capital and financial reporting requirements.  These swap dealers may seek a comparability determination based on the capital and financial reporting rules of their home jurisdictions, provided certain conditions are met.  In providing this option, the final rule supports international comity while enhancing the regulatory experience for market participants abroad.[20]

Conclusion

Today we mark a decade and a day following the enactment of the Dodd-Frank Act by completing the CFTC’s required rulemakings under Section 731.  The final capital rule is flexible and tailored, to accommodate the wide array of swap dealers that touch every corner of our markets.  The final rule is also long on customer protection and systemic risk mitigation, advancing the CFTC’s mission of promoting the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation.  After 10 years of hard work by CFTC staff, I am pleased to support the final rule and the long-awaited certainty it brings to our markets.  Given the current economic crisis the world faces in light of the continuing COVID-19 pandemic, we are fortunate to have a final rule that has come late, but not too late. 

Introduction

Good morning and thank you all for attending this Market Risk Advisory Committee (MRAC) meeting via teleconference.  I would especially like to thank Commissioner Behnam and his staff for convening this meeting.  I am also grateful to Alicia Lewis, the Designated Federal Officer for the MRAC, for organizing the meeting.  And of course, I must thank Nadia Zakir for serving as the MRAC Chair, and all the MRAC members for taking the time to share your valuable perspectives.

A number of important issues will be discussed this morning, including climate-related market risk, CCP risk and governance, market structure, and interest rate benchmark reform.  These are all important issues, and I look forward to the discussion. 

The meeting will also discuss the performance of the market during the early months of the COVID-19 pandemic in the United States.  This morning I want to say just a few words about market volatility during this time and the LIBOR transition.

Market Volatility During the Early Months of the Pandemic

We witnessed significant volatility in the derivative markets in the wake of the coronavirus pandemic, particularly during the early months.  For example, we saw a historic drop in the May futures contract for West Texas Intermediate Crude, which briefly traded at negative prices for the first time ever. 

Clearly, there were unique macroeconomic factors at play: a historically high supply of oil, a fight between Saudi Arabia and Russia for market share, and a simultaneous drop in demand that was unprecedented in both speed and severity due to the coronavirus.  The markets were digesting a lot of information and it happened to coincide with the expiration of a futures contract.  

The possibility of negative futures prices was not a surprise for the CFTC.  For weeks, we had been in regular contact with exchanges in anticipation of just such an event.  To help markets prepare, we issued a joint Staff Advisory to remind DCMs, FCMs, and DCOs of their responsibility to prepare for the prospect that certain contracts may continue to experience extreme market volatility, low liquidity, and possibly negative pricing. 

We have completed a detailed forensic study of the West Texas Intermediate crude oil price aberration on April 20th that led to negative oil prices and plan to make that report public this fall. The analysis points to a confluence of fundamental and technical reasons including a few market structure considerations that have not been previously highlighted that we will address to ensure that the price formation, price discovery, reliability and soundness of this important derivative market that serves our U.S. energy industry is further strengthened.

One of the most interesting things about the recent market volatility is how well the derivatives markets have performed.  Far from amplifying risk throughout the financial system, the derivatives markets have so far acted as shock absorbers.  Unlike during the 2008 financial crisis, derivatives have internalized the impact of market swings.   And while no one can predict the future, derivatives markets have been resilient in part because the CFTC has deployed tools to help prevent financial contagion. 

Over the past few months, the CFTC has been focused on responding to the tremendous impact of the COVID 19 pandemic on the markets we regulate.

First, the agency has continued to monitor closely and prioritize agricultural and energy markets.  As a just mentioned, we issued a joint Staff advisory on market volatility.

Second, we have issued additional targeted, temporary relief to market participants.  This includes relief to registrants listing new principals and to applicants for registration as associated persons from the requirement to submit a fingerprint card for those individuals.  I am proud of how the CFTC has risen to this occasion, acting on a bipartisan basis to approve more than a dozen temporary relief measures since this crisis began.

Third, we have also continued to bolster the CFTC’s customer education efforts.  Times such as these unfortunately create new opportunities for fraud, and we have increased our efforts to arm the public with information so they can detect and avoid these illegal schemes.

Finally, the CFTC’s advisory committees, including this one, have been hard at work and enabling our Commission to gain valuable insight from external stakeholders.

LIBOR Transition

Turning to the LIBOR transition, I am looking forward to the report by ARRC chairman Tom Wipf on the table top exercise conducted in June for the transition to SOFR.  Thank you to Tom, Commissioner Behnam, and Alicia for their leadership in this exercise.  The MRAC Interest Rate Benchmark Reform Subcommittee’s work has helped set the path for what I anticipate will be a smooth transition away from LIBOR and other impaired interest rates. 

I would also stress that the CFTC is in active dialogue with the ARRC on various issues affecting the transition.  We are working to provide reasonable relief to market participants to both encourage the transition away from LIBOR and to make that transition as smooth as possible.

Conclusion

In closing, let me just emphasize how important these advisory meetings are to the Commission, as we consider the most pressing issues facing our markets today. I look forward to today’s discussion.