Statement of Chairman Heath P. Tarbert in Support of Further Revisions to the Volcker Rule

January 30, 2020

Several months ago, I supported a rulemaking addressing the proprietary trading provisions of the Volcker Rule[1] and laid out my views as CFTC Chairman as well as someone who has witnessed the rule’s implementation over the last decade.[2]  The proposal before the Commission today focuses on the other side of the Volcker Rule: the prohibition on activities related to private equity and hedge funds (the “covered funds” provisions).

Although this part of the Volcker Rule has only limited implications for the CFTC and the derivatives markets that our agency regulates,[3] I have voted for the proposal because it represents a more accurate reading of the law Congress actually passed.[4]  With this proposal, however, the Volcker Rule is laid bare and several inherent flaws become all the more apparent.  At the same time, the good news is that, if the proposal is adopted, the Volcker Rule will no longer be applied to investments Congress never intended to be included, such as credit funds, venture capital funds, customer facilitation vehicles, and family wealth management vehicles.  The proposal also contains important modifications to several existing exclusions from the covered funds provisions—for foreign public funds, loan securitizations, and small business investment companies.  In these ways, the proposal moves toward addressing the over-breadth of the covered fund definition and related requirements.

Origins of the Covered Funds Prohibition

The Volcker Rule was intended to address two concerns with banking organizations: conflicts of interest and excessive risk taking.  I think proprietary trading raises legitimate concerns on both counts.  Trading for a bank’s[5] own account presents a potential conflict when buying and selling for customer accounts alongside it.  And there is little question that large-scale trading operations can create risks for a bank that directly or indirectly benefits from deposit insurance and discount window access.[6]  While the Volcker Rule has been poorly implemented, I believe the proprietary trading restrictions were at least well-intended.[7]

I unfortunately cannot say the same for the attendant prohibition on activities related to “private equity and hedge funds.”  It is worth noting that, before the politicization of the rule, Chairman Volcker did not even propose this part of the ban, and instead focused solely on proprietary trading.  In fact, he appeared disappointed to see the covered funds provisions in the bill.  He noted: “I’d write a much simpler bill.  I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance.”[8]  It is hard to argue with such a common-sense approach.

Flaws in the Covered Funds Provisions

There are several inherent flaws with the so-called covered funds side of the Volcker Rule:  (1) it represents a politicization of prudential supervision; (2) it does not address purported risks of non-banking activities; (3) it paradoxically reinforces conflicts of interest; and (4) it has been overly complicated and full of loopholes for lawyers.  In many ways, the proposal today would correctly implement what the statutory Volcker Rule actually says; it cannot fix the law’s fundamental problems, but it can bring us a step closer to reasonable implementation.

1. Politicizing Prudential Supervision

The proposal correctly acknowledges that Congress chose its words carefully.  The law refers to “private equity and hedge funds.”[9]  The congressional record includes a number of instances where congressional intent is explicitly stated regarding the desire of Congress to exempt investments by banks in venture capital funds.  For example, on the day the Senate passed the Dodd-Frank Act, the very namesake of the law, Senator Chris Dodd, stressed that “properly conducted venture capital investment will not cause the harms at which the Volcker rule is directed.”[10]  During the initial implementation of the Volcker Rule, regulators largely ignored this rather inconvenient language.  Yet it is there.

Congress offered no reason for why venture capital funds were explicitly excluded.  But I can make an educated guess:  venture capital funds are viewed by the public—and rightly so—as incubators for entrepreneurship in our country.[11]  Venture capital generally has a good reputation relative to private equity and hedge funds.  In fact, now some legislators at least have been transparent about their motives.  For example, the recently proposed legislation, Stop Wall Street Looting Act of 2019,[12] takes aim at a very specific corner of the financial industry:  private equity funds.  Notably, the restrictions in that bill do not apply to venture capital funds.  At least here the political purpose is clear on its face; it does not hide behind a prudential rationale.

Banning activities related to private equity and hedge funds may make good political sense to some.  Being less controversial, however, has nothing to do with whether something is less risky for our banking system.[13]  Indeed, while venture capital funds play a critical role in our economy, the high returns they typically generate are correlated with the risks they take in concentrating their investments in yet-unproven start-ups.  There is little or no evidence that participation in venture capital funds is less risky than investments in private equity and hedge funds.  And hence the congressional choice to exclude them was political, not prudential.  We should not kid ourselves.

2. Inconsistent Treatment of Non-Banking Risks

The exclusion of venture capital is just the tip of the iceberg.  Congress had every chance to address the so-called merchant banking authority that had been added to the Bank Holding Company Act when the Glass-Steagall Act was repealed.[14]  Under that authority, banks can invest in commercial companies far outside the field of financial services.  Supervisors have largely restricted the ability of banks to go beyond activities that are “financial in nature” or “closely related to banking” because the government cannot adequately supervise such risk taking.  Under the theory that a bank is simply holding a commercial company as a financial investment as opposed to part of its operations, the merchant banking authority allowed large banks to buy all sorts of companies—either outright or through funds.[15]  While the Volcker Rule restricted banks from investing in companies through private equity or hedge funds, Congress left the merchant banking authority fully intact, even though it is entirely inconsistent from a risk standpoint.

The end result has been that banks can continue to make investments (even 100% controlling investments) in all sorts of commercial enterprises directly.  The irony is that making investments directly in commercial companies is far more risky than the diversification benefits that come with making those investments indirectly through private equity or hedge funds.  From a risk standpoint, therefore, Congress’s approach to the Volcker Rule makes little sense.  It is simply hard to see how American taxpayers are better protected under this approach.

3. Misalignment with Investors                                                  

Reducing conflicts of interest was the other key goal of the Volcker Rule.  But the covered funds restrictions get this issue backwards.  The Volcker rule actually does not ban sponsorship of private equity and hedge funds.  Rather, Congress has allowed banks to organize and offer covered funds to their customers, but only if the bank’s interest in those funds is de minimis, i.e., three percent or less.  Customers who invest in these funds want to know the bank has “skin-in-the-game.”  That is, rather than just paying management fees, investors want to know that the fund sponsor has invested its own capital alongside theirs.  In many private equity and hedge funds, the sponsor commits up to 10% of its own capital in each fund to prove its interests are aligned with those of its investors.  With private funds, skin-in-the-game largely mitigates any potential conflicts.[16]  Yet the Volcker Rule cuts in the opposite direction, significantly reducing banks’ “skin in the game” and leading to questions about whether Congress carefully assessed conflicts and investor protection when adding the covered funds provisions.

4. Full Employment  . . .  for Lawyers

A final flaw is that the ban on private equity and hedge fund activities has become a game of legal charades.  It has made many Wall Street law firms wealthier, while doing little with respect to the risk portfolios of banks.  That is because Congress took a legalistic approach to defining what a private equity or hedge fund is—at the same time being over-inclusive and under-inclusive.[17]

Specifically, rather than defining “private equity or hedge fund” as they are commonly understood, the Volcker Rule defines a “covered fund” to include an issuer that would be an “investment company” under the Investment Company Act of 1940 (“1940 Act”) but for Section 3(c)(1) or Section 3(c)(7) of the 1940 Act[18] and certain commodity pools under the Commodity Exchange Act.[19]  These exclusions from the “investment company” definition are the principal ones relied upon by private equity and hedge funds, but many other investment companies also rely on these exclusions, including venture capital funds.  Thus, the Volcker Rule’s treatment of covered funds is overly inclusive.  At the same time, it has created a cottage industry for lawyers to devise ways of restructuring investments to fit into one of the many other exclusions from the definition of “investment company” in Section 3(c) of the 1940 Act (e.g., the exemption in Section 3(c)(5)).  Together with the vagueness and subjectivity present in the proprietary trading provisions,[20] the Volcker Rule is a gift that keeps on giving for lawyers.

A Modest Step Forward

While I support these further refinements to the Volcker Rule, I cannot help but ask whether the proposal is ultimately tilting at windmills.  The flaws of the Volcker Rule as enacted by Congress remain.  However, we can at least avoid erroneously applying the Volcker Rule to investments to which Congress clearly did not intend.  While venture capital funds do not necessarily provide less risky alternatives to hedge fund and private equity investments, increased bank financing and investments will likely have a positive impact on economic growth and encourage entrepreneurial ventures.  This improvement, while modest, nevertheless aligns with the CFTC’s strategic goals and core values as it enhances the regulatory experience and provides clarity for market participants.

Finally, I am pleased that the proposal requests comment on whether to clarify the scope of the exclusion for public welfare investments, including as it relates to rural business investment companies and qualified opportunity zone funds.  I look forward to the views of commenters on these issues, as I believe avoiding restrictions on opportunity zones, for example, will allow money from the banking sector to flow into many of our inner cities and underdeveloped communities.

Statement of Commissioner Brian D. Quintenz in Support of Proposed Rule on Position Limits before the Commission Open Meeting

January 30, 2020

I am pleased to support the agency’s revitalized approach to position limits. Today’s iteration marks the CFTC’s fifth proposed position limits rule since the Dodd-Frank Act[1] amended the Commodity Exchange Act’s (CEA) section on position limits. This proposal is, by far, the strongest of them all.

Today’s proposed rule promotes flexibility, certainty, and market integrity for end-users – farmers, ranchers, energy producers, transporters, processors, manufacturers, merchandisers, and all who use physically-settled derivatives to risk manage their exposure to physical goods. The proposal includes an expansive list of enumerated and self-effectuating bona fide hedge exemptions, and a streamlined, exchange-centered process to adjudicate non-enumerated bona fide hedge exemption requests.  

Of the five proposed rules, this proposal is the most true to the CEA in many significant respects: by requiring, as has long been the Commission’s practice, a necessity finding before imposing limits, by including economically equivalent swaps, and, perhaps most importantly, by following Congress’ instruction that, “to the maximum extent practicable,” any limits set by the Commission balance the interests among promoting liquidity, deterring manipulation, squeezes, and corners, and ensuring the price discovery function of the underlying market is not disrupted.[2] The confluence of these factors occurs most acutely in the spot month for physically-settled contracts where the delivery process and price convergence is most vulnerable to potential manipulation or disruption due to outsized positions. By focusing exclusively on spot month position limits in the new set of physically-settled (and closely related cash-settled) contracts, the proposal elegantly balances the countervailing policy interests enumerated in the statute.  

Necessity Finding

Today’s proposal, unlike the recent prior proposals, premises new limits on a finding that they are necessary to diminish, eliminate, or prevent the burden on interstate commerce from extraordinary price movements caused by excessive speculation (“necessity finding”) in specific contracts, as Congress has long required in the CEA and its legislative precursors since 1936.[3] I am pleased that the proposal complies with the District Court’s ruling in the ISDA-position limits litigation: that the Commission must decide whether Section 4a of the CEA mandates the CFTC set new limits or only permits the CFTC to set such limits pursuant to a necessity finding.[4]  As the District Court noted, “the Dodd-Frank amendments do not constitute a clear and unambiguous mandate to set position limits.”[5] I agree with the proposal’s determination that, when read together, paragraphs (1) and (2) of Section 4a demand a necessity finding. 

Section 4a(a)(2)(A) states that the Commission shall establish limits “in accordance with the standards set forth in paragraph (1) of this subsection.”[6] Paragraph (1) establishes the Commission’s authority to, “proclaim and fix such limits on the amounts of trading… as the Commission finds are necessary to diminish, eliminate or prevent [the] burden” on interstate commerce caused by unreasonable or unwarranted price moves associated with excessive speculation. This language dates back almost verbatim to legislation passed in 1936, in which Congress directed the CFTC’s precursor to make a necessity finding before imposing position limits. The Congressional report accompanying the CEA from the 74^th Congress includes the following directive, “[Section 4a of the CEA] gives the Commodity Exchange Commission the power, after due notice and opportunity for hearing and a finding of a burden on interstate commerce caused by such speculation, to fix and proclaim limits on futures trading ...”[7] In its ISDA opinion, the District Court noted the following: “This text clearly indicated that Congress intended for the CFTC to make a ‘finding of a burden on interstate commerce caused by such speculation’ prior to enacting position limits.”[8]

I support the proposal’s view that the most natural reading of Section 4a(a)(2)(A)’s reference to paragraph (1)’s “standards” is that it logically includes the “necessity” standard. Paragraph (1)’s requirement to make a necessity finding, along with the aggregation requirement, provide substantive guidance to the Commission about when and how position limits should be implemented.

If Congress intended to mandate that the Commission impose position limits on all physical commodity derivatives, there is little reason it would have referred to paragraph (1) and the Commission’s long established practice of necessity findings. Instead, Congress intended to focus the Commission’s attention on whether position limits should be considered for a broader set of contracts than the legacy agricultural contracts, but did not mandate those limits be imposed.

Setting New Limits “As Appropriate”

The proposal preliminarily determines that position limits are necessary to diminish, eliminate, or prevent the burden on interstate commerce posed by unreasonable or unwarranted prices moves that are attributable to excessive speculation in 25 referenced commodity markets that each play a crucial role in the U.S. economy. I am aware that there is significant skepticism in the marketplace and among academics as to whether position limits are an appropriate tool to guard against extraordinary price movements caused by extraordinarily large position size. Some argue there is no evidence that excessive speculation currently exists in U.S. derivatives markets.[9] Others believe that large and sudden price fluctuations are not caused by hyper-speculation, but rather by market participants’ interpretations of basic supply and demand fundamentals.[10] In contrast, still others believe that outsized speculative positions, however defined, may aggravate price volatility, leading to price run-ups or declines that are not fully supported by market fundamentals.[11]

In my opinion, position limits should not be viewed as a means to counteract long-term directional price moves. The CFTC is not a price setting agency and we should not impede the market from reflecting long term supply and demand fundamentals. It is worth noting that the physically-settled contract which has seen the largest sustained price increase recently is palladium,[12] which has also seen its exchange-set position limit decline four times since 2014 to what is now the smallest limit of any contract in the referenced contract set.[13]  Nevertheless, between the start of 2018 and the end of 2019, palladium futures prices rose 76%.[14] Taking these conflicting views and facts into account, it is clear the Commission correctly stated in its 2013 proposal, “there is a demonstrable lack of consensus in the [academic] studies” as to the effectiveness of position limits.[15] 

With that healthy dose of skepticism, I think the proposal appropriately focuses on the time period and contract type where position limits can have the most positive, and the least negative, impact - the spot month of physically settled contracts - while also calibrating those limits to function as just one of many tools in the Commission’s regulatory toolbox that can be used to promote credible, well-functioning derivatives and cash commodity markets.  

Because of the significance of these 25 core referenced futures contracts to the underlying cash markets, the level of liquidity in the contracts, as well as the importance of these cash markets to the national economy, I think it is appropriate for the Commission to protect the physical delivery process and promote convergence in these critical commodity markets.  Further, the limits proposed today are higher than in the past, notably because the proposal utilizes current estimates of deliverable supply - numbers which haven’t been updated since 1999.[16]  I am interested to hear feedback from commenters about whether the estimates of deliverable supply, and the calibrated limits based off of them, are sufficiently tailored for the individual contracts.

Taking End-Users Into Account

Perhaps more than any other area of the CFTC’s regulations, position limits directly affect the participants in America’s real economy: farmers, ranchers, energy producers, manufacturers, merchandisers, transporters, and other commercial end-users that use the derivatives market as a risk management tool to support their businesses. I am pleased that today’s proposal takes into account many of the serious concerns that end-users voiced in response to the CFTC’s previous five unsuccessful position limits  proposals. 

Importantly, and in response to many comments, this proposal, for the first time, expands the possibility for enterprise-wide hedging,[17] proposes an enumerated anticipated merchandising exemption,[18] eliminates the “five-day rule” for enumerated hedges,[19] and no longer requires the filing of certain cash market information with the Commission that the CFTC can obtain from exchanges.[20] Regarding enterprise-wide hedging – otherwise known as “gross hedging” – the proposal would provide an energy company, for example, with increased flexibility to hedge different units of its business separately if those units face different economic realities. 

With respect to cross-commodity hedging, today’s proposal completely rejects the arbitrary, unworkable, ill-informed, and frankly, ludicrous “quantitative test” from the 2013 proposal.[21] That test would have required a correlation of at least 0.80 or greater in the spot markets prices of the two commodities for a time period of at least 36 months in order to qualify as a cross-hedge.[22] Under this test, longstanding hedging practices in the electric power generation and transmission markets would have been prohibited. Today’s proposal not only shuns this Government-Knows-Best approach, it also proposes new flexibility for the cross-commodity hedging exemption, allowing it to be used in conjunction with other enumerated hedges.[23] For example, a commodity merchant could rely on the enumerated hedge for unsold anticipated production to exceed limits in a futures contract subject to the CFTC’s limits in order to hedge exposure in a commodity for which there is no futures contract, provided that the two commodities share substantially related fluctuations in value.

Bona Fide Hedges and Coordination with Exchanges

For those market participants who employ non-enumerated bona fide hedging practices in the marketplace, this proposal creates a streamlined, exchange-focused process to approve those requests for purposes of both exchange-set and federal limits. As the marketplaces for the core referenced futures contracts addressed by the proposal, the DCMs have significant experience in, and responsibility towards, a workable position limits regime. CEA core principles require DCMs and swap execution facilities to set position limits, or position accountability levels, for the contracts that they list in order to reduce the threat of market manipulation.[24] DCMs have long administered position limits in futures contracts for which the CFTC has not set limits, including in certain agricultural, energy, and metals markets. In addition, the exchanges have been strong enforcers of their own rules: during 2018 and 2019, CME Group and ICE Futures US concluded 32 enforcement matters regarding position limits.

As part of their stewardship of their own position limits regimes, DCMs have long granted bona fide hedging exemptions in those markets where there are no federal limits. Today’s proposal provides what I believe is a workable framework to utilize exchanges’ long standing expertise in granting exemptions that are not enumerated by CFTC rules.[25] This proposed rule also recognizes that the CEA does not provide the Commission with free rein to delegate all of the authorities granted to it under the statute.[26] The Commission itself, through a majority vote of the five Commissioners, retains the ability to reject an exchange-granted non-enumerated hedge request within 10 days of the exchange’s approval.  The Commission has successfully and responsibly used a similar process for both new contract listings as well as exchange rule filings, and I am pleased to see the proposal expand that approach to non-enumerated hedge exemption requests that will limit the uncertainty for bone fide commercial market participants.

I look forward to hearing from end-users about whether this proposal provides them the flexibility and certainty they need to manage their exposures in a way that reflects the complexities and realities of their physical businesses. In particular, I am interested to hear if the list of enumerated bona fide hedging exemptions should be broadened to recognize other types of common, legitimate commercial hedging activity.

Proposed Limits on Swaps

The CEA requires the Commission to consider limits not only on exchange-traded futures and options, but also on “economically equivalent” swaps.[27] Today’s proposal provides the market with far greater certainty on the universe of such swaps than the previous proposals.  Prior proposals failed to sufficiently explain what constituted an “economically equivalent swap,” thereby ensuring that compliance with position limits was essentially unworkable, given real-time aggregation requirements and ambiguity over in-scope contracts. In stark contrast, today’s proposed rule narrows the scope of “economically equivalent” swaps to those with material contractual specifications, terms, and conditions that are identical to exchange-traded contracts.[28] For example, in order for a swap to be considered “economically equivalent” to a physically-settled core referenced futures contract, that swap would also have to be physically-settled, because settlement type is considered a material contractual term. I believe the proposed narrowly-tailored definition will provide market participants with clarity over those contracts subject to position limits.  I also welcome suggestions from commenters regarding ways in which the definition can be further refined to complement limits on exchange-traded contracts. 

Conclusion

Section 2a(10) of the CEA is not an often cited passage of text.  It describes the Seal of the United States Commodity Futures Trading Commission, and in particular, lists a number of symbols on the seal which represent the mission and legacy of our agency: the plough showing the agricultural origin of futures markets; the wheel of commerce illuminating the importance of hedging markets to the broader economy; and, the scale of balanced interests, proposing a fair weighing of competing or contradicting forces.

As I think about the proposal in front of us today, I believe it speaks to all of those elements enshrined in our agency’s legacy, but the scale of balanced interests comes most to mind with this rule: new flexibility combined with new regulation, the removal of a few exemptions with the expansion or addition of others, the reliance on exchange expertise but with Commission review and oversight, and the balance of liquidity and price discovery against the threat of corners and squeezes. I am very pleased to support today’s revitalized, confined, and tempered approach to position limits and look forward to comment letters, particularly from the end-user community. 

Statement of Chairman Heath P. Tarbert in Support of Proposed Rule on Speculative Position Limits

January 30, 2020

I am pleased to support the Commission’s proposed rule on limits for speculative positions in futures and derivatives markets.  Today’s proposal is a pragmatic approach that will protect our agricultural, energy, and metals markets from excessive speculation.  But just as importantly, it will ensure fair and easy access to these markets for businesses producing, consuming, and wholesaling commodities under our jurisdiction.

When I came to the Commission, I set out several strategic goals.  Among them is to regulate our derivatives markets to promote the interests of all Americans.  Another goal is to enhance the regulatory experience of market participants.  The proposal we are issuing today will deliver on both.  We also drew from each of our agency core values to craft it—commitment, forward-thinking, teamwork, and clarity.  Clarity is of particular importance here because, ultimately, markets and their participants deserve regulatory certainty.  We provide that today.

Making our Markets Work for the American Economy

If adopted, our proposal will help ensure that futures markets in agricultural, energy and metals commodities work for American households and businesses.  Farmers, ranchers, energy producers, utilities, and manufacturers are the backbone of the American economy.  Our derivatives markets generally, and in particular the markets addressed in this proposal, are designed specifically to allow these businesses to hedge their exposure to price changes.

This Commission’s proposal will protect Americans from some of the most nefarious machinations in our derivatives markets.  First, capping speculative positions in the covered derivatives contracts will help prevent cornering and squeezing.  Such manipulative schemes can cause artificial prices and can injure the users of commodities linked to the futures markets.  Limiting speculative positions can also reduce the likelihood of chaotic price swings caused by speculative gamesmanship.  In effect, position limits should help ensure that prices in our markets reflect real supply and demand.

Position limits are not a solution born inside the Washington Beltway and imposed on the market from afar.  Instead, they are one of many tools that exchanges have used since the 19^th century to mitigate the potentially damaging effects of excessive speculation.  They are a pragmatic, Midwestern solution to a real-world problem.  Recognizing the usefulness of exchange-set limits, the Commission has worked collaboratively with our exchanges since 1981 to put sensible position limits and accountability levels on speculative positions in all physical commodity futures markets.

Our proposal would also end the “risk management” exemption that has allowed banks, hedge funds, and trading firms to take large and purely speculative positions in agricultural markets.  Nearly a decade ago, Congress directed the Commission to address this issue.  Today we are acting.

Some observers have gone so far as to call position limits “at best, a cure for a disease that does not exist or a placebo for one that does.”[1]  I respectfully disagree.  To be sure, position limits are not a silver bullet against the damaging impact of excessive speculative activity.  But I also believe, as did Congress when it amended the Commodity Exchange Act, that position limits can help to “diminish, eliminate, or prevent” potential damage to the commodities markets that are so critical to our real economy.

Still, setting limits requires balancing the competing need for liquidity in our markets against the potential for disruptive speculative positions.  I believe that the spot month levels we are proposing are reasonably calibrated.  They are based on the current rule of thumb that limits should be no more than 25 percent of the deliverable supply of the referenced commodity, in order to prevent corners and squeezes that everyone can agree are bad for the market.

For the nine grain futures contracts currently subject to position limits,[2] revising non-spot limits required the Commission to consider an additional complication.  Eliminating the risk management exemption could potentially take away a source of liquidity further out the curve.  For a farmer who needs to hedge the price risk on crops that are still in the ground, a bank with a risk management exemption may be the only willing buyer.  To mitigate the impact of eliminating the risk management exemption, we have raised the non-spot month limits for the grain contracts.  This should allow a broader set of market participants to provide liquidity and help farmers hedge their crop risk as far in advance as they need.

Ensuring Access for Bona Fide Hedgers

Position limits is the rare rule where the exception is as important as the rule itself.  It cannot be said too often that these limits are on speculative activity.  Congress has always intended that positions that are a bona fide hedge of price risk should not be subject to limits.

It is critical, therefore, that we not disrupt the regulatory experience of American producers, middlemen, and end-users of commodities.  The greatest risk of a position limits rule is that hedgers are caught in the limits aimed at speculators.  This could reduce their ability to protect themselves from risk, which could in turn negatively impact the broader economy.  If a farmer cannot offset a risk on next year’s crop —if a refiner cannot offset a risk on crude oil for a new plant—or if a wholesaler cannot offset risks on inventory it is buying, those businesses will not expand their operations.

Any position limits rule must therefore be written with those hedging needs in mind.  Congress and the American people expect nothing less.  The proposal addresses those needs through (i) a broad exemption for “bona fide” hedging, and (ii) a streamlined and non-intrusive process for recognizing those exemptions.

On the first point, the proposal will expand the types of hedging strategies that are presumed to meet the bona fide hedging definition—and therefore be eligible for an exemption from position limits.  For the first time, we have included anticipated merchandising, meaning that wholesalers and middlemen connecting producers and consumers could more readily hedge their risks.  We have also expanded the definition to conform to the hedging strategies that are common in energy markets.  This will ensure that the new federal speculative limits on energy markets do not inadvertently undermine the producers, refiners, pipeline operators, and utilities that keep this country running.

On the second point, we have built on prior proposals to create a practical and efficient way for hedgers to avail themselves of the bona fide hedging exemption.  Creating burdensome red tape or slowing down approvals to take on hedging positions could result in lost business opportunities for the participants we are called to protect.

For parties whose hedging needs fit within the enumerated list, they could exceed federal position limits without requesting approval from the Commission.  They also would not need to submit information on their cash market positions—a duplicative and burdensome exercise that is better handled by the exchanges.

For parties whose hedging needs do not fit within the enumerated list, we are offering a process whereby an exchange could evaluate that hedging need.  If the exchange finds that the need is a bona fide hedge not captured by our list, the exchange would notify the Commission.  Unless the Commission votes to reject it within 10 business days, the exchange’s recognition would be deemed effective for purposes of federal position limits.  Given our expanded definition of bona fide hedging, I anticipate that it would be a rare case that a market participant finds its legitimate hedging needs are not already covered in the list of enumerated exemptions.  Still, this process would provide flexibility and legal certainty, without excessive red tape.

Striking the Right Balance

The Commission has grappled with position limits for a decade.  The 2011 proposal was finalized, but struck down by a court because of concerns over its legal justification.  Subsequent proposals in 2013 and 2016 were never finalized, following pushback from market participants about access to bona fide hedge exemptions.  The Commission and staff have worked with diligence and good faith to solve this puzzle.  There are difficult, often competing interests to address in this seemingly simple rule.  If an easy solution exists, I have no doubt that the Commission would have found it.

Today’s proposal is the culmination of ten years of effort across four Chairmen’s tenures.  I sincerely thank my predecessors, as well as the Commission staff, who have worked so hard for so long to strike the right balance.  Each proposal and every piece of feedback has helped improve the proposal before the Commission today.  I believe that the proposal offers the pragmatic, workable solution that would protect markets from corners and squeezes while preserving the ability of American businesses to manage their risks.

Putting the Burden in the Right Place

Finally, I want to draw attention to one fundamental shift in approach between prior position limits rules and the present proposal.  Previously, the Commission had read the Commodity Exchange Act to require federal limits to be placed on every futures contract for a physical commodity.  This would have required the Commission to evaluate approximately 1,200 individual contracts to determine the appropriate levels.

The 2011 position limits rule was challenged in court on this ground and was struck down.  The court found that the statute was ambiguous about whether the Commission must impose limits on all futures, or whether it should impose limits only “as the Commission finds are necessary[.]”  The court said that “it is incumbent upon the agency not to rest simply on its parsing of the statutory language.  It must bring its experience and expertise to bear in light of competing interests at stake to resolve the ambiguities in the statute.”[3]

The Commission is now bringing its experience and expertise to bear on this matter.  We have taken a big picture approach to determine when position limits are in fact necessary.  In short, we are proposing that speculative limits are necessary for those futures contracts that are physically delivered and where the futures market is important in the price discovery process for the underlying commodity.  The Commission also examined whether a disruption in the distribution of that commodity would have a significant impact on our economy.  This has led us to propose limits on 25 physically delivered futures contracts,[4] which covers the vast majority of trading volume and open interest in physically delivered derivatives.  In addition to the nine grain futures contracts currently subject to federal limits, this includes the largest energy, metals, and other agricultural futures contracts.

Position limits are like medicine; they can help cure a symptom but can have undesirable side effects.  And like medicine, position limits should be prescribed only when necessary.  I believe this change in the underlying rationale for the proposal will require thoughtful reflection before imposing additional position limits on additional contracts in the future.  Position limits will always create a burden on someone in the market—whether a compliance burden on parties having to track their positions relative to limits, or potentially the loss of a business opportunity because the risks cannot be hedged.

The statutory provisions on position limits can reasonably be read in two ways.  The first reading would put the burden on the Commission to find position limits to be necessary before imposing them on new contracts.  The second reading would mandate federal limits on all futures contracts irrespective of any need, reflexively putting placing a burden on all markets and all market participants.  Given the choice of burdening a government agency or private enterprise, I think it is more prudent to put the burden on the government.  That is what today’s proposal does.  As Thomas Jefferson said, “Government exists for the interests of the governed, not for the governors.”

January 3, 2020

Statement of Division of Swap Dealer and Intermediary Oversight on Annual Compliance Report Requirements

Washington, DC — On December 4, 2019, the Division of Swap Dealer and Intermediary Oversight (DSIO) issued an advisory regarding annual compliance report requirements for swap dealers, futures commission merchants, and major swap participants (Advisory).[1] The Advisory clarifies annual compliance reporting requirements for those categories of registered firms and provides additional recommendations to those firms regarding the manner in which they prepare their reports. DSIO intends the Advisory to help registrants improve the quality and usefulness of their reports in accordance with their existing obligations under CFTC Regulation 3.3.[2]

DSIO considers the Advisory to be targeted in scope and to reflect certain iterations in its thinking about how annual compliance reports can be more effective, based on its years of experience in reviewing reports submitted by registered firms. At the same time, DSIO is aware that having issued the Advisory in December may present challenges for chief compliance officers (CCOs) of registered firms to adapt their existing reporting procedures in time to produce reports in 2020 that take the Advisory into full consideration.  

The Advisory is merely guidance and does not impose any new requirements. As such, DSIO expects that CCOs will take reasonable measures to implement the Advisory’s recommendations when preparing their annual compliance reports for 2019. DSIO recognizes that CCOs may not be able to implement those recommendations fully for their 2019 reports given the potential timing constraints identified above. DSIO does expect, however, that CCOs will be able to consider those recommendations more completely when preparing their 2020 annual reports, which will be due in 2021.

Any questions regarding this statement should be directed to the following DSIO Staff members: Amanda Olear, Acting Deputy Director (202.418.5283, [email protected]); Pamela Geraghty, Special Counsel (202.418.5634, [email protected]); and Owen Kopon, Special Counsel (202.418.5360, [email protected]).

Joshua B. Sterling
Director
Division of Swap Dealer and Intermediary Oversight

[1] https://www.cftc.gov/csl/19-24/download; see also https://www.cftc.gov/PressRoom/PressReleases/8090-19.

[2] 17 C.F.R. § 3.3.

Supporting Statement of Commissioner Brian D. Quintenz Regarding Final Rule: Derivatives Clearing Organization General Provisions and Core Principles

December 18, 2019

I am pleased to support today’s final rule that amends the Commissions regulations governing derivatives clearing organizations (DCOs).[1] 

Before highlighting aspects of the final rule, I would like to review the importance of central clearing, DCOs, and the Commission’s oversight over these institutions.  DCOs play a truly crucial role in the futures and swap markets by serving as a central counterparty to every transaction that they clear.  When a transaction is cleared, the DCO guarantees performance of the contract until final settlement so that market participants do not bear counterparty credit risk to each other.  The DCO sets collateral and daily-mark-to-market requirements, according to rules enforced by the CFTC, and otherwise maintains the financial integrity of cleared transactions, under CFTC-supervision.  The CFTC’s Division of Clearing and Risk (DCR) regularly examines DCOs for compliance with the Commission’s regulations; reviews new DCO rules; and assesses how DCOs manage market and liquidity risks.

Central clearing has long been a hallmark of the futures market, dating back to the 1920s and functioning extremely well since then.  Following Congress’ 2010 amendments to the Commodity Exchange Act (CEA),[2] CFTC-regulated DCOs began clearing interest rate swaps and credit default swaps pursuant to revised statutory core principles[3] and revised CFTC DCO regulations.[4]  Sixteen DCOs, located in the U.S., Canada, the U.K, France, Germany, and Singapore, are currently registered with the Commission to clear a diverse set of derivatives ranging from agricultural, energy, and Bitcoin futures, to overnight index swaps, to foreign exchange options.[5]  Every day, these sixteen DCOs settle over $10 billion in daily mark-to-market obligations and hold over $450 billion in initial margin collateral.[6]  Financial institutions, commercial end-users, and retail investors rely on the continued success of DCOs in order to ensure the integrity of their risk management transactions.  The public also relies on the CFTC to ensure that DCOs are subject to meaningful regulations that prevent undue risk, while also providing DCOs with sufficient discretion to manage aspects of their operations that they are best equipped to handle without unnecessary government intervention.  Today’s final version of revised regulations for DCOs includes carefully considered enhancements which the Commission believes DCOs can fulfill without incurring overly burdensome compliance costs.

I am proud that the CFTC is one of only a few authorities around the world to have issued DCO rules that are consistent with the internationally-recognized CPMI-IOSCO Principles for Financial Market Infrastructures (PFMIs).[7]  The Commission was a leader in both the development of the PFMIs as well as adopting rules consistent with the PFMIs, having done so in 2013.[8]  The CFTC’s rules for DCOs were augmented again in 2016 to include industry-accepted best practices for cybersecurity, business continuity, and disaster recovery.[9]

The amendments set forth in today’s final rule include new requirements for: governance; reporting clearing members’ positions to the Commission; reporting changes in liquidity funding and settlement bank arrangements; determining initial margin requirements; default management procedures; enterprise risk management; reviewing haircuts on assets submitted as initial margin; exemptions for DCOs clearing only fully-collateralized contracts; cross-margining programs; transfers of open interest; and public disclosures issued in response to an CPMI-IOSCO initiative.[10]  

I would like to highlight some of the provisions of the final rule.  Regarding reporting to the Commission, a DCO will be required to report daily the amounts of initial and variation margin for “individual customer accounts” held within each futures commission merchant (FCM)-clearing member’s overall “customer account.”[11]  Such individual customer accounts include individual funds sponsored by an asset manager and an asset manager’s separate accounts for institutional investors.  DCR can use this information to more precisely assess the risks and exposures of a DCO’s clearing members.  In adopting this new requirement, the Commission noted that much of this information is already reported, meaning the burden to comply with the revised rule should be minimal.  Regarding default management, the final rule requires a DCO to include clearing members in annual tests of its default management plan.[12]  Finally, I note that while the proposal would have required a DCO to file a new report with the Commission 30 days in advance of clearing a new product,[13] the final rule eliminates this requirement, noting that both designated contract markets (DCMs) and swap execution facilities (SEFs) already file notices of new product offerings with the Commission under the “self-certification” process.

In conclusion, I am pleased that in finalizing these new rules, the Commission has genuinely taken the public’s comments into account, reviewing input not only from the DCOs themselves, but also from the market participants that clear their trades at DCOs, including investment funds, futures commission merchants, and other financial institutions.  I recognize that commenters raised important issues that are beyond the scope of, or not included in, today’s rulemaking concerning the relationship between a DCO and its members.  While the Commission will continue to consider the public’s views on these issues, the Commission is focused on ensuring DCOs comply with the CEA’s core principles.  I hope that the DCOs, their members, and their members’ customers can continue working in good faith to find constructive solutions to other issues not included here.

Supporting Statement of Commissioner Brian D. Quintenz Regarding Proposed Rule: Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to SDs and MSPs

December 18, 2019

I am very pleased to support today’s proposed rule, which, in my view, delineates important boundaries of the Commission’s regulation of swaps activity conducted abroad, which would codify elements of the Commission’s 2013 interpretive guidance,[1] and make important adjustments with the benefit of six years’ additional experience in swaps market oversight.

Direct AND Significant

As I have said before, the foundational principle underlying any CFTC regulation of cross-border swaps activity, and the prism through which all extraterritorial reach by the CFTC must be viewed, is the statutory directive from Congress that the agency may only regulate those activities outside the United States that “have a direct and significant connection with activities in, or effect on commerce of, the United States.” [2]  Congress deliberately placed a clear and strong limitation on the CFTC’s extraterritorial reach, recognizing the need for international comity and deference in a global swaps market.

I believe the proposal strikes a strong balance in interpreting Section 2(i) of the CEA. The proposal before us would interpret this provision in ways that both provide important safeguards to the U.S. financial markets, and avoid duplicative regulation or disadvantaging U.S. commercial and financial institutions acting in foreign markets.

Registration

 The proposal would require a foreign institution dealing in swaps to count the notional value of the swaps it executes towards the CFTC’s recently finalized $8 billion registration threshold[3] only in certain, enumerated circumstances that clearly concern U.S. institutions and implicate risk to the U.S. financial system when that risk is not otherwise addressed by the Commission or by the banking regulators.[4]  I would like to highlight a few of these circumstances. 

First, a foreign swap dealing firm would generally be required to count swaps executed opposite a “U.S. person.”[5]  I believe the proposed definition of U.S. person[6] is an improvement upon the one included in the 2013 guidance.[7]  The proposed definition of U.S. person is also consistent with the one published by the SEC in connection with that agency’s oversight over security-based SDs and MSPs.[8] Only in Washington could two financial regulators have different definitions of a U.S. Person. Such a harmonized definition, if finalized, will facilitate compliance with the CFTC’s and SEC’s swaps regulations by dually registered entities.  The proposed definition is largely similar to the definition of U.S. person issued by the Commission in 2016 in connection with the rule for cross-border applicability of the margin requirements for uncleared swaps,[9] and more streamlined than the one included with the Commission’s 2013 cross-border guidance, for example in the context of investment funds.  This will make it easier for market participants readily to determine their status. One element of the definition that I would like to highlight, an element that is consistent with the SEC’s rule, is that an investment fund would be considered a U.S. person if the fund’s primary manager is located in the U.S.[10]

In addition to counting swaps opposite a U.S. person, a foreign firm would also be required to count swaps executed opposite a non-U.S. entity, if that firm’s obligations under the swap are “guaranteed” by a U.S. person, or if the counterparty’s obligations are U.S.- guaranteed.[11]  Here too, the proposal provides a simpler, more targeted definition of guarantee[12] than the one published in the 2013 guidance,[13] and the definition is consistent with the one included in the Commission’s cross-border rule for uncleared swap margining.[14]  The definition would include an arrangement under which a party to a swap has rights of recourse against a guarantor, including traditional guarantees of payment or performance, but it would not include other financial arrangements or structures such as “keepwells and liquidity puts” or master trust agreements. 

Notably, if a non-U.S. firm’s obligations to a swap are guaranteed by a non-financial U.S. entity (meaning a U.S. commercial end-user), then that swap would be excluded from the foreign dealer’s tally towards possible CFTC registration.[15]  Commercial end-users typically enter into swaps for hedging purposes, and their swaps generally pose less risk to the financial system than swaps by financial institutions.  The fact that a foreign dealer would not be required to count a swap with a U.S.-guaranteed commercial end-user towards the dealer’s possible CFTC registration may give foreign subsidiaries of U.S. commercial firms a greater choice of swap dealers.  This flexibility is consistent with Congress’ decision not to apply to commercial end-users either the requirement that certain swaps be cleared at a derivatives clearing organization (DCO) (“swap clearing requirement”) or that uncleared swaps be subject to margin requirements.[16]

I would also like to highlight that the proposal properly does not require a foreign dealer to count towards the CFTC’s registration threshold a swap opposite a foreign branch of a U.S. institution already registered with the CFTC as an SD.[17]  While a U.S. SD of course stands behind a swap executed by its foreign branch, I believe it makes sense for the Commission not to require a foreign dealer to count that swap towards the foreign dealer’s tally for possible CFTC registration because the CFTC is already overseeing the U.S. firm, and its swaps, due to the U.S. firm’s SD registration.

FCS – Not “Significant” on Accounting Consolidation Alone

Today’s proposal makes an important, and appropriate, distinction from the Commission’s 2016 proposal on the cross-border application of the SD registration threshold and SD business conduct standards.[18]  That proposal would have required thousands of non-U.S. firms to count all of their dealing swaps, with U.S. and non-U.S. counterparties alike, towards possible CFTC SD registration.  For instance, the 2016 proposed rule would have required every foreign subsidiary of a U.S. firm that, for accounting purposes, consolidates its financial statements into its parent, (referred to as a “foreign consolidated subsidiary”) to count all of its swaps.[19] While an accounting link between a foreign subsidiary and its U.S. parent may have satisfied the “direct” connection to U.S. activities under CEA 2(i), an accounting link alone is meaningless in terms of the 2(i) “significant” connection to commerce of the U.S.

By contrast, today’s proposal creates a sensible “significance” test for a foreign subsidiary of a U.S. firm through the classification of  a “significant risk subsidiary,” which would be required to count every dealing swap towards possible CFTC SD registration.[20]  The proposed significant risk subsidiary class targets only a foreign entity that may present major risk to a large U.S. institution and appropriately scopes out the limits of Section 2(i) of the CEA.[21]  Moreover, a significant risk subsidiary does not include an entity already subject to supervision either by the Federal Reserve Board or by a foreign banking regulator operating under Basel standards in a jurisdiction that the Commission determined has instituted a margining regime for uncleared swaps that is comparable to the Commission’s framework for margining uncleared swaps.[22] This construct makes sense.  The Federal Reserve already reviews swaps activity by foreign subsidiaries of bank holding companies.[23] Additionally, the CFTC has already found multiple jurisdictions’ uncleared margin regimes comparable to ours. In order to eliminate duplicative regulation, and for the sake of international comity and respect for foreign jurisdictions’ sovereignty, it is prudent for the Commission to rely on other authorities, either the Federal Reserve or its counterparts in comparable jurisdictions, to supervise the swaps entered into by non-U.S. subsidiaries of the banks they supervise on a consolidated basis.

By limiting the number of foreign firms registered with the CFTC as SDs, I believe the Commission, together with the National Futures Association (NFA), will best apply the agency’s limited resources to the non-U.S. entities outside of the Federal Reserve’s purview, especially given that there are already over 100 registered SDs organized in more than 10 countries.[24]

Business Conduct Requirements

In addition to setting boundaries in the area of non-U.S. firms counting swaps towards possible CFTC registration, today’s proposal would build on the 2013 guidance by providing certainty regarding when a non-U.S. firm, which is registered with the CFTC as an SD, must comply with the Commission’s SD standards. Again, importantly and appropriately out of respect for foreign jurisdictions, the proposal would exempt swaps executed with certain counterparties located abroad and make available compliance with local rules that the CFTC has determined comparable to its own (“substituted compliance”).[25]   The proposed rule also sets forth exemptions and substituted compliance for foreign branches of U.S. financial institutions registered as SDs with the CFTC.[26]  As in 2013, the Commission believes that certain of the Commission’s SD rules, or comparable foreign rules, should apply to every registered SD, including one organized in a foreign jurisdiction, with respect to all of the dealer’s swaps, namely requirements concerning: a Chief Compliance Officer; a risk management program, including special rules for when the SD is a member of a DCO; addressing conflicts of interest and antitrust considerations; recordkeeping; disclosing information to the CFTC and banking regulators; and position limits monitoring (collectively, the “Group A requirements”).[27]  I note that substituted compliance is currently available for particular Group A requirements for SDs established in, and operating out of, Australia, Canada, the E.U., Hong Kong, Japan, and Switzerland.[28]

With regard to other SD requirements, namely daily trading records, confirmations, documentation, and portfolio reconciliation and compression (collectively, the “Group B requirements”),[29] today’s proposal reasonably exempts foreign firms registered with the Commission as SDs, as well as foreign branches of U.S. registered as SDs, from these requirements for swaps with certain counterparties located outside of the U.S., including those non-U.S. counterparties whose swap obligations are not guaranteed by a U.S. person and those foreign counterparties not covered by the proposed definition of significant risk subsidiary.[30]  As with the 2013 guidance, substituted compliance is also available.[31]  Finally, under today’s proposal, both a non-U.S. firm registered with the Commission as an SD, and the foreign branch of a U.S. firm registered as an SD, would only be required to comply with a set of business conduct requirements, those addressing how registered SDs transact with certain counterparties (collectively, the “Group C requirements”),[32] for swaps with U.S. counterparties, but not with non-U.S. counterparties.[33]

“ANE” - Eliminating the “Elevator Test”

Today’s proposal makes an important distinction from how the Commission’s Division of Swap Dealer and Intermediary Oversight (DSIO) addressed compliance with “transaction-level requirements” (referred to in today’s proposal as Groups B and C requirements) in 2013.  A November 2013 DSIO Advisory[34] suggested that a foreign CFTC-registered SD must comply with CFTC transaction-level requirements even in connection with a swap opposite another non-U.S. person if the SD used personnel located in the U.S. to “arrange,” “negotiate” or “execute” (ANE) the swap. Such a broad, vague, and burdensome application caused such widespread confusion and international condemnation that it was, within 13 days of publishing, placed under no-action relief.[35]  That no-action relief exists to this day, having been renewed six times.[36]

Prudently, today’s proposal eliminates the ANE standard.  I believe the Commission should only consider applying its transaction-level requirements to a foreign registered SD when a swap is executed opposite a U.S. counterparty.[37]  The fact that the foreign SD may be using U.S. personnel to support the transaction does not implicate how the swap should be executed with a foreign counterparty. Under the limited extra-territorial jurisdiction Congress gave to the CFTC in overseeing the swaps market, it is appropriate that the Commission refrains from requiring foreign firms to comply with the CFTC’s SD transaction-level requirements, or comparable foreign requirements, for swaps where both counterparties are outside of the United States and there is no U.S. nexus.

Enhancing Substituted Compliance

I am pleased that today’s proposal codifies a process under which the Commission will issue future substituted compliance determinations.[38]  Substituted compliance is the lynchpin of a global swaps market. Said differently, the absence of regulatory deference has been the fracturing sound we hear as the global swaps market fragments.  The 11 substituted compliance determinations the Commission has issued to date for registered SDs, concerning business conduct and uncleared swap margining rules, highlight the progress other jurisdictions have made in issuing swaps rules. While not identical, those rulesets largely address the same topics and guard against the same risks.  I hope that the Commission will soon be in a position to issue additional comparability determinations, particularly for Group B requirements.  Whereas Group A substituted compliance determinations have been issued for six jurisdictions (Australia, Canada, the E.U., Hong Kong, Japan, and Switzerland), Group B substituted compliance determinations have been issued for only two jurisdictions (the E.U. and Japan).

In conclusion, I am pleased that the Commission is making meaningful progress in providing legal certainty to the market with regard to complying with the Dodd-Frank swaps regulations on a cross-border basis.  I hope that the Commission will soon propose other cross-border regulations regarding other areas of the CFTC’s swap regulations, including the swap clearing requirement, the trade execution requirement,[39] and the swaps reporting requirement.[40]

I would like to thank the staff of DSIO for their efforts on this proposal, as well as a personal thank you to Matt Daigler from the Chairman’s office, who worked tirelessly on this proposal and its unpublished predecessor and has held countless conversations with me and my staff on this issue over the past year.

Statement of Dissent by Commissioner Rostin Behnam Regarding Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to Swap Dealers and Major Swap Participants; Proposed Rule

December 18, 2019

Introduction

I respectfully dissent from the Commodity Futures Trading Commission’s (the “Commission” or “CFTC”) notice of proposed rulemaking addressing the cross-border application of the registration thresholds and certain requirements applicable to swap dealers (“SDs”) and major swap participants (“MSPs”) (the “Proposal”).  I support the Commission’s effort to make good on its commitment to periodically review its approach to evaluating the circumstances under which the swaps provisions of Title VII of the Dodd-Frank Act[1] ought to apply to swap dealing and related activities outside the United States.[2]  Indeed, the Guidance currently in place and Section 2(i) of the Commodity Exchange Act (the “Act” or “CEA”) itself provide the Commission the flexibility to evaluate its approach on a case-by-case basis, affording interested and affected parties the opportunity to present facts and circumstances that would inform the Commission’s application of the relevant substantive Title VII provisions in each circumstance.[3]  Today, the Commission, without adequate explanation of its action, consideration of alternatives, or deference to the wisdom of the United States District Court for the District of Columbia on the matter, is proposing to discard both the existing Guidance and the use of agency guidance and non-binding policy statements altogether in addressing the cross-border reach of its authority in favor of hard and fast rules.  I simply do not believe the Commission has made a strong enough case for wholesale abandonment of guidance at this point in the evolution of our global swaps markets, and in light of current events that are already impacting market participants and their view of the future global swaps landscape.  As well, I have serious questions and concerns as to what the Commission may give up should the Proposal be codified in its current form.

Whereas the Commission understands the scope of our jurisdictional reach with respect to Title VII, a federal district court has affirmed that understanding, and we have operated within such boundaries—aware of the risks and successfully responding in kind, the Commission is now making a decision based on the most current thinking that we should retreat under a banner of comity and focus only on that which can fit on the head of a pin.  Oddly enough, that pin will hold only the giants of the swaps market.  Indeed, where our jurisdiction stands on its own, the ability to exercise our authority through adjudication[4] and enforcement has allowed the Commission to articulate policy fluidly, refining our approach as circumstances change without the risk of running afoul of our mandate.  Today’s Proposal suggests that we can resolve all complexities in one fell swoop if we alter our lens, abandon our longstanding and literal interpretation of CEA section 2(i), and limit ourselves to a purely risk-based approach.  I cannot support an approach that would limit our jurisdiction and consequently oversight directly in conflict with Congressional intent, and potentially expose the U.S. to systemic risk.

Throughout the preamble, the Proposal evinces a clear understanding that the complexity of swaps markets, transactions, corporate structures and market participants create channels through which swaps-related risks warrant our attention by meeting the jurisdictional nexus described in CEA Section 2(i).[5]  However, in many instances, we manage to simply acknowledge the obvious risk and step aside in favor of the easier solution of doing nothing, assuming that the U.S. prudential regulators will act on our behalf, or waving the comity banner.  The Proposal provides shorthand rationales for each of its decision points without the support of data or direct experience as if doing so would reveal the vision’s vulnerabilities.  Perhaps most concerning are the Proposal’s contracted definitions of “U.S. person” and “guarantee,” its introduction of “substantial risk subsidiaries,” and its determination that “ANE” means something akin to “absolutely nothing to explain” regarding our jurisdictional interest—even when activities are occurring within the territorial United States.  These represent some notable examples where the Proposal undermines the core protections sought to be addressed by section 2(i), as the Commission has, until now, understood them to be.

My concerns aside for a moment, I am grateful that within the four corners of the document, the requests for comment seek to build consensus and operatively provide the public an option to maintain the status quo with regard to most aspects of the Guidance—albeit without sticking with guidance.  While this leads me to more questions as to whether and how the Proposal could go final absent additional intervening process, I am pleased that there is recognition that the public and market participants may have lost their appetite for this brand of rulemaking or perhaps have come to agree with the D.C. District Court that the Commission’s decision to issue the Guidance benefits market participants.[6]  Further, as the Commission currently engages with our foreign counterparts regarding impending regulatory matters related to Brexit, I hope we are measured in timing and substance on the Proposal.

Before I highlight certain aspects of the Proposal, I want to take a brief moment to acknowledge why—as a general matter—we are here, and why this particular proposal is so important.  Without rehashing market realties that led to the economic devastation of 2008, it should never be lost on our collective consciousness that a significant driving force that exacerbated the financial crisis and great recession, at least within the context of the over-the-counter derivatives market, was housed overseas.  Although much of the risk completed its journey within the continental U.S., it was conjured up in foreign jurisdictions.[7]  But, as we all also know too well, more than 10 years later, despite the products often being constructed, sold, and traded overseas, the highly complex web of relationships between holding companies, subsidiaries, affiliates, and the like, created a perfect storm that brought our financial markets to a near halt, and the global economy to a shudder.  Those experiences should always serve as the foundation from which we craft cross-border derivatives policy.  Always. 

Cutting to the Chase on Codification

Since 2013, when the Commission announced its first cross-border approach in flexible guidance as a non-binding policy statement,[8] the Commission has understood that addressing the complex and dynamic nature of the global swaps market cannot be described in black and white, and that even describing it in shades of gray quickly overwhelms our regulatory sensibilities.  Cutting through the haze with bright line rules for identity, ownership, control, and attribution to find comfort in comity seems to be our approach in addressing the nature of risk in the global swaps market.  However, Congress has granted the Commission authority without any attendant instruction to engage in rulemaking.[9]  Under such circumstances, the Commission must critically evaluate whether a rule-driven application of policy amid a global market that is only growing in size and in its complexity may prove inadequate as we carry out our mandate and protect our domestic interests.  It seems in this instance that the Commission is barreling toward hard and fast comprehensive rules without acknowledging the benefits of what we have today.

To be clear, while I support the Commission’s efforts to address problems resulting from its current approach to regulating swaps activities in the cross-border context, it is not clear to me at this moment that we have reached a point where codification would provide immediate benefits to either the Commission or the public.  While the Guidance is complex, it is difficult to say it is any more complex than the Proposal.  The complexity is and will be inherent to whatever action we take as it, “merely reflects the complexity of swaps markets, swaps transactions, and the corporate structures of the market participants that the CFTC regulates.”[10]  It is this type of complexity that supported the Commission’s initial determination to issue the Guidance, and to my knowledge, such determination has not hindered the Commission’s ability to pursue enforcement actions that apply Title VII extraterritorially[11] or to participate in discourse with and decision-making among our fellow international financial regulators.

CEA Section 2(i) Preservation

As recognized by the D.C. District Court, the Title VII statutory and regulatory requirements apply extraterritorially through the independent operation of CEA section 2(i), which the CFTC is charged with enforcing.[12]  Congress did not direct—and has not since directed—the Commission to issue rules or even guidance regarding its intended enforcement policies pursuant to CEA section 2(i).  To the extent the CFTC interpreted Section 2(i) in the Guidance, an interpretation carried forward in the Proposal, such interpretation is drawn linguistically from the statute; its interpretation has not substantively changed the regulatory reach.[13]  Putting aside the anti-evasion prong in CEA section 2(i)(2), it remains that the Commission construes CEA section 2(i) to apply the swaps provisions of the CEA to activities, viewed in the class or aggregate, outside the United States that, meet either of two jurisdictional nexus: (1) a direct and significant effect on U.S. commerce; or (2) a direct and significant connection with activities in U.S. commerce, and through such connection, present the type of risks to the U.S. financial system and markets that Title VII directed the Commission to address.[14]  Accordingly, to any extent the Commission is moving away from guidance towards substantive rulemaking, it must preserve that interpretation. 

As I read the Proposal—which purports to reflect the Commission’s current views[15]—I cannot help but notice that our “risk-based approach” seems to focus on individual entities that present a particular category of significant risk--the giants among global swap market participants-- and ignores smaller pockets of risk that, in the aggregate, may ultimately raise systemic risk concerns.[16]  What is lacking is any discussion of how our laser focus on individual corporate families and their ability to singularly impact systemic risk to the U.S. financial system adequately ensures that we are not disregarding the potential for similar swap dealing activities of groups of market participants, regardless of individual size, and in the aggregate, present a similar risk profile, or at the least a risk profile worth monitoring.  Perhaps more troubling, the Proposal is focused largely on the threshold matter of swap dealer registration requirements.  However, as the Commission has acknowledged, “Neither the statutory definition of ‘swap dealer’ nor the Commission’s further definition of that term turns solely on risk to the U.S. financial system.”[17]  And to that end, “[T]he Commission does not believe that the location of counterparty credit risk associated with a dealing swap—which…is easily and often frequently moved across the globe—should be determinative of whether a person’s dealing activity falls within the scope of the Dodd-Frank Act.”[18]

I also cannot help but notice the Proposal seems to frequently reference “comity” without providing supporting rationales for deferring to our fellow domestic regulators and foreign counterparts or for providing per se exemptions.  I support working closely with foreign regulators to address potential conflicts with respect to each of our respective regulatory regimes, and I believe that our cross-border approach must absolutely align with principles of international comity.  But, I do not understand how we can reach regulatory absolutes and conclusions based on comity, absent a finding that the exercise of our authority under CEA section 2(i) would be patently unreasonable under international principles.  I believe that substituted compliance is generally the most workable and respectful solution, and I believe we must engage with our fellow global regulators to address matters of risk that may impact each of our jurisdictions regardless of size and nature.  

Contraction Justifies Inaction—“U.S. Persons” and “Guarantees”

The bulk of the Proposal is dedicated to codifying 23 definitions “key” to determining whether certain swaps or swap positions would need to be counted towards a person’s SD or MSP threshold and in addressing the cross-border application of the Title VII requirements.  While most of the defined terms are familiar from the Guidance, there are some differences that stand out as more than a simple exercise in conformity.  For example, the preamble of the Proposal describes the proposed definition of “U.S. person” as “largely consistent with” and the definition of “guarantee” as “consistent with” the Commission’s Cross-Border Margin Rule.[19]  However, both represent a narrowing in scope from the current Guidance, and in turn, may potentially retract our authority under CEA Section 2(i) with respect to swap dealing activities relevant to swap dealer registration and oversight. 

With regard to “U.S. persons,” the definition harmonizes with the definition adopted by the Securities and Exchange Commission (“SEC”) in the context of its regulations regarding cross-border security-based swap activities, which largely encompasses the same universe of persons as the Commission’s Cross-Border Margin Rule.  However, among other things, the proposed “U.S. person” definition, unlike the Cross Border Margin Rule, would not include certain legal entities that are owned by one or more U.S. person(s) and for which such person(s) bear unlimited responsibility for the obligations and liabilities of the legal entity (“unlimited U.S. responsibility prong”).[20]  In support of its decision, the Commission puts forth what almost reads as an incomplete syllogism that fatally fails to address how such relationships may satisfy the jurisdictional nexus laid out in CEA section 2(i).  After noting (1) that the SEC does not include an unlimited U.S. responsibility prong because it considers this type of arrangement as a guarantee, and (2) that when considering the issue in the context of the  Cross-Border Margin rule, the Commission does not view the unlimited U.S. responsibility prong as equivalent to a U.S. guarantee, the Proposal states that (3) the Commission is not revisiting its interpretation of “guarantee” and is not including an unlimited U.S. responsibility prong in the “U.S. person” definition because it “is of the view that the corporate structure that this prong is designed to capture is not one that is commonly used in the marketplace.”[21] 

To be clear, the Guidance includes an unlimited U.S. responsibility prong in its interpretation of “U.S. persons” for purposes of applying CEA section 2(i) that is intended to cover entities that are directly or indirectly owned by U.S. person(s) such that the U.S. owner(s) are ultimately liable for the entity’s obligations and liabilities.[22]  Among other things, where this relationship exists, the Commission’s stated view is that, “[W]here the structure of an entity is such that the U.S. owners are ultimately liable for the entity’s obligations and liabilities, the connection to activities in, or effect on, U.S. Commerce would generally satisfy section 2(i)...”[23]

While I am not arguing that the Commission cannot change its views regarding the necessity for including a U.S. responsibility prong in a proposed “U.S. person” definition, I do believe that if we do so, we must articulate a rationale relevant to the particular context at issue and explain why our past reasoning with regard to the jurisdictional nexus is no longer valid.   

More concerning, the proposed “guarantee” definition is narrower in scope than the one used in the Guidance in that it would not include several different financial arrangements and structures that transfer risk directly back to the United States such as keepwells and liquidity puts, certain types of indemnity agreements, master trust agreements, liability or loss transfer or sharing agreements, etc.[24]  While in this instance, the Proposal explains the Commission’s rationale for the broader interpretation of “guarantee” for purposes of CEA section 2(i) in the Guidance, and admits that the rationale is still valid, it nevertheless chooses to ignore the truth of the matter and focus on what is more “workable” for non-U.S. persons.[25]  Further concerning, as I will explain shortly, the Proposal puts forth that while the proposed “guarantee” definition could lead to entities counting fewer swaps towards their de minimis threshold calculation relevant to SD registration as compared to the Guidance, related concerns could be mitigated to the extent such non-U.S. person meets the definition of a “significant risk subsidiary.”[26]  In this instance, the Commission is simply ignoring its responsibilities under CEA section 2(i) to save non-U.S. persons a little extra work, or as the Proposal might say, “overly burdensome due diligence.”[27]

SOS on SRS

The introduction of the “significant risk subsidiary” or “SRS” is perhaps the most elaborate departure from the Commission’s interpretation of CEA section 2(i) and almost seems to be an attempt to ensure that no non-U.S. subsidiary of a U.S. parent entity will ever have to consider its swap dealing activities for purposes of the relevant SD or MSP registration threshold calculations.  Save for a single footnote reference to a request for comment and passing references to SRSs likely being classified as conduits in the explanation of Cost-Benefit Considerations, the Proposal does not mention anything regarding the Guidance’s concept of a conduit affiliate—despite the fact that the SEC includes the concept of conduit affiliate in its definitions relevant to cross-border security-based swap dealing activity.[28]  Rather, instead of elaborating on whether and how the concept of conduit affiliates described in the Guidance failed to achieve its purpose, is no longer relevant, resulted in loss of liquidity, fragmentation, proved unworkable, etc., or should be deleted from all frame of reference in favor of harmonizing with the SEC, the Proposal simply introduces the SRS as a new category of person and walks through an elaborate analysis that really begins where it ends—an exclusion.  It is a policy decision of the worst ilk because it masquerades as a solution by diminishing the problem. 

SRSs represent a tiny subset of the consolidated non-U.S. subsidiaries of U.S. parent entities that the Commission believes are of supervisory interest in light of their clear potential to permit U.S. persons to accrue risk that, in the aggregate, may have a significant effect on the U.S. financial system or may otherwise be used for evasion.[29]  The Proposal’s stated rationale for targeting only a subset of non-U.S. subsidiary relationship focuses on comity and the application of a risk-based approach acts like a sieve on CEA section 2(i) such that only the largest entities that themselves as individual entities may pose risk to the financial system.  An approach that outright acknowledges the potential for widespread swap activities within the scope of CEA section 2(i), which could ultimately result in significant risk being transferred back to U.S. parent entities, only to be met with a bright line induced shrug by the Commission – is simply untenable.

Rather than rehashing the elements of the SRS definition, I will focus on two aspects that I find most troubling.  First is the requirement that the U.S. parent entity meet a $50 billion consolidated asset threshold.  This threshold is intended to limit the SRS definition to only those entities whose U.S. parent entity may pose a systemic risk to the U.S. financial system.  Foremost, given CEA section 2(i)’s focus on activities in the aggregate, a bright line threshold at the entity level is irrelevant.  Not to mention that if Congress had wanted the Commission to focus its cross-border authority on systemically significant entities, it would have used language that was not so embedded in common law[30] or would have articulated that directive clearly in the Dodd-Frank Act.[31]

Second, even if a non-U.S. person met one of three tests for being a significant subsidiary of a U.S. parent with over $50 billion in consolidated assets, it would not be an SRS if it is either subject to prudential regulation as a subsidiary of a U.S. bank holding company or subject to comparable capital and margin standards and oversight by its home country supervisor.  While I believe these exclusions are appropriate in the context of the policy the Proposal is putting forward in its vision of the SRS, I am concerned that we are substituting our oversight with that of the Federal Reserve Board, in one instance, on the grounds that being subject to consolidated supervision and regulation by the Federal Reserve Board with respect to capital and risk management requirements provides appropriate regulatory coverage.  While I do not disagree with respect to risk management that the Federal Reserve Board provides comparable oversight, finding that comparability satisfies our regulatory oversight concerns in this instance may lead us down a slippery slope in which we find ourselves fighting to maintain our own Congressionally delegated jurisdiction with respect to swaps activities.  This fact is only further validated— considering the breadth of the exclusions—by the high likelihood that a non-U.S. subsidiary of a U.S. parent entity with over $50 billion in consolidated assets is a financial entity subject to some form or prudential regulation in its home jurisdiction.  Indeed, the Proposal suggests that of the current population of 59 SDs, “few, if any, would be classified as SRSs.”[32] 

While the concept of an SRS is interesting to me, the Proposal’s attempt to draw multiple bright lines in a web of interconnectedness almost ensures that risk will find an alternate route back to the U.S. with potentially disastrous results.  Without a better understanding of how the SRS proposal would work in practice and whether it is truly better than the conduit affiliate concept currently outlined in the Guidance and presumably similar to the SEC’s own approach, it is difficult to get behind a policy that could most certainly bring risk into the U.S. of the very type CEA Section 2(i) seeks to address.

ANE—Anyone? Anyone?

The issue of how to address the application of certain transaction-level requirements with respect to swap transactions arranged, negotiated, or executed by personnel or agents located in the United States of non-U.S. SDs (whether affiliates or not of a U.S person) with non-U.S. counterparties (“ANE Transactions”) is one aspect of the Commission’s cross-border approach that has continually raised concerns and demands greater certainty.  First articulated in a 2013 Staff Advisory,[33] the issue boils down to whether transactional requirements apply to ANE swaps, and if so, whether substituted compliance may be available.  A 2014 Commission Request for Comment[34] sought to address the complex legal and policy issues raised by the 2013 Staff Advisory.  It was followed by the Commission’s 2016 Proposal, which among other things, addressed ANE transactions, including the types of activities that would constitute arranging, negotiating, and executing within the context of the 2016 Proposal, and the extent to which the SD registration threshold and external business conduct standards apply with respect to ANE Transactions.[35]  Today’s Proposal withdraws the 2016 Proposal on grounds that the Commission’s views have changed and evolved as a result of market and regulatory developments and “in the interest of international comity.”[36]

The proposal sets forth an approach largely based on comments to the 2014 Request for Comment[37] and seemingly in response to a recommendation made in an October 2017 report of the U.S. Treasury Department that both the CFTC and SEC “reconsider the implications of applying their Title VII rules to transactions between non-U.S. firms or between a non-U.S. firm and a foreign branch or affiliate of a U.S. firm merely on the basis that U.S. located personnel arrange, negotiate, or execute the swap, especially for entities in comparably regulated jurisdictions.”[38]  The proposed approach is simply to ignore ANE Transactions within the scope of the Proposal as irrelevant “because the transactions involve two non-U.S. counterparties, and the financial risk of the transactions lies outside the United States…”[39]  That may be the case in some circumstances; however, casting an overly broad net on a category of activities may run the risk of slippage, and I am concerned we have not given this important element of our cross-border jurisdiction enough thought to warrant such an expeditious solution.

Conclusion

Despite my concerns regarding this Proposal, I look forward to hearing constructive input from market participants and the public.  I am encouraged by the balanced nature of the requests for comment, and would like to modestly request that in responding to the Proposal, commenters indicate whether they believe it is appropriate and prudent for the Commission to proceed with a rulemaking at this time, or whether the preference is to adhere to the current Guidance, or some hybrid of the two.

As with all rulemakings, input the Commission receives through public comment drives the conversation, and sets us on a course that balances diverse interests; seeks transparency, resiliency, and efficiency; and above all else, focuses on protecting U.S. markets, its participants and most importantly the customers that rely on this truly global marketplace.  One might assume that making targeted, surgical changes to an existing regulatory framework is easier than creating a framework.  But, in some circumstances, it is exactly the opposite.  Global swaps markets have grown and evolved around rule sets that were completed and implemented in the very recent past.  As regulators I believe we should caution against any wholesale rewrite when we find well regulated, transparent, and generally well running financial markets.  But, if we do find vulnerabilities or inefficiencies in our rules (certainly both old and new), the process to reconsider should be deliberate, balanced, and inclusive to ensure the Commission, as a collective body, understands the gravity of its decisions.