Speech of Enforcement Director James M. McDonald Regarding Enforcement trends at the CFTC, NYU School of Law:  Program on Corporate Compliance & Enforcement

November 14, 2018

As Prepared for Delivery

Introduction

Thank you for that introduction.  I’m happy to be back here at NYU as part of the Program on Corporate Compliance & Enforcement (PCCE).  Over the years, the PCCE has brought together some of the best thinking in the enforcement, business, and academic community to develop a richer and deeper understanding of the causes of corporate misconduct, and how enforcement and compliance programs can most effectively deter it.  The result is that the work here at the PCCE has been a driver of some of the most significant developments in Enforcement and Compliance.

We’ve followed these developments closely at the Commodity Futures Trading Commission (CFTC).  At every stage of our agency’s history, we’ve sought to bring impactful enforcement actions in the markets we regulate, and to ensure we stand ready to meet the challenges presented as these markets continue to evolve.  Our most recent challenges have included responding to the dramatic expansion of our jurisdiction under Dodd-Frank in the wake of the financial crisis.  Under David Meister, the first post-Dodd-Frank Director of Enforcement, the Division literally wrote the rules that set out some of our new enforcement jurisdiction.  With the next Director, Aitan Goelman, the Division brought first-of-their-kind cases under these new rules.  And under both Directors’ leadership, we began to define our major priorities and to develop some of the initiatives we rely on today, like the Division’s cooperation program.  Thanks to their hard work and that of the dedicated career civil servants who staff the Division, we’re well positioned today to continue to build on those priorities and initiatives.  As part of that effort, we’re constantly surveying the enforcement world to identify best practices and to incorporate them into our program.

The work of the PCCE has been particularly helpful to us in this regard.  In fact, it was only a little more than a year ago that we talked about some of our priorities here at the PCCE.  We emphasized in particular the development of the Division’s cooperation and self-reporting program. 

But a lot has happened at the CFTC in the past year.  So my plan tonight is to do three things.  First, to give you an update on what we in the Division have been up to over the last year.  Our most recent Fiscal Year closed on September 30.  This evening, in connection with this speech, we’re releasing the Division’s first Annual Report, which details our work during the last Fiscal Year.  To save you the suspense, the report shows that, by any measure, enforcement during the past Fiscal Year has been among the most vigorous in the history of the CFTC.

Second, I’ll outline some of the major priorities and initiatives that guided us over the last Fiscal Year and that will continue to guide us going forward.  And finally, I’ll offer an update on some recent developments in our cooperation and self-reporting program.

FY 2018 Overview

I’ll start with an overview of our last Fiscal Year.  But before I begin, let me say a word about how we measure our success.  Any time we talk about year-end results, some of that discussion necessarily includes numbers.  But a strong enforcement program is about more than just numbers.  It’s about preserving market integrity, protecting customers, and deterring potential bad actors from engaging in misconduct in the first place.  It’s about being tough, to be sure, but it’s also about being fair.  And it’s about allocating resources efficiently to ensure our efforts target the most pernicious forms of misconduct.  These sorts of things can’t be measured by numbers alone.  But that’s a good thing:  Federal agencies should not be motivated to hit certain numbers when enforcing the law.

At the same time, we recognize that numbers do tell part of the story.  They might help show the direction an enforcement program is heading.  They might reflect the types of cases that stand as priorities.  Or they might offer some perspective on the program’s broader goals.  So in our annual report—and this evening—we offer quantitative and qualitative measures to tell the full story of our enforcement program.

The Annual Report walks you through these numbers, so I won’t belabor them here.  But I’ll share with you the headline:  This was a year of incredibly vigorous enforcement at the CFTC.  That’s true whether you measure it by the number of filed cases (third highest in CFTC history), amount of penalties imposed (fourth highest), number of large-scale matters (highest), types of cases charged (most ever involving manipulative conduct), number of parallel criminal actions (highest), percentage of cases that include individual charges (more than 2/3), or the number and amount of whistleblower awards (highest on both counts).  For more detail on these numbers, I refer you to the Annual Report.

FY 2018 Priorities and Initiatives

What I’d like to do for the rest of the evening is to take you behind these numbers—to walk you through how these numbers reflect our priorities, and how we’ve begun or continued initiatives to advance these priorities.

Let’s start with priorities.  Our enforcement program over the last year largely centered around four priorities:  (1) preserving market integrity; (2) protecting customers; (3) promoting individual accountability; and (4) enhancing coordination with other regulators and criminal authorities.  Let me say a few words about each.

Preserving market integrity.  Well-functioning commodity and derivatives markets are necessary to ensure the stability in prices that customers have come to expect, and the growth in the economy that Americans enjoy.  When these markets are working, producers are able to hedge the risk that this year’s output might not be as good as the last, which protects them and consumers against price increases.  And these markets allow entities and individuals to allocate their capital more efficiently, which contributes to the growth of the broader American economy.  But these markets won’t function well if participants don’t have confidence in the integrity of the market.  That is why the Division has focused on detecting, investigating, and prosecuting misconduct that has the potential to undermine market integrity—misconduct like manipulation, spoofing, and disruptive trading.

These cases are complex, and they can be difficult.  But they’re essential.  A primary function of our markets is to facilitate the price discovery process.  And one of our principal responsibilities as regulator of these markets is to ensure that the price discovery process is sound.  That means identifying, investigating, and prosecuting those who seek to interfere with this price discovery process.

The work of the Division over the last Fiscal Year reflects this priority.  During Fiscal Year 2018, we brought more cases involving this type of misconduct than ever before.  Indeed, from 2009 to 2017, the CFTC, on average, brought about six such cases per year.  This past year, we filed twenty-six.

Many of these cases required us to address particularly complex and novel patterns of manipulation—including those that cross markets, cross exchanges, or even cross international borders.[1]  Others required us to adapt to relatively new forms of manipulative conduct—like those that abuse technology or seek to manipulate the structure of the electronic order book.[2]

Protecting customers.  Since its inception, the CFTC has focused on protecting customers in its markets from fraud and other forms of abuse.  That focus remained a priority during the last Fiscal Year.  The Division aggressively prosecuted fraud in some of these traditional areas, like precious metals, forex, and binary options.  But this last Fiscal Year, we also saw some fraudsters evolve, as they sought to use new products or new technologies to target unwitting customers in markets like virtual currencies.  We have worked hard to ensure that we are evolving with these bad actors—and indeed, staying one step ahead.

We saw success in this area as well.  In one of the largest binary options frauds ever brought by the CFTC, we charged a massive national and international binary options fraud ring, which we allege harmed approximately 75,000 victims.[3]  We charged numerous cases involving fraud in connection with virtual currencies.[4]  We charged one case that started out as a binary options fraud and then morphed into a virtual currency fraud during the life of the scheme.[5]  And we have taken these cases to trial when necessary, winning significant trial victories during the past Fiscal Year—including a precedent-setting victory in a trial involving Bitcoin fraud.[6]

Promoting individual accountability.  A consensus has now developed in the enforcement and business communities that individual accountability must sit at the center of any effective effort to deter misconduct.  We share in that consensus.  It’s not enough simply to hold the responsible companies accountable.  The responsible individuals must be held accountable too.  Individual accountability ensures that the person committing the illegal act is held responsible and punished; it deters others, fearful of facing individual punishment, from breaking the law in the future; it incentivizes companies to develop cultures of compliance and to report to regulators when they find bad actors in their entity; and it promotes the public’s confidence that we are achieving justice.  In pursuing individual accountability, we must look beyond the employees who actually commit the wrongful acts.  We must also seek to hold accountable the supervisors and others in control who may be culpable as well.

We prioritized individual accountability during the past Fiscal Year, with more than two-thirds of our cases involving charges against individuals.  We’ve charged individuals at financial institutions,[7] proprietary trading firms,[8] and managed funds.[9]  We’ve charged primary wrongdoers, and also those who have facilitated that misconduct as aiders and abettors.[10]  And we’ve used all available theories of liability that allow us to reach up the chain, like supervisory and control person liability—leading to charges against supervisors and desk heads,[11] CEOs,[12] and a Chairman of the Board.[13]

Enhancing coordination with other regulators and criminal authorities.  We can most effectively protect our markets when working closely with our colleagues in the enforcement and regulatory community, both domestic and international.  That is particularly true as our markets evolve and become more interconnected.  Bad actors, it turns out, don’t conform their misconduct to the technical boundaries of different regulatory jurisdictions, nor do they pause as their conduct crosses international borders.  So regulators here in the United States and abroad must work together to ensure the entire scope of the misconduct is identified, investigated, and prosecuted.  This approach yielded results this past year, as we investigated and filed a numerous of actions in parallel with our enforcement and regulatory counterparts.

Particularly noteworthy is our expanded effort to charge cases in parallel with our criminal law enforcement counterparts.  A robust combination of criminal and regulatory enforcement in our markets is critical to achieving optimal deterrence.  Perhaps the most significant development on this front was the announcement of the parallel actions involving spoofing and manipulative conduct we filed together with the Department of Justice and Federal Bureau of Investigation in January 2018.[14]  A senior member of the Justice Department stated that these filings constituted “the largest futures market criminal enforcement action in Department history.”[15]  These filings were equally significant for the CFTC, which filed charges against three financial institutions and six individuals for manipulative conduct and spoofing, including the largest civil monetary penalty ever imposed for spoofing-related misconduct.[16]

But during the last year we filed a number of other actions in parallel with our criminal counterparts as well.  These include cases ranging from retail and virtual currency fraud, to manipulation of global benchmarks, to efforts to obstruct our investigation.[17]  And that’s just to name a few.  All of this means that wrongdoers in our markets now face the reality not just of substantial fines, but also, in appropriate cases, the prospect of criminal prosecution.  This marks a trend that we expect to continue going forward and, we believe, will significantly deter wrongdoers from committing misconduct in our markets.

So those are the priorities.  How have we advanced them?  By beginning or continuing several key initiatives during the past Fiscal Year.  I want to talk about a few of these initiatives this evening.

Data analytics.  Anyone in our markets knows that these markets are going through a revolution—a revolution from analog to digital, from pit trading to electronic order books, from human trading to algorithmic, and from stand-alone trading centers to interconnected trading webs.  Emerging digital technologies are impacting trading markets and the entire financial landscape with far ranging implications for capital formation and risk transfer.

We’ve worked hard to keep pace with this technological change, and to ensure we stand at the cutting edge of the data analytics world.  We’ve done this primarily in three ways:  (1) increasing the amount of data available to the Division; (2) ensuring the Division has the tools necessary to assess, evaluate, and analyze the data; and (3) developing the human capital in the Division so we can marshal this data to uncover and prosecute illegal conduct in our markets.

Particularly significant in this area has been the realignment within the Commission to move the Market Surveillance Unit from the Division of Market Oversight into the Division of Enforcement.  Our Market Surveillance Unit includes market experts, economists, statisticians, and quantitative analysts, among others, who are dedicated to detecting fraud, manipulation, and disruptive trade practices.  They typically do this by analyzing available data—including the activities of large traders, key price relationships, and relevant supply and demand factors—and by building data analytical tools that can be used to detect misconduct across our markets.  Integrating the Market Surveillance Unit into the Division of Enforcement reflects the data-centric approach we pursued during the last Fiscal Year, and expect to continue going forward.

Specialized task forces.  Also during the last Fiscal Year, we expanded the foundation of our enforcement program into new areas where we see or suspect misconduct—areas like spoofing, virtual currency, and insider trading.  Developing our program in these new areas presented a challenge:  How do we move as quickly as required, while ensuring each of our teams, across each of our offices, approach the matters in a smart and consistent manner?  Our answer was to develop a set of specialized task forces in the Division to ensure consistency, identify best practices, and develop new approaches and ideas based on past lessons learned.  Each task force includes members from each of our offices, in Chicago, Kansas City, New York, and Washington, D.C.  These task forces focus on four different substantive areas.

• Spoofing and Manipulative Trading:  A little more than a decade ago, our markets moved from in-person trading in the pit, to computer-based trading in an electronic order book.  The advent of the electronic order book brought with it significant benefits to our markets—it increased information available, reduced friction in trading, and significantly enhanced the price discovery process.  But at the same time, this technological development has presented new opportunities for bad actors.  Just as the electronic order book increases information available to traders, it creates the possibility that false information injected into the order book could trick them into trading to benefit a bad actor.
  
  Efforts to manipulate the electronic order book—which can include spoofing—are particularly pernicious examples of bad actors seeking to gain an unlawful advantage through the abuse of technology.  These efforts to manipulate the order book, if left unchecked, drive traders away from our markets, reducing the liquidity needed for these markets to flourish.  And this misconduct harms businesses, large and small, that use our markets to hedge their risks in order to provide the stable prices that all Americans enjoy.  The Spoofing Task Force works to preserve the integrity of these markets.
• Virtual Currency:  The story of virtual currency is also about new technology.  And it is a story about the need for robust enforcement to ensure technological development isn’t undermined by the few who might seek to capitalize on this development for unlawful gain.  New and potentially market-enhancing technologies like virtual currencies and distributed ledger technology need breathing space to survive.  Through work across the Agency, the CFTC has shown its continued commitment to facilitating market-enhancing innovation in the financial technology space.  But part of that commitment includes acting aggressively to root out fraud and manipulation from these markets.  The Virtual Currency Task Force is dedicated to identifying misconduct in these areas and holding bad actors accountable.
• Insider Trading and Protection of Confidential Information:  Illegal use of confidential information can significantly undermine market integrity and harm customers in our markets.  This type of misconduct could include misappropriating confidential information, disclosing a client’s trading information, front running, or using confidential information to unlawfully prearrange trades.  As we continue to build the foundation of our enforcement program, we will continue to work to ensure our market participants are not misappropriating confidential information for their own benefit.
• Bank Secrecy Act:  Many of our registrants are required to comply with the Bank Secrecy Act and anti-money laundering rules.  These registrants’ obligations include following rules related to suspicious activity reporting (SAR) and know-your customer programs (KYC).  These laws exist for good reason, as they require these market participants that serve as a first-line of defense against fraud, money-laundering, and related offenses to be on the lookout for misconduct.  Indeed, SARs and other Bank Secrecy Act reports significantly contribute to the Division’s ability to detect and prosecute the sort of misconduct that may flow through our registrant intermediaries.  Our Bank Secrecy Act task force works to ensure all of our registrants live up to these obligations.

Cooperation and Self-Reporting:  Recent Developments

The final item I’ll discuss this evening is our cooperation and self-reporting program.  Last year, we explained our view that this program would serve as a powerful tool to hold wrongdoers in our markets accountable.  We explained that the program is designed to get companies and individuals who know about the misconduct to tell us about it; to enable us to identify all of those involved in the wrongdoing; and to allow us to prosecute the most culpable individuals and companies.  It’s a tool that originated in organized crime and gang prosecutions, and has been employed aggressively and with success in white collar prosecutions as well.  We’ve now incorporated this tool into our enforcement efforts at the CFTC.

We’re still just getting started, but the early returns look good.  Through the end of last Fiscal Year, we had issued three significant orders that involved self-reporting.  Each included a civil monetary penalty that reflected a significant reduction on account of the self-report, cooperation, and remediation.[18]  We also employed our individual cooperation program to sign up individuals to cooperation agreements, which also led to significantly reduced penalties—some of which even included no civil monetary penalty.[19]

When we announced the program, we made clear that it should not be viewed as giving anyone a pass.  That’s been borne out over the last year, in which we filed cases against more financial institutions than any prior year but one.  We brought charges against several individuals who work at these institutions.  And through our cooperation and self-reporting program, we were able to charge both companies and individuals, including supervisors and senior management, that we otherwise might not have been able to charge.

What’s more, this program is continuing to grow.  We’re only a little more than five weeks into the new fiscal year.  Yet already we’ve had two significant new developments.

The first involved spoofing and manipulation charges against Kamaldeep Gandhi, formerly a trader at several proprietary trading firms.  As part of our investigation, Gandhi agreed to cooperate with the CFTC and entered into a cooperation agreement with the Division.  Under the terms of that agreement, Gandhi admitted to his own conduct, and told the CFTC about others who were also involved.  Among other things, Gandhi’s cooperation agreement binds him to continue to cooperate throughout the course of the CFTC’s broader investigation.

Because Gandhi’s cooperation was not yet complete at the time of the resolution, the CFTC bifurcated Gandhi’s case—deciding liability in an order issued on October 11, 2018,[20] but leaving the amount of the penalty to be determined at a later date, once Gandhi’s cooperation is complete.  This bifurcation mirrors the criminal process, where the guilty plea comes first, and sentencing later.  And bifurcation allows the CFTC to consider the entire range of cooperation when determining the appropriate penalty.  Gandhi’s case stands as an example of the sorts of tools we’ll employ to ensure we can use our cooperation program in the most effective way possible.  I expect you’ll see more bifurcated orders in these types of cases going forward.

The second development involved a case announced last week involving a former managing director at Deutsche Bank named Jacob Bourne.  During June and July of 2017, Bourne mismarked the valuations of swaps in an attempt to cover up more than $10 million in trading losses.  The mismarked swaps were then reported to counterparties and the CFTC.

Deutsche Bank’s internal controls identified the discrepancies in Bourne’s swap valuations.  Having caught the discrepancies, the bank conducted an internal investigation, which determined that Bourne had mismarked the swaps in question and then altered documents to cover it all up.  The bank moved quickly to reach this conclusion:  The bank identified the discrepancies less than a week after Bourne began mismarking the swaps, and it reached its conclusion less than a month later.  Three days after that, the bank self-reported Bourne’s conduct to the Division.  Bourne was placed on administrative leave and then terminated.

The CFTC brought an action against Bourne for fraud arising out of this mismarking.  But the Division declined to prosecute the bank, on account of its self-reporting, cooperation, and remediation.  The declination letter is available on the CFTC’s website, and it includes more detail, which I recommend you read.

But stepping back just a bit, the takeaway here is that this is how our self-reporting program is designed to work.  We want companies to have sufficient internal controls to catch wrongdoing when it happens.  When they find misconduct, we want them to take appropriate remedial steps—to fix the problem, and to make sure it won’t happen again.  And yes, we also want them to tell us about it, and to cooperate proactively in our investigation.  If they do that, the individuals responsible will be prosecuted, as Bourne was here.  But the company will gain a substantial benefit as a result of their self-report, cooperation, and remediation.  And in extraordinary cases like Deutsche Bank’s, the company may receive a declination of prosecution altogether.

 Stepping back even further, this all really goes to the heart of what we’re trying to achieve with our enforcement program more generally.  The end goal for us in Enforcement extends well beyond the number of cases filed, or the amount of penalties imposed.  We intend for our enhanced emphasis on individual accountability, cooperation, and self-reporting—together with the other priorities I’ve discussed this evening—to have a far broader social impact.  Our end goal is to foster a true culture of compliance in our markets.

What do we mean when we talk about a culture of compliance?  Think about it this way:  Imagine a CEO standing in front of the company’s new hires on their first day on the job.  Imagine the CEO telling the new staff about the various trainings to come as part of the onboarding process—compliance, ethics, human resources and the like.  And imagine the CEO telling the new staff that, notwithstanding these various internal company regimes, if they break the law, their problems won’t stop with the compliance, ethics, or human resources department.  Their problems will come from the CFTC (and perhaps even the DOJ and the FBI).  That’s because, the CEO tells the staff, the company is committed to identifying any misconduct, and to reporting it out to the relevant authorities.

That’s the sort of commitment we’re seeking to foster.  That’s the sort of commitment that creates the culture of compliance we want to see in all of our market participants.  And that’s the end goal to which all of our enforcement efforts are aimed.

We believe this past Fiscal Year, particularly when viewed in light of the robust enforcement program we’ve built over the years, shows that we’ve taken significant steps towards achieving this culture of compliance in our markets.  We’ll work hard during this next Fiscal Year and beyond to ensure this trend continues.

Thank you.

Statement of Concurrence of Commissioner Rostin Behnam Regarding De Minimis Exception to the Swap Dealer Definition

November 5, 2018

Today, the Commission acts decisively to set the aggregate gross notional amount (“AGNA”) threshold for the de minimis exception at $8 billion in swap dealing activity entered into by a person over the preceding 12 months.  I am comfortable supporting today’s final rule because it is limited to establishing a clear and certain de minimis threshold.  While I was unable to support the proposed rule—which moved the Commission far beyond the task before it towards unilaterally redefining swap dealing activity absent meaningful, congressionally-required collaboration with the Securities and Exchange Commission (“SEC”)—I am gratified that the Commission is not moving forward with aspects of the Proposal which would have further complicated the distinction between dealing and non-dealing activities. [1]  Such action would have been detrimental to market participants.  To the extent the Commission continues to consider addressing long standing concerns with the IDI Swap Dealing Exclusion,[2] ambiguity regarding the treatment of swaps used for hedging, or relief applicable to swaps that result from multilateral portfolio compression exercises, it should do so jointly with the SEC.

NFC Swap Data

Today’s decision to maintain the AGNA threshold at $8 billion follows a period of prolonged uncertainty during which Commission staff conducted more complete data analysis regarding the de minimis exception.[3]  While swap data repository (“SDR”) data quality has improved, AGNA data was unavailable for non-financial commodity (“NFC”) swaps.[4]  Nevertheless, Commission staff used counterparty and transaction counts and a series of assumptions to analyze likely swap dealing activity in the NFC swap market and concluded that reducing the $8 billion AGNA threshold could lead to reduced liquidity in NFC swaps, negatively impacting end-users and commercial entities who utilize NFC swaps for hedging.[5]  The Commission further relied upon findings and comments that the unique characteristics of the NFC swap market pose less systemic risk than financial swaps.[6]  

It is my hope that Commission staff will continue to examine and monitor data and activities in the NFC swap market to ensure that concentrated activity by unregistered NFC counterparties in segments of that swap market, such as in energy-related swaps, do not present outsized risk or harm to end-users, and most importantly, the general public. 

[1] De Minimis Exception to the Swap Dealer Definition, 83 FR 27444, 27481-2 (proposed June 12, 2018).

[2] If the proposed IDI Minimis Provision truly better aligns the swap dealer regulatory framework with the risk mitigation demands of bank customers, as commenters suggested, then it would seem that there should be few hurdles in the way of the CFTC and SEC engaging to reconsider the parameters of the IDI Swap Dealing Exclusion.

[3] 83 FR at 27445-6.

[4] 83 FR at 27445.

[5] 83 FR at 27450, 27456-7.

[6] 83 FR at 27457; De Minimis Exception to the Swap Dealer Definition, 83 FR 56666, 56675 (Nov. 13, 2018).

Remarks of Chairman J. Christopher Giancarlo at the Global Financial Leadership Conference, Naples, Florida

November 12, 2018

Introduction: A Great American Institution

It is great to be at The Global Financial Leadership Conference.  It is one of the most important annual events on financial market evolution and economic thought leadership.  It is an honor to speak to such a distinguished audience.

I want to start off by stating something that is widely known, but inadequately voiced by those of us in the official sector.  That is that the Chicago Mercantile Exchange and its family of listed exchanges and the marketplaces they serve are profoundly essential institutions in our economy.  Indeed, they are a foundational pillar of the American way of life.

That is because the CME operates platforms on which the risks of variable production costs, such as the price of raw materials, energy, foreign currency and interest rates, are transferred from those who cannot afford them to those who can.  These platforms serve the needs of society to help moderate price, supply and other commercial risks to free up capital for economic growth, job creation and prosperity.

The risk conveyance instruments so critically traded on CME platforms are futures, options, swaps and other derivatives.  Some of you know how derivatives markets work, but I think a basic example will be useful.  Let’s start with your local grocery store.  Its shelves are stocked with food at stable prices week after week, rain or shine, year after year.  We never have to wonder how the weather is affecting the growing season or if it was a bountiful or lean harvest in America’s farmland.

Yet, the constant bounty of food at steady prices which we enjoy in our grocery shelves here in America is not the case everywhere.  In too much of the world, plentiful food still depends on a good harvest.  A bad harvest means there is little to eat.  With little to no income from a bad harvest, farmers are unable to plant next year causing further hunger and misery.

The use of risk hedging instruments, namely commodity futures, swaps and other derivatives, is one of the key reasons Americans find plenty of food at stable prices in our grocery stores.  But derivatives are not just beneficial for food security.  They moderate the price of warming our homes, powering our factories, driving our cars, paying our home mortgages and investing our retirement savings.  In short, derivatives provide stability and predictability to our way of life.

That’s why these markets are so essential.  That’s why CME’s work is so important.

Economic Bedrock: Free Market Capitalism

But I am not standing here before you to merely confirm the importance of an important American institution.  I want to assert the essentialness of an even greater foundation.  And that is nothing less than free market capitalism, the bedrock on which our entire economy and its great institutions and critical infrastructure stands.

And I want to assert this importance here and now.  I do so knowingly, indeed, forthrightly, in a time of growing erosion of trust and respect for long serving institutions.  I do so amidst growing efforts here and abroad to increase political control over markets.  I do so at a time of calls to prioritize political goals and objectives over sound financial regulation.

Loss of Faith in Free Markets

Today, we see distrust, and even disdain, for so much of society’s core institutions: from government to political parties from law to law enforcement from social conventions to organized religion.  We see it in some our young generation and their fascination for socialism.

And yet, the growing antipathy to free enterprise and market capitalism are not merely generational.  Some, like Thomas Piketty, see the 2008 recession as a failure of capitalism.  They cite growing inequality as a reason for stronger political control over the economy and its institutions: more government activism, new forms of shared socialism and less private property.

Others foretell capitalism’s coming demise. They call for a new international order, a new Bretton Woods, where politically-motivated decision-makers divine and create the economic future better than financial markets evolving through innovation, choice and competition.  They champion new global bodies with greater authority that can impose political solutions for market problems.

Enduring Value Proposition

That is why I wish to reassert today the value proposition of free market capitalism.  That proposition is that broad and sustained prosperity generally occurs wherever in the world you have open and competitive markets, combined with free enterprise, personal choice, voluntary exchange and legal protection of person and property.

This value proposition is a source of human expression, aspiration and creativity. It is unrivaled in creating wealth, employment, innovation, personal financial security, and opportunity.  It has lifted hundreds of millions out of poverty.

But the case for free market capitalism is not just a utilitarian one – that it reduces poverty - but it is a moral one as well.  Freedom of choice is a social good in its own right, a moral and economic imperative.  Life, liberty and the pursuit of happiness are about the freedom of the individual – not just moral or political freedom - but economic freedom as well, freedom to live in a self-directed manner and conduct commerce as one may determine.

Freedom in the economy is a part of freedom itself.  Billions of consumers, following their own self-interests and individual needs, make the decisions that direct the future, not have it directed for them.  For an emerging generation fascinated by crowd sourcing, free capital markets are the ultimate in crowd sourced decision making.  Young people today and always, aspire to bright and self-actualized futures – something that is no more freely and openly chosen than under free market capitalism.

The American Model

The classic American model of free market capitalism is one where well-regulated and well-ordered trading activity is considered a forum of human self-expression and economic advancement. The legitimacy of capital markets is not derived from furthering other governmental, social, or industrial policy goals.  Rather, free and fair capital markets are considered a social good in their own right.

And a critical part of this model is the independence of financial regulation from politics and political control.  That is why the framers of the US market regulatory structure wisely made the CFTC and SEC independent agencies, not under the direct control of either the executive or legislative branches, but subject to the thoughtful oversight of both.  The effect is to shield Federal market regulators from the political tempests of the times.  It allows them to regulate in the best interest of markets and not in furtherance of a broader political agenda.

Having served under both Obama and Trump Administrations, I have witnessed consistent avoidance of interference in the CFTC’s regulatory mission.  And that is right.  It is a credit to US political institutions. Society may choose to address certain concerns such as climate change, poverty or gender discrimination but they are properly addressed through legislative action.  Markets offer a platform to value those concerns, not institute them.

I believe that insulation from political control and direction is one of the reasons why US markets remain the world’s deepest and most liquid.  And interestingly, despite being the most venerable, US futures markets are today among the fastest growing markets in the world.  Their continued expansion reflects their universally-recognized integrity and independence from particular government social, monetary or political policies.

Political Encroachment on Free Markets

It is unfortunate that around the world today we witness political encroachment on free markets.  In some overseas markets, “home teams” of regulated market participants are compelled to adjust their trading activity to move markets in directions complimentary to prevailing government economic policy.  In other cases, market access and trading activities of non-domestic market participants are heavily burdened and limited.  In many jurisdictions market regulation is subordinated to government political, social, and industrial policy.

These infringements on free markets are misguided.  Whatever the short term expediency, treating markets as instrumentalities for social, political and other government policies diminishes market integrity and investor confidence in the long term.  That is why we must resist attempts, domestic or foreign, to subject US markets to policies or regulations designed for any purpose – no matter how worthy – that is not in the strict best interest of the markets themselves.

Truth, Freedom and Free Markets

I would never wish otherwise, yet, the fall of Soviet Communism is a perverse loss for Western liberal democracy.  The Soviet Block provided context for the free market institutions that support our civil and commercial liberties.  The current disintegration of socialist Venezuela reminds us that surrendering individual liberty - not only political and social liberty, but economic liberty - is destructive to humanity.

And, frankly, it’s time to say it.  The late president of the Czech Republic, Václav Havel, who knew something about the loss of personal liberty, urged us to “live in truth.”   Let’s tell the truth about socialism and government encroachment on free market capitalism and human choice.  Havel said that morality is part of our ideas…truth and freedom are intertwined.  Human freedom is indivisible:  if it is denied to anyone, it is denied to us all.

And countries that don’t safeguard free markets, like Venezuela, are ruined, a previously bountiful economy destroyed by central planning and corrupt government control.  There are rampant shortages in every commodity from wheat to paper.  There is human misery.  There is economic destruction that will take decades to repair while the people continue to suffer…or leave for free markets elsewhere.

Conclusion 

In closing, we must champion and defend free market capitalism and the disciplined and independent financial regulation that safeguards it.  We must do this so that individuals have the freedom to choose and prosper.  We are entering a complex and conflicting new world and must respond with a fresh unleashing of the creative power of humanity.  In a future of unimaginable possibilities, we need the vision of a Steve Wozniak, the clarity of a Václav Havel and the courage of the CME’s eminence gris, Leo Melamed.

Where others see the deterioration of venerable institutions, we see their rebirth and renewal.  While others argue for a future of imposed conformity, we see a future of more human potential and possibility.  Where some encourage collective bridling of economic activity, we reassert the unrivaled power of free market capitalism, the best foundation for a future of human creativity and aspiration.

We must renew faith in free markets for ourselves and our children.  We must encourage the initiative, productivity, drive, and dreams of everyone on this planet…not just in Chicago, New York or Paris or Tokyo and in other developed economies, but also in places that lack infrastructure, or nations facing economic crisis like Venezuela or growing needs like the Congo.

We invite the world to follow this model of free market capitalism.  We welcome others to join us in a thriving future of human potential.  A future where creativity and economic expression is a social good all by itself – and a good for us all.

Thank you.

Keynote Address of Chairman J. Christopher Giancarlo at Fintech Week, Georgetown University Law School

“Quantitative Regulation:  Effective Market Regulation in a Digital Era”

November 7, 2018

Thank you.  Let me begin by thanking Georgetown Law Professor and Director of the Institute of International Economic Law, Chris Brummer. In only a few short years under his leadership, the Georgetown Law Fintech Conference has become one of the true forums for thought leadership in the overcrowded industry of fintech conferences.

Thank you, Professor Brummer.  It is an honor to be invited to be here today.

Introduction

This year, we celebrate an important, though somewhat forgotten, anniversary.  We are now seventy years from the creation in 1948 of the world’s initial stored program computer, the “Manchester Baby”.  The “Baby” was designed as a test platform for the first true random-access computer memory.  It was constructed in a separate building at the University of Manchester and housed in a room that was smaller than the one in which we meet today.

Clearly, so much has changed in the seven decades since the birth of the “Baby”.  The average modern laptop computer has 30 million times its processing speed.  The average contemporary smart phone has 500 million times its storage capacity.  Just in the past decade alone, we have witnessed technological advancements ranging from the internet’s permeation through all sectors of the economy to exponential increases in computing power to computer science breakthroughs in developing permission-less and largely autonomous economic networks.

So much change – the course of a single human lifetime.

So much of our world today – from information to education, from journalism to free speech, from music to manufacturing, from transportation to commerce, from travel to leisure, and from agriculture to nutrition – is undergoing a digital transformation.  You might call it the digitization of modern life.  Others call it the 4th industrial revolution,[1] a melding of science and technology with human existence and society.

That is why it is so good to be with you today.  This 2018 Georgetown Law Fintech conference is ever so timely.  The topics under consideration reflect a common realization that we are entering a new phase in human history, when exponential digital technologies are rapidly changing the very nature of human identity, work, leisure and community.

It is certainly no surprise to this audience that, just as our lives are being transformed, so the world’s trading markets are going through the same digital revolution from analog to digital, from human to algorithmic trading and from stand-alone centers to interconnected trading webs.  Emerging digital technologies are impacting trading markets and the entire financial landscape with far ranging implications for capital formation and risk transfer.  They include algorithm-based trading, “smart” contracts, Distributed Ledger Technology (DLT), and the topic that I want to discuss with you today: big data, automated data analysis, and artificial intelligence (AI).

Quantitative Regulation

The CFTC has been no bystander to the digitization of modern markets.  We have been closely engaged through three points of contact: our Technology Advisory Committee (TAC)[2], our market intelligence branch,[3] and LabCFTC, the first ever innovation and technology engagement initiative by a U.S. market regulatory agency that seeks to modernize both our external and internal approach to such developments.[4]

Yet, there is one area of the technology revolution that is central to all the others and where the CFTC must run harder to keep pace.  That is in the area of big data and its uses, including automated data analysis and machine learning and intelligence.  The CFTC must run faster because the amount of market data continues to grow exponentially and infinitely more granular, quantitative data analysis increasingly drives commercial trade execution and strategy, and limited agency funding requires increasing operational efficiency.

Indeed, as we move to a world of scalable data lakes – or perhaps even oceans – many market processes and decisions will become increasingly reliant on the ability to proficiently glean insights and take actions based on thoughtful data analysis.  For America to continue to provide a home to the most robust and well-regulated markets, our taxpayers rightly expect that we in government keep pace with digitization and execute our regulatory missions in the most effective and efficient ways possible.

Today, I will explain how the CFTC regulatory response to the increasing centrality of data in every aspect of contemporary market activity must be enhanced with up-to-date quantitative data analytics capability.  The CFTC and other modern market regulators must start the next phase of regulatory data collection, automated analysis and data-driven policy application.  We must pioneer a new frontier of quantitative regulation or “QuantReg.”  We must become a truly quantitative regulator.

The Centrality of Data

At least three common threads run through the digitization of modern financial and commodity derivatives markets:  first, the central role of data; second, the critical importance of automated data analysis to enhance efficiencies; and third, the introduction of state of the art machine learning and artificial intelligence to increase effectiveness.  All three of these threads must be woven into the fabric of a modern market regulator capable of being fit-for-purpose in our digital world.

Let’s unpack these three threads a bit further.  With respect to the centrality of data, trading market participants are now able to generate, consume, process, organize, and analyze such volumes of data such that the term “Big Data” no longer appears novel or even requisite to note.[5]  To put it simply, all activity in trading markets is being digitized and captured in bytes and bits – data is King.

All of this big data, however, is of little use to us unless it can be cleaned, organized, standardized, and made sense of.  Many efforts today are focused on these elements of data collection and processing – how can we take what has to-date been messy, unstructured data and convert it to a form that is consumable.  And perhaps even more importantly, how can we design future computing systems, databases, and networks that standardize data formats and fields and speak to each other in order to ensure rich, coherent, and complete data sets?[6]

A World of Automation

If data is King, then automating processes which previously required mindless and error-prone human effort is the critical work of the King’s Court.  Robotic process automation (RPA) refers to the application of computer technology in order to process relatively simple, repetitive tasks in a consistent and automated fashion.[7]  This type of automation frequently relies on the consumption and processing of standardized data, which can then result in a response less prone to human-error and less costly to implement.  Additionally, automating simple or low-value functions allows human resources to focus on higher-value efforts – essentially eliminating mindless paper-pushing and potentially boosting worker morale.

Many view automation as part of an evolutionary bridge to machines that can learn and generate autonomous insights from data, and in some instances the two innovations work in conjunction (more on this in a minute). Even if this is the case, it should not lead to underestimating the value that automation brings to economic activity.  As we think about the application of these technologies to trading markets, it is no leap of the imagination to consider how automation could help reduce cost and bring efficiencies to trade matching, processing, and clearing and settlement.  Indeed, when paired with systems inspired by DLT that standardize and distribute data to market actors – and even regulators – we begin to see a world where the majority of standard tasks are managed by machines.[8]

A New Age of Artificial Intelligence

If data is King, and automation is the work of the King’s Court, then machine learning and AI may be the tools to build an enlightened Kingdom.[9]  Undoubtedly, historical efforts to create general AI have largely failed to live up to the promise.[10]  Today, however, it appears a combination of enhancements in computing power and breakthroughs in computer science may mark the beginning of what will be a steady stream of advancements around the development of machine learning and AI.[11]  And these advancements are likely to have a profound impact on our economy, markets, and by extension on how we regulate.

In fact, development and deployment of AI in financial services and amongst regulators is said to be accelerating.[12]  Investment banks and insurance firms are utilizing AI in automation of repetitive acts, such as know your customer, anti-money laundering, claims processing, trade reconciliations and fraud identification.[13]  Hedge funds, prop desks and asset managers are increasingly leveraging AI techniques to automate trading strategies to achieve, maintain and increase potential trading returns[14] and support or disprove fundamental investment theories.[15]  We at the CFTC have been exploring application of machine learning techniques through our Division of Enforcement and in conjunction with our Whistleblower Program, and colleagues at FINRA have made great and informative strides in leveraging the cloud and machine learning, particularly in the surveillance space.[16]

Moreover, market participants are indeed moving well beyond mere automation of tasks.  No longer is artificial intelligence simply automation based on heuristic modeling and programming “if-then” rules.  New machine learning techniques make it possible for computers to learn on their own.[17]  Unlike mere RPA, recent breakthroughs in machine learning are predicated on the idea that data can be fed to machines without prescribed rules – instead, the machine can sort data and find connections and correlations that may not be observable to a human analyst.[18]  This, of course, does raise questions about “explainability,” which I will discuss further momentarily, but more broadly will underpin further technological advances.

At their core, efforts to advance machine learning are focused on enhancing predictive and actionable analytics capabilities.  Activity will likely occur across this spectrum with ongoing quant and computer science breakthroughs making even more complex predictive analytics and operations possible.  Today, innovators have already begun integrating machine learning and RPA, with this collaboration referred to as “cognitive RPA.”  While RPA focuses on the simple repetitive tasks explained earlier, the machine learning function is identifying patterns or making predications in order to help prioritize tasks for the RPA system.[19]

What is also becoming clear is that these higher-order computing technologies are likely to become as ubiquitous to our commodity and financial derivatives markets as the Internet has become today.  This means that all organizations and actors – including market regulators like the CFTC – will need to keep pace with the advance of AI in order to succeed.  Indeed, as management author Ram Charan stated, “Any organization that is not a math house now or is unable to become one soon is already a legacy [organization].”[20]

Quantitative Regulation Supporting Human Judgement

As we think about market regulation that is powered by data automation and machines, it is easy to fear what this may mean for humans.[21]  And, to be sure, there will be real challenges presented by these technologies ranging from impacts on labor markets to questions surrounding the explainability of a machine’s conclusions or actions and their consistency with existing regulations to the societal impact of big data collection and automating traditionally human processes. [22]

Yet, in my view, being a quantitative regulator does not mean replacing human judgment and market intelligence; it means reinforcing it.  In fact, the objective of quantitative regulation is to more firmly support the skilled teams that carry out the agency’s ongoing activities in market surveillance, enforcement, regulatory compliance and rule examinations, market intelligence, policy development, and market reform.  It means freeing agency staff from repetitive and low value tasks to focus on high value activities that require their expert judgment and domain knowledge.[23]  It means marshalling quality data that is efficiently and, perhaps, algorithmically analyzed upon which human judgement can be deployed, unfurled and expanded.[24]  Quantitative regulation means melding machines and humans, not separating them.

For example, on the oversight side of the spectrum one can envision using machines to independently identify segments of the markets where concentration risks or unrecognized counterparty exposures are emerging and flag them for staff consideration and action.  In enforcement, new machine-learning based surveillance tools could sniff out patterns of likely illegal trading activity or attempts to manipulate markets for enforcement analysis.  These tools will become even more paramount as emerging blockchain technologies seek to decentralize markets or disintermediate traditional actors.  It is critical that we have the ability to keep pace with those who attempt to defraud, distort, or manipulate.

We can also envision the day where rulebooks are digitized, compliance is increasingly automated or built into business operations through smart contracts, and regulatory reporting is satisfied through real-time DLT networks.  The machines here at the CFTC would have the ability to communicate regulatory requirements and consume and analyze the data that comes in through such systems.

This last point is one worth pondering for a few minutes further.  The ability to digitize rule-sets and consume, process, and analyze data in real-time could very well be the capability that allows us to explore application of so-called “agile regulation.”  Rather than rely on static rules and regulations that were put in place without knowing exactly the consequences or results they would drive in the market, we may be able to actually measure data, real-world outcomes, and success in satisfying regulatory objectives.[25]

An example may be helpful here.  Imagine you've got a speed limit sign - that's a static speed limit.  The two regulatory objectives you're trying to solve for with a speed limit are safety and the efficient flow of traffic.  If you actually had a dynamic speed limit that measured road and weather conditions (imagine a digital display), you might be able to slow the speed limit down if it’s raining in order to better satisfy the safety objective or increase the speed limit on a sunny weekday afternoon when traffic is light to achieve a safe, but more efficient, flow of traffic.[26]

This is a good example of thinking about agile forms of regulation, and regulation that is tied to satisfying real-world objectives.  As we move forward in transforming our capabilities, we should also think about transforming how we regulate.  As machines assume more economic tasks and functions, we would expect that these machines can be programmed with rules that ensure compliance with laws and regulations.  Indeed, the field of “RegTech,” which holds promise in enhancing compliance capabilities, and at lower cost, will be intertwined with advances in machine learning.  The concept of machine executable regulatory rulebooks will increasingly become a reality.

The Realization of CFTC 2.0

The launch of LabCFTC in May 2017 was in recognition that market regulation needed to keep pace with today’s digital transformation.[27]  Financial markets have always been amongst the quickest to adopt emerging technologies and continue to do so.  Falling behind in terms of basic understanding or adoption of technological advancements would undermine the agency’s effectiveness in overseeing the safety and soundness of contemporary markets.

To address this concern, we organized a series of our efforts under a LabCFTC work stream called “CFTC 2.0.”  Beyond LabCFTC’s broader engagement focus, the goal of CFTC 2.0 is to understand, test, facilitate, and in some cases incorporate emerging technologies that can improve the efficiency and effectiveness of our markets or our core activities as a regulator.  These efforts can serve to help inform our internal technology strategies as well as broader policy considerations.

To this end, we have been able to identify new surveillance tools through our outreach efforts, and are exploring ways to stimulate innovative activity through planned competitions.[28]  We are also assessing new RegTech tools and how smart contracts can code compliance, as well as considering the role of the regulator in advancing robo-rulebook efforts.  We continue to learn how cloud technologies and interoperable database systems are driving the next evolution in computing infrastructure.

Ultimately, our learnings over the past year have led us to a simple but profound conclusion:  we have no choice but for the CFTC to adopt effective and up-to-date, big data analysis capability.  Although our present capacity has adequately served the agency through the past few years,[29] it struggles to keep pace with our growing data needs.  Commercial trade execution and strategy in CFTC regulated markets is increasingly driven by quantitative data analysis of highly granular market data.  We must increase our own big data analysis capability to increase market intelligence, optimize market surveillance and oversight, and formulate smart policy prescriptions. The right path, indeed, the only path is to combine robust data collection, automated data analysis and state-of-the-art artificial intelligence capability to transform the CFTC into a highly effective, big data math shop – what I call a “Quantitative Regulator.”

A Roadmap for Modernization

The starting point for any modernization effort is the recognition of the enormous and comprehensive body of high quality trading data currently received by the CFTC.  That preeminent body of data needs to be processed through an upgraded, state of the art data collection and automated analysis engine processing both structured and unstructured data with enhanced AI capability.  This engine needs to be overseen by a highly competent, in-house data architect and trained support team.  These efforts will enhance our existing activities in the AI area.

We also must provide greater prominence within our agency for quantitative data collection and analysis.  We should decouple it from the management of computer and communications hardware and systems.  To this end, I have developed a belief and vision that the CFTC should establish a new office of data and analytics as a stand-alone department ready and capable of serving the needs of the Commission and the operating divisions.  The new office would be headed by a Chief Data Officer with strong data science qualifications.  And, of course, establishing such “QuantReg” capabilities would be based on thoughtful and prudent technology and procurement strategies that ensure we satisfy the end-goal of more effective and efficient regulation.

I look forward to exploring these concepts further and working on a bipartisan basis with my fellow Commissioners, Members of Congress, the current Administration, outside thought-leaders, and leading technology and trading firms.  I am confident that there are many leaders and stakeholders who share my conviction that America must lead when it comes to quantitative data collection and analysis in regulating contemporary digital markets.

Quantitative Regulators Must be Responsible

Before concluding, I would like to come back to a thread I have raised throughout my remarks – and that is with respect to the need to be careful, thoughtful, and responsible in identifying and addressing inevitable challenges that will arise with the rise of machines.

With quantitative regulatory capabilities comes great responsibility.  For example, market participants are rightly concerned about the handling of confidential data.  That is why it is appropriate for the CFTC generally to undertake to gather no more data than it is prepared to analyze, and then process and analyze all of the data that it does in fact collect.  The centrality of data does not justify boundless regulatory fishing expeditions, and we must be vigilant against the risk of overreach.  Additionally, the CFTC must handle all data in a confidential manner with the highest level of security and protection, and the CFTC should be candid and transparent in its data collection practices and uses.  Finally, the CFTC should to the greatest extent possible seek to make publically available anonymized data and value-added data analysis that can be utilized broadly by market participants.[30]

Conclusion

American derivatives markets are the world’s largest, most developed and most influential.  They are also among the world’s best regulated.  The CFTC has overseen the U.S. exchange-traded derivatives markets for over 40 years.  The agency is recognized for its principles-based regulatory framework and econometrically-driven analysis.  The CFTC is recognized around the world for its depth of expertise and breadth of capability.

This combination of regulatory expertise and competency is one of the reasons why U.S. derivatives markets continue to serve the needs of participants around the globe to hedge price and supply risk safely and efficiently.  It is why well-regulated U.S. derivatives markets continue to serve a vital national interest – safe and efficient U.S. Dollar based commodity and financial risk transfer.

Yet, modern markets are rapidly going through a fundamental data and technological transformation.  The amount of market data continues to grow exponentially and infinitely more granular, quantitative data analysis increasingly drives commercial trade execution and strategy, and limited agency funding requires increasing operational efficiency.

We have seen the computational revolution that has taken place in the past seven decades since the birth of the Manchester Baby.  We have seen the digital revolution that has taken place in the last decade of the seven.

In the next decade, the CFTC and, indeed, all market regulators, have no choice but to transform alongside modern digital markets and become quant-driven agencies conducting robust data collection, automated data analysis, and state-of-the-art artificial intelligence.  We have no choice but to become highly effective, “Quantitative Regulators.”

The world’s preeminent derivatives markets need the world’s most advanced regulatory and technological competency.  The time has come for the CFTC to match its unparalleled market intelligence capability with unparalleled quantitative data analytical capability.  The CFTC is ready to lead the world in QuantReg.

I look forward to hearing from all of you – leaders in law, our markets and in technology – as we move forward with our transformation.  It’s an exciting world we live in; one filled with new ideas, innovations, and opportunities.  And we at the CFTC look forward to confidently and proactively stepping into the future.

Thank you.

Opening Statement of Commissioner Brian D. Quintenz before the Open Commission Meeting on November 5, 2018

Open Meeting on Final Rule: Amending the De Minimis Exception to the Swap Dealer Definition; Proposed Rule: Amendments to Regulations on Swap Execution Facilities and the Trade Execution Requirement; and Request for Comment regarding the Practice of “Post-Trade Name Give-Up” on Swap Execution Facilities

November 5, 2018

Mr. Chairman, thank you for calling this meeting.  It is a great pleasure to participate today with you and my fellow Commissioners in the first open meeting since 2013 with a full complement of Commissioners.  The matters before us today are of critical importance to the derivatives markets, impacting two fundamental Dodd-Frank reforms:  swap dealer registration and trading on swap execution facilities.  I appreciate all the hard work of staff to put these two rulemakings before us and support their ongoing efforts to continue improving and refining our regulatory framework.  I look forward to hearing their presentations as well as my fellow Commissioners’ questions and comments.

Final Rule: De Minimis Exception to the Swap Dealer Definition

I support today’s final rule to rescind the de minimis threshold’s scheduled reduction to $3 billion of gross notional swap dealing activity.  Every iteration of data analysis completed by CFTC staff on this issue, from the 2015 Preliminary Report,[1] to the 2016 Final Report,[2] to the updated data and analysis in the 2018 June proposed rule, and to the data presented in this final rule, clearly and unequivocally supported eliminating this ill-conceived reduction.  I am pleased that today’s action will remove a large source of negative regulatory uncertainty for market participants in managing their swaps business and serving their customers.

However, this is just the first of many necessary steps toward correcting what I believe is a flawed swap dealer registration policy.  Therefore, it is my hope that today’s final rule should be viewed with finality only in this one regard.

The Dodd-Frank Act advanced three main and substantial policy objectives for swap dealer registration:  systemic risk reduction, counterparty protection, and enhanced swap market transparency and efficiency.  As I have emphasized on many prior occasions, given the significant costs of swap dealer regulation, it is critical that the de minimis exception be appropriately calibrated to ensure that the correct market group – those best situated to realize the corresponding policy goals of registration – shoulders the burdens of swap dealer regulations.

As I have also said repeatedly in the past, notional value is a poor measure of activity, and it is a meaningless measure of risk. Therefore, by itself, notional value is an incredibly deficient metric by which to impose large costs and achieve substantial policy objectives.  A one-size-fits-all notional value test for swap dealer registration captures entities that engage in low volume, low risk activity with high notional amounts, and places those firms under the same regulatory regime as the world’s largest, most complex financial institutions that deal in trillions of dollars’ worth of swaps.[3]  The end result is that smaller firms are disincentivized from engaging in lower risk activity when faced with justifying the cost of swap dealer registration.

I have heard anecdotally from certain small to mid-sized players in the swap markets that the breakeven point of the costs of swap dealer registration as measured by a level of notional swap dealing activity is much higher than the $8 billion level in this rule.  If that is the case, the current $8 billion notional threshold effectively forces these smaller players to curtail their swap dealing business, thereby limiting competition and further concentrating swaps activity with their larger competitors.[4]

In my view, an appropriately calibrated de minimis exception would better align the criteria of the de minimis threshold with the costs of swap dealer regulation, particularly the largest costs tied to mitigating systemic risk, like capital and margin.  A de minimis threshold based on metrics more closely correlated with the risk of the products traded, as opposed to the current risk-insensitive notional value metric, would better measure dealing activity and more appropriately capture the entities warranting Commission oversight.

I am pleased the Chairman continues to recognize this and has directed staff to study many of the alternative risk-based registration metrics that were suggested in the proposed rule.  The staff report will provide the Commission with additional data and insights into the impact that alternative approaches may have on swap dealer registration.  For example, staff’s analysis should show how removing or haircutting cleared swaps from the de minimis calculation would impact the number and composition of firms required to register as swap dealers. The report will also provide staff with an opportunity to consider, for the first time, how a registration threshold tied to initial margin for cleared swaps could better represent a de minimis quantity of swap dealing activity.  For uncleared products, staff can examine the impact of using entity-netted notional amounts, a more accurate measure of a firm’s risk and market size, as a metric of swap dealing activity.  The results of the staff report will be critical to any future Commission consideration of a more risk-sensitive swap dealer registration threshold.

In addition, many of the policy recommendations discussed in the proposed rule, such as better allowing insured depository institutions to assist their customers in hedging loan-related risks and excluding non-deliverable forwards from an entity’s de minimis count – would advance the policy goals of the de minimis exception by encouraging greater participation and competition in the swap markets.  I would eagerly anticipate the Commission’s action on these important reforms.  As the Commission’s recent no-action letter to a Main Street bank this past August shows, the deficiencies of the current de minimis exception are beginning to squeeze firms’ activity and constrain their ability to serve clients.[5]

Any de minimis threshold must always be put into context of the broader swaps market regulatory regime.  The Commission is not establishing the de minimis exception in a vacuum. Since the swap dealer definition was adopted in 2012, a broad range of rigorous regulatory requirements have gone into effect which also advance the goals of swap dealer registration, such as mandatory clearing, SEF trading, swap data reporting, and margin requirements for uncleared swaps.

The Commission’s regulatory framework for the swap market has greatly evolved from its state six years ago; it is only common sense that the swap dealer registration threshold should evolve as well.  It will be a great day when financial regulators, including the CFTC, finally move away from gross notional value as any sort of metric or test of derivatives exposure, activity, or risk.  I look forward to that day, and I am committed to working with the Chairman, my fellow Commissioners, and our staff to make sure we get the swap dealer de minimis exception policy right.

Proposed Rule: Amendments to Regulations on Swap Execution Facilities and the Trade Execution Requirement; and Request for Comment regarding the Practice of “Post-Trade Name Give-Up” on Swap Execution Facilities

I will vote in favor of issuing today’s proposed rule and the request for comment reforming the regulatory regime of swap execution facilities (SEFs).  The Chairman has shown great thought leadership and transparency in consistently and fully articulating his vision for swaps trading rules that would create a more cohesive, liquid swap marketplace.  Today’s proposal represents a significant step toward executing that vision.  I look forward to hearing from market participants about how these broad reforms will work collectively to impact SEF trading dynamics and liquidity formation.  Mr. Chairman, I know this day has been a long time coming, and I congratulate you and the Division of Market Oversight for all of your and their tireless work on this proposed rule.

Statement of Concurrence of Commissioner Rostin Behnam Regarding Swap Execution Facilities and Trade Execution Requirement

November 5, 2018

Introduction

Today, the Commission votes to issue proposed rules that would constitute an overhaul of the existing framework for swap execution facilities (SEFs).  I wish to commend staff for all of their very hard work in producing the document before us.  I appreciate the long hours that were spent by the staff presenting today, and by many other members of our dedicated staff working behind the scenes. 

The Commission’s action today begins the process of public notice and comment under the Administrative Procedure Act.[1]  Given the breadth and complexity of the proposed rules before us, the process of public comment is particularly important.  I look forward to receiving input from market participants and the public who would be impacted, in any way, by a reworking of the SEF rules. 

Background

As we consider the goals and therefore the direction of any SEF reform, I think it is very important that we first review how we got where we are today.  Prior to the 2008 financial crisis, swaps were largely exempt from regulation and traded exclusively over-the-counter, rather than on a regulated exchange.[2]  Lack of transparency in the over-the-counter swaps market contributed to the financial crisis because both regulators and market participants lacked the visibility necessary to identify and assess swaps market exposures and counterparty relationships.[3]  In the aftermath of the financial crisis, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 (Dodd-Frank Act).[4]  The Dodd-Frank Act 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.[5]  Title VII of the Dodd-Frank Act amended the Commodity Exchange Act (CEA or Act) to establish a comprehensive new swaps regulatory framework that includes the registration and oversight of a new registered entity – SEFs.  A key goal of Title VII of the Dodd-Frank Act is to bring greater pre-trade and post-trade transparency to the swaps market.  The concept of transparency runs throughout Title VII – starting with the title itself:  the “Wall Street Transparency and Accountability Act of 2010.”[6] 

As part of the Dodd-Frank effort to provide more transparency, in 2013 the Commission adopted the part 37 rules in order to implement a regulatory framework for SEFs.[7]  In so doing, the Commission emphasized that “[pre-trade] transparency lowers costs for investors, consumers, and businesses; lowers the risks of the swaps market to the economy; and enhances market integrity to protect market participants and the public.”[8] 

The relatively young SEF framework has in many ways been a success.  There are currently 25 registered SEFs.[9]  Trading volume on SEF has been steadily growing each year.[10]  The Commission’s work to promote swaps trading on SEFs has resulted in increased liquidity, while adding pre-trade price transparency and competition. [11]

This is not to say that the SEF rules were perfect from the start and would not benefit from some targeted changes.  Most SEFs operate under multiple no-action letters granted by the Division of Market Oversight.  While the purpose of this form of targeted relief was often to smooth the implementation of the SEF framework, codifying or eliminating the need for existing no-action relief would provide market participants with greater legal certainty. 

The current SEF rules have not brought as much trading onto SEFs as intended or envisioned.  We can improve upon that.  Currently, the Commission has a regulatory process for SEFs to demonstrate through a multi-factor analysis that a swap has been made-available-to-trade, or “MAT,”[12] meaning that it is required to trade on a SEF or DCM.  The current process has resulted in relatively few MAT determinations and, after an initial flurry of submissions for the most standardized and liquid products, no further submissions have been made.  I believe that addressing the MAT process could bring more activity on SEF, bringing pre-trade transparency to more products without dismantling the aspects of the SEF rules that are working currently. 

Notice of Proposed Rulemaking (NPRM)

While I believe targeted reforms could bring more products onto SEFs, increase transparency, and lower costs for market participants, today’s NPRM is far from targeted, and in some instances may represent a regulatory overreach.  I therefore have a number of very serious concerns with the NPRM’s approach and its far-ranging alterations.  First, the NPRM violates the clear language of the Act, which states that one of the major goals of the SEF regulatory regime is to promote pre-trade transparency in the swaps market.  As discussed below, the NPRM does exactly the opposite.  Second, in addition to reducing transparency, the proposed rule also increases limitations on access to SEFs.  The NPRM purports to increase choice and flexibility for SEFs; however, it simultaneously allows SEFs to limit choice and flexibility for market participants.  Third, as commenters and the Commission think about the NPRM, I think it is also important to consider whether we would be creating a new registration scheme that adds significant costs for market participants, while failing to address the fixable issues that exist in the market today. 

Pre-trade Transparency

Section 1a(50) of the Act defines a SEF as “a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce . . ..”[13]  Section 5h(e) of the Act states that “[t]he goal of this section is to promote trading of swaps on swap execution facilities and to promote pre-trade transparency in the swaps market.”[14]  The existing SEF rules establish two methods of execution for required transactions:  the central limit order book (CLOB) and the Request for Quote (RFQ) system.[15]  These methods were chosen specifically because they provide pre-trade transparency.

I am concerned that the NPRM goes too far by allowing, literally, any means of execution.  The NPRM’s preamble states that the approach “should also promote pre-trade transparency in the swaps market by allowing execution methods that maximize participation and concentrate liquidity. . .”  This simply cannot be true.  Absent a clear standard of what constitutes pre-trade transparency, it is fairly easy to envision an execution method that would not provide pre-trade transparency – one need look no further than the over-the-counter system that preceded the financial crisis.  But this is more than a case of what the Commission should or should not do.  The statute is clear.  The Commission must “promote pre-trade transparency in the swaps market.”  Today’s NPRM would not do that. 

That is not to say that expanding methods of execution – in a more limited and targeted way – is a bad idea or violates the Act.  There are likely other execution methods that fit within section 1a(50) and would promote pre-trade transparency.  I look forward to hearing from commenters as to what those methods might be, and debating with my fellow Commissioners as to whether they are appropriate within the confines of congressional intent and ultimately the Act.    

Made Available to Trade

As I mentioned earlier, the MAT process is seemingly broken.  The Commission stopped receiving MAT submissions after an initial set of submissions for the most standardized and liquid swaps contracts.[16]  The Commission has not received any MAT submissions or made any MAT determinations since 2014.[17]  This is not what the Commission envisioned in promulgating the Made Available to Trade rule.[18]  The solution posited today is, in a sense, a simple, elegant one.  The NPRM states that the phrase “makes the swap available to trade” in CEA section 2h(8) should be interpreted to mean that “once the clearing requirement applies to a swap, then the trade execution requirement applies to that swap upon any single SEF or DCM listing the swap for trading.”  This would take both the SEF and the Commission out of the determination process. 

My concern, however, is that there may be products that are more appropriately traded off SEF.  In addition, tying the trade execution requirement to the clearing requirement could have unintended consequences – it could actually discourage voluntary central clearing. 

I look forward to hearing from commenters regarding the appropriate interpretation of the term “made available to trade”, including how to improve the existing process. 

Impartial Access

One of the most troubling aspects of the NPRM is that it would alter the Commission’s interpretation of “impartial access” under SEF Core Principle 2.  Core Principle 2 of the Act requires SEFs to establish and enforce participation rules that “provide market participants with impartial access to the market.”[19]  Current Commission regulation 37.202(a) states that a SEF “shall provide any eligible contract participant . . . with impartial access to its market(s) and market services.” (emphasis added).  The Commission was clear in the preamble to the existing rules that “the purpose of the impartial access requirement is to prevent a SEF’s owners from using discriminatory access requirements as a competitive tool” against certain eligible contract participants.[20]  The current rule provides that a SEF can restrict access based on disciplinary history or financial or operational soundness, if objective, pre-established criteria are used.  What a SEF cannot do is restrict access to certain types of participants. 

Today’s NPRM would roll back this interpretation, leaving the term “impartial access” an empty shell.  The proposed rule would “allow SEFs to serve different types of market participants or have different access criteria for different execution methods.”  This is exactly the type of discrimination that the “impartial access” provision in the Act was intended to prevent.

I believe that all market participants should have impartial access to a SEF whose access criteria is applied in a fair and non-discriminatory manner.  Rather than erecting new barriers to participation, we should focus on applying our existing regulations as they are clearly written.  It seems to me that impartial access theoretically would go hand-in-hand with the proposed widening of SEF execution methods.  Instead, the Commission seems to be bending over backwards to be impartial regarding SEFs’ modes of execution, while allowing the SEFs themselves to discriminate.  This threatens to take us back to the world as it was pre-Dodd-Frank and pre-financial crisis, undermining some of the key successes of the existing SEF regulatory regime regarding transparency and market access. 

Registration/Costs

I would like to turn for a minute to the potential costs to market participants – and the Commission – from this proposed rule.  Currently, there are 25 registered SEFs.[21]  The Proposal will drastically increase the number of SEFs – likely by multiples.  In the cost benefit considerations to the NPRM, the Commission estimates that approximately 40-60 swaps broking entities, including interdealer brokers, and one single-dealer aggregator platform would need to register as a SEF.  That is the universe that we know – the market as we understand it to exist today.  There could be more – perhaps many more – entities that will fall under the expanded registration requirements.  Just as importantly, we do not know how these new rules will incentivize SEFs – whether they will lead to consolidation or myriad SEFs with myriad methods of execution. 

The new registration regime, and the many changes that come along with it, will result in substantial costs all around:  to both existing SEFs and new SEF registrants, and to their participants.  I note with some concern that, while the preamble provides a laundry list of what rule changes will result in costs, there is no effort to quantify them.  Operating or participating in a regulated market comes with costs; but, these incremental costs are offset, in part, by the benefits of having access to a transparent, safe market ecosystem that demands accountability and punishes wrongdoers.  I do not mean to suggest anything else.  However, as the Commission proceeds with this NPRM, I am hopeful that the best, most cost effective regulatory solutions will prevail as the Commission seeks to improve and advance the health and vibrancy of the SEF marketplace.    

Comment Period

I also want to quickly raise a non-substantive concern, but one that may greatly impact the substance of the NPRM.  The comment period for the proposal is only 75 days.  As I have stated previously, this rulemaking is complex and impacts a wide range of market participants in fundamental ways.  There are 105 numbered questions for commenters in the NPRM’s preamble, in addition to general requests for comment.  I think it is very important that we give market participants time to carefully consider the proposed rule and make reasoned comments.  Recent proposed rules that raised complex issues, like the capital rule and Reg AT, had 90 day comment periods followed by extensions of at least an additional 60 days.[22]  The original part 37 notice of proposed rulemaking ultimately had open comment periods totaling 90 days, and market participants had 7 months between publication of the notice of proposed rulemaking and the end of the final comment period.[23]  Today’s NPRM deserves careful consideration, both from the public and from the Commission, and I hope that the Commission will give market participants the time they need to respond thoughtfully and thoroughly. 

Name Give Up Request For Comment

Before I conclude, I would like to turn briefly to the name give-up request for comment that is before us as well, as it is inextricably tied to the SEF NPRM.  Post-trade name give-up also relates to the issue of impartial access, which I discussed earlier.  While today’s SEF NPRM reworks the SEF rules generally, the NPRM does not address the long standing practice of disclosing the identity of each swap counterparty to the other after a trade has been matched anonymously.  Instead, the Commission is voting to issue a request for comment seeking public comment on the practice.  While I appreciate the desire to be measured and thoughtful on this issue, I fear that not taking a view at this time in the proposal may function as an endorsement of the status quo.  The request for comment puts name give-up on a slower track than the rest of the rule.  Any rule to address the issue will now be well behind the process for the rest of the SEF rules. 

Conclusion

As outlined above, I have numerous concerns about this NPRM, both in terms of what the Commission should do as policy makers, and in terms of what the Commission can do under the law.  Congress was clear in the Dodd-Frank Act – the Commission is tasked with bringing greater pre-trade transparency to the swaps market.  Today’s NPRM not only fails to advance pre-trade transparency, it actually undermines pre-trade transparency that has been achieved through our existing regulations.  In addition to the few issues I raise today, the NPRM’s changes also demand thoughtful deliberation on equally important issues related to cross-border implications, investigations, audit trails, recordkeeping, and disciplinary hearings to name just a few. 

As I read through the NPRM, I noticed a common thread that naturally aims to shift the current part 37 regime to a less prescriptive, and more principles based regime.  The frequent weaving of words into the text of the NPRM like, defer, flexible, reasonable, and discretion stand as a clear declaration of where this proposal’s authors want it to go.  I have long been a proponent of sensible principles based regulation.  I believe our markets, and more importantly this agency, are strongly rooted in a principles based regulatory regime.  However, like the words of this NPRM, I have woven my own thoughts on striking the right balance between principles based and rules based regulation.  Principles based regulation certainly does not mean an absence of rules—or the absence of supervision.

In remarks I delivered in February of this year, I stated, “…[w]hile I strongly oppose any roll backs of Dodd-Frank initiatives, I believe a principles-based approach to implementation can be suitable in certain instances.  A principles-based approach provides greater flexibility, but more importantly focuses on thoughtful consideration, evaluation, and adoption of policies, procedures, and practices as opposed to checking the box on a predetermined, one-size-fits-all outcome.  However, the best principles-based rules in the world will not succeed absent: (1) clear guidance from regulators; (2) adequate means to measure and ensure compliance; and (3) willingness to enforce compliance and punish those who fail to ensure compliance with the rules.” [24]  

If the Commission was voting on a final rule today, my vote would be no.  However, I fully recognize that our existing part 37 rules are not perfect.  Bringing more activity on SEF is a laudable goal, both from a policy perspective and because Congress has tasked the Commission with doing so.  I will support  today’s proposed rule because I believe that it is important that we hear from market participants regarding what aspects of the NPRM will improve the regulatory framework for SEFs, while staying within our responsibilities under the law.

Dissenting Statement of Commissioner Dan M. Berkovitz Regarding Proposed Rulemaking on Swap Execution Facilities and Trade Execution Requirement

November 5, 2018

I.          Summary of Dissenting Views

I respectfully dissent from the Commodity Futures Trading Commission’s (“CFTC” or “Commission”) notice of proposed rulemaking regarding Swap Execution Facilities and Trade Execution Requirement (the “Proposal”).  This Proposal would reduce competition and diminish price transparency in the swaps market, which will lead to higher costs for end users and increase systemic risks.

The Proposal would abandon the commitments the United States made at the G20 Summit in Pittsburgh in 2009 to trade standardized swaps on exchanges or electronic trading platforms and is contrary to Congressional direction in the Dodd-Frank Act and the Commodity Exchange Act (“CEA”) reflecting those commitments.  It would retreat from the progress made by the Commission and the financial industry in implementing those reforms.

The Proposal would reduce competition by cementing the oligopoly of the largest bank dealers as the main source of liquidity and pricing in the swaps markets.  It would diminish transparency by removing the requirement that highly liquid swaps be traded through competitive methods of trading.  By reducing competition and diminishing price transparency, the Proposal would increase systemic risks and lead to higher swaps prices for commercial and financial end-users.  Ultimately, the millions of Americans who indirectly participate in the swaps market through their investments in retirement accounts, pension plans, home mortgages, and mutual funds will pay that higher cost.  Finally, the Proposal would provide SEFs with too much discretion to set their own rules and in so doing, weaken regulatory oversight and enforcement capabilities.

II.         Major Flaws in the Proposal

The evidence is clear that the Dodd-Frank reforms, including the Commission’s swap execution regulations, have led to more competition, greater liquidity, more electronic trading, better price transparency, and lower prices for swaps that are required to be traded on regulated platforms.  Numerous academic studies and reports by market consultants have documented these benefits.[1]  The Proposal ignores this evidence and analysis.

The Proposal would jettison the regulatory foundation for the way swap execution facilities (“SEFs”) currently operate.  It would delete the requirement that swaps that are subject to the trade execution mandate (“Required Transactions”) be traded either on Order Book or by a request for quote from at least three market participants (“RFQ-3”).  This would undermine the Congressional directive in the Dodd-Frank Act that for Required Transactions, a SEF provide multiple participants with “the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system.”[2]  Consequently, the Proposal would lead to less price transparency and less competition.

The Proposal also would gut the impartial access requirement in the Dodd-Frank Act. The statute requires SEFs to establish rules that “provide market participants with impartial access to the market.”[3]  Authorizing discrimination based on the type of entity will permit the largest bank-dealers to establish and maintain exclusive pools of liquidity for themselves.  By denying other market participants access to the most favorable prices in the dealer-to-dealer market, bank dealers can prevent others from cost-effectively competing with them for customers.  Eliminating competition will result in higher prices for customers.  Permitting large banks and dealers to discriminate in this manner is inconsistent with sound economic principles underpinning competitive markets and the CEA’s impartial access requirement.

In pursuit of the goal of “flexibility” for SEF markets, the Proposal deletes, reverses, or waters down many key trading, access, and compliance requirements for SEFs.  The wide latitude that would be granted to SEFs as to how swaps may be traded, who may trade them, the oversight of the marketplace, and the conduct of the brokers looks very much like the “light-touch” approach to regulation that was discredited by the financial crisis.

Seven years ago, as the Commission was formulating the current regulations, very little data was available on swap trading and pricing.  But now, after six years of experience with those regulations, we have an extensive amount of data, collected by SEFs and swap data repositories.  The Commission should base its regulatory decisions on this data and the studies and literature that have analyzed this data and demonstrated the benefits of the current swap trading requirements.

Unfortunately, the Proposal does not consider the available data and market studies that demonstrate the current RFQ-3 system is working well to provide highly competitive prices and low transaction costs.  For example, the Proposal ignores the following studies and conclusions:

• CFTC economists’ study (2018).[4]  This study, conducted by four CFTC economists, concluded:  “Judged from our evidence, SEF-traded index CDS market seems to be working well after Dodd-Frank—dealers’ response rates are high, the vast majority of customer orders result in trades, and customers’ transaction costs are low.”[5]  With respect to the most liquid CDS index swaps, the CFTC economists found that “the average transaction cost is statistically and economically close to zero.”[6]
• Bank of England Staff Working Paper (2018).[7]  This Bank of England paper concluded that the CFTC’s trade execution mandate, including the RFQ-3 requirement, has led to a “sharp increase in competition between swap dealers” in dealer-to-customer transactions for interest rate swaps subject to the mandate.[8]  The study concluded that this competition had led to “a substantial reduction in execution costs,” amounting “to daily savings in execution costs of as much as $3-$6 million for end-users of USD swaps.”[9]
• Study of “Market Structure and Transaction Costs of Index CDSs” (2017).[10]  This study found that prices customers obtained in the dealer-to-customer market through the RFQ system often were better than the prices that were available on the interdealer Order Book.[11]   “[O]ur results show that the current market structure delivers very low transaction costs. . . .[12]

The Proposal conjectures that novel “flexible methods of execution” will benefit the trading of all swaps.  The Proposal, however, does not identify any trading methodology that can provide lower costs than the RFQ-3 method as applied to interest rate swaps and index CDS subject to the current trade execution mandate.  In discarding the trading requirements for Required Transactions to bring more swaps onto SEFs, the Proposal throws the baby out with the bathwater.

Today, a small number of large dealers provide liquidity to the swaps market.  Five very large banks were party to over 60 percent of interest rate swap transactions.[13]  Liquidity in highly standardized swaps is fragmented between a dealer-to-dealer market and a dealer-to-customer market.  There are no non-dealers in the dealer-to-dealer market.  This high degree of reliance on a few large bank dealers to supply liquidity to all swaps market participants presents systemic risks as well as other types of risk that arise in highly concentrated markets.

One of the fundamental purposes of the CEA is to “promote responsible innovation and fair competition among boards of trade, other markets and market participants.”[14]  It is the CFTC’s mission, and incumbent upon this agency in carrying out that mission, to ensure that there is fair competition among all market participants.  This means ensuring no market participant or limited group of participants has excessive market power.  Market structure and price competition should develop in the interest of all market participants, rather than in the interest of just a few of the largest banks.  The Commission should strive to remove the existing barriers to broader participation and fair competition in the swaps markets.  In my view, the Proposal seeks to perpetuate existing barriers.

III.        Targeted Reforms to Consider

The current system is not perfect; there are flaws that should be addressed.  But the evidence is clear that the current system has provided substantial benefits over the unregulated system that existed prior to the financial crisis and the Dodd-Frank reforms.  The Proposal would return the swaps market to the dealer-dominated, trade-however-you-want system heavily reliant on voice brokers that existed prior to the financial crisis.  At the G20 Summit in Pittsburgh in 2009, the United States made an international commitment to move away from the dealer-dominated, voice-brokered approach and Congress expressly rejected the dealer-dominated, flexible approach when it adopted the Dodd-Frank Act.

My sense from working with and talking to swap market participants is that many do not see a need for a major overhaul of the swaps regulatory framework.  The benefits of the current system are due not just to the regulations, but also are the result of major efforts and investments by market participants and operators of SEFs in electronic trading technology and personnel.  Many market participants do not want to deal with another round of costs and uncertainties that wholesale regulatory changes will generate.  They believe the current system is working, despite its flaws.  They prefer that we consider more targeted reforms to address specific issues with the current system, rather than scrap the current system entirely.  They do not want to face the possibility that the Commission will continue to engage in a repetitive cycle of de-regulation and re-regulation.

Rather than completely rewrite the SEF regulatory structure, and turn our back on the progress made in transparency and competition, I favor a more limited, data-based approach to build on our progress and improve upon the current structure.  This could be accomplished by removing some of the unnecessary barriers to greater participation on SEFs.  Banks and other swap dealers play a critical role in providing liquidity.  We need them to participate.  However, a highly concentrated dealer oligopoly is not a prerequisite for sufficient liquidity.  We should seek ways to bring in more sources of liquidity and competition.  Robust competition leads to healthier markets and improves the overall welfare of all market participants.

I support the goal of bringing more types of swaps onto the SEF trading environment.  I could support a more narrow approach to achieve this goal that does not undermine the progress that has been made to date.

I am not persuaded that we should continue to have two separate pools of liquidity in the swaps market for all types of swaps, regardless of liquidity characteristics—one in which the dealers trade amongst themselves, and another in which the dealers trade with customers.  Perhaps we should look for ways to consolidate rather than separate the swaps markets.

Specifically, I support considering the following regulatory measures to improve competition in the swaps market:

• Abolish Name Give-Up.  The Commission should prohibit the practice of name give-up for cleared swaps.  On many platforms that provide anonymous trading, the identity of a counterparty is provided to the dealer after the completion of a trade.  Name give-up is a major deterrent to non-dealers seeking to participate on dealer-only platforms as it provides the dealers with valuable information about a counterparty’s positions.  Name give-up is a relic of the pre-Dodd Frank era when most swaps were not cleared and the identity of the counterparty was necessary to manage credit risks.
• Expand Floor Trader registration.  The Commission should amend the floor trader provision in the swap dealer definition to remove overly restrictive conditions.  This would permit a wider range of proprietary traders to provide liquidity and compete with large bank dealers on price.
• Revise capital requirements.  The Commission should work with the prudential regulators to ensure that capital requirements do not unduly restrict the availability of clearing services by futures commission merchants (“FCMs”).  The current capital requirements have had the unintended consequences of discouraging FCMs from providing additional clearing services to the cleared swaps market.
• Enable average pricing.  The Commission should work with market participants and facilities to enable buy-side firms to obtain average pricing for buy-side swap trades.  Although average pricing is available for futures, it currently is not available for swaps, which limits the direct participation of buy-side asset managers on SEFs.

We should explore these and other ways to increase competition in the swaps market rather than retreat from the progress that has been made.  What follows is a more detailed explanation of how the current regulatory system has improved the swaps market and how the Proposal would undermine those improvements.

IV.       Specific Concerns with the Proposal

The Proposal raises the following specific concerns:

• Less competition
• Less transparency
• Higher prices for end-users
• Diminished CFTC supervision and enforcement abilities

A. Less competition, less transparency, and higher prices

The first three concerns—higher prices, less competition, and less transparency—arise from the repeal of two critical and inter-related provisions of the current regulations.

Elimination of Order Book/RFQ-3.  The Dodd-Frank Act sets forth a Rule of Construction that the goal of the SEF regulations is “to promote the trading of swaps on swap execution facilities and to promote pre-trade price transparency in the swaps market.”[15]  A key requirement facilitating the statutory goal of pre-trade price transparency is that all Required Transactions must be traded by Order Book or RFQ-3.[16]  Under RFQ-3, a customer must request quotes from at least three dealers prior to entering into a transaction.  In this manner, dealers must compete on price.

The Proposal would delete the Order Book/RFQ-3 requirement, even for swaps already traded on SEFs and subject to the trade execution requirement.  Instead, the Proposal states that “a SEF may utilize ‘any means of interstate commerce’ for purposes of execution and communication, including, but not limited to, the mail, internet, email and telephone.”[17]

Authorizing discrimination; eviscerating impartial access.  Next, the Proposal flips on its head the impartial access requirement.  CEA Section 5h(f)(2)(B)(i) requires a SEF to “provide market participants with impartial access to the market.”[18]  Under existing Commission Regulation 37.202, which implements this statutory provision, any SEF criteria governing access must be “impartial, transparent, and applied in a fair and non-discriminatory manner.”[19]  In the 2013 SEF rulemaking, the Commission explicitly rejected a proposed interpretation that would permit SEFs to discriminate against types of market participants.  “[T]he Commission believes that the impartial access requirement of Core Principle 2 does not allow a SEF to limit access to its trading systems or platforms to certain types of [eligible contract participants (“ECPs”)] or [independent software vendors (“ISVs”)] as requested by some commenters.  The Commission notes that the rule states ‘impartial’ criteria and not ‘selective’ criteria as recommended by some commenters.”[20]

The Proposal would replace this critical requirement and allow each SEF to establish exclusionary criteria determining what types of market participants are “similarly situated market participants” that are allowed to trade on the SEF (let’s call this what it is, the “Discriminatory Access Provision”).  This approach flips the statutory “impartial access” requirement on its head by empowering SEFs to build limited liquidity pools for a select few market participants such as the dealers seeking to hedge with each other.

Under the Discriminatory Access Provision, it is reasonable to expect that the large bank swap dealers would encourage discriminatory SEF participation criteria such that only large bank swap dealers would be “similarly situated market participants” able to participate in dealer-to-dealer liquidity pools.  Proprietary trading firms and smaller dealers provide competition to the large banks in pricing swaps, and are one major reason customers are able to obtain favorable prices through the current RFQ process.  If discrimination is permitted, these other types of firms would not be able to use the dealer-to-dealer market to effectively hedge or offset trades with customers, and therefore would not be able to compete with the large bank swap dealers in the dealer-to-customer market.  In this manner, the Discriminatory Access Provision would result in a significant loss of competition in the dealer-to-customer market, which ultimately would result in higher prices for end users.[21]

If the current trade execution requirement is repealed, dealers also could establish single-dealer platforms and call them SEFs to siphon liquidity away from the RFQ platforms.  The dealers wield significant market power in the swaps market.  Five dealers currently account for nearly two-thirds of the interest rate swap market, which is the largest swap product category.[22]   Although SEFs that currently offer RFQ-3 functionality might continue to do so even if the requirement is repealed, once the customers are no longer required to use that functionality, the dealers could undermine the effectiveness of the RFQ process by offering incentives to trade on single-dealer platforms or voice-brokered SEFs.  This outcome would reduce liquidity for the RFQ platforms.  In the long run, draining liquidity from RFQ-3 platforms to single-dealer or voice-brokered systems will result in less direct competition between dealers, less transparency, and higher costs for customers.[23]

The Proposal asserts that all-to-all markets are “inimical” to “fundamental” swaps trading features.[24]  The Proposal also states that “market participants have rarely used Order Books to trade swaps on SEFs,” and that “this low level of swaps trading on Order Books is attributable to an Order Book’s inability to support the broad and diverse range of products traded in the swaps market that trade episodically, rather than on a continuous basis.”[25]  Following a brief discussion of why the Order Book is unsuitable for some swaps, the Proposal states that the Order Book should be eliminated for all swaps:  “[B]ased in part on its experience, the Commission proposes to eliminate the minimum trading functionality requirement and the regulatory Order Book definition.”[26]

Similarly, the Proposal eliminates the RFQ requirement because it states that this method of execution may be unsuitable for some additional types of swaps that are currently traded off SEF.  “[T]he Commission believes that [Order Book and RFQ-3] would not be suitable for the broad swath of the swaps market that would become newly subject to the trade execution requirement.”[27]

This reasoning is flawed.  From the proposition that an Order Book may be unsuitable for some episodically traded swaps, it does not follow that an Order Book is unsuitable for all swaps, even highly liquid ones.  Nor does it follow from the proposition that the RFQ process may be unsuitable for some swaps that it should be removed for all swaps.  Yet this flawed logic appears to be the rationale for the elimination of both the Order Book and RFQ-3 functionality requirements, even for highly liquid standardized swaps.[28]

RFQ-3 has improved competition and lowered trading costs.  Empirical evidence demonstrates that the Order Book/RFQ-3 and impartial access requirements for standardized, highly liquid cleared swaps have increased competition and transparency and brought low trading costs to swap markets.  The Bank of England Study found that the RFQ-3 requirement significantly improved liquidity for U.S. dollar interest rate swaps, which reduced swap execution costs for end-users by an estimated $3 to $6 million per day relative to Euro swaps, which were not traded pursuant to the trade execution mandate.[29]

The Bank of England Study also assessed the impact of the SEF trading mandate on dealer market power.[30]  The study found that, prior to the SEF trading mandate, 28 percent of customers for US and Euro interest rate swaps that became subject to the mandate dealt with only a single dealer, and over 50 percent of customers dealt with three or fewer dealers.[31]  After the SEF trading requirements went into effect, those percentages dropped to 8 percent and 20 percent, respectively.[32]  The study states that “[w]ith the improvements in pre-trade transparency, customer search costs have fallen and it has become easier for customers to trade with the dealer showing the best price.”[33]

Other studies have found similar results.  Collin-Dufresne, Junge, and Trolle compared the prices on the Order Books used in the interdealer market with the prices generated in the dealer-to-customer market through the RFQ system.  The authors found that prices customers obtained in the dealer-to-customer market through the RFQ system often were better than the prices that were available on the interdealer Order Book.[34]

Economists in the CFTC’s Office of Chief Economist examined data regarding the customer trading of index CDS on the Bloomberg and Tradeweb SEFs, which are the leading SEFs for dealer-to-customer trading.[35]  The CFTC economists found that very little customer trading occurred on the Central Limit Order Book (“Clob”) of either facility, but rather that most of the trading occurred either by RFQ or by request-for-streaming (“RFS”).[36]  Focusing on customer trading through the RFQ mechanism, the CFTC economists found that, on average, a customer requests quotes from 4.1 dealers and gets back 3.6 responses.[37]

The CFTC economists concluded that the current regulatory structure is working well: “Judged from our evidence, SEF-traded index CDS market seems to be working well after Dodd-Frank—dealers’ response rates are high, the vast majority of customer orders result in trades and customers’ transaction costs are low.”[38]  Specifically, the CFTC economists found that transaction costs were low for index CDS contracts:

The transaction costs of on-the-run CDX.NA.IG and iTraxx Europe have a mean around 0.2 bps and a standard deviation of 1.4 bps, so the average transaction cost is statistically and economically close to zero.  For on-the-run CDX.NA.HY and iTraxx Crossover, the average costs are larger, at about 0.5 and 1.1 bps, but again not significant compared to their standard deviations of about 2.6 and 3.5 bps.  The first off-the-run contracts have comparable average transaction costs but a much higher standard deviation due to the relatively few number of trades in these contracts.[39]

Market participants have expressed similar concerns about removing the Order Book/RFQ-3 and impartial access requirements.  One senior executive at a trading firm recently stated that the SEF regulations have helped halve the bid-offer spread in US dollar swaps and increased price competition.  “My fear is we take too big a step back from having the competitive pricing in the market,” he said. “It is still a dealer-controlled market and if the biggest dealers simply say: ‘Great, I don’t have to put a competitive price on the screen anymore, and if someone wants my most competitive price then you’ve got to pick up the phone again,’ I don’t want to take that step backwards.”[40]

Similarly, the CEO of one SEF cautioned, “[o]ne of the risks of this concept of ‘any means of interstate commerce’ is you have benchmarks and fixings that rely on better liquidity coming in from liquid Clobs. You wouldn’t want to go backwards in that respect.”[41]

In 2016, Greenwich Associates reported that “the buy side feels the executions they are receiving under the current paradigm are sufficient, if not excellent.”[42]  Greenwich Associates noted that, for many asset managers, sending a request for quote to three market participants and selecting the best-priced response (no matter how many respond) “has long been considered an appropriate approach to achieving best execution.”[43]

The Proposal does not reference any of these findings or views of market participants.  In contrast to these data-based empirical studies regarding the benefits of the current regulatory system, the Proposal speculates—without any evidentiary support—that the “flexibility” afforded by the elimination of the Order Book/RFQ-3 requirement may provide various benefits.  For example, the Proposal asserts “SEFs would have broader latitude to innovate and develop new and different methods of execution tailored to their markets.”[44]  The Proposal further opines that these new, flexible methods “could be more efficient,” “may lead to reduced costs and increased transparency,” and “may provide opportunities for new entrants in the SEF market.”[45]

However, the Proposal provides no factual basis for any of these hypothetical benefits.  In light of the very low execution costs that have been documented for interest rate and index CDS swaps traded through RFQ-3, it is difficult to understand why RFQ-3 should be eliminated, at least for the swaps to which is currently applies.

Effect of expanded trading mandate on liquidity.  The overriding rationale for the Proposal is to attract greater liquidity formation to SEFs.  The Proposal seeks to accomplish this goal by expanding the SEF trading requirement to include all mandatorily cleared swaps for which SEF trading exists, with several exceptions.  Although the Proposal would expand the trade execution mandate in this manner, it also would eliminate the Order Book/RFQ-3 requirements and provide effectively unlimited flexibility as to the trading methods for all swaps subject to the expanded trading mandate.  The Proposal broadly asserts, without providing any evidentiary support, that the expanded trading mandate will improve liquidity and pre-trade price transparency and reduce market fragmentation.

In asserting that the expanded execution mandate will increase on-SEF liquidity, the Proposal appears to measure liquidity solely in terms of volume.  But volume does not equal liquidity.  It is not apparent how simply moving this volume from off SEF to being traded within a SEF will have any effect on other traditional measures of liquidity, such as cost of transaction or price dispersion.  Indeed, the only difference is that the swaps would be traded on SEF, but by the same people and using the same methods that they now use to trade them off SEF.  It is not apparent how this would lead to any greater price transparency or lower costs.

How many and what types of swaps would be brought onto SEFs under the expanded trading mandate?  The Proposal presents little data to answer this question.  One approach would be to assume that all swap transactions that are currently subject to clearing would become subject to the expanded trading mandate under the Proposal.  This amount may be significantly larger than the actual result because many swaps subject to clearing may not be easily traded on SEF.  But by comparing this amount to the amount of swaps currently traded on SEF, we can estimate an upper bound on the incremental increase in on-SEF trading resulting from the Proposal.

The Proposal notes that an estimated 57% of the notional amount of interest rate swaps are being traded on SEF, and that 85% are subject to the clearing requirement.  Accordingly, an upper bound of about 28% of interest rate swaps could be moved on SEF under the Proposal.[46]  This estimate is consistent with a recent estimate provided by Clarus that approximately two-thirds of the fixed/float USD interest rate swap market is traded on SEF.[47]  Examining the one-third of interest rate swaps that are being traded off SEF, Clarus found that “[g]enerally speaking, everything off-SEF is bespoke.”[48]

Again, it is not apparent how moving the trading of bespoke swaps from being traded by introducing brokers (“IBs”) outside a SEF to being traded by swap trading specialists inside a SEF will have any effect on the prices of those bespoke swaps.  It is even less apparent how the trading of these bespoke swaps within a SEF will have any impact upon the trading of the highly liquid standardized swaps already being traded within a SEF under the RFQ-3 methodology.  In fact, eliminating RFQ-3 for those liquid swaps could raise the prices for those swaps, and in turn may also negatively impact pricing for less liquid swaps, because most interest rate swaps—including bespoke swaps—are priced in part on a standard rate curve developed from prices for liquid swaps at various point along the curve.

Other impacts from excessive flexibility and discretion.  The Proposal establishes an overly flexible approach that allows each SEF to self-determine how it will operate in almost every respect.  Among other areas, a SEF would use discretion (a word used over 150 times in the Proposal) to tailor policies and procedures regarding trading procedures and rules, access, pre-execution communication, personnel oversight and ethics training, SEF compliance requirements, trading surveillance, error trade policies, record keeping, trade documentation, internal investigations and enforcement, setting fees, financial resource requirements, and supervision of third party services.  Most of these changes would loosen current regulatory requirements.

Documentation of executed swaps would no longer be required at the time of execution, but as soon as technologically possible.  The Proposal acknowledges that creating flexibility for execution methods and trading technology makes simultaneous documentation “impracticable.”[49]  In other words, moving away from electronic trading back to telephones will delay the time within which counterparties receive full confirmation of price and terms, preventing precision in the time of pricing, creating a higher likelihood of errors, and leading to less pre-trade price transparency.

Many of the changes in the Proposal would allow the SEF to exercise discretion in brokering trades and establishing rules to facilitate broking away from electronic platforms.  The Proposal explains that one of the reasons for granting the SEF greater discretion is to allow voice-broking to occur directly within the SEF.

Traditional introducing broking, by its nature, is slower and less transparent at establishing prices as compared to electronic trading.  As a broker calls around to multiple dealers for prices, the broker might make trade adjustments over time and prices from one call to the next may change.  As time passes, prices may become stale, even within seconds.  Dealers and other liquidity providers will add a cushion to the spread to account for this delay.  This means that as the length of time increases between when a quote is first received and when the trade is executed and the price is reported, spreads become wider and pricing becomes less transparent.  For certain trades, such as block trades, timing delays in price transparency might be appropriate for reasons related to the unique nature of each trade.  However, we should not be adopting regulations that would degrade the current level of transparency for liquid swaps that are being efficiently traded using an Order Book or RFQ system.

Similarly, the Proposal would allow extensive pre-trade negotiation for all swaps so long as the SEF defines it into the SEF’s trading rules.  Pre-trade negotiation may be appropriate for certain bespoke or large sized swaps.  However, to create flexibility in SEF trading methods, the Proposal would allow SEFs to include pre-trade negotiations for any and all types of swaps including standardized swaps currently traded electronically.  However, the Proposal would allow SEFs to include pre-trade negotiations for more liquid, standardized swaps for which pre-trade price transparency is better achieved through electronic trading, as explained in the studies discussed above.

 In addition, the Proposal would allow SEF trading specialists, when acting as brokers, to exercise discretion in sharing different market information with different market participants.  The Proposal acknowledges that this “trading discretion exercised by SEF trading specialists may affect the manner in which market participants are treated on a facility.”[50]  The Proposal suggests that this is somehow “consistent with impartial access” because it facilitates more trading.  More likely, this greater degree of sanctioned discretion—the extent of which is largely left up to the SEFs to determine—would lead to unfair treatment of different market participants and less pre-trade price transparency because SEF trading specialists can decide who gets what information pre-trade.

The statements above should not be interpreted as critical of intermediary broking services.  These services provide important options for trading and pricing certain types of swaps, such as bespoke swaps, package trades, and block sizes.  Rather, my concern is that these important services and the professionals who provide them may become less regulated, and that they will become intermediaries for transactions that are required to be traded electronically.

B. Diminished Oversight and Enforcement

I am also concerned that this Proposal waters down the robust, and uniform, standards of conduct and supervision to which it currently holds SEFs, IBs, associated persons (“APs”) of IBs, and other market participants.  This could lead to SEFs reducing their focus on compliance, require the Commission to take on an enhanced oversight role, and constrain the Commission’s ability to investigate and prosecute abusive trade practices involving SEFs.

As previously discussed, this Proposal grants extensive discretion to SEFs to create rules governing their operations and does away with some of the specific compliance and recordkeeping obligations currently required by the regulations governing SEFs, set forth in Part 37 of the Commission’s Regulations.[51]  The Proposal suggests that providing SEFs with greater flexibility to tailor their compliance and oversight programs will mitigate compliance challenges that SEFs have encountered in implementing part 37, yet fails to describe in any detail those challenges.[52]  On the other hand, we know that our current system of oversight provides market participants and regulatory authorities with uniform and descriptive standards of conduct and compliance procedures.  Enumerating these standards (1) prevents a race to the bottom, in which market participants pare back their policies and procedures to the bare minimum, and (2) provides the registrant and the Commission with the tools they need to successfully enforce compliance with those standards.

As an example, the Proposal would remove the requirement set forth in Regulation 37.203(c) that a SEF establish and maintain sufficient compliance staff and resources to (i) conduct specific monitoring, including audit trail reviews, trade practice and market surveillance, and real-time market monitoring; (ii) address unusual market or trading events; and (iii) complete investigations in a timely manner.  Rather, the Proposal would only require that the SEF establish and maintain sufficient compliance staff and resources to ensure that it can fulfill its self-regulatory obligations under the CEA and Commission Regulations.  Without specific requirements on what compliance resources are needed, each SEF will be free to determine what level of resources is sufficient for such a broad mandate.  In essence, the SEF need not map its compliance resources to specific compliance tasks.  Additionally, experience has shown that conducting oversight and examinations of the sufficiency of a registrant’s compliance resources is more difficult to undertake on a standard and fair basis across registrants when each one has a different view of what resources will meet the generalized requirement.

As another example, the Proposal eliminates the specific requirements that a SEF establish an annual audit trail review and related enforcement program, and retain certain categories of documents currently required by Regulation 37.205.  The Proposal assumes, however that “SEFs would continue to fulfill their information collection burdens in a manner similar to the status quo.”[53]   If the expectation is that SEFs will continue to comply with the current requirements, then why is it necessary to remove or weaken them?   Many still view the compliance function as a cost center.  It is unrealistic to assume that we can remove many of the specific conduct and recordkeeping obligations and expect that market participants will continue to comply, when competitive market pressures will drive the allocation of resources elsewhere.  Moreover, market participants have dedicated significant resources to developing these compliance policies and systems, and changing them without sufficient justification does not make practical sense.

As a final example, the Proposal removes some of the specific requirements in Regulation 37.204 for oversight of third-party regulatory services.  SEFs would no longer be required to conduct regular meetings with, and periodic reviews of, service providers or provide records of such oversight to the Commission.  Instead, SEFs are given broad latitude to determine the necessary processes to supervise these providers.  When registrants delegate critical functions to third-party providers, it is imperative that the registrant maintain diligent supervision over the provider’s handling of these functions. [54]  In my view, the Proposal does not provide satisfactory reasons for removing these unambiguous requirements, considering that doing so could hamper the Commission’s ability hold SEFs accountable for supervising third-party providers.

Equally concerning is the sweeping change the Proposal makes to the way in which SEFs and their employees and agents will be registered, and in turn, the Commission’s oversight of their conduct.  Under the current system, swaps broking entities that meet the definition of an IB must be registered with the Commission as such.  The individuals who are involved in soliciting or accepting orders at IBs, or involved in supervising such individuals, must register as APs of IBs.  As NFA members, IBs and APs are not only subject to the applicable Commission Regulations, but are also subject to uniform rules governing swaps brokering, trade practices, reporting, minimum financial requirements, proficiency testing, training standards, and supervision.  In addition, NFA monitors IBs’ swaps broking activity and compliance with all applicable statutes and rules.  In furtherance of that responsibility, NFA conducts periodic examinations of swap IB member firms and has the ability to discipline IBs and APs where appropriate.

Under the Proposal, which limits the activity that can be conducted off SEF, IBs will need to register with the Commission as SEFs to continue to broker swaps transactions.  Given that the majority of IBs engaging in swap transactions on SEF are affiliated with SEFs, it is likely that many of these entities, or their employees, will merge into or join the affiliated SEF.  We can also expect to see the formation of new SEFs, which presumably would not be required to register as IBs.[55]  SEFs and SEF employees would be free to withdraw their IB and AP registrations and memberships with NFA, leaving a regulatory vacuum with no self-regulatory organization oversight.  Already strained Commission resources inevitably would need to fill that void.

Further, the Proposal creates an entirely new category of persons:  the SEF trading specialist.  As proposed, SEF trading specialists will perform “core functions” that facilitate swaps trading and execution, including negotiating trade terms, arranging bids and offers, and discussing market color with market participants, or directly supervising a person who engages in such functions.  In fact, the Proposal notes that broadening the SEF registration and trade execution requirements would increase the level of discretion that these SEF employees and agents would exercise in connection with swaps trading.  However, despite these key, customer-facing functions, SEF trading specialists would not be required to register with the Commission.

For this reason, I am also concerned that the Proposal would weaken the supervisory function within the SEF.  Regulation 166.3 imposes a duty on all Commission registrants who act in a supervisory capacity, including APs, to diligently supervise the activities of employees and agents relating to their business as a Commission registrant.[56]  However, if the SEF is not registered as an IB, and its employees are thereby not registered as APs, the SEF employees themselves will have no duty to supervise under Regulation 166.3.  The Proposal imposes a separate duty on SEFs to supervise the activities of its SEF trading specialists “in the facilitation of trading and execution on the swap execution facility.”[57]  Critically, however, that duty runs only to the SEF as an entity and not to its employees, including the SEF trading specialists.  As a result, SEF trading specialists or other SEF employees with supervisory duties cannot be held individually liable for failure to supervise under any Commission regulation if they are not duly registered as APs of IBs.  Individual accountability is an important tool in incentivizing corporate responsibility and I think it must be preserved.

Finally, in at least one instance, the flexibility afforded to SEFs to establish a code of conduct for their SEF trading specialists is in direct conflict with the supervision rules applicable to all registrants under Regulation 166.3.  The Proposal states that a SEF’s Code of Conduct “may provide” that, among other things, a SEF trading specialist “not engage in fraudulent, manipulate, or disruptive conduct.”[58]  However, Regulation 166.3 requires that Commission registrants establish and maintain meaningful procedures for detecting and deterring fraud and other prohibited conduct by their employees and agents.[59]  This could create another potential gap in our supervisory structure that could weaken the Commission’s enforcement capabilities.

V.        Conclusion

This Proposal is a fundamental overhaul of the SEF regulatory regime.  The changes create a trading system that is so flexible that all swaps traded on SEFs—including the most liquid—could be traded the same way they were before the Dodd-Frank reforms were adopted.  The Proposal would allow the largest dealers to establish separate dealer-to-dealer liquidity pools through exclusionary access criteria.  Competition would be reduced and price transparency diminished.  This is not what Congress intended when it passed the Dodd-Frank Act.

I am open to appropriate, targeted amendments to the regulations, several of which I have suggested above.  However, empirical studies have shown that the existing SEF regulations have made great progress in achieving the statutory goals of promoting on-SEF trading and pre-trade price transparency.  With respect to the swaps markets that are working and providing low costs to the buy side and end users, we should live by the adage, “if it ain’t broke, don’t fix it.”

Public Meeting Opening Statement of Commissioner Rostin Behnam

November 5, 2018

Thank you Mr. Chairman.  I would like to start by thanking all of the Commission staff who worked to make today’s meeting possible – both those who will be presenting at the table today and those who provided the knowledge and analysis supporting their statements.  I’d also like to welcome Commissioners Stump and Berkovitz to the dais.  I look forward to continuing to deliberate on these and other issues on the agenda.

The De Minimis Exception

Today, the Commission puts an end to undue and prolonged uncertainty in the swaps market and acts decisively to set the aggregate gross notional amount (“AGNA”) threshold for the de minimis exception at $8 billion in swap dealing activity entered into by a person over the preceding 12 months.  Despite opposing the rule as proposed in June,[1] I am comfortable supporting today’s final rule because it is limited to establishing a clear and certain de minimis threshold. 

My gravest concern with the proposal for the de minimis exception was that the Commission may have been using the rulemaking to redefine swap dealing activity absent meaningful collaboration with the Securities and Exchange Commission (“SEC”), as required by the Dodd-Frank Act,[2] and to the detriment of market participants eager for regulatory certainty.  I was also concerned that the proposal’s multiple ancillary components might signify a willingness to exploit the de minimis exception as a means to further unilaterally alter the swap dealer definition in clear circumvention of Congressional intent.  In short, I was disappointed that the Commission was not focusing on what it needed to do—provide regulatory certainty for a critical cohort of market participants—and instead, was exploring the limits of its authority and creating impracticable expectations.  

I appreciate the Chairman and staff’s willingness to address my concerns and for their thoughtful consideration of the comments. 

Inasmuch as I am pleased that the final rule is narrowly focused purely on the numerical setting of the AGNA threshold, I am concerned that the Commission has yet to resolve longstanding concerns with the IDI loan-related swap exclusion referred to in today’s final rule as the “IDI Swap Dealing Exclusion.”  The IDI Swap Dealing Exclusion codifies part of the statutory swap dealer definition in section 1a(49)(A) of the Commodity Exchange Act[3] and was jointly adopted with the SEC as paragraph (5) to the regulatory swap dealer definition.[4]  This is not to be confused with the proposed IDI De Minimis Provision, which would have established an alternative to the exclusion, absent SEC coordination, that would have in effect, revised the scope of activity that constitutes swap dealing. 

Today’s final rule is vague regarding whether the Commission will work with the SEC in its ongoing commitment to continue considering issues raised by commenters towards appropriately amending the Swap Dealing Exclusion, consistent with the Dodd-Frank Act, or whether it will continue to attempt to finalize a separate exception.  I stand by my prior statement and continue to believe that the only correct path forward is for the CFTC and SEC to jointly consider and amend, as appropriate, the IDI Swap Dealing Exclusion.  I would be happy to participate in support of this effort.

The current data—absent consideration of the non-financial commodity (“NFC”) asset class—demonstrates that allowing the AGNA to decrease to $3 billion may capture an additional 13 swap dealers.[5]  Almost all are banking entities subject to prudential or comparable regulation in their respective jurisdictions, such that they are examined for safety and soundness and required to comply with customer protection rules.[6]  The few that are not banking entities are financial entities that are likely subject to regulation on a federal or state level.  Moreover, for all thirteen entities, the Commission was unable to exclude data regarding swaps that fall under the IDI Swap Dealing Exclusion, possibly lowering that number even further.

I’m pointing this out because I would like to stress that, while I support today’s decision to maintain the AGNA threshold at $8 billion, there is still work to be done on improving our data.  While swap data repository (“SDR”) data quality has improved, AGNA data was unavailable for NFC swaps.[7]  Nevertheless, Commission staff used counterparty and transaction counts and a series of assumptions to analyze likely swap dealing activity in the NFC swap market and concluded that reducing the $8 billion AGNA threshold could lead to reduced liquidity in NFC swaps, negatively impacting end-users and commercial entities who utilize NFC swaps for hedging.[8]  The Commission further relied upon findings and comments that the unique characteristics of the NFC swap market poses less systemic risk than financial swaps.[9] 

It is my hope that Commission staff will continue to examine and monitor data and activities in the NFC swap market to ensure that concentrated activity by unregistered NFC counterparties in segments of that swap market, such as in energy-related swaps, do not present outsized risk or harm to end-users, and most importantly the general public.

Swap Execution Facilities and Trade Execution Requirement

Staff also will be presenting proposed rules that would constitute an overhaul of the existing framework for swap execution facilities, or SEFs.  The Commission’s action today begins the process of public notice and comment under the Administrative Procedure Act.[10]  Given the breadth and complexity of the rule before us, the process of public comment is particularly important for this rule.  I look forward to receiving input from the many market participants who would be impacted, in any way, by a reworking of the SEF rules. 

As we start to consider the direction and breadth of SEF reform, I think it is very important that we first review how we got where we are today.  Prior to the 2008 financial crisis, swaps were largely exempt from regulation and traded exclusively over-the-counter, rather than on a regulated exchange.[11]  The opaque over-the-counter swaps market contributed to the financial crisis because both regulators and market participants lacked the visibility necessary to identify and assess swaps market exposures and counterparty relationships.[12]  In the aftermath of the financial crisis, Congress enacted the Dodd-Frank Act in 2010.[13] 

The Dodd-Frank Act 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.[14]  Title VII of the Dodd-Frank Act amended the Commodity Exchange Act to establish a comprehensive new swaps regulatory framework that includes the registration and oversight of a new registered entity – SEFs.  A key goal of Title VII of the Dodd-Frank Act is to bring greater pre-trade and post-trade transparency to the swaps market.  The concept of transparency runs throughout Title VII – starting with the title itself:  the “Wall Street Transparency and Accountability Act of 2010.”[15] 

As part of the Dodd-Frank effort to provide more transparency, in 2013, the Commission adopted the part 37 rules in order to implement a regulatory framework for SEFs.[16]  In so doing, the Commission emphasized that “[pre-trade] transparency lowers costs for investors, consumers, and businesses; lowers the risks of the swaps market to the economy; and enhances market integrity to protect market participants and the public.”[17] 

The SEF framework has in many ways been a success.  There are currently 25 registered SEFs.[18]  Trading volume on SEFs has been steadily growing each year.[19]  The Commission’s work to promote swaps trading on SEFs has resulted in increased liquidity, while adding pre-trade price transparency and competition. [20]

This is not to say that the SEF rules were perfect from the start and would not benefit from some targeted improvement.  Most SEFs rely upon multiple no-action letters granted by the Division of Market Oversight.  While the purpose of this form of targeted relief was often to smooth the implementation of the SEF framework, codifying or eliminating the need for existing no-action relief would provide market participants with greater legal certainty. 

The current SEF rules have not brought as much trading onto SEFs as intended or envisioned.  We can improve upon that, and I am hopeful that this process will bring about a thoughtful, inclusive, well-reasoned debate that limits changes to those issues that will result in policy consistent with congressional intent and the overarching goals of supporting strong, liquid, transparent markets.

Conclusion

Thank you again to staff for your hard work on today’s rules.  I look forward to the presentations.