Remarks of CFTC Commissioner Rostin Behnam at the 2018 ISDA Annual Japan Conference, Shangri-La Hotel, Tokyo

Our Collective Strength

October 25, 2018

[Delivered in Tokyo October 26, 2018]

Introduction

Thank you for the kind introduction; it is a great pleasure and honor to join you today.  I want to thank Scott O’Malia and the International Swaps and Derivatives Association (“ISDA”) for organizing this event and for bringing us together.  Before I begin, please allow me to remind you that the views I express today are my own and do not represent the views of the Commodity Futures Trading Commission (the “CFTC” or “Commission”) or my fellow Commissioners. 

As you will see, that reminder appears in the text of these remarks.  I haven’t always remembered to include such language in the text, and I often assume that it is understood that although I am part of the Commission, I am not the Commission.  The Commission comprises five commissioners, who are appointed by the President and approved by the Senate, who serve five-year staggered terms.[1]  No more than three of the five commissioners may be members of the same political party.[2]  The President appoints one of the commissioners as Chairman, and it is the Chairman who oversees the administrative functions of the Commission, such as supervising Commission personnel and directing their work agenda.[3]

The CFTC, like other independent federal agencies, is unique, in part because the membership is bipartisan and the terms of service are fixed.  Ultimately, the Commission provides the commissioners, republican or democrat, the opportunity to consider issues in a manner that aims to provide a full spectrum of ideas to reach the most informed and balanced outcomes.  If we, as a commission, are held to the highest standards of accountability, there should be no question that when the Commission speaks, the policy it’s announcing or the message it’s delivering is the outcome of well-reasoned and responsible deliberation.

Someone recently asked me: “What does success look like for a CFTC Commissioner in our current environment?” Answering that question first requires considering what success for the Commission looks like.  I believe that success for the Commission looks like what it has always looked like: fostering open, transparent, competitive, and financially sound markets; preventing and deterring misconduct and disruptions to market integrity; and protecting all market participants—whether institutional, retail or otherwise—from fraud, manipulation, and abusive practices.  I believe it also means avoiding being overconfident in the systems we’ve built and remaining nimble in our reconsideration of our past policies and practices and vigilant as we prepare for the challenges to come. 

Understanding the Commission’s goal, I was then able to think about what I believe success as an individual commissioner looks like.  For me, success means that I have done my best to make sure that every interested party is working collectively to address the issues facing the markets today.  It means moving beyond domestic political polarity and nationalistic animus to collaboratively address new and emerging risks with lessons learned from a decade of recovery and almost a century of history.  Simply put, success means working together to manage the day-to-day risks in our markets and creating plans to manage and resolve uncertainties.

Planning for a day or event that might never come seems especially tedious and wasteful, but it is essential.  It is the regulator that is ultimately accountable when things go awry and it is the regulator who will be looked to for strength and direction.  To achieve and maintain success, I believe that we individual Commissioners must adhere to regulatory process and transparency, be wary of false and incomplete progress, and hold one another accountable.

There is strength in the Commission. As the famous Japanese saying implies, “A single arrow is easily broken, but not ten in a bundle."  Each Commissioner may have their own opinion, but when the Commission speaks, it carries strength greater than each one individually.  This helps us ensure that the Commission meets success.

Along those lines, it is with that strength that the CFTC is participating, and in some cases taking the lead, in various work streams aimed at bringing international consensus to the issues facing the global derivatives market.  As the CFTC is strengthened by the participation of each commissioner, the regulatory framework for the global derivatives market is strengthened by the participation of every jurisdiction’s regulatory bodies.  While each agency may have responsibilities to their own constituency, we should remember that we can best achieve success by working collaboratively to ensure the integrity of markets that affect each and everyone one of us.

As 2018 draws to its close, enormous challenges such as benchmark reform, initial margin phase-in, cross-border regulation, Brexit, and emerging financial technologies are bringing regulators from around the world together in efforts to ensure that we put the right structures in place to absorb emerging risks.  With each of these issues, there is an uncomfortable level of uncertainty, as well as a sense of disdain for the anticipated costs of regulatory friction.  I believe that we must coordinate and work collectively to create plans that address and overcome any uncertainties.  Obscurity should not disqualify or deter us from moving forward: the decision must be to act.

Today I would like to address our greatest challenges of this moment and provide some insight and updates on the CFTC’s role in building the regulatory structures to eliminate or limit–and at least not amplify–the impact of the risks posed by benchmark reforms, margin, Brexit, new approaches to cross-border regulation, and fintech.  I will, at times, share some of my personal views and aspirations on these issues, but please remember that my views remain my own and are just one arrow in the bundle.

Benchmark Reform

I would like to begin with an issue that has surged and ebbed to the forefront of the derivatives market over the last decade: the erosion of the unsecured interbank term borrowing market.  This market underlies the world’s most prominent benchmark, the London Interbank Offered Rate (LIBOR), and as LIBOR has declined, we have witnessed rampant misconduct in the form of pervasive fraud, abuse, and manipulation.  Since June 2012, the CFTC has levied sanctions of more than $3.3 billion for LIBOR-related misconduct by individuals and the financial institutions that employed them.

What much of the public learned as a result of these enforcement cases is that LIBOR and other key IBORs are not merely financial tools for large institutions; the IBORs directly impact the everyday lives of retail customers across the globe.  For example, US dollar (USD) LIBOR is used in determining interest payments for over $200 trillion in derivatives, futures, corporate bonds, mortgages, retail and commercial loans and other financial products.  It has been estimated that over 15 million retail customers globally hold products such as mortgages, loans (student, auto, small business), and credit cards that reference LIBOR.  Since 2013, U.S. and international financial monitoring and advisory bodies have concluded that having hundreds of trillions of dollars of financial instruments referencing a rate based on judgements is a source of risk to the safety and soundness of the global financial system.[4]  As we move toward adopting risk-free rates, or “RFRs,” as alternatives to IBORs, our objectives should include both guaranteeing the reliability of viable benchmarks anchored in observable transactions and supported by appropriate governance structures and ensuring that such benchmarks are resistant to fraud and manipulation.

Our most recent call to action came in July 2017, when Andrew Bailey, Chief Executive of the UK Financial Conduct Authority (FCA)—which regulates LIBOR—acknowledged that despite significant improvements to LIBOR, the goal of anchoring LIBOR submissions and rates to the greatest extent possible to actual transactions cannot be achieved.[5]  The underlying market that LIBOR seeks to measure, the market for unsecured wholesale term lending to banks, is no longer sufficiently active. 

Further, under European Union benchmark regulations that LIBOR is subject to, regulatory authorities can only compel submissions to a critical benchmark for two years.  Recognizing the difficulties in transitioning towards an alternative reference rate, Andrew Bailey announced an agreement between the FCA and the panel banks to voluntarily sustain LIBOR until the end of 2021.  At that time, a critical number of panel banks will most likely stop making submissions, causing the FCA to determine that the LIBOR is no longer a representative benchmark.  Market participants have coined a new term for such a rate, “zombie LIBOR.” As a market regulator, it would be indefensible to allow hundreds of trillions of dollars of transactions to reference a zombie LIBOR after several years of lead time. 

Thankfully, the work to prepare for the adoption of alternative RFRs has been underway for more than five years.  Global regulatory authorities have been working closely with one another and with private sector entities on this effort.  This level of cooperation has been critical given the global nature of our markets and our shared interest in facilitating efficient cross-border transactions.  The CFTC, representatives from the Bank of Japan and the Japan Financial Services Agency (JFSA), and other regulators have been participating in the Official Sector Steering Group, the coordinating body set up by the Financial Stability Board (FSB) to drive this effort.  

To date, there has been strong mutual recognition that there are fundamental differences in the underlying market structures in the various jurisdictions.  Hence, we are moving away from a one-size-fits-all approach.  For example, in Singapore, the regulator and market participants have collectively agreed to take concrete steps to strengthen the existing rate, SIBOR.  The Hong Kong market is taking a similar approach.  On the other hand, here in Japan, as in the U.S., the U.K., and Switzerland, the focus has been on identifying or developing new alternative reference rates and then facilitating a transition to the new rate. 

There is good progress being made in Japan with TONA (Tokyo Overnight Average Rate), and progress is also being made in the U.S.  Thanks to a collaborative effort between the official and private sectors known as the Alternative Reference Rates Committee or ARRC, we have a new rate available to serve as a robust and reliable RFR: the Secured Overnight Financing Rate or SOFR.  SOFR is a fully transactions-based rate with the widest coverage of any U.S. Treasury repurchase rate available.[6]  The transactions underlying SOFR regularly exceed US $700 billion in daily volumes.  In contrast, based on statistics shared by the Federal Reserve Board, there are less than six to seven transactions per day at market rates to support the one- and three- month LIBOR across submitting banks.  For the three-month LIBOR, the standard reference rate in the derivatives markets, there is less than US $1 billion of borrowing among the largest banks.  On many days, that number drops below $100 million. 

SOFR futures began trading on the Chicago Mercantile Exchange (CME) in May, with both one- and three-month contracts offered.  Daily volume during August and September averaged more than 5,400 contracts per day with more than 75 global participants.[7]  In the five months since launching, SOFR futures have traded the equivalent of nearly $1 trillion in notional value.[8]  LCH began clearing SOFR-based over-the-counter (OTC) overnight index and basis swaps in July, and just a few weeks ago, CME announced that five market participants had cleared trades worth more than $200 million in notional of OTC SOFR swaps since October 1.[9]  

In view of the real threat that LIBOR might disappear post 2021, you should examine the fallback language in your financial contracts and update them to ensure that they will address the impact of LIBOR termination.  Fortunately, there are multiple efforts under way to develop alternative contract language for OTC derivatives and a range of cash securities and loan products.  In July, the ARRC issued a set of guiding principles for the development of fallback language for new financial contracts for loans, securitizations, and floating rate notes that reference USD LIBOR so they will continue to be effective in the event that USD LIBOR is no longer published.[10]  The principles provide a framework for the use of fallback rates, credit spread adjustments, and trigger events while stressing the urgency to incorporate replacement language into new contracts as a risk reducing measure.   

Separately, ISDA recently ended the comment period on an open consultation seeking comments on fallbacks for British pound, Swiss franc, and Japanese yen LIBOR, among others.[11]  ISDA is expected to launch a second consultation for the Euro and the USD.  I encourage market participants to actively participate in these and other public and private consultation efforts.  

Additionally, given the risks to the financial system presented by relying on a reference rate based on the judgements of a few rather than the robust, transparent trading by active market participants, to the extent you have USD exposure, I encourage you to start transacting in the new derivatives markets referencing SOFR.  Participant-led development of this market will help avoid consequences of dealing with a zombie LIBOR. It will help avoid liquidity fragmentation uncertainty, and possibly, litigation over weak or inadequate fall back language. 

The transition process, from identifying an alternate rate, coming up with a transition plan, and implementing it, is a huge coordination exercise among many market participants, many with competing interests.  While some participants might prefer that regulators force change through rule making, this is not the approach global authorities have taken.  Authorities do stand ready to facilitate these efforts by helping to avoid market dislocations, but our policies, mandates, and missions do not always support requiring compulsory industry standard setting or change through regulation.  Thus to achieve success, it is critically important that we have broad participation in these kinds of consultative efforts. 

Internally, if you have not already done so, mobilize a formal transition program in your firm—bundle your arrows.  In that bundle, include a budget with ample resources, a governance structure, and work streams with clear mandates to: conduct impact assessments; develop inventories of legacy exposures and contracts that mature after 2021; prepare for new products and financial instruments that will be linked to the new RFRs; and develop internal education and client outreach and communication plans. 

What’s next for the U.S.?  The ARRC’s published paced transition plan anticipates the adoption of the SOFR as the benchmark for interest rate derivatives in the first quarter of 2019.[12]  Given that futures and cleared OTC derivatives are now available and building liquidity, we are working towards a more secure future.  While many in my position have heard that there is some preference for continuing with LIBOR, regulators charged with ensuring that the markets provide for fair and efficient risk management that is free from fraud and manipulation are anticipating a clear and certain break from LIBOR. 

What’s next for me?  At the CFTC, each Commissioner sponsors an Advisory Committee to provide input and make recommendations to the Commission on a variety of regulatory and market issues that affect the integrity and competitiveness of U.S. markets.  I sponsor the Market Risk Advisory Committee (MRAC), which advises the Commission on matters relating to evolving market structures and the movement of risk across clearinghouses, exchanges, intermediaries, market makers and end users.  It examines systemic issues that threaten the stability of derivatives and other financial markets, and makes recommendations on how to improve market structure and mitigate risk.  MRAC members include representatives from clearinghouses, exchanges, intermediaries, academia, and market participants.  
 

In July, I convened the MRAC to focus on benchmark reform in an effort to unpack the myriad impending issues specifically related to the derivatives market.[13]  As a starting point, members of the ARRC and key market participants first discussed the role of interest rate benchmarks in the economy, the impetus for LIBOR reform, and the current status of global reform initiatives.  The discussion focused on the efforts of the FSB and the ARRC, as well as public and private sector coordination efforts in other jurisdictions.  A second panel of speakers addressed the development of SOFR, SOFR derivatives, and efforts to improve LIBOR. 

A final panel discussed the effect of LIBOR reform on the derivatives markets.  The discussion focused on LIBOR reform’s impact on legacy derivatives contracts, the development of fallback language, and key risk management and governance considerations for market participants.  End user and dealer representatives discussed the risks their firms and clients face with respect to LIBOR reform and how they or their clients are preparing to mitigate those risks.

Following the MRAC, the Commission voted to establish the Interest Rate Benchmark Reform Subcommittee to provide reports and recommendations to the MRAC regarding efforts to transition U.S. dollar derivatives and related contracts to SOFR and the impact of such transition on the derivatives markets.[14]  This subcommittee may consider the treatment of both existing derivatives contracts that are amended to include new fallback provisions or otherwise reference RFRs like SOFR and new derivatives contracts that reference RFRs.  It may also consider how liquidity in derivatives and related markets is impacted during the transition. 

My goal is to use the subcommittee to complement the work of the ARRC—as one more arrow in the bundle—by shedding more light on the potential challenges heading toward 2021, identifying the risks for financial markets and individual consumers, and, above all else providing solutions within the derivatives space. My expectation is that the subcommittee’s work—and that of the Commission itself—will recognize the critical importance of benchmarks while demanding integrity and reliability.

Initial Margin

Another challenge we are collectively facing is the impending final phases of the uncleared margin rules.  In October 2011, the Basel Committee on Banking Supervision (BCBS) and IOSCO, in consultation with the Committee on Payment and Settlement Systems and the Committee on Global Financial Systems, formed a working group to develop international standards for margin requirements for uncleared swaps, the “WGMR.”  The WGMR includes representatives from more than 20 regulatory authorities from Australia, Canada, the EU, Hong Kong, India, Japan, Korea, Mexico, Russia, Singapore, Switzerland, and the United States.  The U.S. is represented by the CFTC, the prudential banking regulators, the Securities and Exchange Commission, and the Federal Reserve Bank of New York. 

In September 2013, the WGMR published a policy framework establishing BCBS/IOSCO standards for margin for uncleared swaps to be recommended to regulatory authorities in member jurisdictions.[15]  The report was updated in March 2015 to revise the implementation timelines for the margin standards, extending the beginning of the five-step phase-in period for the exchange of initial margin, or “IM,” from December 2015 to September 1, 2016.[16]  

In 2016, WGMR created the Monitoring Group to ensure consistent implementation of the standards across products, jurisdictions, and market participants.  Since its inception, the WGMR Monitoring Group has submitted a series of non-public reports to the parent committees.  In April 2017, the parent committees re-authorized the WGMR, subsequently tasking the WGMR to monitor certain areas, including, in particular, the “IM big bang”: the end of the IM phase-in in September 2020 and its effect on the marketplace.  The WGMR Monitoring Group resumed activities in April 2018, putting forth a plan to conduct a new stocktaking exercise and produce a report on the implementation status of the margin standards, with a focus on the challenges of the 2020 phase-in.

The full phase-in of IM requirements by the September 2020 deadline raises a number of potential challenges for the marketplace.  Trade associations, including ISDA, estimate that over 1,100 additional counterparties and 9,500 relationships with new documentation requirements will result from the phase-in.[17]

Staffs at the CFTC and the U.S. prudential regulators agree that the WGMR should focus on 2020 concerns, and I want you to know that we are listening to these concerns.  We see the tip of the iceberg on the horizon and are doing our best to alert others.  At the same time, we are gathering information so that we can understand and confirm the depth and breadth of the situation and then engage further with industry to ensure that we avoid catastrophe: a plan is in motion.

Industry representatives, in particular ISDA and SIFMA (the Securities Industry and Financial Markets Association), have provided analyses indicating that the vast majority of the firms that will be impacted by a drop in the compliance threshold from $750 billion to $8 billion will post little or no IM because the size of their derivatives exposures fall below the $50 million IM exchange threshold.  Despite not posing enough of a systemic risk to require posting of margin, they argue that without a change to the $8 billion level, such smaller entities face compliance hurdles.  Accordingly, ISDA and SIFMA are advocating the following solutions: (1) increase gross notional thresholds for 2020 from $8 billion to an amount between $50 and $100 billion for a temporary period; (2) remove physically settled foreign exchange swaps and forwards from aggregate notional amount calculations; and (3) alleviate the burden of requiring custodial documentation when the $50 million IM threshold is crossed.[18]

As part of the Monitoring Group, staff at the CFTC will focus on addressing implementation and market developments through information gathering to further identify and evaluate implementation issues.  It will also work towards establishing a common understanding regarding potential gaps or challenges in the implementation framework.  A key goal of this exercise is providing the CFTC and prudential regulators an opportunity to engage further with one another and with industry to understand the various impacts of legal frameworks on effective segregation and collateral arrangements, on different derivative products, and on different types of entities.  Consideration of cross-border, substituted compliance and equivalence assessments will, of course, be another consideration as we collectively bundle our efforts and work towards appropriate recommendations and guidance.

Cross-Border Regulation

There has been much talk in our industry about the U.S. derivatives regulator’s potential plan to “rein in” its swaps trading rules,[19] but there is, as of yet, little consensus about the right way to accomplish that goal.  During the first half of September, Chairman Giancarlo traveled here to Tokyo to announce and promote his vision and upcoming proposal to update and improve the CFTC’s approach to applying its statutory authority over swaps activities to cross-border activities.[20]  At the time, he was completing work on his white paper, “Cross-Border Swaps Regulation Version 2.0: A Risk-Based Approach with Deference to Comparable Non-U.S. Regulation,” which I saw for the first time a day before it was released to the public on October 1, 2018.[21] 

This paper is an arrow outside of its bundle.  In the United States, when federal agencies seek public participation in the formulation of a regulatory change, they do not use white papers. Instead, federal agencies like the CFTC follow a statutorily mandated notice and comment process under the Administrative Procedure Act[22] that ensures that the public receives official notification, can comment on proceedings of, and have access to a record of Federal agency action.  And even if the agency is not quite ready to engage in a full rule-making, there are procedures for publishing a request for comments in the Federal Register, a daily publication of the Federal Government and the official repository for all such actions.  Following these procedures ensures that an agency can get its arrows together before completing regulatory change and creates a record of its path.

Thus to be clear, the Chairman’s release of his white paper was not action by the Commission, nor was it the first step in a statutorily mandated process towards taking a particular regulatory action.  Rather, the white paper expresses the views and ambitions of the Chairman—of one arrow—and neither binds nor bundles any other Commissioner or the Commission on the path forward.  As the Chairman himself acknowledges, the white paper is not quite a concept release and its proposals have not yet been presented to the full Commission for input, consideration, or consensus.[23] 

Our expectations of regulatory change should follow accordingly.  As I mentioned at the beginning of my remarks, the Chairman is authorized to direct the Commission’s agenda, and he has spoken publicly on plans to turn the proposals advocated in his white paper into Notices of Proposed Rulemakings, published in the Federal Register. However, the timing on these official steps is unclear.  The Chairman himself acknowledged that it will be “several quarters” to begin to make the sea-change and it remains unclear as to how the Commission will approach the rulemaking process within our existing set of regulations.[24]  This delay is just as well: certain aspects of the proposal represent departures from existing policy and may even conflict with our governing statute and prior Commission interpretations thereof or lead to gaps in certain protections afforded to U.S. persons transacting overseas.[25]  There are many issues that the Commission needs to work out to ensure that its arrows are collected into a bundle before it moves forward.

For my part, I agree that the Commission should address any problems resulting from its current approach to regulating swaps activities in the cross-border context.  But I also think that the Commission should build its internal consensus in accordance with formal, statutory procedures while appropriately considering its own mission in context with the needs of and affording deference towards our fellow global regulators.  Likewise, I disagree with the Chairman’s criticism of those who served the Commission before us and had difficult choices to make at a time of great crisis.  Our predecessors discovered the global breadth and depth of the derivatives markets only through feeling the acute pain of the 2008 financial crisis, and it was within that context that the relationships between the world’s many regulators took shape. 

In trying to address that crisis, the CFTC exercised its strength when it needed to while preserving the opportunity to change its approach as the derivatives markets recovered.  It was with deference to future CFTC leadership, such as the Chairman, and fellow foreign regulators that the Commission expressed its first cross-border approach in flexible “guidance,” or as a “non-binding policy statement.”  This adaptable regulatory tool can be fine-tuned by the Commission without engaging in lengthy, procedural rulemaking, and it was perhaps chosen for just that reason.  As stated by the Commission in the Federal Register release announcing its cross-border guidance, “The Commission understands the complex and dynamic nature of the global swaps market and the need to take an adaptable approach to cross-border issues, particularly as it continues to work closely with foreign regulators to address potential conflicts with respect to each country's respective regulatory regime.”[26]  The Commission further committed to periodically reviewing its guidance in light of future developments.[27]    

I agree that it is appropriate to take stock of our global reforms and work together towards mutually recognizing each other’s exercise of authority over activities that take place across one another’s borders.  I support the Chairman’s stated objectives of (1) increasing CFTC cooperation with global regulators to reduce duplicative regulation and redundant supervision; (2) reducing the operational burdens and complexity of overlapping regulations where appropriate; and (3) reducing market fragmentation and fostering deeper liquidity pools. I am looking forward to working with the Chairman and my fellow commissioners as we build consensus towards taking the next, stronger step in the process together.

Brexit

In the immediate future, one area that we can and should look to meet those objectives as a collaborative team is around the United Kingdom’s (UK) impending exit from the European Union (EU).  Should no deal materialize, there will be a considerable amount of uncertainty surrounding what each phase of a derivatives trade—from connecting a salesperson with a client, to executing the trade, and processing the trade through a central clearing party (CCP)—will look like after Brexit.[28]  Where each of those actions takes place will be another question, and how market participants geographically shift those functions will carry substantial risks.[29]

Whatever the disposition between the EU and the UK, the reaction to those risks should not be a deviation from the current paradigm of regulatory deference.  As Chairman Giancarlo has mentioned,[30] having a healthy respect for regulations that ensure market transparency and stability, and which also respect local commercial custom, have become a mainstay of our global regulatory infrastructure.  Deference to comparably robust regulatory regimes prevents overly burdensome and conflicting regulatory requirements from reducing market efficiencies while ensuring that global markets are successfully protected. 

While we will continue to look for ways to build consensus across borders, the CFTC will not allow an adjacent regulator to upset that paradigm.  I look forward to working with both my fellow commissioners and foreign regulators to make sure that derivatives markets are prepared to deal with the complex implications of Brexit.

Fintech

Before I close, I would like to briefly speak about fintech and share some of thoughts about new technologies in our markets.  I recently completed my first year as a Commissioner, and  looking back on that year, I am surprised by the amount of time I spent examining issues related to bitcoin, crypto assets, distributed ledger technology (DLT), artificial intelligence, and cloud-based programming.  As part of a self-directed listening tour, I met with designers, developers, providers, and marketers of both prominent and newer, perhaps less mainstream technologies.  I engaged with think tanks, academics, and practitioners focused on everything from cybersecurity to aiding the underbanked in the remotest parts of the world.  I had no single goal in mind, just a desire to avoid being the typical regulator on the tail end of technological advancement, scurrying to keep pace with swift innovations that capture market efficiencies, open markets to new products and participants, and often reward those willing to take risk. 

I could speak for another twenty minutes on what I’ve learned, my concerns, the risks, and all of the new questions I have…but I will keep it brief. 

I have come to understand that innovation at the edge allows others to be creative and pursue their dreams and missions.  Just take a moment to think about all the possible use cases for DLT from agriculture to healthcare, finance to art, CryptoKitties to Dogecoin.  These innovations are more than just technology: They inspire us to find solutions for every problem or hurdle we encounter—and sometimes, they are just fun.   

I believe that we as regulators must approach fintech with an open mind and a healthy respect for our role in the markets.  There is great regulatory uncertainty regarding how fintech fits into our existing rules and regulations.  Every innovator at the edges of what is permitted is hoping that his or her product will prove to be what is desired by the market and deemed compliant by the regulator.  Everyone wants a clear statement of support for what they are doing, and yet, most cannot describe—or maybe haven’t even considered—the risks.  And this is critical:  if innovators want access to financial networks, we regulators, whose job it is to ensure fair, safe, and transparent markets, need to understand how their technologies work and the risks that they bring into the world’s markets. 

Whether it’s a black box or a white box, we cannot afford to be awed by new technology: we need to comprehend it.  Though we regulators must balance the urgency to create new laws and regulation with our current lack of a full understanding of the promise and perils of fintech, we are nevertheless accountable to all those whom the markets affect, and we must ensure that the legal issues and risks presented by all technologies are identifiable and solvable before they cross the horizon.  As we move forward, market regulators will serve an essential role in fintech development by making sure that innovators are socialized into a culture of regulation and compliance.

The G20, which Japan will host in 2019, has acknowledged that, while fintech innovation is fundamentally reshaping the global economy in a positive way by improving efficiency and inclusiveness, the transition to digitalization presents new challenges for the public and private sectors.[31]  The G20 further noted in March and reiterated in July that, “Policy responses, including international cooperation, are needed to harness the opportunities and ensure the benefits are shared by all.”[32]  As we move forward, one of the challenges for regulators is that the risks and rewards of fintech are not always anchored within the organizational structure of supervised firms. However, regulators already have tools in their bundle that could serve as models for the future–we can take a horizontal view of the services provided by these companies to ensure that specific conduct requirements are met.  We can successfully mitigate the risks and uncertainties posed in this space if we collectively shoot arrows from our bundle and create a framework that continues to ensure market integrity and appropriate protections for all of our participants.  I look forward to Japan’s leadership in the G20 on these and other issues.

Closing

I hope I’ve given you more insight into how the Commission is facing the challenges to our markets, and how I view some of the hurdles we are all facing. I am optimistic by nature, and take my role as one arrow in the bundle very seriously.  We are all on course to solve the issues before us, and we should not be deterred from moving forward.  Thank you for having me, it’s been an honor.

[1] Commodity Exchange Act § 2(a)(2)(A), 7 U.S.C. § 2(a)(2)(A).

[2] Id.

[3] Commodity Exchange Act § 2(a)(2)(A) and 2(a)(6), 7 U.S.C. § 2(a)(2)(A) and 2(a)(6).  

[4] In 2013, the Financial Stability Oversight Council (FSOC), a collaborative body chaired by the U.S. Secretary of the Treasury that brings together the expertise of federal and state financial regulators, identified that reliance on reference rates such as LIBOR, with their weaknesses in governance and scarce underlying transactions, as a major theme affecting financial stability.  The FSOC recommended that U.S. regulators cooperate with foreign regulators, international bodies, and market participants to identify alternative interest rate benchmarks that are anchored in observable transactions and supported by appropriate governance structures.  FSOC also recommended that these agencies develop a plan to transition to new benchmarks while alternatives are still being identified.  Financial Stability Oversight Council, 2013 Annual Report 3, 6, 14 137-142 (2013), https://www.treasury.gov/initiatives/fsoc/Documents/FSOC%202013%20Annual%20Report.pdf.  In 2014, the Financial Stability Board (FSB) reviewed major interest rate benchmarks and concluded that having hundreds of trillions of dollars of financial instruments referencing a rate based on judgements is a source of risk to the safety and soundness of the global financial system.  Financial Stability Board, Reforming Major Interest Rate Benchmarks (2014), http://www.fsb.org/wp-content/uploads/r_140722.pdf.  Also in July 2013, the International Organization of Securities Commissions (“IOSCO”) published its “Principles for Financial Benchmarks: Final Report,” with the objective of creating an overarching framework of principles for financial market benchmarks commonly referred to as the “IOSCO Principles.”

[5] Andrew Bailey, Chief Executive, Financial Conduct Authority, Speech at Bloomberg London: The Future of LIBOR (July 27, 2017), https://www.fca.org.uk/news/speeches/the-future-of-libor.

[6] SOFR has been published daily by the Federal Reserve Bank of New York since April 3, 2018.  See, e.g. Federal Reserve Bank of New York, Reference Rates (2018), https://www.newyorkfed.org/medialibrary/media/research/advisory_panel/far/lieber_far_april2018.pdf?la=en.

[7] CME Group, October Rates Recap (data as of October 5, 2018), https://www.cmegroup.com/education/rates-recap/2018-10-rates-recap.html.  

[8] Id.

[9] Press Release, LCH, LCH Clears First SOFR Swaps (July 18, 2018), https://www.lch.com/resources/news/lch-clears-first-sofr-swaps; Press Release, CME Group, CME Group Announces First OTC SOFR Swaps Cleared (Oct. 9, 2018), https://www.cmegroup.com/media-room/press-releases/2018/10/09/cme_group_announcesfirstotcsofrswapscleared.html.

[10] Alternative Reference Rates Committee, ARRC Guiding Principles for More Robust LIBOR Fallback Contract Language in Cash Products (2018), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-principles-July2018.pdf.

[11] International Swaps and Derivatives Association, Consultation on Certain Aspects of Fallbacks for Derivatives References GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW (July 12, 2018), https://www.isda.org/2018/07/12/interbank-offered-rate-ibor-fallbacks-for-2006-isda-definitions/.

[12] See Alternative Reference Rates Committee, Presentation by Sandra O’Connor, Chair (2017),  https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/OConnorpresentation.pdf.

[13] Press Release Number 7752-18, CFTC, CFTC’s Market Risk Advisory Committee Announces Agenda for July 12 Public Meeting (July 10, 2018), https://www.cftc.gov/PressRoom/PressReleases/7752-18.

[14] Press Release Number 7819-18, CFTC, CFTC Commissioner Behnam Announces the Establishment of New Subcommittee of the Market Risk Advisory Committee and Seeks Nominations for Membership (Oct. 3, 2018), https://www.cftc.gov/PressRoom/PressReleases/7819-18.

[15] Basel Committee on Banking Supervision and Board of the International Organization of Securities Commissions, Margin Requirements for Non-Centrally Cleared Derivatives (July 2013), https://www.bis.org/publ/bcbs261.pdf.

[16] Basel Committee on Banking Supervision and Board of the International Organization of Securities Commissions, Margin Requirements for Non-Centrally Cleared Derivatives (March 2015), https://www.bis.org/bcbs/publ/d317.pdf.  The revisions also included a six-month phase-in of the requirement to exchange variation margin, beginning September 1, 2016. 

[17] Letter from ISDA, et al. to the Secretariats of the BCBS and IOSCO Re: Margin Requirements for Non-Centrally Cleared Derivatives – Final Stages of Initial Margin Phase-In (Sept. 12, 2018), https://www.isda.org/a/5evEE/Initial-Margin-Phase-In-Implementation-Joint-Trade-Association-Comments.pdf.

[18] Id.

[19] See, e.g., Philip Stafford, US Regulator to Unveil Plans to Rein in Swaps Trading Rules, Financial Times, Sept. 30, 2018, https://www.ft.com/content/6e9a7956-c48c-11e8-8670-c5353379f7c2.

[20] See J. Christopher Giancarlo, CFTC Chairman, A New Approach to Cross-Border Swaps Reform: One Market, One Regulator, One Set of Rules, Remarks by Chairman J. Christopher Giancarlo at FIA Japan, Tokyo, Japan (Sept. 11, 2018), https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo54.

[21] Press Release Number 7817-18, CFTC, Chairman Giancarlo Releases Cross-Border White Paper (Oct. 1, 2018), https://www.cftc.gov/PressRoom/PressReleases/7817-18. 

[22] Administrative Procedure Act, 5 U.S.C. § 500 et seq.

[23] See Press Release Number 7817-18, supra note 21; Robert Mackenzie Smith, Q & A: CFTC’s Giancarlo on the Race to Overhaul Cross-Border Rules, Risk.net, Oct. 4, 2018, https://www.risk.net/regulation/6002076/qa-cftcs-giancarlo-on-the-race-to-overhaul-cross-border-rules.

[24] Smith, supra note 23.

[25] See, e.g., Rostin Behnam, A Decade After the Financial Crisis: Remaining Challenges and New Approaches for the Next Ten Years and Beyond, Keynote Remarks of CFTC Commissioner Rostin Behnam at the Federal Reserve Bank of Chicago’s Fifth Annual Conference on CCP Risk Management, Chicago, Illinois (Oct. 16, 2018), https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam10.

[26]Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 45292, 46297 (July 29, 2013).

[27] Id.

[28] Lukas Becker, Day One of a No-Deal Brexit: Swaps and Chaperones, Risk.net (Oct. 9, 2018), https://www.risk.net/derivatives/6016721/day-one-of-a-no-deal-brexit-swaps-and-chaperones.

[29] Phillip Stafford, European Banks Worry about Clearing in No-Deal Brexit, Financial Times (Oct. 9, 2018), https://www.ft.com/content/e5bef5b6-c8a1-11e8-ba8f-ee390057b8c9.

[30] J. Christopher Giancarlo, Chairman, Commodity Futures Trading Comm’n, Remarks at FIA Expo, Chicago Illinois (Oct. 17, 2018), https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo58.

[31] G20, Communiqué Finance Ministers & Central Bank Governors (Mar. 19-20, 2018), https://g20.org/sites/default/files/media/communique_-_fmcbg_march_2018.pdf.

[32] Id.; G20, Communiqué Finance Ministers & Central Bank Governors (July 21-22, 2018),
https://calculators.io/g20-communique-on-cryptocurrency/.

Chairman J. Christopher Giancarlo Comments on Brexit, Financial Stability Oversight Council

October 16, 2018

As regulators of United States derivatives markets, world’s largest, the CFTC carefully monitors developments in Europe, especially in London, which is a key institutional service center for cross-border derivatives transactions.  The CFTC’s analysis of the potential effect on the US economy of an unresolved and disorderly Brexit (“Hard Brexit”) is informed by data the CFTC has gathered directly and analyzed internally as well as by recent statements of the Bank of England, the IMF and other public and private organizations.

The CFTC is concerned that a Hard Brexit would likely have an immediate and significant impact on the global financial system, including the US economy.  The CFTC is concerned about the specific impact of such an event on US banks and financial institutions, which account for between 40 and 60 percent of trading activity and liquidity provision in the global derivative markets.

The CFTC sees four possible sources of significant market disruption caused by a Hard Brexit.  The first, and perhaps most imminent, is central clearinghouses (CCPs) of derivatives transactions located in London being forced to disassociate with EU 27 banks and other CCP clearing members to avoid the legal uncertainty of their CCP membership obligations.  Such disassociation would likely take place as much as 90 days before a Hard Brexit pursuant to applicable CCP rules and regulations.  The second source of potential market disruption is U.K. institutions losing authorization to service uncleared over-the-counter derivative contracts and insurance contracts with EU 27 counterparts.  The third concern is EU 27 firms losing the ability to use U.K. exchanges for hedging and risk management of a range of existing derivatives products, and needing to find alternatives that in many cases do not exist in EU 27 countries, such as derivatives on interest rates, Brent crude oil and various precious and industrial metals.  The final concern is that amendments to existing swap contracts undertaken as a result of Brexit may be considered the creation of new swaps, subject to a panoply of new swaps regulations.

The CFTC identifies a number of financial stability risks arising from these four sources.  Such an abrupt transfer of hundreds of thousands of cleared swaps positions across CCPs in a matter of weeks would be unprecedented.  It could be the source for enormous operational risk.  It could cause a fire-sale scenario, with EU 27 institutions rushing to dispose of open CCP positions to non-EU 27 financial institutions that have limited absorption capacity.  There is also potential for EU27 bank distress from tens of billions of Dollars in unanticipated costs, additional margin and the write down of cleared swaps positions.  There is also concern that the wholesale exit of EU 27 banks from London client clearing would exacerbate concentration of activity in other non-EU 27 banks.  The impact of any and all of these concerns may well reverberate globally causing increased volatility and disruption across world markets for derivatives and other traded products.

Remarks of Chairman J. Christopher Giancarlo at FIA Expo Chicago, Illinois

“A Week in the Life of the CFTC”

October 17, 2018

Introduction

Thank you.  I especially want to thank the organizing committee, Walt Lukken, and the rest of the speakers.  Thank you for the invitation to speak here.  This expo is advertised as the “hub” of the derivatives and swaps universe.  Indeed, it is, and I am pleased to have this time with you.

Recent Developments at the CFTC

It may have been a quiet week in Lake Wobegon, but the first week in October was a rather busy time at the CFTC.  I would like to tell you about a week in the life of the agency.

On Wednesday and Thursday, October 3-4, the CFTC hosted its first ever financial technology conference, Fintech Forward.  LabCFTC and the CFTC’s Office of Customer Education and Outreach (OCEO) worked together to bring innovators, regulators, market participants, thought-leaders, and the general public together to examine the wide range of fintech developments impacting markets, including crypto assets, machine learning, cloud technologies, regtech, and other emerging financial technologies.

The collaboration underscores the Commission’s multi-pronged approach to keeping pace with a rapidly changing market and ensuring market integrity.  In its first year, LabCFTC has actively and effectively executed on its mission of facilitating market-enhancing innovation and helping to inform policy, and the Office of Customer Education and Outreach continues to pursue opportunities to educate customers in our markets across all asset classes.

In fact, LabCFTC is here in Chicago at FIA Expo holding office hours with financial technology innovators.  Next week, the Lab will conduct lab hours in Austin, Texas.  Sign-ups are underway.

Fintech Forward 2018 focused on key tech-driven developments in the financial markets.  Conference participants considered the impact of new technologies on markets and customers, and what regulators must do to remain forward-looking, mitigate risks, educate customers and market participants, and identify emerging opportunities, risks, and challenges.  It was a fine event that we hope to reprise next year.

Perhaps an even more significant event was the meeting of the Technology Advisory Committee on Friday, October 5.  That is because the TAC Committee met in front of a full Commission.  The last time that happened was on April 30, 2013 – five and a half years ago.  In fact, that was the last time any advisory committee took place before a full CFTC Commission.  Thus, it was very satisfying to have our new and full Commission together ten days ago.

You know, there is logic to having a five-member Commission.  And, it is right that all CFTC Commissionerships be filled, as they are now.  In fact, we may well have on board the most experienced and knowledgeable group of Commissioners in the history of the CFTC.  You will hear from most of us here at Expo.  I thank Senator Roberts, Senator Stabenow, and the Senate Ag Committee for their work in the current Congress to confirm all five members of this Commission.

One of the capabilities of a full Commission is to sponsor and activate all of the CFTC’s advisory Committees.  I thank Commissioner Stump for agreeing to sponsor the Global Markets Advisory Committee.  In that role, Dawn is representing the CFTC this week at the IOSCO meeting in Madrid.  It has been too long since the last meeting of GMAC, but it is now in good hands and will soon be off to a good restart.

I also thank Commissioner Berkovitz for taking over sponsorship of the Energy and Environmental Markets Committee.  Dan is busy finalizing the EEMAC membership for an upcoming meeting.  We look forward to that.

I will be taking on sponsorship of the Agriculture Advisory Committee and will be reaching out soon to members.  The Ag Advisory Committee met last year in Kansas City under Commissioner Behnam’s interim sponsorship, for which we are grateful.  I look forward to sponsoring another Ag Advisory Committee meeting in Kansas in conjunction with the CFTC’s 2nd Ag Commodity Futures Conference in early April 2019.

I also want to thank Commissioner Behnam for standing up the Market Risk Advisory Committee with energy and determination.

The MRAC’s formation of a sub-committee to address emerging issues related to the movement away from LIBOR to SOFR was just unanimously approved by the Commission.  The MRAC’s work in this area will complement and further the work of the Alternative Reference Rate Committee.  Commissioner Behnam has taken a thoughtful approach to this important task.[i]  I support this coordinating effort and the fine work that will surely result.

That brings me back to the TAC Committee meeting.  I thank Commissioner Quintenz, Daniel Gorfine, and all the distinguished TAC members for preparing a thorough and diverse program.

I want to briefly comment on one topic raised at the TAC Committee.  That is the report of the TAC’s Automated and Modern Trading Markets Subcommittee and its discussion around an IOSCO Consultation Report on “Mechanisms Used by Trading Venues to Manage Extreme Volatility and Preserve Orderly Trading.”[ii]  I query to what extent the recommendations contained in the IOSCO report may address some of the concerns underlying the CFTC’s 2016 proposed Regulation AT.[iii]

As you know, Regulation AT was an initiative of my predecessor, Chairman Massad.  My position was and continues to be that, while there were some good things in the proposal, there were other things that were unacceptable and perhaps unconstitutional, including that proprietary source code used in trading algorithms be accessible without a subpoena at any time to the CFTC and the Justice Department.

At heart, Reg AT is a registration scheme that would put hundreds if not thousands of automated traders under CFTC oversight, a role for which our agency has inadequate resources and capabilities.  While I share genuine concerns about the inevitability of some future market disruption exacerbated by automated trading algorithms, there is nothing in Reg AT’s proposed imposition of burdensome fees and registration requirements that will prevent such an event.  The blunt act of registering automated traders does not begin to address the complex public policy considerations that arise from the digital revolution in modern markets.  Worse is that it would give a false sense of security that the CFTC had regulatorily foreclosed such market disruption, which is impossible.  That is why I voted against Reg AT.  I do not intend to advance it in its current iteration.

Nevertheless, I remain quite open to thoughtful consideration by my fellow Commissioners, market participants, and the public about whether there are elements in Reg AT that could serve as the basis for a new and more effective rule.  Our new Market Intelligence Branch and Office of Chief Economist can help with market analysis.  In February, the UK FCA and the Prudential Regulatory Authority published papers outlining their respective regulatory governance and compliance expectations in respect of algorithmic trading.  These are worth careful study.  The IOSCO recommendations discussed by the TAC Subcommittee also appear helpful.  I commend the TAC Committee for its work to review the impact of automated trading on markets.  I look forward to well-informed and balanced policy recommendations that the Commission can consider for appropriate action.

Record Setting Enforcement

Let me now pivot to another issue that was addressed the same first week in October: enforcement.  We reported on the agency’s enforcement efforts for the fiscal year that ran from October 2017 through September 2018 – the first fiscal year under my administration.

In short, it was one of the most vigorous periods of enforcement activity in the history of the agency.  We reported:

• More enforcement actions than ever;
• More penalties resulting from those actions than five out of eight years of the prior administration;
• More large cases than ever before;
• More cases for manipulative conduct and spoofing;
• More whistleblower awards than in the entire history of the program;
• More partnering, including with federal and state law enforcement, other market and prudential regulators and self-regulatory organizations; and
• More accountability, with 70% of cases involving charges against individuals from the front office to the C-Suite.

Why such an emphasis on enforcement?

Because it is the duty of government generally and the particular mission of the CFTC to enforce market regulation and prosecute bad actors.  We fulfill that mission so that America’s financial markets are places for good people to fulfill their dreams and grow the economy. 

During an administration pledged to broad-based prosperity, the CFTC’s robust enforcement program is important to the health and safety of U.S. financial markets.  When conducted in a disciplined fashion, assertive regulatory enforcement is fully compatible with vibrant economic growth.

Before I entered government service, I spent a decade and a half working on Wall Street.  My commitment to robust regulatory enforcement derives from that experience.  I have enormous respect for the good men and women of America’s financial service industry who conduct themselves each and every day with integrity and honesty.  They are the ones who are betrayed by the very few who engage in wrongful behavior.  They are the ones who count on the CFTC to police U.S. commodity and financial markets that remain the envy of the world.

A New Approach to Cross-Border Regulation

Let me comment on one other event from the first week in October.  That was the release of a White Paper on cross-border regulation.[iv]  As you may know, the White Paper provides thoughts on how the CFTC should revise its current ad-hoc cross-border regime into a holistic risk-based framework that furthers the cause of swaps market reform.  I want to focus the balance of my remarks this morning on one of the foundational elements of the White Paper: regulatory deference.

In September, I embarked on an extensive trip to Europe and Asia where I gave a preview of the White Paper through a series of speeches laying out my ideas for improving the CFTC’s cross-border application of swaps regulation.  The speeches contained both a mea culpa and an apologia.  The mea culpa acknowledged that in the past the CFTC has been accused of an over-expansive assertion of jurisdiction in applying Title VII of the Dodd-Frank Act outside the United States.  That expansive assertion is responsible, at least in part, for fragmenting global markets into a complex series of ever more shallow pools of trading liquidity.

At the same time, the apologia recognized the fact that the CFTC’s cross-border overreach may have been understandable back in 2013, when no other G20 jurisdiction had yet to fully implement the G20 swaps reforms.  To ostensibly protect U.S. markets, the CFTC sought to impose U.S. law abroad regardless of whether activity had a “direct and significant” impact on the United States.

However, all of this is water under the bridge.  Times have changed.  Markets have changed.  A new approach to cross-border regulation is necessary.

The White Paper does not purport to address every cross-border issue, but to lay out a high-level framework for approaching the matter.  It seeks to offer enough detail to give readers a good sense of direction, yet acknowledges that details and substance must be worked out through the rulemaking process.  The purpose of the White Paper, therefore, is to serve as a concept release to generate more focused discussion of these important issues.

Since returning from Europe and Asia, I have begun discussing the recommendations contained in the White Paper with many market participants and fellow regulators both domestically and abroad.  Further, I have directed the staff to begin the rulemaking process with the aim to publish certain proposed and final regulations through the APA process with appropriate public notice and comment in the first half of next year.

So, what do we mean by “deference?”  It is a word that is frequently thrown about in regulatory circles.  Yet, it is a mistake to dismiss it as a slogan.  It is a regulatory approach that can be applied to concrete regulatory challenges – regulation of swaps trading venues, regulation of central clearinghouses (CCPs), and regulation of swap dealers.  It is the basis for any realistic chance to preserve functioning global markets.

During my travels in Europe and Asia, I called for policymakers and regulators to join me in adopting a deferential approach to the cross-border application of swaps reform regulation.  I said we have a rare and precious opportunity to trust one another; an opportunity to put into place contemporaneously laws, rules, and regulations that enshrine regulatory and supervisory deference in how we treat third-country firms and transactions.  This approach can help to end the imposition of unnecessarily duplicative, overlapping, and costly burdensome regulatory requirements and thereby alleviate the market fragmentation that plagues the swaps markets today.

The majority of regulators with whom I spoke welcomed the return to deference.  It was discussed favorably at last week’s G-20 meeting in Bali.  Many are expressing enthusiasm for regulatory coordination and want to seize the opportunity to put in place relevant laws, standards, and policies that reflect a path of deference.

I am committed to establishing a CFTC cross-border framework that is risk-based and offers deference to comparable non-U.S. regulations.  It is my sincere hope that the regulators of the world’s largest swaps markets will choose to join me on this path forward.  I believe this is the right path whether or not any other jurisdiction moves toward this approach.

2017 Proposed Amendments to EMIR

As many of you know, the current EU legislative proposals on third-country CCP supervision appear to be headed in the opposite direction of what I am proposing.  It is a flashback to the CFTC’s 2013 guidance.  The proposed amendments to EMIR will expand the regulatory and supervisory authority of ESMA over both EU and third-country CCPs (including ongoing surveillance and on-site inspections), and to provide the European Central Bank (ECB) and other EU central banks with new oversight authority over both EU and third-country CCPs.

Under ESMA’s new authority, the proposal would designate each recognized third-country CCP as either Tier 1 or Tier 2 depending on how systemically important the CCP’s clearing activities are to the European markets.  Tier 1 CCPs would be considered “non-systemic” and would be subject to essentially the current existing equivalence determination and recognition regime.  Tier 2 CCPs would be considered “systemic” and would be subject to additional EU regulatory and supervisory requirements (i.e., must be fully consistent with all provisions of EMIR).

And of course, as you know, a number of EMIR requirements will dramatically increase the costs to clear at U.S. CCPs that are operating in the EU and are inconsistent with U.S. law.  This is because EMIR is applied to all of the clearing operations of the non-EU CCP – even clearing activity that happens outside of the EU –irrespective of the domestic law that the non-EU CCP is subject to in its home jurisdiction.  This is very different than the CFTC approach.

In my talks with European authorities, I have asked them to reconsider such an expansive approach.  I have repeatedly given the example of letters of credit as one matter of contention.  Under the CFTC DCO regime, letters of credit are accepted for initial margin for futures contracts.  This type of financing has been used for generations in American agriculture.  However, letters of credit are not a permitted form of initial margin payment under EMIR.  Prohibiting the use of letters of credit would cause American FCMs to have to post tens of billions of Dollars in additional clearinghouse margin.  It would be devastating to the FCM industry and to American agriculture.[v]

There are other substantive differences that are equally problematic.  For example, EMIR would dictate matters of board composition and corporate governance for U.S. clearinghouses, including those designated as SIDCOs, overriding existing legal obligations under U.S. securities and state corporations law.  Such overseas interference with sovereign U.S. federal and state law is unprecedented and wholly unacceptable.

The proposed amendments to EMIR, when understood alongside comments from some European officials, raise serious doubts about the European commitment to a policy of deference.  In contrast to the CFTC’s approach to the regulation and supervision of cross-border CCPs to limit CFTC oversight to primarily U.S. business activity, the EU’s approach is to apply EU law to a third-country CCP’s entire clearing business, even business activity of long-standing commercial practice, comprehensively regulated under established U.S. law.

Make no mistake: the CFTC cannot and will not allow its regulated markets and market participants to become subject to conflicting or overly burdensome regulation from abroad.  No sovereign regulator would agree to it, let alone a regulator overseeing the world’s largest derivatives markets.  The CFTC will not allow U.S. market participants to be put in the completely untenable position of having to choose between violating domestic laws and regulations or violating foreign laws and regulations.  It is completely irresponsible for European regulators to seek to put U.S. market participants in this position.

If a satisfactory resolution of this situation cannot be found, the CFTC will have no choice but to consider a range of readily available steps to protect U.S. markets and market participants.  Be assured that the CFTC has a range of options, short of further legislative action, that it can execute unilaterally in response to an extraterritorial overreach by a non-U.S. authority.  They include revisiting the CFTC’s Part 30 regime to withdraw existing exemptions in particular overseas jurisdictions.  They also include delaying or withholding CFTC staff relief for non-U.S. entities from such jurisdictions.  Other effective options are available in conjunction with fellow U.S. regulatory agencies.

These are blunt and strong tools.  We are fully aware of the devastating impact they would have on market access and trading liquidity provision on national markets in which they would be applied.  None of these options represent a course of action that I wish to pursue.

I much prefer the approach of regulatory deference that I have spent the past six weeks traveling the globe to promote.  In fact, I am ready to jump on even more planes, trains, and automobiles bound for any European capitol to work out a sensible approach.  I do not want to reach a point where we give up on deference and start restricting market access and critical provision of trading liquidity on both sides of the Atlantic.

So, let me end on a positive note.  I am cheered by the warm reception my White Paper has received in so many international quarters.  Most people understand what it was intended to do.  I hold my hand out to colleagues in Europe and across the globe.  I am hopeful that we can work together to reduce global market fragmentation and build upon regulatory deference as the basis for well-ordered and robust world markets that support global economic growth and prosperity.  We must.  There is no other sensible choice.

Conclusion

So, in conclusion, it has indeed been a busy week at the CFTC – a full and engaged Commission, a fintech conference, a new look at automated trading in today’s digital markets, addressing the move away from LIBOR, record regulatory enforcement, and new thinking on the crucial role of regulatory deference in the cross-border implementation of swaps reform, just to name a few topics.

Some say there is a lot of noise coming out of Washington of late.  It is an election season after all.  Whatever the season, the CFTC is busy, has its head down, and is getting on with the job it has to do – the CFTC, where the enforcement is strong, the Commissioners are good looking, and the staff are all well above average.

Thank you.

Remarks of Commissioner Brian D. Quintenz at the 38th Annual GITEX Technology Week Conference

October 16, 2018

Good morning.  Thank you very much Matteo for that kind introduction.  Before I begin, let me quickly say that the views I express today are my own and do not represent the views of the Commission.  For those of you not familiar with the Commission’s mission, the CFTC is responsible for regulating the derivatives markets in the United States.  As such, we have oversight authority over the futures and swaps market, including derivatives on commodity cryptocurrencies.

This is the first GITEX Technology Week Conference that I have had the pleasure of attending and I am delighted to be here with you today.  I would especially like to thank the Dubai World Trade Centre for being such a generous and gracious host.  This is a spectacular event and it is a fascinating conference.

While this is my first time at GITEX, it is not my first time in Dubai.  I had the pleasure of visiting here for the first time in March earlier this year at the invitation of Saeb Eigner, the Chairman of the Dubai Financial Services Authority (DFSA).  I first met Saeb in Washington, D.C. on a visit he made there almost a year ago exactly.  Our conversation turned quickly from financial regulation to shared interests of art and fishing, and I am lucky to now consider him a friend.  When he extended an invitation to meet him here, I readily accepted.

During that trip, I had the pleasure of meeting a number of senior leaders and government officials, including His Excellency Mohammad Al Gergawi, Minister of Cabinet Affairs and the Future of the United Arab Emirates, and His Excellency Essa Kazim, Governor of Dubai International Financial Centre.  As the world looks forward to Expo 2020, let me say that Dubai will be the perfect host for such a wonderful event.  It will give the world a chance to celebrate all that you have accomplished as well as look forward to all that you have yet to achieve.

One of the highlights of my trip last March had nothing to do with financial regulation; rather, it involved Saeb showing me around the enormous Art Dubai exposition.  Saeb is an expert in Middle Eastern art, having written a famous book on the topic, and it was a joy to learn from him as we viewed brilliant works by Chaouki Choukini, Kourosh Shishegaran, Ben Bella, and Khaled Zaki.  There was one exhibit that I remember distinctly, however, but mostly for the discussion it elicited.  An artist group called teamLab[1] created a digital art piece presented through a video screen that evoked a living, moving water pond.  Art by Algorithm, Saeb and I thought.  Or was it?  Could an algorithm actually be considered art?  How easily could it be copied and reproduced, with or without the artists’ permission?  What is it exactly that a purchaser owns – a computer program?  As I looked at the piece, it was unquestionably artistic, but was it artwork?

I began reflecting on other art I had seen which contained distinct algorithmic components.  A chandelier titled “Volume” by artist Leo Villareal displayed in the Renwick Gallery across from the White House in Washington, D.C. uses an algorithm to control its 23,000 different LED lights.  According to an article describing the exhibit, “[i]t requires hours using his custom software to tune it, adjust it, and refine the light patterns to create the right brightness and tempo—part conductor, part programmer.”[2]  During my tour of Bloomberg’s new London headquarters last year, one point of interest was a water feature installation by Spanish artist Cristina Iglesias, titled “Forgotten Streams,” with different water speeds and volumes controlled by an algorithm for various effects.

We are living during a period of large-scale technological advancement and adoption.  These developments are challenging our current beliefs, as well as our current constructs.  Just as my discussion with Saeb reflected the potential transition of artwork from the physical to the algorithmic, so too are discussions in financial markets and regulatory spheres reflecting a transition from the intermediated to the distributed, dis-intermediated environment of the internet-based blockchain world.  How can our regulatory apparatus, built to register and oversee intermediaries, adequately police our markets and set standards for a disintermediated market?

A particular area of interest to me is how regulators apply existing legal paradigms to novel technologies not contemplated when those laws were adopted.  In the past, the CFTC has supervised the derivatives markets through the registration of market intermediaries.  For example, much of the CFTC’s regulatory structure for promoting market integrity and protecting customers revolves around the regulation of exchanges, swap dealers, futures commission merchants, clearinghouses, and fund managers.  However, this supervisory framework is not applicable in the disintermediated world of blockchain, which raises several complex legal and policy issues.  In the context of decentralized blockchains, like ethereum, on top of which multiple applications can run autonomously via smart contracts, it requires identifying who is responsible for ensuring that activity on the blockchain complies with the law.

Blockchain Smart Contracts

Before we go on, let’s review the key players essential to powering smart contracts on the blockchain.

First, there is the group of “core developers,” who write the foundational open-source software underlying the public blockchain.  Typically, these “core developers” do not play an active role in managing the blockchain.  However, they do tend to retain some responsibility for its ongoing operability.[3]  For example, in the past, core developers of some chains have developed software updates to address bugs in the code or put forth solutions to address events, such as hackings, that may threaten the viability of the chain.[4]

Second, you have users – for example, individuals who own cryptocurrency, like bitcoin or ether, and use the blockchain to transact.

Next, in order to validate those transactions, “miners” bundle groups of transactions into blocks and solve a complex mathematical problem to arrive at a unique solution – a process called “hashing.”  If a majority of the nodes on the chain confirm the miner’s solution, then the block is validated and added to the chain.

Some blockchain networks, like ethereum, allow smart contracts to be integrated into the chain.  In brief, a smart contract is a computer code containing all terms of the contract and is self-enforcing – meaning the software can execute the terms of the contract without additional input from the parties.[5]  Once the smart contract is formed on the ethereum network, it operates without further intervention.  Some software developers have written code that allows users to create specific types of smart contracts that can be deployed on the blockchain.  Once users download this application, they can easily find others using that same protocol willing to transact.

To recap, there are many actors essential to the functioning of the blockchain ecosystem:  the core developers of the blockchain software, the developers of smart contract applications, miners that validate transactions, and users, who transact and execute smart contracts on the chain. 

Smart contracts are easily customized and are almost limitless in their applicability.  For example, a protocol could create smart contracts for flight insurance.  If you were worried about a flight being late, you could check how much it would cost to buy insurance, and if you thought the price was reasonable, you could purchase the contract with cryptocurrency.  Then, if your flight was late, the contract, by consulting public flight records, would automatically compensate you for the delay.  Smart contracts could also be used to facilitate the sharing economy by enabling users to rent houses, cars, and other property.

Other protocols could create smart contracts that more closely resemble traditional financial products.  For example, individuals who believe they have developed predictive data about future financial events, like a stock’s performance, could offer their data for purchase via smart contracts.  Depending upon the facts and circumstances, this activity could present regulatory issues.  It could look like providing investment advice, or, given the anonymity of the predictions, could be used nefariously to facilitate insider trading.

Other protocols could allow individuals to create their own smart contracts predicting future events more broadly.  Essentially, these contracts would allow individuals to bet on the outcome of future events, like sporting events or elections, using digital currency.  If your prediction is right, the contract automatically pays you the winnings.  Again, depending on the facts and circumstances, this could look like what the CFTC calls a “prediction market,” where individuals use so-called “event contracts,” binary options, or other derivative contracts to bet on the occurrence or outcome of future events.  In the past, the CFTC has generally prohibited prediction markets as contrary to the public interest, only permitting them in limited circumstances when it has found that they operate on a small-scale, non-profit basis, and serve academic purposes.[6]

As we just noted, there are innumerable types of smart contracts on the blockchain, many of which operate entirely outside of the CFTC’s jurisdiction.  But, what steps should the CFTC take if it learns of a smart contract protocol that may implicate its regulations?

Applying Old Law to New Products

In my view, with respect to any smart contract protocol, the first step in the analysis is defining the basic nature of the contract.  Is it a contract for sale or a rental agreement?  Or, does it have the essential characteristics of a swap, future or option?  If so, is the product accessible by U.S. persons?  If the contract is a product within the CFTC’s jurisdiction, then regardless of whether it is executed via a written ISDA confirmation or software code, it is subject to CFTC regulation.

If the smart contract is within the CFTC’s jurisdiction, then the next question becomes, is the method by which it is being transacted on the blockchain compliant with CFTC regulations?  If the contract is a swap, is it being offered to retail participants?  Is it a product that must be traded on an exchange?  Does the protocol itself perform exchange-like functions by facilitating trading, thereby potentially implicating registration requirements?  These are all open questions that the CFTC must consider and resolve as smart contracts proliferate and perhaps become a common feature of our financial markets.

Now, let’s assume the CFTC has answered all of these questions for a particular smart contract it is examining.  Let’s say the hypothetical product at issue is within our jurisdiction, but is not being executed in a manner compliant with CFTC rules.  Who should be held responsible for this activity?  How should the CFTC enforce its regulations against a software code, rather than a registered intermediary or an exchange?  The answers to these questions are still being contemplated, but I have a few thoughts of my own that I would like to share and on which I would welcome feedback and discussion.

Let’s apply the general analytical framework I’ve described above to our earlier example of the “prediction market.”  In this hypothetical, after performing a facts and circumstances analysis, the CFTC has determined that the smart contracts executed on the blockchain are binary options, which are within the CFTC’s jurisdiction.  Binary options are a type of option whose payoff is either a fixed amount or zero.  For example, there could be a binary option that pays $100 if the price of gold is above $1,200 per ounce on a specified date and zero otherwise.

Moreover, the contracts in our scenario likely qualify as event contracts that are based upon the occurrence or non-occurrence of an event (as opposed to a price of a commodity).  Event contracts have a unique spot in CFTC jurisprudence because of the public policy concerns they raise.  For example, event contracts based upon war, terrorism, assassination, or other similar incidents may be contrary to the public interest – in which case, the CFTC can prohibit an exchange from offering the contract.[7]  Because of these concerns, as noted above, the CFTC has historically only authorized off-exchange trading in event contracts in limited circumstances, on specific types of events, for academic purposes, and with strict limits on the amounts retail customers can invest.[8]  Therefore, the particular fact pattern described above – event contracts, executed in a potentially for-profit manner, between retail customers, on any conceivable event, for any sum of money – raises multiple CFTC regulatory concerns.

But who should be held accountable for this activity?

Enforcement on the Blockchain

One could look to the core developers of the underlying blockchain code.  Without this foundational code, the smart contracts could never be executed.  However, these core developers had no involvement in the development of the smart contract code.  They invented a code upon which any number of applications can run and, in my view, it seems unreasonable to hold them accountable for every subsequent application that uses their underlying technology, without further evidence of knowledge or intent.  They may not even be aware that this particular type of smart contract has been deployed.

Similarly, miners and general users of the blockchain are not in a position to know and assess the legality of each particular application on the blockchain.  The anonymous, decentralized nature of the chain makes it difficult or even impossible for miners and users to monitor the activity of other miners and users.

That leaves us with the developers of the smart contract code that underlies these event contracts, as well as the individual users who then use that code to create and wager on their own event contracts.  The developers of the code could claim that they merely created the protocol and therefore have no control over whether and how users choose to use it once it is part of the public domain.  They would place the liability on the individual users, who are the actual creators and counterparties of the event contracts.

In my view, this analysis misses the mark.  Instead, I think the appropriate question is whether these code developers could reasonably foresee, at the time they created the code, that it would likely be used by U.S. persons in a manner violative of CFTC regulations.  In this particular hypothetical, the code was specifically designed to enable the precise type of activity regulated by the CFTC, and no effort was made to preclude its availability to U.S. persons.  Under these facts, I think a strong case could be made that the code developers aided and abetted violations of CFTC regulations.[9]  As such, the CFTC could prosecute those individuals for wrongdoing.

Think of someone asking you to borrow the keys to your car because they want to rob a bank.  If you let them borrow your car, it would be reasonable for the government to hold you partially responsible for the ensuing criminal activity.  However, it would be unreasonable for the government to prosecute the car manufacturer.

Enforcing CFTC regulations against those individuals does not immediately stop the activity from occurring, because individual users could continue to use the software to execute their own event contracts.  What does the CFTC do then?  The CFTC could attempt to raise awareness by U.S. participants that the activity is illegal.  In addition, it could attempt to prosecute individual users of the contracts to discourage future participation.  Ultimately, however, going after users may be an unsatisfactory, ineffective course of action.  From a practical perspective, the blockchain is an anonymized, global network.  It seems likely that determined users will be able to gain access.

The variability of international regulations also raises issues.  For instance, although the CFTC heavily regulates trading in event contracts, other jurisdictions view them differently.  In the United Kingdom, for example, event contracts are not viewed as financial instruments, but rather as a permitted form of wagering regulated by the Gambling Commission.  And, although the United States permits binary options based on commodity prices, the European Union bans that very same type of product.[10]  How then does the CFTC enforce its regulations on U.S. activity when the marketplace for that activity has become seamless, anonymized, and global?  I do not have all the answers today, but I expect it may be an issue that the CFTC faces in the future, as public blockchains create international markets in which everyone wants to participate.

Engagement Instead of Enforcement

Yet, this outcome may be avoidable.  Developers of smart contract code could also engage with CFTC staff to see if there is way the code’s product can comply with CFTC regulations.  CFTC staff is open to engaging with innovators to understand new technological infrastructures and applications and to work to ensure these activities are undertaken in a manner compliant with the law.  In some cases, it may be that new products require the Commission to rethink its existing regulations or provide regulatory relief – both courses of action that I think would be appropriate depending upon the technology in question.

It is for precisely this reason that CFTC Chairman Giancarlo created the LabCFTC group at the Commission.  One of LabCFTC’s primary goals is to interface with the fintech community and other regulators to deepen the agency’s understanding of technological innovations and provide guidance to innovators about how CFTC regulations may be implicated by their work.  In its first year of existence, LabCFTC has already held 200 meetings with innovators, fintech start-ups, and well-established financial players to engage on their views and innovations.

I would much rather pursue engagement than enforcement – but in the absence of engagement, enforcement is our only option.

Code as Law

This discussion leads me to my final point today.  I have heard some say that “the code is law,” meaning that if the software code permits it, an action is allowed.  I disagree with this fundamental premise.  Case law, statutes, and regulations are the law.  They apply to the code, just as they apply to other activities, contracts, or agreements.

But what about when the law’s applicability has yet to be tested?  For example, in the case of a 51% attack, where one bad actor, or a coordinated group of bad actors, amass more than 51% of a blockchain’s computing power, so that they can insert their own false values and transactions into the system to steal cryptocurrency from other users.  Or, take the example of The DAO, where users exploited a bug uncovered in the code and stole 3.6 million ether.  In that instance, the perpetrator(s) argued strenuously that the action was not theft, but rather the rightful gains he or she earned by detecting and exploiting an error in the code.[11]

Technically, all the users on the blockchain are aware of the possible risks posed by a 51% attack or a bug in the code.  By participating on the chain, are they knowingly assuming the risk of these incidents occurring?  Or, is there an implicit agreement among participants on the blockchain that they will not take actions to undermine the operability and integrity of the blockchain?  It is certainly possible that the software code does not represent the entirety of the participants’ agreement and must be interpreted in connection with traditional contract law concepts like good faith and fair dealing.

In addition, derivative or investment contracts are still subject to regulations, with the CFTC responsible for promoting the market integrity of the derivatives markets.  In other words, a contract can’t say anything that it wants.

A recent market integrity issue in the credit default swap space provides an interesting example.  The issue raised the possibility of a “manufactured default” – a scenario where a company would technically default on an obligation in a way that would benefit an outside party’s CDS holdings in exchange for favorable financing by that party to the company.  While potentially valid under the terms of the written CDS contracts, such activity, especially if it were to become commonplace, would threaten the integrity of the CDS market.  While I am strongly opposed to inserting the agency into private contract disputes, where market integrity is clearly threatened through widely adopted contract loopholes - such as arranged default scenarios or 51% attacks on a blockchain - I believe the CFTC could consider investigating such conduct for fraud or manipulation.

Conclusion

Smart contract applications on blockchain networks hold great promise.  They have the potential to open up new markets and create efficiencies in existing ones.  At the same time, they also raise novel issues of accountability that users and policy makers alike must consider.

In the course of my reading to prepare for this speech, I came across a quote from acclaimed American scientist, Carl Sagan, who stated, “[w]e live in a society exquisitely dependent on science and technology, in which hardly anyone knows anything about science and technology.”  Unfortunately, I think his observation has only grown truer with time.  I am hopeful, however, that it does not apply to the U.S. Commodity Futures Trading Commission.

Our rapidly evolving technological landscape poses challenges for all of us.  As such, I think it is incumbent upon regulators to continually educate ourselves on new technological developments, so that we can accurately evaluate their benefits and risks and develop appropriate policy responses.

Thank you for having me at this magnificent event.  It is truly a pleasure to be with you.

Keynote Remarks of CFTC Commissioner Rostin Behnam at the Federal Reserve Bank of Chicago’s Fifth Annual Conference on CCP Risk Management, Chicago, Illinois 

A Decade After The Financial Crisis: Remaining Challenges and New Approaches for the Next Ten Years and Beyond

October 16, 2018

Introduction

Thank you for the kind introduction President Evans; it is a pleasure to be here with all of you today, and an honor to kick off day two of this great conference.  I wish to thank the Federal Reserve Bank of Chicago, particularly Bob Cox and Robert Steigerwald, for the invitation to speak with you and for organizing this event.  Before I begin my remarks, please allow me to remind you that the views I express today are my own and do not represent the views of the Commodity Futures Trading Commission (the CFTC or Commission) or my fellow Commissioners.

Since the 2008 financial crisis, new language has entered the financial regulatory and governance lexicon, or at least taken on new importance.  One word that has taken on new significance, and is acutely important to both the CFTC and the Federal Reserve, is resiliency.  I always think of this conference, and more specifically this city as the perfect locale to talk about resilience – not only because of the expertise regarding central counterparties (CCPs) risk management represented in the room, but also because Chicagoans know a thing or two about resilience.  Cubs fans endured 108 years of losing between World Series titles.  Along the way, they saw a baseball go through Leon Durham’s legs, and another ball go into Steve Bartman’s glove.  Yet the team and its fans persevered, demonstrating steadfast resilience in their quest for what was then an elusive title. 

The theme for this year’s conference, Examining Regulatory Initiatives, is quite timely considering a decade has passed since the financial crisis and eight years since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)^[1].  During the past ten years, domestic and international regulators have focused on identifying systemic risks in their financial markets, and designing and implementing policies to execute the G-20 financial regulatory reforms,^[2] which address those risks.  The G-20 reforms have strengthened the resilience of large financial institutions, including CCPs, and substantial progress has been made in many jurisdictions toward mitigating systemic risk.

Here in the United States we have achieved substantial implementation of the core reforms agreed upon by the G-20.  As a result, many regulators and market participants are now turning to post-implementation evaluation of the effects of the G-20 reforms.^[3]  Therefore, this is an opportune time to engage in a constructive dialogue regarding whether the Dodd-Frank Act reforms are achieving their intended outcomes, and to identify any material unintended consequences.  Returning to the Cubs for a moment, like the team’s President, Theo Epstein, and Manager, Joe Maddon, this is a perfect time to think about new approaches to solving old problems. 

Listening Tour and CFTC Market Risk Advisory Committee

I recently completed my first year as a Commissioner.  Slightly less than one year ago, and shortly after I started my term, I announced a listening tour, focused on visiting the full scope of CFTC market participants and stakeholders in order to get a better sense of what was working and what was not working with our regulations.^[4]  Like CFTC registrants and market participants, the listening tour has been vast in geographic scope, but most importantly provided me with an opportunity to fully digest and analyze the full spectrum of issues, concerns, and comments of CFTC stakeholders, including CCPs, futures commission merchants (FCMs), end users, and service providers.

In addition to the listening tour, I heard the concerns of market participants through the nominations process for CFTC’s Market Risk Advisory Committee (MRAC), which I sponsor.^[5]  In the federal register release seeking nominations for membership on the MRAC, I requested suggestions for topics for the MRAC’s consideration and over 75 topics were submitted; 17 of which focused on clearing and clearinghouse risk issues.^[6]  With that said, I would like to share with you today some of the topics that were mentioned during the listening tour and included in the MRAC submissions as challenges for CCPs and swaps market participants since the G-20 reforms and the passage of the Dodd-Frank Act: (i) FCM concentration and access to clearing services; (ii) cross-border issues; (iii) CCP governance and risk; and finally (iv) some parting words regarding developments in financial technology.

FCM Concentration and Access to Clearing Services

Throughout the year, a number of market participants have expressed concerns to me regarding FCM concentration and its effects on access to clearing.  This important issue is certainly not new, but the years long trend continues to head in the wrong direction because of a number of factors.^[7]  The statistics paint a very concerning picture.  For futures, the number of FCMs has declined from 100 CFTC-registered entities in 2002 to 54 as of August 2018, with the top five and ten FCMs holding 54% and 73% of total client margin, respectively.^[8]  For swaps, the client clearing landscape is concentrated further to less than 20 FCMs.  Only 17 FCMs are holding client margin for swaps clearing with the top five and ten FCMs holding 77% and 98%, respectively.^[9]  Further, the Consultation Report prepared by the Financial Stability Board’s Derivatives Assessment Team (DAT) on incentives to centrally clear OTC derivatives appears to be consistent with these findings.  The DAT Consultation Report, which seeks to assess whether reforms to capital, margin, and clearing adequately incentivize central clearing of OTC derivatives, highlights that the provision of client clearing services is concentrated in a small number of banks.  Specifically, “five firms, all bank-affiliated, account for over 80% of total client margin for cleared OTC derivatives in the United States, the United Kingdom and Japan.”^[10]

Many large bank-owned FCMs have exited the swaps clearing business citing as one reason the global introduction of the Basel Committee on Bank Supervision’s Basel III leverage ratio and the Supplementary Leverage Ratio (SLR) in the United States.^[11]  The SLR, a bank-based capital charge designed, in part, to reduce risk posed by on-balance-sheet lending activities, has been applied to centrally cleared derivatives.  The adoption of swaps clearing moved segregated client initial margin off the balance sheets of clearing member FCMs and into CCPs.  However, the SLR treats customer margin as an on balance sheet asset. 

The global implementation of the central clearing mandate has produced a significant demand for clearing services and a substantial increase in overall clearing volumes in the swaps market, and yet there have been FCM consolidations and market exits, which have resulted in a substantial reduction in clearing capacity.  Given that central clearing is a key component of the G-20’s effort to improve derivatives markets, policymakers, both bank and market regulators, must take the necessary steps to ensure that client clearing remains a commercially viable business.  However, according to the DAT Consultation Report, 89% of client clearing service providers surveyed said that the leverage ratio, in particular, was negatively impacting their ability to provide client clearing services.^[12]

Given the G20 reform mandate, I have concerns about the systemic risk implications of the current FCM concentration levels, the effect of the SLR on bank-owned FCMs, as well as the portability of a failing clearing member’s book of business to other clearing members in times of stress.  During stressed market conditions, when firms are more conservative with capital allocations, there may not be clearing members willing to acquire a failed clearing member’s book of business in a default.  The inability of clearing members to accept the porting of this book may ultimately result in liquidations of client positions.^[13]  Mass liquidations would negatively impact the clients being liquidated and exacerbate volatility at a vulnerable moment.  As a few market participants, including end-users suggest, increased volatility “…could lead to additional client defaults perpetuating the cycle of stress and reducing market participants’ ability to withstand such stressful events.  The negative impact to systemic financial stability of such a situation would be significant.”^[14] Clients both large and small are likely evaluating the costs and risks associated with establishing and maintaining business relationships with FCMs. 

This is the moment in my prepared remarks where I would like to pause, and emphasize that I support strong bank capital requirements, including the SLR.  The regulatory and market participant community must never forget the extraordinary actions taken in September, 2008, and shortly thereafter, which included massive capital injections into the world’s largest banking institutions because of a liquidity crisis.  Capital is not merely a cost or set aside, lying dormant; it is a critical source of funding, provided by a bank’s owners, which supports many traditional banking activities.  I believe it is a commonly shared view that the strong capital position of U.S. banks, on the heels of strong reform initiatives passed in 2010, has led to the leading position of these banks relative to their global counterparts.  However, as I have stated this morning, within the context of centrally cleared derivatives, the SLR is contributing to higher FCM concentration levels and reduced access to clearing.  This misalignment must be addressed to resolve the large systemic risk concern.^[15]

Of note, the European Union has proposed to amend its capital rules to exclude cash collateral on centrally cleared derivatives transactions held at CCPs from the leverage ratio.^[16] Additionally, in the House of Representatives, the Financial Services Committee reported out bipartisan legislation this past August that would amend relevant U.S. law to exclude initial client margin from leverage exposure calculations.^[17]  Finally, in April 2016, the Basel Committee on Banking Supervision issued a consultative document in which comments were requested on the impact of the Basel III leverage ratio on clearing member business models, including the impact on the cost of clearing members’ provision of clearing services to clients.^[18]  Despite most solutions being focused on balance sheet treatment of initial margin, I welcome a broader conversation to discuss any regulatory or market based solutions that may address this concentration and access issue, while preserving key reforms.^[19]

Additionally, in the event of a default, as I noted earlier, porting defaulting clearing member positions, specifically within the context of absorbing both the positions and related capital charges, remains a concern that could have systemic implications.  During stressed market conditions, clearing members are likely to be constrained by capital requirements, and therefore may be unwilling or unable to acquire the portfolio absent temporary relief from the SLR.^[20] 

Now is the time to devise solutions to these critically important challenges.  As we move into the next decade past the crisis, a study of the health of the FCM model for client clearing is vital to ensure continued compliance with post-crisis reforms, reduction of systemic risk, and that current regulations do not have unintended consequences that may undermine the same reforms meant to address old problems.

European Commission Proposal regarding Supervision of Third-Country CCPs

Now I would like to turn to a few important cross-border issues.  The European Commission’s proposed legislation to amend the European Market Infrastructure Regulation (EMIR) and create a new European Framework for the regulation and supervision of CCPs^[21] has been a source of concern for the CFTC and for our U.S. CCPs that do business in the EU.  The regulation would, in effect, make EU authorities primary supervisors of U.S. CCPs classified as systemically risky by the EU, and would apply EU law to all aspects of their business (U.S. business included).  U.S. CCPs recognized by the EU would be subject to overlapping regulation and duplicative supervision without due deference to existing CFTC regulation and supervision of those U.S. CCPs – due deference that was agreed upon in the 2016 CFTC and European Commission equivalence agreement (the Equivalence Agreement).^[22]

Deference is the cornerstone of the CFTC’s cross-border approach, and an essential regulatory tool that not only alleviates practical domestic budgetary constraints; but, also respects the strength of deserving foreign counterparts, and encourages the fundamentals of working together towards a cohesive cross-border regulatory framework that supports strong, robust, and transparent regulations.  If a home country authority implements a comprehensive regulatory and supervisory framework that is comparable to our regulations and laws, then that home country authority should maintain primary oversight over its domestic entities to which other foreign regulators should defer.  A solid, outcomes-based comparability assessment of the consistency of the home regulator’s relevant regulations and supervisory programs is the foundation of such deference.

The Equivalence Agreement is a testament to the successful cross-border regulation of CCPs, and a milestone agreement that represents the strong, bilateral relationship between the U.S. and European Union.  Our global markets are more efficient because of this agreement; there are less regulatory and supervisory burdens for our clearinghouses and less market fragmentation.  

I would like to highlight one challenge the current proposal before the European Council presents to cross-border harmony.  Under the CFTC’s swaps framework, customer collateral provided for swaps is required to be segregated from a FCM’s own property pursuant to the legally segregated and operationally commingled segregation model (known as LSOC).  This is in contrast to EMIR, which requires that individual segregation be offered to clients for swaps.  U.S. CCPs recognized by the EU would not be able to offer individual segregation to their U.S. clients because individual segregation is inconsistent with the U.S. Bankruptcy Code.  Consequently, this nuanced difference in regulation has direct and detrimental effects, among other things, on a recognized U.S. CCP’s ability to comply with U.S. law.

I do not have a crystal ball to predict outcomes, and fully recognize the overwhelming challenge of resolving the multitude of issues the European Union and the United Kingdom are faced with today; but, I maintain that the European Commission should honor its commitment to the Equivalence Agreement and treat U.S. CCPs in accordance with it.

Cross-Border Rethink

I would like to spend a few minutes to share my general thoughts on Chairman Giancarlo’s latest white paper, “Cross-Border Swaps Regulation Version 2.0: A Risk-Based Approach with Deference to Comparable Non-U.S. Regulation”.^[23]  As you know, the Chairman’s white paper expresses the views and ambitions of the Chairman only and neither binds any other Commissioner nor the Commission on the path forward.  I agree that the Commission should address any problems resulting from its current approach to the oversight of cross-border swaps activities, and that it should do so both internally as a Commission in accordance with statutory procedures, and externally with appropriate consideration of and deference towards our fellow global regulators.  Moreover, I support the Chairman’s stated objectives of (1) recognizing the distinction between swaps reforms intended to mitigate systemic risk and reforms designed to address particular market and trading practices; (2) increasing CFTC cooperation with global regulators to reduce duplicative regulation and redundant supervision; (3) reducing the operational burdens and complexity of overlapping regulations where appropriate; and (4) reducing market fragmentation and fostering deeper liquidity pools.^[24]  

As the Chairman himself acknowledges, the white paper is not quite a concept release and its proposals have not yet been presented to the full Commission for input, consideration, or consensus.^[25]  It remains unclear as to how the Commission will approach the rulemaking process within our existing set of regulations.  Certain aspects of the proposal represent departures from existing policy with respect to swaps clearing and may even conflict with our governing statute or prior Commission interpretations. 

One popular proposal that raises policy questions is the extension of the derivatives clearing organization (DCO) exemption to U.S. customer clearing because it would not afford U.S. persons transacting overseas certain protections under the U.S. Bankruptcy Code.  U.S. persons clearing swaps at an exempt DCO through non-U.S. clearing members that are not registered with the CFTC would not be customers under the U.S. Bankruptcy Code, and conversely, the local jurisdiction’s bankruptcy laws would apply.  This is particularly concerning since the CFTC’s regulatory framework is based, in part, on customer protection and these U.S. persons would lose that protection.  This is but one example that I look forward to engaging with the Chairman and my fellow commissioners on, and more importantly hearing your thoughts on in the weeks and months ahead.

CCP Governance and Risk Management

CCP governance is a topic of increasing emphasis among domestic and international regulators, particularly the potential conflict of interest between shareholders and clearing members arising from the CCP’s mutualization of risk.  Conflicts between CCPs and clearing members have focused on risk management or risk-related issues generally.  Many clearing members have expressed concerns that their interests may not be adequately represented in governance structures that focus on shareholders, considering the clearing members, through mutualized default funds, are the bearers of a vast majority of the CCP’s tail risk.  As you know, there is an ongoing debate about the appropriate amount of CCP capital in the default waterfall.

Separately, there is a discussion percolating about the interests being served by the “hat” worn by clearing member employees who sit on the risk management committee.  Specifically, how do clearing member employees manage conflicts between their incentives and duties regarding (1) prioritizing the safety and soundness of the clearinghouse, (2) any duty owed to the shareholders of the clearinghouse, and (3) advancing the interests of their firm?  There is considerable potential for value from including clearing member employees as expert members of risk management committees.  However, in order for this value to be realized, any conflict or tension must be addressed and resolved.

Mostly through my sponsorship of the MRAC, I have heard that further review and discussion of CCP governance structures, particularly with respect to the risk committee, is necessary.  Therefore, I will be convening the MRAC for a meeting on December 4^th to discuss these issues.  I believe the recent clearing default at NASDAQ is further evidence that governance and risk management issues must be continually discussed, debated, and refined as necessary.  There is no shortage of hypotheticals.  There is no shortage of unique market factors.  There is no shortage of unexpected events that will drive markets into scenarios not foreseen and potentially plausible.  We all must remain diligent, patient, and open to continuous discussions to prevent defaults and market crises in the future.  Clearing will not eliminate losses.  But, the collective regulatory and market participant community must do everything to reduce them.

Use of Fintech by the Clearing Industry

I would like to close by spending a few minutes discussing the potential use cases for blockchain technology or distributed ledger technology (“DLT”) for clearing and settlement, and share some thoughts on how I have been thinking about new technologies being applied to the financial services sector.  During the listening tour, I met with technologists of both established and newer applications.  I also met with think tanks, academics, and practitioners.  The goal of these meetings was to get an understanding of these technologies and the associated risks.  The utilization of DLT for post-trade clearing and settlement has the potential to bring powerful efficiencies and increased resiliency, as well as disruptor even transform our industry.  Specifically, DLT can be used for position keeping, global collateral management,^[26] settlement, and reporting.  However, the use of DLT by the clearing industry is still in its infancy.^[27]  As a regulator, I know that this will not be for long.  Although the FSB has concluded that there are currently no compelling financial stability risks from emerging fintech innovations,^[28] I think about how regulation should respond to the challenges brought by DLT for clearing and settlement, or just fintech generally.

Regulators must approach fintech with an open mind, despite there being great regulatory uncertainty regarding how fintech fits into existing rules and regulations.  However, CFTC registrants planning to use DLT or other technologies should be prepared to analyze how existing rules and regulations could apply.  As a regulator, I will be looking closely to ensure that our core principles are observed and that the vital interests we protect are safeguarded.

Conclusion

I hope I have given you more insight into my views on the challenges facing the clearing industry and regulation of the derivatives markets and how I view some of the hurdles we are all facing. We are all on course to solve the issues before us, and we should not be deterred from moving forward.  Most significantly I would like to end by thanking the Federal Reserve.  Although the CFTC and the Fed have worked closely for many decades, the relationship has taken on a new dynamic since the passage of the Dodd-Frank Act.  In the one short year I have been a Commissioner, I have seen the relationship grow stronger, and I hope that relationship will continue to grow stronger in the years ahead.  I firmly believe a strong relationship will benefit regulators, the market, and the American public through safe and transparent markets.   Thank you for having me today.

^[1] The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203 § 712(d), 124 Stat. 1376, 1644 (2010).

^[2] In response to the Financial Crisis, the G-20 Leaders at the Pittsburgh Summit in 2009 commenced a comprehensive reform of over-the-counter (“OTC”) derivatives markets with the goals of mitigating systemic risk, improving transparency in the derivatives markets, and protecting against market abuse.  The G-20 Leaders made five commitments to reform OTC derivatives markets.  Specifically,

• standardized OTC derivatives should be centrally cleared;
• non-centrally cleared derivatives should be subject to higher capital requirements;
• non-centrally cleared derivatives should be subject to minimum standards for margin requirements;
• OTC derivatives should be reported to trade repositories; and
• standardized OTC derivatives should be traded on exchanges or electronic trading platforms, where appropriate.
   

Financial Stability Board, Review of OTC derivatives market reforms:  Effectiveness and Broader Effects of the Reforms, June 2017, available at http://www.fsb.org/wp-content/uploads/P290617-1.pdf ; see the Pittsburgh Summit Leaders’ statement, paragraph 13 of body, http://www.fsb.org/wp-content/uploads/g20_leaders_declaration_pittsburgh_2009.pdf.

^[3] See Financial Stability Board, Evaluation of the Effects of the Financial Regulatory Reforms on Infrastructure Finance, July 2018, available at http://www.fsb.org/wp-content/uploads/P180718.pdf; Financial Stability Board, Incentives to Clear Over-The-Counter (OTC) Derivatives, August 2018, available at http://www.fsb.org/wp-content/uploads/P070818.pdf (hereinafter, “DAT Consultation Report”).

^[4] Rostin Behnam, Remarks of CFTC Commissioner Rostin Behnam at the Georgetown Center for Financial Markets and Policy, Washington, D.C. (Nov. 14, 2017), https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam1.

^[5] https://www.cftc.gov/About/CFTCCommittees/MarketRiskAdvisoryCommittee/index.htm.

^[6] https://www.cftc.gov/LawRegulation/FederalRegister/finalrules/2018-05271.html.

^[7] https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-Capital-Markets-FINAL-FINAL.pdf

^[8] See Financial Data for FCMs, Aug. 31, 2018, available at https://www.cftc.gov/MarketReports/financialfcmdata/index.htm.

^[9] Id.

^[10] DAT Consultation Report at 3.

^[11] See Joe Rennison and Laura Noonan, Deutsche Bank walks away from US swaps clearing, Financial Times, Feb. 9, 2017, available at https://www.ft.com/content/2392bc42-ee47-11e6-930f-061b01e23655;  Joe Rennison, Nomura Exits Swaps Clearing for US and European Customers, Financial Times, May 12, 2015, available at https://www.ft.com/content/e1883676-f896-11e4-be00-00144feab7de;  Silla Brush, State Street Exiting Swaps Clearing Business, Citing New Rules, Bloomberg, Dec. 4, 2014, available at https://www.bloomberg.com/news/articles/2014-12-04/state-street-exiting-swaps-clearing-business-citing-new-rules;  Philip Stafford, RBS to Wind Down Part of Swaps Clearing Unit, Financial Times, May 18, 2014, available at https://www.ft.com/content/4d906d92-dea4-11e3-9640-00144feabdc0;  Rick Baert, BNY Mellon closes U.S. derivatives clearing business, Pension & Investments, Dec. 10, 2013, available at http://www.pionline.com/article/20131210/ONLINE/131219993/bny-mellon-closes-us-derivatives-clearing-business.

^[12] DAT Consultation Report at 63.

^[13] Joanna Wright, US Clearing Banks Still Push for Leverage Ratio IM Offset, Risk.net, Feb. 26, 2018, available at https://www.risk.net/regulation/basel-committee/5426961/us-clearing-banks-still-push-for-leverage-ratio-im-offset.

^[14] Letter from the Commodity Markets Council and Managed Funds Association to the Basel Committee on Banking Supervision, Nov. 2, 2015.  https://www.managedfunds.org/wp-content/uploads/2015/11/CMC-MFA-Leverage-Ratio-Letter-End-User-Impact-Final.pdf.

^[15] Prior to Dodd-Frank, from 2002 through 2011, an average of 14 firms entered the FCM marketplace annually.  Since Dodd-Frank, the average has been four, with only one last year and none so far this year.

^[16] Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 575/2013 as regards the leverage ratio, the net stable funding ratio, requirements for own funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures to collective investment undertakings, large exposures, reporting and disclosure requirements and amending Regulation (EU) No 648/2012, COM (2016) 850 final (Nov. 23, 2016); Wright, supra note 8.

^[17] H.R. 4659, 115^th Cong. (2017), https://www.congress.gov/115/bills/hr4659/BILLS-115hr4659rh.pdf.

^[18] Bank for International Settlements, Revisions to the Basel III Leverage Ratio Framework, April 2016, available at https://www.bis.org/bcbs/publ/d365.pdf.

^[19] In April, 2018, the Federal Reserve Board and the Office of the Comptroller of the Currency proposed a rule to tailor leverage ratio requirements to the business activities and risk profiles of the largest domestic firms.  However, the proposal did not include amendments regarding off-sets for centrally cleared derivatives. https://www.federalreserve.gov/newsevents/pressreleases/bcreg20180411a.htm

^[20] Separately, temporary relief from Know Your Customer and Anti-Money Laundering requirements could facilitate smoother onboarding of a defaulting clearing member’s book.

^[21] Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 1095/2010 establishing a European Supervisory Authority (European Securities and Markets Authority) and amending Regulation (EU) No 648/2012 as regards the procedures and authorities involved for the authorization of CCPs and requirements for the recognition of third-country CCPs, COM (2017) 331 final (June 13, 2017); see also Commission proposes more robust supervision of central counterparties (CCPs) (June 13, 2017), available at http://europa.eu/rapid/press-release_IP-17-1568_en.htm.

^[22] Comparability Determination for the European Union:  Dually-Registered Derivatives Clearing Organizations and Central Counterparties, 81 F.R. 15260 (March 2016), https://www.cftc.gov/PressRoom/PressReleases/pr7342-16. 

^[23] J. Christopher Giancarlo, Commissioner, U.S. Commodity Futures Trading Commission, Cross-Border Swaps Regulation Version 2.0:  A Risk-Based Approach with Deference to Comparable Non-U.S. Regulation (2018), https://www.cftc.gov/sites/default/files/2018-10/Whitepaper_CBSR100118_0.pdf.

^[24] J. Christopher Giancarlo, Cross-Border Swaps Regulation Version 2.0; A Risk-Based Approach with Deference to Comparable Non-U.S. Regulation, Oct. 1, 2018, at ii-iii.

^[25]See CFTC, Chairman Giancarlo Releases Cross-Border White Paper, Oct. 1, 2018, https://www.cftc.gov/PressRoom/PressReleases/7817-18;  Robert Mackenzie Smith, Q & A: CFTC’s Giancarlo on the race to overhaul cross-border rules, Risk.net, Oct. 4, 2018, available at https://www.risk.net/regulation/6002076/qa-cftcs-giancarlo-on-the-race-to-overhaul-cross-border-rules.  

^[26] See, e.g., Mattia Calzetta, Blockchain, clearing & settlement:  Everything there is to know, Mogul News, Oct. 3, 2018, available at https://mogul.news/blockchain-clearing-settlement/?utm_source=tmm&utm_medium=article&utm_campaign=blockchain-clearing&utm_content=21 (noting that “CITI and CME Clearing have implemented a real-time distributed ledger platform, which allows banks to view the collateral in its ledgers in real-time, send cash or securities with one click to a Clearing House, and receive an immediate acknowledgment.”)

^[27] David Mills et al, Distributed Ledger Technology in Payments, Clearing and Settlement, 6(2/3) J. of Fin. Mkt. Infrastructures, 207, 208 (2017).

^[28] Financial Stability Board, Financial Stability Implications from Fintech, June 27, 2017, available at http://www.fsb.org/wp-content/uploads/R270617.pdf.

October 11, 2018

Remarks of Chairman J. Christopher Giancarlo at the Hispanic Heritage Month Event, Washington, D.C.

Welcome

Good afternoon, and welcome to the CFTC’s 2018 Hispanic Heritage Month Program.  Each year, Americans observe National Hispanic Heritage Month from September 15 to October 15, by celebrating the histories, cultures and contributions of American citizens whose ancestors came from Spain, Mexico, the Caribbean, and Central and South America.   We show our “respeto”…a Spanish word with deep meaning … a respect for the experience and contributions made by Hispanic Americans, who have made our nation nobler, better, more diverse, and  stronger.   As the great Mexican novelist, Carlos Fuentes, observed “Cultures only flourish in contact with others.”  And we flourish by observing Hispanic Heritage Month.  Through honoring Hispanic Americans, in Fuentes words, “we honor ourselves…. We find ourselves.”  We give to each other.  He said each of us look “into the mirror.”

Let’s look into the mirror.  Today, we have an outstanding educator and academic with us, someone who has been one of the major contributors to American education and society.  We are honored to have Ms. Aimee Viana as our guest speaker.  Her background is stellar.  She will help us look into the mirror.  Aimee Viana was appointed on Feb. 26, 2018, to the position of executive director of the White House Initiative on Educational Excellence for Hispanics.  Prior to assuming her position, Aimee was the senior executive director of the Secretariat for Lay Formation, Marriage, and Family Life for the Catholic Diocese of Raleigh, North Carolina.  Previously, she served as a school principal and assistant principal, including at a U.S. Department of Education Blue Ribbon School of Excellence. She was honored as a top middle school principal in Western Wake County (North Carolina) by Cary Magazine in 2016. Aimee was also recognized by Latino American Who's Who in 2012 for her achievement in advancing the culture of the Latino-American community.

Aimee began her teaching career in Miami-Dade County Public Schools (Florida).  A daughter of Cuban immigrants, Aimee holds a Bachelor of Science degree in elementary education, with endorsement to teach English as a second language, and a Master of Science degree in early childhood education—both from Florida International University in Miami, Florida. 

This is an impressive background, a life of giving and sharing.  Aimee is a quintessential teacher who helps each of us learn, and grow, and understand each other.  We are delighted to have her with us today.  Please join me in welcoming Aimee Viana to the Commodity Futures Trading Commission. 

References:

Library of Congress
https://hispanicheritagemonth.gov/about/

Department of Education
https://www2.ed.gov/news/staff/bios/aviana.html

Carlos Fuentes.  The Buried Mirror:  Reflections on Spain and the New World.  Houghton Mifflin Company, 1992.