[House Hearing, 112 Congress]
[From the U.S. Government Publishing Office]
IMPLEMENTING DODD-FRANK: A REVIEW OF THE CFTC'S RULEMAKING PROCESS
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
GENERAL FARM COMMODITIES
AND RISK MANAGEMENT
OF THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
__________
APRIL 13, 2011
__________
Serial No. 112-10
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Printed for the use of the Committee on Agriculture
agriculture.house.gov
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66-248 PDF WASHINGTON : 2011
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COMMITTEE ON AGRICULTURE
FRANK D. LUCAS, Oklahoma, Chairman
BOB GOODLATTE, Virginia, COLLIN C. PETERSON, Minnesota,
Vice Chairman Ranking Minority Member
TIMOTHY V. JOHNSON, Illinois TIM HOLDEN, Pennsylvania
STEVE KING, Iowa MIKE McINTYRE, North Carolina
RANDY NEUGEBAUER, Texas LEONARD L. BOSWELL, Iowa
K. MICHAEL CONAWAY, Texas JOE BACA, California
JEFF FORTENBERRY, Nebraska DENNIS A. CARDOZA, California
JEAN SCHMIDT, Ohio DAVID SCOTT, Georgia
GLENN THOMPSON, Pennsylvania HENRY CUELLAR, Texas
THOMAS J. ROONEY, Florida JIM COSTA, California
MARLIN A. STUTZMAN, Indiana TIMOTHY J. WALZ, Minnesota
BOB GIBBS, Ohio KURT SCHRADER, Oregon
AUSTIN SCOTT, Georgia LARRY KISSELL, North Carolina
STEPHEN LEE FINCHER, Tennessee WILLIAM L. OWENS, New York
SCOTT R. TIPTON, Colorado CHELLIE PINGREE, Maine
STEVE SOUTHERLAND II, Florida JOE COURTNEY, Connecticut
ERIC A. ``RICK'' CRAWFORD, Arkansas PETER WELCH, Vermont
MARTHA ROBY, Alabama MARCIA L. FUDGE, Ohio
TIM HUELSKAMP, Kansas GREGORIO KILILI CAMACHO SABLAN,
SCOTT DesJARLAIS, Tennessee Northern Mariana Islands
RENEE L. ELLMERS, North Carolina TERRI A. SEWELL, Alabama
CHRISTOPHER P. GIBSON, New York JAMES P. McGOVERN, Massachusetts
RANDY HULTGREN, Illinois
VICKY HARTZLER, Missouri
ROBERT T. SCHILLING, Illinois
REID J. RIBBLE, Wisconsin
______
Professional Staff
Nicole Scott, Staff Director
Kevin J. Kramp, Chief Counsel
Tamara Hinton, Communications Director
Robert L. Larew, Minority Staff Director
______
Subcommittee on General Farm Commodities and Risk Management
K. MICHAEL CONAWAY, Texas, Chairman
STEVE KING, Iowa LEONARD L. BOSWELL, Iowa, Ranking
RANDY NEUGEBAUER, Texas Minority Member
JEAN SCHMIDT, Ohio MIKE McINTYRE, North Carolina
BOB GIBBS, Ohio TIMOTHY J. WALZ, Minnesota
AUSTIN SCOTT, Georgia LARRY KISSELL, North Carolina
ERIC A. ``RICK'' CRAWFORD, Arkansas JAMES P. McGOVERN, Massachusetts
MARTHA ROBY, Alabama DENNIS A. CARDOZA, California
TIM HUELSKAMP, Kansas DAVID SCOTT, Georgia
RENEE L. ELLMERS, North Carolina JOE COURTNEY, Connecticut
CHRISTOPHER P. GIBSON, New York PETER WELCH, Vermont
RANDY HULTGREN, Illinois TERRI A. SEWELL, Alabama
VICKY HARTZLER, Missouri
ROBERT T. SCHILLING, Illinois
Matt Schertz, Subcommittee Staff Director
(ii)
C O N T E N T S
----------
Page
Boswell, Hon. Leonard L., a Representative in Congress from Iowa,
opening statement.............................................. 3
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, opening statement....................................... 1
Prepared statement........................................... 2
Witnesses
Berkovitz, Dan M., General Counsel, Commodity Futures Trading
Commission, Washington, D.C.................................... 4
Prepared statement........................................... 5
Duffy, Hon. Terrence A., Executive Chairman, CME Group, Inc.,
Chicago, IL.................................................... 22
Prepared statement........................................... 24
Scott, J.D., Hal S., Director, Committee on Capital Markets
Regulation; Nomura Professor and Director, Program on
International Financial Systems, Harvard Law School, Cambridge,
MA............................................................. 38
Prepared statement........................................... 39
Overdahl, Ph.D., James A., Vice President, National Economic
Research Associates, Washington, D.C........................... 47
Prepared statement........................................... 48
McMillan, Karen H., General Counsel, Investment Company
Institute, Washington, D.C..................................... 53
Prepared statement........................................... 54
Greenberger, J.D., Michael, Professor, University of Maryland
School of Law, Baltimore, MD................................... 90
Prepared statement........................................... 91
IMPLEMENTING DODD-FRANK: A REVIEW OF THE CFTC'S RULEMAKING PROCESS
----------
WEDNESDAY, APRIL 13, 2011
House of Representatives,
Subcommittee on General Farm Commodities and Risk
Management,
Committee on Agriculture,
Washington, D.C.
The Subcommittee met, pursuant to call, at 10:00 a.m., in
Room 1300, Longworth House Office Building, Hon. K. Michael
Conaway [Chairman of the Subcommittee] presiding.
Members present: Representatives Conaway, Neugebauer,
Schmidt, Crawford, Gibson, Hultgren, Schilling, Boswell,
McIntyre, Kissell, McGovern, David Scott of Georgia, and
Courtney.
Staff present: Tamara Hinton, John Konya, Kevin Kramp, Josh
Mathis, Ryan McKee, Matt Schertz, Debbie Smith, Liz
Friedlander, Clark Ogilvie, and Jamie Mitchell.
OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE
IN CONGRESS FROM TEXAS
The Chairman. Let's call the hearing to order. The hearing
of the Subcommittee on General Farm Commodities and Risk
Management entitled, Implementing Dodd-Frank: A Review of the
CFTC's Rulemaking Process, will now come to order.
Mr. Berkovitz, thank you for being here this morning.
Today, we continue our series of hearings to review the
CFTC's implementation of the derivatives provisions of the
Dodd-Frank Act.
The CFTC is currently engaged in what is easily said to be
a pretty colossal effort to write dozens and dozens of new
regulations for a market that is critically important to our
economy. This effort is unmatched in its scope and implication
for a domestic and global financial system. Yet, by all
accounts, it seems the CFTC has placed speed over deliberation.
Rules have been proposed in a sequence that has created
confusion and made it difficult for the public to orchestrate
their input. There has been a lack of consideration regarding
costs and benefits of the Commission's proposed regulations.
The CFTC has proposed rules that we believe exceed
Congressional intent and demonstrate a lack of regulatory focus
among a shortage of resources. It has made clear to me that the
statutory deadlines for Title VII simply do not give regulators
enough time to do this right. The old adage, there is never
enough time to do it right, but there is always time to do it
over seems to come to mind.
It should be noted that the derivatives provisions
contained within Dodd-Frank will impact thousands of end-users
across the country that engage in hedging responsibly and who
had no role in the financial crisis that Dodd-Frank seems to
proffer to fix. Rushing to regulate will have a harmful and
punitive impact on non-financial businesses if we don't get
this correct.
Moreover, the short timeframes have been exacerbated by the
sequence of rule proposals and have had a negative impact on
the ability of stakeholders to actually understand the impact
of the regulations on their businesses, and to know whether or
not they should comment or not.
The cost-benefit analysis performed at the CFTC appears to
be the bare minimum needed to comply with the CEA. To date,
projections of costs have been vague and inaccurate; and in one
instance, when the CFTC has tried to quantify them, they were
4,000 times lower than the estimates performed by the
stakeholders themselves. Yet when I joined with Chairman Lucas
to ask Chairman Gensler to voluntarily adhere to the
President's Executive Order that demanded a higher standard of
regulatory review, I was told that the requirements of CEA were
specific enough to preclude the CEA from adherence to the
Executive Order.
In addition, we have heard concerns from many stakeholders
that several of the proposed rules exceed what is required by
Dodd-Frank or intended by Congress. For example, both the
proposed rules relating to ownership and governance of DCOs,
DCMs, and SEFs and on position limits directed the CFTC to
issue rules only after that review determined that they were
appropriate. Yet the CFTC has dedicated significant resources
to proposing these rules without such finding.
In another example, the CFTC's proposed business conduct
standard rules, that rule, according to the Department of Labor
regulations, makes swap dealers fiduciaries to pension plans,
despite Congress' specific omission of such a standard in Dodd-
Frank.
Last, there are several areas in which the CFTC proposals
are inconsistent with those of other regulatory agencies. Rules
governing swap execution facilities, real-time reporting and,
just yesterday, larger requirements for swap entities have all
shown inconsistencies that will only make it more difficult and
confusing to comply.
I look forward to exploring these topics in more detail
with our witnesses today.
[The prepared statement of Mr. Conaway follows:]
Prepared Statement of Hon. K. Michael Conaway, a Representative in
Congress from Texas
Today, we continue our series of hearings to review the CFTC's
implementation of the derivatives provisions in Dodd-Frank.
The CFTC is currently engaged in a colossal effort to write dozens
of new regulations for a market that is critically important to the
economy. This effort is unmatched in its scope and implication for the
domestic and global financial system.
Yet, by all accounts, it seems the CFTC has placed speed over
deliberation. Rules have been proposed in a sequence that has created
confusion and made it difficult for the public to provide input. There
has been a lack of consideration regarding the costs and benefits of
the Commission's proposed regulations. The CFTC has proposed rules that
exceed Congressional intent and demonstrate a lack of regulatory focus
amid a shortage of resources. Further, there are inconsistencies among
regulatory agency proposals, despite Congressional directives to
coordinate.
It has been made clear to me that the statutory deadlines for Title
VII simply do not give regulators enough time to get this right. It
should be noted that the derivatives provisions contained within Dodd-
Frank will impact thousands of end-users across the country that engage
in hedging responsibly and had no role in the financial crisis. Rushing
to regulate will have a harmful and punitive impact on non-financial
businesses that were not a part of the problem.
Moreover, these short timeframe have been exacerbated by the
sequence of the rule proposals that have had a negative impact on the
ability for stakeholders to comment or to understand the impact it will
have on their businesses and customers.
The cost-benefit analysis performed by the CFTC has been the bare
minimum simply to tout compliance with the CEA. To date, projections of
costs have been vague and inaccurate; in one instance when the CFTC has
tried to quantify them, they were 4,000 times lower than estimates
performed by stakeholders. Yet, when I joined with Chairman Lucas to
ask Chairman Gensler to voluntarily adhere to the President's Executive
Order that demanded a higher standard of regulatory review, I was told
that the requirements of the CEA were specific enough to preclude the
CFTC from adherence to the Executive Order.
In addition, we have heard many concerns from stakeholders that
several of the proposed rules exceed what is required by Dodd-Frank or
intended by Congress. For example, both the proposed rules relating to
ownership and governance of DCO's, DCM's and SEF's, and on position
limits, directed the CFTC to issue rules only after review by the
Commission determined that they were appropriate. Yet, the CFTC has
dedicated significant resources to proposing these rules without any
such finding. In another example, the CFTC has proposed business
conduct standard rules that would, according to Department of Labor
regulations, make swap dealers fiduciaries to pension plans, despite
Congress' specific omission of such a standard in Dodd-Frank.
Last, there are several areas in which the CFTC's proposals are
inconsistent with those of the other regulatory agencies. Rules
governing Swap Execution Facilities, real-time reporting, and--just
yesterday--margin requirements for swap entities, have all shown
inconsistencies that will only make it more difficult and confusing for
businesses to comply.
I look forward to exploring these topics in more detail and to
hearing from our witnesses today.
The Chairman. I now turn to our Ranking Member for his
statement, if any.
OPENING STATEMENT OF HON. LEONARD L. BOSWELL, A REPRESENTATIVE
IN CONGRESS FROM IOWA
Mr. Boswell. Thank you, Mr. Chairman; and I want to thank
you and our witnesses for coming today to review the CFTC's
rulemaking process for implementation of the Wall Street Reform
and Consumer Protection Act.
The law and regulation we are reviewing today, and in the
future, are critical to Americans in all of our districts. More
than 38 million U.S. citizens, whether they are farmers,
manufacturers, accountants, or municipal workers, are employed
with a business that uses derivatives to hedge risk and protect
against market volatility.
The reason this legislation, it would appear, was crafted
today is to protect the pensions of hardworking Americans from
vulnerability and ensure our market is protected against epic
job loss like the eight million they lost in 1 year due to the
financial crisis on Wall Street. It is not to penalize the end-
users who, like consumers, were victims in the financial
crisis. Our efforts instead should focus on preventing the
markets from enriching a few players and making sure that never
again are American taxpayers left with the bill.
To ensure greater transparency in the markets, we must
provide an open process; and I want to thank the Chairman and
my colleagues for working together with the CFTC, SEC, and
market participants to provide a clear picture of our progress
and shed light on areas that need more work.
As you know, Members of Congress face important and
difficult decisions regarding our nation's budget. However, we
also have a responsibility to assess our nation's needs and
priorities.
I am particularly interested in the state of the
infrastructure and technology in place for the implementation
of the Wall Street Reform and Consumer Protection Act. Are the
personnel and the tools available to implement this Act?
I look forward to comments from the witnesses. I believe
our partnership is crucial for the future of market
regulations. I am committed to working with you to ensure this
market is regulated with efficiency and transparency without
hindering its practical uses. Your thoughts and comments are
greatly appreciated.
And thank you, Mr. Chairman, for having this hearing.
The Chairman. Mr. Boswell, thank you.
Members are reminded or asked to submit their opening
statements for the record so that our witnesses may begin their
testimony to assure that there is ample time for questions.
So, with that, we welcome the first panel. I guess a single
person can testify as a panel, Mr. Berkovitz. But at any rate,
nonetheless, our first panel is Dan Berkovitz, General Counsel,
Commodity Futures Trading Commission.
We look forward to hearing your comments. Thank you for
being here.
STATEMENT OF DAN M. BERKOVITZ, GENERAL COUNSEL, COMMODITY
FUTURES TRADING COMMISSION,
WASHINGTON, D.C.
Mr. Berkovitz. Good morning, Chairman Conaway, Ranking
Member Boswell, and Members of the Subcommittee. Thank you for
inviting me to today's hearing.
My name is Dan Berkovitz, and I serve as the General
Counsel of the Commodity Futures Trading Commission. I am
pleased to testify before you today regarding the CFTC's Dodd-
Frank rulemaking process.
The CFTC is working deliberatively and efficiently to issue
the rules needed to implement the Dodd-Frank Act. This process
is guided by two basic principles: First, the CFTC seeks to
ensure that its rules implement the substantive requirements of
the statute and follow the intent of Congress. Second, the CFTC
is relying extensively on consultation with other regulators,
both domestic and international, and public participation.
Rulemakings are conducted in compliance with the
Administrative Procedure Act and other applicable laws. The
CFTC is committed to an open and transparent rulemaking
process. The staff has solicited written comments on
rulemakings prior to the proposal stage. The agency has
received thousands of written comments on proposed rules,
issued several advance notice of public rulemakings, held
public roundtables, met with hundreds of market participants
and members of the public, and established comment mailboxes
and files on the CFTC website.
The Commission has held 13 public meetings to issue
proposed rules. The CFTC has engaged in extensive consultation
and cooperation with other Federal financial regulators, both
foreign and domestic, to harmonize regulations.
Domestically, the CFTC has worked closely with the SEC, the
Federal Reserve, and other prudential regulators. The CFTC is
consulting and coordinating with international regulators to
harmonize the approach to swaps oversight globally. Discussions
have focused on clearing and trading requirements,
clearinghouses generally, and swaps data reporting issues,
among many other topics.
The CFTC has now issued proposals in most of the rulemaking
areas. As the Commission receives comments from the public, it
is looking at the entire mosaic of rules and how they
interrelate. The Commission will begin considering final rules
only after the staff can analyze, summarize, and consider
comments; the Commissioners are able to review the comments and
provide guidance to the staff; and the Commission consults with
fellow regulators.
The CFTC has certain flexibility to tailor the timing of
the implementation of the rules to the ability of entities
subject to the new Dodd-Frank regulations to develop the
systems, processes, and capabilities necessary to comply with
the new requirements.
The Commission has been seeking comments from market
participants and interested members of the public on the phase-
in of the regulatory requirements that will be established in
the final rules. Yesterday, the CFTC and the SEC announced a
joint 2 day staff roundtable discussion with market
participants and interested members of the public on how to
phase in implementation of the Dodd-Frank requirements. The
staffs are seeking comments on: whether to phase in
implementation dates, based on a number of factors related to
the ability to transition into compliance with the new
requirements including: the type of swap, the type of market
participant, the speed with which entities can meet the new
requirements, and whether market infrastructures such as
exchanges or clearinghouses or swap execution facilities or
participants might be required to have policies and procedures
in place ahead of compliance with such policies and procedures
by persons entering into transactions on such facilities or
with such participants.
In summary, the Commission has established a transparent
rulemaking process to implement Dodd-Frank. The Commission
encourages public comments on the rules and their
implementation and will continue to consult and coordinate with
other Federal regulators and our international counterparts
prior to issuing final rules.
Thank you, and I would be happy to answer any questions.
[The prepared statement of Mr. Berkovitz follows:]
Prepared Statement of Dan M. Berkovitz, General Counsel, Commodity
Futures Trading Commission, Washington, D.C.
Good morning, Chairman Conaway, Ranking Member Boswell, and Members
of the Subcommittee. I am Dan Berkovitz, and I am privileged to serve
as the General Counsel at the Commodity Futures Trading Commission
(``CFTC'' or ``Commission''). I thank you for inviting me to today's
hearing on the CFTC's rulemaking process to implement the Dodd-Frank
Wall Street Reform and Consumer Protection Act (the ``Dodd-Frank
Act'').
The Dodd-Frank Act
On July 21, 2010, President Obama signed the Dodd-Frank Act. The
Act amended the Commodity Exchange Act (``CEA'') to establish a
comprehensive new regulatory framework for swaps and made similar
amendments to securities laws for security-based swaps. Title VII of
the Dodd-Frank Act was enacted to reduce risk, increase transparency
and promote market integrity within the financial system. To accomplish
these goals, the Act:
1. Provides for the registration and comprehensive regulation of
swap dealers and major swap participants;
2. Imposes clearing and trade execution requirements on
standardized derivatives products;
3. Creates robust record-keeping and real-time reporting regimes;
and
4. Enhances the Commission's rulemaking and enforcement authorities
with respect to, among others, all registered entities and
intermediaries subject to the Commission's oversight.
The Dodd-Frank Act brings to the swaps markets the same basic
regulatory goals of transparency and risk reduction that have governed
the regulation of the futures and securities markets since the 1930s.
The measures provided in the Act to lower risk and improve transparency
are intended to improve the ability of American businesses to use these
markets and derivatives to reduce their risks and costs.
Rulemakings
The Dodd-Frank Act generally requires the CFTC to issue rules that
are required to implement the provisions of the Act within 360 days
from the date of enactment. Under Dodd-Frank, the effective date of any
such rule shall be at least 60 days after publication of the final rule
implementing such provision.
The CFTC is working deliberatively and efficiently to issue these
rules. The rulemaking process is guided by two basic principles. First,
the CFTC is working to ensure that its rules implement the substantive
requirements of the statute and follow the intent of Congress. Second,
the CFTC is relying extensively on consultation with other regulators,
both domestic and international, and the participation of market
participants and other interested members of the public. The
Commission's rulemakings are conducted in compliance with the
Administrative Procedure Act and other applicable laws.
Rulemaking Teams
As the Congress was finalizing the Dodd-Frank Act, the CFTC formed
30 rulemaking teams to begin to implement the Act's rulemaking
requirements. Each team consists of a team leader from one of the CFTC
divisions, as well as staff from the other CFTC divisions. Chairman
Gensler held the first meeting with the 30 team leads the day before
the President signed the Act into law.
A number of months ago the CFTC created a 31st rulemaking team
tasked with developing conforming rules to update the CFTC's existing
regulations to take into account the provisions of the Dodd-Frank Act.
The CFTC has thus far proposed rulemakings or interpretive orders in 28
of the 31 areas.
Public Participation
The CFTC is committed to a transparent and open rulemaking process.
The Commission has encouraged public participation throughout this
process. The CFTC's rulemakings to implement the Dodd-Frank Act have
included the following opportunities for public participation:
Public participation during rulemakings. Immediately after the
Dodd-Frank Act was passed, the CFTC solicited comments from the public
regarding the rules required to be proposed under the Act. These pre-
proposal initiatives included staff roundtables, meetings with market
participants, several advance notices of proposed rulemakings, and the
establishment of public comment mailboxes and files on the CFTC
website. As of this past Monday, we had received 2,907 submissions from
the public through these e-mail inboxes. The Commission also encourages
the public to submit comments once rules are proposed, and provides a
number of ways for comments to be submitted. As of Monday, we had
received 8,991 comments in response to notices of proposed rulemaking.
Transparency of all public comments and meetings. The CFTC posts
all written comments received and summaries of all meetings with the
public on Dodd-Frank Act rulemakings on the Commission's website, at
cftc.gov. These summaries of meetings identify the participants and the
issues discussed. Any written materials provided to the agency for
these meetings are posted on the CFTC website. As of this past Monday,
we have had 675 such meetings.
Open meetings. The Commission has utilized thirteen public meetings
to issue proposed rules under the Dodd-Frank Act. The meetings are
broadcast live via webcast and a call-in telephone number is available
for the public to connect to a live audio feed. Archived webcasts are
available on our website as well.
Consultation and Coordination
The CFTC has engaged in extensive consultation and cooperation with
other Federal financial regulators, both foreign and domestic, to seek
input on the rulemakings and to harmonize the regulations of the swaps
markets to the fullest extent practical.
Domestically, the CFTC has worked closely with the Securities and
Exchange Commission (``SEC''), the Federal Reserve, the Federal Deposit
Insurance Corporation, the Office of the Controller of the Currency and
other prudential regulators. The consultation and collaboration with
these agencies includes sharing many of the staff memos, term sheets
and draft documents. The CFTC also is working closely with the Treasury
Department and the new Office of Financial Research. As of last Friday,
CFTC staff has had 598 meetings with other U.S. regulators on
implementation of the Act.
In addition to working with the agency's domestic counterparts, the
CFTC has reached out to, and is consulting and coordinating with,
international regulators to harmonize the approach to swaps oversight
globally. As with domestic regulators, the CFTC is sharing memos, term
sheets and draft documents with international regulators as well.
Discussions have focused on clearing and trading requirements,
clearinghouses generally and swaps data reporting issues, among many
other topics.
Specifically, the CFTC has been consulting directly and sharing
documentation with the European Commission (``E.C.''), the European
Central Bank, the United Kingdom Financial Services Authority and the
new European Securities and Markets Authority. Three weeks ago,
Chairman Gensler traveled to Brussels to meet with the European
Parliament's Economic and Monetary Affairs Committee and discussed the
most important features of swaps oversight reform.
The CFTC also has shared documents with the Japanese Financial
Services Authority and consulted with Members of the European
Parliament and regulators in Canada, France, Germany and Switzerland.
Through its consultation with these foreign regulators, the CFTC has
sought to bring consistency to regulation of the swaps markets.
In September of last year, the E.C. released its swaps proposal.
Similar to the Dodd-Frank Act, the E.C.'s proposal covers the entire
derivatives marketplace--both bilateral and cleared--and the entire
product suite, including interest rate swaps, currency swaps, commodity
swaps, equity swaps and credit default swaps. The proposal includes
requirements for central clearing of swaps, robust oversight of central
counterparties and reporting of swaps. The E.C. also is considering
revisions to its existing Markets in Financial Instruments Directive
(``MiFID''), which includes a trade execution requirement, the creation
of a report with aggregate data on the markets similar to the CFTC's
Commitments of Traders reports and accountability levels or position
limits on various commodity markets.
The CFTC has now issued proposals in most of the rulemaking areas.
As the Commission receives comments from the public, it is looking at
the entire mosaic of rules and how they interrelate. The Commission
will begin considering final rules only after staff can analyze,
summarize and consider comments, the Commissioners are able to review
the comments and provide guidance to staff, and the Commission consults
with fellow regulators on the rules. The Commission has stated that it
hopes to move forward in the spring, summer and fall with final rules.
Administrative Procedure Act
The Commission's rulemakings to implement the Dodd-Frank Act are
conducted in accordance with the procedural requirements for informal
rulemakings under the Administrative Procedure Act (``APA'') and other
applicable laws. The Commission has provided opportunities for public
comment in addition to those specified in the APA, such as providing an
opportunity for public comment prior to the issuance of a notice of
proposed rulemaking as discussed above.
For most of the proposed rulemakings, the Commission has solicited
public comments for a period of 60 days. On some occasions, the public
comment period lasted 30 days. The Commission also has discretion to
accept late comments. The CFTC website informs persons interested in
submitting comments:
``The Commission invites comments on proposed rules. To be
assured consideration by the Commission, comments must be filed
prior to the close of the official comment period. Comments
filed after the close of the official comment period may be
considered, at the Commission's discretion. After the close of
the comment period, persons may continue to submit comments
through this website.''
To date, the Commission has accepted and intends to consider all
late-filed comments.
The Subcommittee also has requested information regarding the
standard for determining when a rule must be re-proposed. The
Commission's actions in this respect also are governed by the APA. In
general, the APA requires that an agency provide the public a
meaningful opportunity to participate in an agency rulemaking. The
first step in the rulemaking process is the publication of a notice of
proposed rulemaking (``NPRM'') that includes the substantive terms of
the proposed rule and informs the public of the issues that are likely
to be significant to the agency's decision.
The APA does not require the final rule to be identical to the
proposed rule. Indeed, in issuing final rules, agencies are expected to
consider and respond to comments on the proposed rule. When reviewing a
final rule to determine if there was adequate notice and opportunity
for comment, the courts will examine whether the connection between the
NPRM and the final rule is sufficient for the final rule to be
considered a ``logical outgrowth'' of the proposed rule. For example,
courts consider a final rule to be a logical outgrowth if the NPRM
expressly asks for comments on a particular issue or otherwise makes
clear that the agency is considering a particular course of action.
Phased Implementation
The Commission has specifically requested comment from market
participants and interested members of the public on the phase-in of
the regulatory requirements that will be established in the final
rules.
The CFTC has certain flexibility to set implementation or effective
dates of rules promulgated to implement the Act, consistent with the
Act's statutory deadlines and requirements. This flexibility allows the
Commission to tailor the timing of the implementation of the rules to
the ability of entities subject to the new Dodd-Frank regulations to
develop the systems, processes, and capabilities to comply with the new
requirements. Accordingly, the Commission is considering whether to
phase implementation dates based upon a number of factors related to
the ability to transition into compliance with the new requirements,
including asset class, type of market participant, and whether the
requirement would apply to market infrastructures or to specific
transactions. The order in which the rules are finalized by the
Commission therefore will not necessarily mean that the rules
themselves will become effective in that same order, or that the
implementation requirements will follow that same sequence.
For example, the Commission may require one asset class or one
group of market participants to comply with certain regulatory
requirements before other asset classes or other groups of market
participants. Similarly, the Commission may require market
infrastructure facilities to be in compliance with certain regulatory
requirements prior to requiring market participants to use those
facilities. Effective dates and implementation schedules for certain
rules may be conditioned upon other rules being finalized, their
effective dates and the associated implementation schedules. For
instance, the effective dates of some final rules may come only after
the CFTC and SEC jointly finalize certain definitions rules.
The Commission is examining issues related to the phasing in of
regulatory requirements with respect to the entire set of rules that
are being proposed, the regulatory requirements that would thereby be
established and the degree of flexibility allowed by the applicable
law. The Commission is seeking comments from market participants and
regulators, both in the U.S. and abroad, regarding the phasing of
implementation of these requirements.
The Subcommittee has also asked about the potential circumstance in
which various provisions of the Dodd-Frank Act may become effective
prior to the promulgation of implementing regulations. The staff is
evaluating these potential circumstances and developing for
consideration alternatives within the Commission's authorities in order
to ensure that transactions will not be disrupted solely as a result of
such transition to the new regulatory regime.
Conclusion
The Commission has established a rulemaking process to implement
the Dodd-Frank Act in compliance with the Act's requirements and
Congressional intent. The rulemakings are being conducted in an open
and transparent manner. The Commission seeks, encourages, and considers
public comments. The Commission also will continue to consult and
coordinate with other Federal regulators and our international
counterparts prior to issuing final rules.
Thank you, and I'd be happy to answer questions.
The Chairman. Mr. Berkovitz, thanks for coming.
I will remind our Members that you will be recognized for
questioning in order of seniority for those who were here at
the beginning of the hearing. Others will be recognized in the
order of arrival.
We will start the 5 minute clock with me.
Mr. Berkovitz, again, thank you for being here today.
Up until about 3 weeks or so ago, it seemed to me that the
Commission was continuing to bluff that they could get all of
this done by July 15; and, since then, now it has been clear
that that is not going to happen, that you are not going to
make the deadline. And while we in Congress can't encourage you
to disobey the law, as my opening statement, you were given an
impossible task to get that done.
I have a couple of questions in that regard. One, is it
time now for the Commission to openly request additional time
so that you can get this done under the law? Or should we
just--is it your recommendation that you continue to ignore the
law's July 15 date or July 21 date, whichever one it is, with
respect to making these rules final?
And the second half of that is, without rules being in
place by that time frame, the law is in effect for those folks
who participate in all these markets. So what guidance can you
give them who have to obey the law without the regulations
being in place, and what risks do they run during that gap
between the guidance that you are intending to give them with
respect to how the law should be implemented versus the law
being out there and their risk that there are plaintiffs'
lawyers all over the country just salivating at the opportunity
to come after some of these folks because they are not in
compliance with the law and the regulations out there?
So could you give us quick comments on both of those?
Mr. Berkovitz. Thank you, Mr. Chairman.
As you mention, the law does establish a 1 year global time
frame for our rulemakings, and the Commission is working
diligently to meet that deadline. I think, as you recognize and
the Chairman has stated, that there are going to be some
rules--a number of rules that are going to be finalized after
that deadline.
The Chairman has established an overall goal to issue a
number of the rules in final form this summer. So the goal is
to have a number of these rules finalized by the summer, and
then obviously there will be a number of them finalized after
that.
The Chairman has not asked for any statutory change to
accomplish that. I think we can accomplish that within the
current statutory authority and current statutory timetable.
There is not going to be a penalty if we don't meet that July
deadline for these final rules.
Regarding the transition, I think the statute also provides
the agency with sufficient flexibility to address that
transition period between the time when certain provisions of
the Act may be effective, and the time when certain other
regulations may be effective. We believe the statute provides
the agency with flexibility, both Dodd-Frank and the existing
underlying Commodity Exchange Act, to address that interim
period
The Chairman. So you are saying that protects the industry,
by and large, from the law being effective and the regulations
not being there, that somehow they are protected through--that
there is no risk of being out of compliance with the law itself
during this time frame, that a cause of action can be brought
against them that they are somehow protected by this cloak that
you are referring to?
Mr. Berkovitz. Well, we believe we have sufficient
authority to address that situation. A number of market
participants----
The Chairman. I am not talking about the implementation
phase-in. I understand you have the authority to do that. But
how do you protect the industry? Do you then weigh in on their
behalf if a court case is brought against them?
Mr. Berkovitz. Well, we believe there is sufficient
authority within the Commodity Exchange Act, as it currently
exists, to address those concerns. We are looking at--we are
examining a number of these specific instances, what happens
before certain rules come into effect, and developing
alternatives for the Commission's consideration, how to address
that very concern.
The Chairman. Most of us have been pretty dissatisfied with
the cost-benefit analysis that we have been allowed to see,
pretty cavalier statements that the costs are small and the
benefits are great and so this rule goes forward.
I guess the other question is, there are other agencies in
the past who have been sued over their lack of proper cost-
benefit analysis work done. Is the Commission somehow protected
under the CEA for those kind of causes of action being brought
by folks who disagreed with your cost-benefit analysis work and
that, if it was flawed, then the underlying regulation itself
shouldn't have gone into place because you didn't really
analyze what should have happened, or what was going to happen
when you put it in place?
Mr. Berkovitz. The guiding principles here, the statutes
that guide us in the cost-benefit analysis are section 15(a) of
the Commodity Exchange Act, and we believe that our proposed
rules have been in compliance and our cost-benefit analyses
have been in compliance with section 15(a).
In terms of the rulemakings themselves, the other statute
that would guide the agency in judicial review and where other
agencies--we have looked at the cases--get challenged is the
Administrative Procedure Act and ensuring that the rulemakings
are based upon a reasoned and rational basis and the agencies
are obligated to respond to comments and ensure that the
decisions are based upon fact and reasoned analysis. And so the
Commission is also guided by the Administrative Procedure Act,
and we intend to follow that as well. And if we follow the APA
and the Commodity Exchange Act, our rules should be found--
upheld.
The Chairman. Okay. I will come back at you a little bit
later on when it is my turn again.
So, Mr. Boswell, for 5 minutes.
Mr. Boswell. Well, thank you, Mr. Chairman.
Kind of along that line, just to carry on a little bit,
Chairman Gensler testified repeatedly about the Commission's
requirement for cost-benefit analysis in his rulemaking. This
requirement had been in place long before Dodd-Frank; and with
regard to the Commission's efforts to meet this statutory cost-
benefit requirement, is the Commission staff doing anything
different now with the Dodd-Frank rules than it did in the
rulemaking prior to Dodd-Frank, or even different from when the
Commission had their previous Chairman?
Mr. Berkovitz. Congressman Boswell, we have adopted and we
put to the statute--section 15(a) of the Commodity Exchange Act
is really unaffected by Dodd-Frank. Dodd-Frank did not amend
section 15(a) which governs cost-benefit analysis. So the
underlying statutory requirement prior to Dodd-Frank is the
same as after Dodd-Frank, and the agency has adopted the same
cost-benefit approach.
In Dodd-Frank, however, we have received a lot of comments.
As I mentioned to Chairman Conaway's questions, we have
received a number of comments on our cost-benefit analysis, and
we are considering those comments in the context of the
rulemaking, and the agency is evaluating the comments and would
respond appropriately in the final rule.
Additionally, the President, in January, issued an
Executive Order regarding cost-benefit analysis.
So, as the Chairman has testified, we are looking at the
Executive Order and seeing what principles of that Executive
Order can be included within our cost-benefit analysis
consistent with the basic statutory requirements in section
15(a).
Mr. Boswell. Thank you.
Your testimony states that the Commission tends to accept
and I think, again along with some of the questions of the
Chairman, consider all late-filed comments. However, it would
seem at some point you have to stop. After all, how do you
consider a comment if it comes in the day before the Commission
is scheduled to vote on the final rule? And how late can
comments be, and how can we and the comment offerer be sure it
will be considered before it is submitted to the whole
Commission for approval?
Mr. Berkovitz. The Commission does have discretion to
consider late comments. To date, the late comments that have
been submitted have been accepted, and the staff intends to
consider them. At some point, when we are--as you have noted,
just before a rule is imminent, just before it goes final, it
actually may be too late to consider a comment as a matter of
practicality. In that situation, the Commission would be unable
to exercise its discretion or would exercise its discretion not
to accept the comment. It can't be an open-ended, never-ending
comment period. But provided that it doesn't delay the
rulemaking, the general practice has been to accept the late-
filed comment.
Mr. Boswell. Thank you.
In your written testimony, you talk about increased
scrutiny by the courts of economic arguments about government
agencies when proposing new rules. Has the CFTC seen such
increased scrutiny by the courts and rules? Historically, have
any challenges been filed against the Commission regarding
rules or orders?
Mr. Berkovitz. We have not had many challenges against
rules or orders in the last few years. The amount of rulemaking
under Dodd-Frank is significantly greater than what the
Commission has experienced in previous years. So we are
devoting significant resources to our rulemakings. We have
rulemaking teams established for each of the rules, with a
number of staff from the various divisions, from the Office of
General Counsel in order to ensure that these rules follow all
the requirements and are sound and will survive any review, any
challenge that people may bring
Mr. Boswell. Mr. Chairman, I will yield back. We are going
to have another round probably. I yield back.
The Chairman. The gentleman yields back.
Mrs. Schmidt, from Ohio, for 5 minutes.
Mrs. Schmidt. Thank you, and I apologize if some of these
questions have been asked, since I was outside.
I am concerned about the timing of the rules and how they
are going to pan out in application. But, given the Dodd-
Frank's emphasis on consistency and comparability, do the CFTC
and the SEC intend to adopt consistent and comparable
schedules, both for promulgation and implementation of the
rules for swaps and security-based swaps? In other words, is
the timing going to be the same or is the timing going to be
different? Because I don't know how it is going to interact in
the real world.
Mr. Berkovitz. We are coordinating with the SEC on that
issue as well as on the substance of the rules themselves. We
are coordinating both at the staff level and Chairman Gensler
and Chairman Schapiro meet regularly and talk about these
issues. So we are attempting to coordinate our schedules to the
greatest extent possible.
There are two different Commissions with various
different--slightly different rulemaking responsibility. So I
don't know exactly how it is going to turn out, but we are
attempting to do that.
Mrs. Schmidt. Well, if you can't get the timing together,
how is it going to work?
Mr. Berkovitz. Well, we are attempting to do it as closely
as possible together.
Mrs. Schmidt. Well, what happens if you don't? That is my
question. What happens if you don't? How is it going to work in
the real world if you have two different sets of rules out
there?
Mr. Berkovitz. Well, it would depend on the particular
requirements. Our requirements would go to swaps. Their
requirements would go to security-based swaps. To the greatest
extent possible, we would like those to be at the same time,
and we are trying to avoid any differences in those two types
of instruments in terms of the timing or the requirements
themselves.
Mrs. Schmidt. Can you respond to concerns that the CFTC
proposes to regulate swap dealers and major swap participants
in the same fashion, even though one is the seller and one is
the buyer? Take for example, sales practice rules applied to
major swap participants when they are the buyer. I mean, aren't
they two different groups?
Mr. Berkovitz. The statute directs the agency to promulgate
certain standards, business conduct standards, certain clearing
requirements equally applicable to the swap dealers and to the
major swap participants. To the extent that there are certain
features about certain transactions or certain requirements
that may be different, we are considering that in the comment
period on the various particular requirements.
Mrs. Schmidt. So what assurances are we going to have that
buyers and sellers are going to be treated differently instead
of in the same mold?
Mr. Berkovitz. Well, it would depend again on the
particular requirement what the particular standard is. We
would have to consider that in the context of a particular
requirement that may or may not be applicable to a buyer or to
a seller as the case may be.
Generally, the statute treats them the same. So any
differences would come when we were looking at a particular
requirement to implement that statutory direction.
Mrs. Schmidt. But I think they are fundamentally different.
It is like when you are buying a house or you are selling a
house, there is a different set of rules out there for buyers
and sellers with a realtor. So why would we have the same mold
for a buyer and seller on these transactions?
Mr. Berkovitz. Well, the statute generally would impose a
duty, for example, on a counterparty. If you are in a
transaction with a counterparty, this is when the transaction
should be reported, what your duty of disclosure may or may not
be to a counterparty, things like that.
So if there is a particular instance when, as you have
posed, that it really can only be done by a seller or really
can only be done by a buyer, if it gets down to that level you
would have to look at that, at the individual transaction
level, which is what we intend to do.
Mrs. Schmidt. Okay. And, finally, in the few seconds I have
left, what authority does the CFTC have to address issues of
extraterritoriality? Can the CFTC exempt from regulation an
entity that is subject to comparable regulation in their home
country?
Mr. Berkovitz. We are looking at that issue also very
closely. The Dodd-Frank Act states--the extraterritorial
provision in Dodd-Frank states that it applies to an activity
if there is a direct and significant connection with activities
in or effect on U.S. commerce.
So we are looking in evaluating at what type of activities
that reaches overseas. We are talking to U.S. banks and U.S.
institutions that have activities overseas. We are talking with
foreign banks that do activities in the U.S., and we are trying
to determine what type of activities and what that connection
is and, therefore, what the requirements might be and which
ones may or may not apply.
Mrs. Schmidt. Okay. Thank you.
The Chairman. The gentlelady yields back.
Mr. David Scott, from Georgia, for 5 minutes.
Mr. David Scott of Georgia. Thank you, Mr. Chairman. I
appreciate your having the hearing.
Mr. Berkovitz, I have had quite a bit of discussion with a
number of industries and companies. I have been very intimately
involved in Dodd-Frank. I serve both on the Financial Services
Committee as well as here on the Agriculture Committee.
The one chief concern that all of them have is the volume,
the pace, and the phasing of the rules and regulations that the
CFTC must create. And, very interestingly, none have complained
about wanting to defund or repeal the law. They have invested
in understanding that this is an important law, that we have an
important issue here. But there are some major, major concerns
and points that I would like to ask you on a number of issues.
But, specifically, I want to ask you about the proposed
rule on ownership of swaps execution facilities. What sort of
weight are you giving to the Department of Justice's comments
about aggregate ownership limits?
Mr. Berkovitz. Obviously, the Department of Justice is a
very significant commenter; and, given their significant
expertise in antitrust issues, issues of competitiveness, this
is something--when they send us a letter, as any Federal agency
would send us a letter, we give it great consideration. We have
also received comments commenting upon the Justice Department
letter, so we are evaluating the comments in response. But they
have written us a very thoughtful letter, and we are giving
that letter very thoughtful consideration.
Mr. David Scott of Georgia. Do you not feel that, given the
large capital requirements for new entrants into the field,
that placing such a requirement could serve as a barrier to
entry and would stifle competition?
Mr. Berkovitz. That is one of the factors that the agency
is considering in determining where to come out on this issue.
Mr. David Scott of Georgia. Mr. Berkovitz, what do you
think? What do you think? Do you personally think it would
stifle the competition?
Mr. Berkovitz. I personally haven't examined that issue in
that great a detail. And my role would be--there are other
folks in the agency who would be probably better suited to
actually evaluate the merits on the competitiveness argument
than myself. So I personally haven't weighed in on that
Mr. David Scott of Georgia. But don't you think on the face
of it, just looking at it, that it could be a barrier to entry?
Mr. Berkovitz. I am aware that that is one of the
arguments; and we have arguments on the other side, too. So I
personally would not be able to address that. The Commission
itself is actually going to be addressing that very issue.
Mr. David Scott of Georgia. Let me ask you one other thing.
Can you say definitively that the CFTC has enough people and a
sophisticated enough information technology infrastructure to
do the work that you are tasked with under Dodd-Frank? I mean,
we are in this era of budget cutting. But this is a very, very
complicated field with an awful lot of different layers in the
swaps and the derivatives and foreign markets. Our companies
are having to compete with an array of rather fuzzy
interpretations of what the rule might or might not say. So the
question that I would like to get on the record from you is, do
you feel that you need additional resources?
Mr. Berkovitz. We are thankful that in the latest--if the
current--if the numbers that we are hearing now are enacted,
that we probably have sufficient resources, as I am talking
about just over $200 million for the rest of this fiscal year,
if the reports are accurate and that is indeed the number. We
would have enough resources to get us through the rulemakings.
Mr. David Scott of Georgia. Right now, with the budget as
is?
Mr. Berkovitz. Correct.
Mr. David Scott of Georgia. Let's suppose--because we are
moving through some very choppy waters as far as the budget is
concerned. Let me ask you this. What would happen to your
ability to properly regulate these markets if your budget was
slashed?
Mr. Berkovitz. Well, the President has requested--the
budget request for Fiscal Year 2012 is $308 million. And that
number is what the agency would really need to be able to
effectively implement the Act.
The $200 million again, if it is accurate, if the deal is
as reported and that is approved by the Congress and signed by
the President, would get us through the rulemaking stage.
Mr. David Scott of Georgia. Before my time is up, so you
are saying it would in effect affect your ability to do the job
if your budget is slashed? Is that what you are saying?
Mr. Berkovitz. Yes, Congressman, that is correct.
The Chairman. Mr. Schilling, from Illinois, for 5 minutes.
Mr. Schilling. Thank you, Mr. Chairman.
Welcome. I appreciate you coming out today. I just have a
couple of questions.
Prior to the Dodd-Frank bill, I was told that the CFTC
averaged about 5\1/2\ rulemakings a year; is that accurate?
Mr. Berkovitz. I don't have the exact number, but it sounds
about right.
Mr. Schilling. Okay. And then, since this past October, I
am told that the CFTC has proposed 43 new regulations to
implement this law, and that is probably pretty accurate as
well.
Mr. Berkovitz. That is correct.
Mr. Schilling. I think the one thing that I see--I am one
of the new 87 freshmen Members coming into Congress, and as I
have been out throughout the district, the big thing that we
hear is the over-regulation and overreaching of the Federal
Government is basically keeping a lot of our investors and
people throughout the country sidelined; and that is one of our
big concerns, of course. But can you respond to the concerns
that the CFTC proposes to regulate swaps, the participants, the
same, even though, one is a seller and one is a buyer?
Mr. Berkovitz. Well, generally, the statute provides for
swap dealers and major swap participants certain business
conduct standards, certain capital requirements, certain
institutional requirements that the institution has to meet,
regardless of whether a particular transaction is a buy or a
sell. These are very large institutions, so--and, generally,
they are going to be doing both types of transactions. So our
regulations are designed to capture the transactions that these
institutions do.
If there is a particular circumstance where a particular
business conduct standard or a requirement may or may not be
applicable to a seller or a buyer, we would look at that in the
individual context of a particular rulemaking. But, generally,
the swap dealers and major swap participants are very large
institutions that do a lot of both buying and selling.
Mr. Schilling. Okay. Very good.
With that, I yield back.
The Chairman. The gentleman yields back.
The gentleman from Connecticut, Mr. Courtney, for 5
minutes.
Mr. Courtney. Thank you, Mr. Chairman; and thank you for
this hearing. Again, I have great respect for your stewardship
on this Committee, and I am glad we are holding this hearing.
I have to say I look at it a little bit differently than
some of the other questioners this morning.
Yesterday, Reuters reported that Goldman Sachs analyzed oil
prices and determined that the price per barrel was inflated by
speculation to the tune of $27 per barrel. In Connecticut right
now, we are paying $4 a gallon for gas. I mean, you can do the
math pretty quickly, but that means basically motorists should
be paying about $3 a gallon.
People who are getting their home heating oil are also
overpaying because of the fact that we have markets which I
think are highly dysfunctional. You know, businesses in my
district who sell home heating oil have basically refused to
get into the business of hedging right now. They will not sell
lock-in contracts for next winter because this market is so
dysfunctional.
And, frankly, CFTC had the authority to implement position
limits back in January. And, if anything, from my perspective
you are being too cautious in terms of moving ahead with what
Dodd-Frank suggested.
And I would just say, following up Mr. Scott's question, in
terms of your budget, Secretary Mabus testified at Armed
Services that every time a price per barrel goes up $10 the
Navy's annual fuel costs go up $300 million.
So, again, if you just do the math in terms of what Goldman
Sachs reported yesterday, the taxpayer is paying double your
budget that the President proposed because of the fact that we
don't have a functioning system of rules in energy trading.
I have just got to tell you, Mr. Berkovitz, the impact on
the economy in terms of energy prices right now is just
potentially catastrophic in terms of trying to get a recovery
moving forward. I hope that you are going to move forward on
those position limits on energy trading as soon as possible. I
mean, people are, in my opinion, getting ripped off because of
the fact that the markets are not functioning in a way that is
connected to supply and demand.
And I don't know if you would like to comment on that.
Mr. Berkovitz. Thank you, Congressman. I will take that
back and will consider those comments.
I know that the Commission staff is devoting considerable
time. We are receiving a lot--one of the most commented on
rules--proposed rules we have out there is the position limits
rule; and we have had thousands, literally thousands, of
comments. Some of them are foreign comments, but, nonetheless,
we have to go through and look at all of these. So we are going
through those comments and evaluating that proposal very
seriously.
Yesterday, I would also note that the agency--Chairman
Gensler and the agency announced a joint effort with the
Federal Trade Commission to look at some of these issues where
the FTC has oversight authority over oil and gasoline prices,
the actual commodity itself, market oversight there; and so we
have announced a cooperative effort with them.
Mr. Courtney. Well, again, I just think it is important to
also remember that there are end-users who now are shying away
from getting involved in hedging. I mean, Hershey's announced
the other day that it was pulling back because, again, the
commodities market makes chocolate hedging almost impossible to
really make an intelligent decision.
Commissioner Chilton sent a letter to my office a couple of
days ago sort of walking through again the sequence that took
place as far as the energy position limits. I know he supports
moving forward; and I, again, think his advocacy hopefully will
be heard by the rest of the Commission. I really believe that,
for the sake of the economy, we have to get some stability in
energy prices, because it just ripples through from every home
owner, motorist, small business on up. And it is really bad out
there.
Mr. Berkovitz. Thank you.
Mr. Courtney. I yield back.
The Chairman. Mr. Crawford, from Arkansas, 5 minutes.
Mr. Crawford. Thank you, Mr. Chairman.
Mr. Berkovitz, it seems to me the most commonsense approach
to the rulemaking process would have been to start with
defining swap. Yet you proposed nearly all of your rules but
have not defined what a swap is, and I wonder why you have
waited until the very end to define a building block of the
entire title.
Mr. Berkovitz. The swap definition in rulemaking is a joint
rulemaking with the Securities and Exchange Commission. We
hope--and we are working with the SEC staff very closely. We
hope to have that proposed rule out very soon, in the next few
weeks, actually, is our hope. I obviously can't guarantee that,
but we do intend to get that out very soon.
Mr. Crawford. Okay. I have some real concerns about what
this excessive rulemaking might do for end-users in my
district, for example, the farmers. That under extreme pressure
the Federal budget is tasked with taking some of the support
away from farmers, and so they are going to have to move into a
free market approach to how they cash-flow their operations. My
concern is that the rules that we are seeing right now may
hinder, may actually make it less attractive for them to avail
themselves of these free market tools. Can you explain how this
is going to affect the average--say, the average cotton farmer
or the average soybean farmer and how they implement a strategy
for risk management under these excessive rules?
Mr. Berkovitz. There are two possible risk management tools
that people would use--or the ones that we would regulate that
folks would use. That would be the futures market or the swaps
market.
Most of Dodd-Frank and the rules that we are doing go to
the swaps market. There are some of the rules that we do that
affect the futures side. But those rules shouldn't
fundamentally affect the ability--on the futures side shouldn't
affect the fundamental ability of the farmer to use our futures
market for hedging.
On the swap side, Congress has provided a number of
exemptions for end-users, such as the exemption from clearing.
So there wouldn't be--if a farmer were using a swap rather than
a future--and, generally, the agriculture swap market is not--
folks use the futures market more than the swaps market. But if
people didn't want to use swaps, didn't want to use these risk
management tools, there would be the end-user exemption that a
farmer, if they were using these for hedging, would qualify
under.
So we have met a lot with farm co-ops, organizations of
end-users, hearing those concerns. We have put out a proposed
rule to implement the end-user exception which we have gotten a
lot of comments on. And so we are meeting and we are--we hear
the, as I talked about in my statement, the intent of Congress
that folks that are using these markets for hedging and to
mitigate their commercial risks, that those typical end-users
are the lower risk activities and that there should be much--
there should be less regulatory burden on those types of
entities. And so we are meeting and trying to achieve that
Congressional intent.
Mr. Crawford. All right. Thank you, sir.
I yield back.
The Chairman. Mr. Kissell, from North Carolina, for 5
minutes.
Mr. Kissell. Thank you, Mr. Chairman. Thanks to the witness
for being here today. I apologize for being late.
But I want to follow up a little bit what my colleague, Mr.
Courtney, was asking you about when he mentioned that Hershey's
was pulling away from the market. Why do you think that might
be? And what do you think it would take to calm those nerves so
that people like Hershey's would have--get back in, have the
confidence, so forth, so on? What are your thoughts on such a
move?
Mr. Berkovitz. I wouldn't know why in particular a firm
would or would not be using the market less right now. I don't
know whether that would be related to if there is an increase
in the commodity price that would increase the margin cost of a
futures contract or something like that, or if it is a
different type of business decision.
But, typically, when prices--in an area of higher prices,
there might be higher costs for using these markets. But I
don't know whether that is in fact the situation or not.
Mr. Kissell. Okay. Mr. Gensler, when he testified, talked
about, and Members talked a lot about, using the cost-benefit
analysis to determine how certain things should be. But, that
has been a requirement even prior to Dodd-Frank. I am just
wondering if you see any different use of cost-benefit analysis
and how they might be used to come up with some of the rules
and how this bill moves forward.
Mr. Berkovitz. Yes. Our fundamental approach to cost-
benefit analysis is still governed by section 15(a) of the
Commodity Exchange Act. That is the section that directs us to
do cost-benefit analysis. So it is not changed by Dodd-Frank.
So, fundamentally, the agency's approach is the same under the
statute as it had been prior.
We have gotten a lot of comments in response to specific
cost-benefit analysis in specific rules in saying you didn't
consider this cost adequately, you didn't consider that cost
adequately, you didn't provide enough detail. So we have gotten
specific comments, and we are addressing the comments on a
rule-by-rule basis as they come in on these specific analyses
within the overall statutory framework.
In addition, the President's Executive Order in January had
a number of principles in terms of how to conduct cost-benefit
analysis. We are also looking at that to see where those
principles are consistent with our statutory direction, whether
those can also be incorporated. Because that has been somewhat
of an overarching comment that we have received. So the
fundamental approach is the same. The statute is the same as it
has been. But in response to these comments and concerns, the
President's Executive Order we are seeing how we can adjust
what we do.
Mr. Kissell. Okay. Thank you, sir.
Mr. Chairman, I yield back.
The Chairman. The gentleman from New York, Mr. Gibson, for
5 minutes.
Mr. Gibson. Thank you, Mr. Chairman.
Mr. Berkovitz, I appreciate your being here. I am learning
from your testimony here.
I represent a district in New York, and I am going to ask
about a couple of different areas, the first one with regard to
financial services and the other one with regard to our near
and dear farmers.
The first one is listening carefully and reading Mr.
Gensler's speeches, one of the things that he has talked about
is harmonizing, going forward, our rules promulgation with
Europe and Asian markets so that we can synchronize our
efforts. And I appreciate those remarks very much. But are you
concerned that if we get out in front of Europe and Asia in
terms of effectuating these rules that we will lose jobs in
financial services overseas?
Mr. Berkovitz. Congressman, as you mentioned, the agency
and the Chairman have been spending a considerable amount of
time on the harmonization and speaking with the Europeans. The
potential job issue is one of a subset of the general notion
that if the regulations are different that is going to affect--
people may trade in jurisdictions that have lesser regulations
and that would have effects on jobs and have effect on
potentially the safety and soundness of our system. So that,
overall, plays into the rationale for trying to get
harmonization. So----
Mr. Gibson. Well, indeed. And I want to affiliate myself
with that and just say that that is what concerns me about the
timing of all this, is that in the effort to work with the
Chairman, work with Mr. Gensler in terms of harmonizing
efforts, that we ought to take that into consideration, Mr.
Chairman, when we look at the timing of the promulgation of
rules. Thank you.
The second point, there is a perception back home among my
farmers that how you make definitions and in particular--for
example, an organization's co-bank, how they are defined will
have an impact on farm credit and ultimately impact our
farmers, restricting access to necessary credit. What would you
say to me that I can carry back to them about how you would be
sensitive to that so that our farmers will continue to have
access to the credit they need, moving forward?
Mr. Berkovitz. The issue of farm credit is being looked at
in the context of one of our rules where we have asked for
public comment on the end-user exception, and so we are
accepting public comment on that very issue. So we have met
with a number of farm cooperatives, smaller institutions, in
terms of how the agricultural markets are structured and how
farmers are able to hedge and use the markets to hedge and the
institutions that are available there. So we have had a number
of meetings with institutions, and that is a concern that has
been brought to our attention, which we are considering in the
various context of the rules.
Mr. Gibson. Okay. I appreciate those remarks.
Mr. Chairman, I will just sum up by saying that these are
two areas I am going to continue to monitor very closely. I
think we can agree that we are not really in a place of
certainty, so that more work needs to be done. I do want to
express that I am concerned about the timing of all these rules
promulgation and want us to be sensitive of that going forward.
And with that, Mr. Chairman, I yield back.
The Chairman. The gentleman yields back.
I have a couple of other questions as well. Let's do
another round if folks want. So we will start another 5 minutes
on me.
The broad statement first in reference to some comments
that our colleague from Connecticut made, is it the role of the
CFTC to set prices for all these commodities?
Mr. Berkovitz. We are not a price-setting agency. Our
mission is to ensure the markets are fair.
The Chairman. But he seemed to imply that somehow the CFTC
could set the price for cocoa or gasoline or whatever. So I
just wanted to make that clear.
Is there anything in 15(a), the CEA, that precludes you
specifically from folding in the President's Executive Order
into your cost-benefit analysis work? What gets excluded?
Because you make kind of a little reference to that.
Mr. Berkovitz. Right. That is what we have been looking at
to the extent that we can incorporate elements from the
President's Executive Order into our analysis.
The Chairman. Okay. Let me ask you a broader question. You
will soon have most all the rules proposed. Is there under the
Administrative Procedures Act or your rules that would allow,
for lack of a better phrase, an interim final set that would
allow the industry to look at the entire mosaic of rules that
are there that they are going to have to comply with? This way
they have some period of time that would allow them to make
comments that would say here is an unintended consequence that
would then allow the agency the time to be able to respond to
that before we get too far down the road with this big brush?
What I have heard the Chairman say, is that we have the
rules out there and the industry can look at those, which
implies that the proposed rules will be the final rules. And if
that is the case, then all of this work that your testimony
talks about--and the Chairman's done a great job of saying we
are taking these comments, we are folding them in. Is there a
way that, once the rules go final, that there will be a period
where the agency can take account and the industry can show you
where these things may have gotten cross-threaded because we
have done them in various pieces? Is there something in the
Administrative Procedures Act that you guys can avail
yourselves of that would get them final but yet not so final
that you have to go through an Act of Congress, so to speak, to
address unintended consequences if those final rules do
something that we don't want to be done?
Mr. Berkovitz. I do think that the Administrative Procedure
Act provides us flexibility for taking into account public
comments as the process goes forward, and I think that is what
we have attempted to do so far. We are nearing the completion,
as I mentioned, of the proposed rule stage. We have three or
four----
The Chairman. This speaks to us about beyond that. When you
do decide this is what it ought to look like and you have it
done across the entirety of what you are trying to do, then the
industry has a chance to know whether or not they were a swap
dealer, whether or not they are a major participant, all these
things to fit together. If we see a gap in the regulations, or
regulations that overlap and do too much before those get so
ingrained into the system and caused harm to it that you could
address that quickly and nimbly.
Mr. Berkovitz. I think so. I think the Act provides us that
flexibility so that, as rules begin to finalize, if there is
something in a final rule that affects--in one final rule that
affects a rule that is still in the proposal stage, that people
still would have potentially, depending on the exact sequence
and the exact rule, the opportunity to comment and say, well,
wait a minute. You just went final here. This affects something
that is yet--that is still in the proposal stage.
The Chairman. I guess I was trying look for something like
that once it is all done, once everything is final. All the
final rules are done, the system would have a chance to look at
all of that, you as well.
And I am apparently not being very articulate in asking the
question, or you are being very artful in saying, no, there is
no way that the agency can provide for an opportunity to look
at all of these, once they are done. Is there a final rule--
that may be an inappropriate term--but to look at the whole
thing other than just piecemeal it across. As you see the
bullet box come in, in whatever order that they decide that you
are coming in, your view is that that is adequate for the
industry to be able to respond, to be able to put in place
systems that they are going to have put in place, even in spite
of the fact of knowing unintended consequences.
Mr. Berkovitz. Well, I am not trying to avoid the question,
but we are attempting to do that. What you have described is
what the roundtables and the implementation roundtables are
doing.
The Chairman. Those are going to happen, though, before
anything is final.
Mr. Berkovitz. And whether a similar process would happen
further down the road at the final stage, we could evaluate
then.
The Chairman. Okay. I am not trying to be argumentative. I
am just trying to get the best answer.
I mean, everybody knows that there is going to be some
regulatory things that have to happen. But they ought to make
sense, they ought to do the minimum damage, and they ought to
cost--allow the industry to comply with them in the most cost-
effective manner possible. And so I think that is the goal.
Mr. Berkovitz. If you are asking in terms of the
Administrative Procedure Act is this something that
procedurally would be permissible, I think the answer is, yes,
and the Commission would decide at the time whether to do it.
The Chairman. Okay. Thank you.
Mr. Boswell for 5 minutes.
Mr. Boswell. I yield.
The Chairman. Anyone else?
Mr. Berkovitz, thank you for coming today. We appreciate
this open exchange. I didn't mean to imply that you were
evading the question. I just couldn't get you to say what I
wanted you to say. But thank you for being here today. I
appreciate that.
Hopefully, there will be enough difference between the
proposed rules and the final rules that the industry can look
at all those comments, the thousands of hours of work done and
untold amount of lawyer fees invested in putting comments to
you, that those had an impact, that had an effect on making
these rules better as we move forward. So we continue to look
forward to working with you on this whole process.
Mr. Berkovitz. Absolutely. Thank you.
The Chairman. We will now have our second panel, if you
wouldn't mind coming to the table, and we will start our second
round.
I want to welcome our second panel of witnesses. This
actually is a panel, since there is more than one of you.
First up will be Terry Duffy, the Executive Chairman of
CME, Inc., in Chicago, Illinois.
We will then hear from Mr. Hal Scott, Director of Committee
on Capital Markets Regulation, Nomura Professor and Director of
the Program on International Financial Systems at Harvard Law
School, Cambridge, Massachusetts.
We will then hear from Dr. James Overdahl, the Vice
President of the National Economic Research Associates here in
Washington, D.C.
Then, Ms. Karrie McMillan, General Counsel for the
Investment Company Institute here in Washington.
And then, Mr. Michael Greenberger, Professor, University of
Maryland School of Law, Baltimore, Maryland.
So, gentlemen, and lady, thank you for being here.
Mr. Duffy, if you wouldn't mind starting us off, please.
STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME
GROUP, INC., CHICAGO, IL
Mr. Duffy. Well, thank you. Thank you, Chairman Conaway,
Ranking Member Boswell, Members of the Committee. And I thank
you for the opportunity to testify on the implementation of the
Dodd-Frank Wall Street Reform and Consumer Protection Act.
I am Terry Duffy, Executive Chairman of CME Group, which
includes our clearinghouse and our four exchanges: the CME, the
Chicago Board of Trade, New York Mercantile Exchange, and the
COMEX.
In 2000, Congress adopted the Commodity Futures
Modernization Act. This leveled the playing field with our
foreign competitors and permitted us to recapture our position
as the world's most innovative and successful regulated
exchange and clearinghouse. As a result, we remain an engine of
economic growth in Chicago, New York, and the nation.
The 2008 financial crisis focused attention on over-
leveraged, under-regulated banks and financial firms. In
contrast, regulated futures markets and futures clearinghouses
operated flawlessly before, during, and after the crisis.
Congress responded to the financial crisis by reining in
the OTC market to reduce systemic risk through central clearing
and exchange trading of derivatives, to increase data
transparency and price discovery, and to prevent fraud and
market manipulation. We support these goals, but we are
concerned that the CFTC has launched an initiative to undo
modern regulation of futures exchanges and clearinghouses.
We are not alone. Most careful observers and some
Commissioners have concluded that many of the proposed
regulations roll back principle-based regulation and
unnecessarily expand the Commission's mandate. In so doing, the
Commission acts outside of its rulemaking authority under the
Dodd-Frank Act and, in many cases, undermines the intent behind
Dodd-Frank.
When Dodd-Frank passed, Congress specifically maintained
principles-based regulation for the futures market. It extended
that approach to the newly regulated swaps market. This would
create core principles for swap execution facilities as well as
swap data repositories.
The intent of Dodd-Frank was not to fundamentally change
the regulation of futures markets; rather, the primary goal was
to close existing regulatory gaps. This would bring swaps which
were largely unregulated into a regulated framework similar to
that which was successful in futures markets. Instead, the CFTC
has proposed to drastically alter the futures regulatory
framework and create a parallel framework for swaps. The CFTC
has proposed extraordinary prescriptive rules. This would, in
effect, repeal the principles-based regulatory approach that
has existed for more than a decade.
In short, the CFTC is attempting to change its role. It is
an oversight agency. Its purpose is to assure compliance with
sound principles. Now it appears as if they are trying to
become a frontline decision-maker, empowered to impose its
business judgments on every operational aspect of derivatives
trading and clearing. This role reversal is inconsistent with
Dodd-Frank.
The listed futures markets performed flawlessly throughout
the financial crisis. Imposing needless regulatory burdens on
these markets will create unnecessary strain on the
Commission's staff and budget. It will also impose unnecessary
costs on the industry and the end-users of derivatives. My
written testimony includes numerous examples of proposed rules
that exceed the boundaries of the Commission's rulemaking
authority under Dodd-Frank.
Further, in proposing rules, the Commission has
consistently failed to conduct a proper cost-benefit analysis,
as required by Section 15 of the Commodity Exchange Act.
Congress should require the CFTC to operate within the
limitations of its authority under Dodd-Frank. This means
encouraging a full and fair cost-benefit analysis on every
proposal.
Also, by extending Dodd-Frank's effective date, it would
permit a realistic opportunity to comment on a full package and
its cost and benefits. Otherwise, we believe that the futures
industry will be burdened by overly prescriptive regulations
that are inconsistent with Dodd-Frank and sound industry
practices. This will make it more difficult to reach Dodd-
Frank's goal of increasing transparency and limiting risk.
Before I close, I would like to touch on one question that
was asked by a Member about regulatory disparities amongst
countries. The word we were looking for would be called
arbitrage. And arbitrage means when there is one price at one
particular place and one price at a different place. If we were
to have regulations here in the United States somewhat
different than is taking place in Europe or in Asia, that would
be considered an arbitrage. People would go to the less-
regulated marketplace because the costs are much different.
This will drive jobs away from the United States of America
and drive capital and finance out of the United States of
America. Mr. Berkovitz did not answer that question directly,
but I would like to just, for the record, answer it. I do
believe it will drive jobs out. Arbitrage is exactly what it
is; it is inefficiencies. And if we have something and someone
else doesn't, they are going to go to that platform.
I thank the Committee for its time and look forward to your
questions.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman, CME
Group, Inc., Chicago, IL
Subcommittee Chairman Conway, Ranking Member Boswell, Chairman
Lucas, Ranking Member Peterson, Members of the Committee, thank you for
the opportunity to testify on the implementation of Title VII of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-
203, July 21, 2010) (``DFA''). I am Terry Duffy, Executive Chairman of
CME Group (``CME Group'' or ``CME''), which is the world's largest and
most diverse derivatives marketplace. CME Group includes four separate
exchanges--Chicago Mercantile Exchange Inc. the Board of Trade of the
City of Chicago, Inc., the New York Mercantile Exchange, Inc. and the
Commodity Exchange, Inc. (together ``CME Group Exchanges''). The CME
Group Exchanges offer the widest range of benchmark products available
across all major asset classes, including futures and options based on
interest rates, equity indexes, foreign exchange, energy, metals,
agricultural commodities, and alternative investment products. CME also
includes CME Clearing, a derivatives clearing organization and one of
the largest central counterparty clearing services in the world; it
provides clearing and settlement services for exchange-traded
contracts, as well as for over-the-counter (``OTC'') derivatives
transactions through CME Clearing and CME ClearPort'.
The CME Group Exchanges serve the hedging, risk management and
trading needs of our global customer base by facilitating transactions
through the CME Globex' electronic trading platform, our
open outcry trading facilities in New York and Chicago, as well as
through privately negotiated transactions executed in compliance with
the applicable Exchange rules and cleared by CME's clearing house. In
addition, CME Group distributes real-time pricing and volume data
through a global distribution network of approximately 500 directly
connected vendor firms serving approximately 400,000 price display
subscribers and hundreds of thousands of additional order entry system
users. CME's proven high reliability, high availability platform
coupled with robust administrative systems represent vast expertise and
performance in managing market center data offerings.
The financial crisis focused well-warranted attention on the lack
of regulation of OTC financial markets. We learned a number of
important lessons and Congress crafted legislation that, we hope,
reduces the likelihood of a repetition of that disaster. However, it is
important to emphasize that regulated futures markets and futures
clearing houses operated flawlessly. Futures markets performed all of
their essential functions without interruption and, despite failures of
significant financial firms, our clearing house experienced no default
and no customers on the futures side lost their collateral or were
unable to immediately transfer positions and continue managing risk.
Dodd-Frank was adopted to impose a new regulatory structure on a
previously opaque and unregulated market--the OTC swaps market. It was
not intended to re-regulate the robustly regulated futures markets.
For example, while Congress granted the Commission the authority to
adopt rules respecting core principles, it did not direct it to
eliminate principles-based regulation. DFA rather reinforced the
principles-based regime for regulated futures exchanges and clearing
houses by adding new core principle obligations and extending this
principles-based regime to swap execution facilities (``SEFs'') and
swap data repositories as well. Yet the Commission has proposed
specific requirements for multiple Core Principles--almost all Core
Principles in the case of designated contract markets (``DCMs'')--and
effectively eviscerate the principle-based regime that has fostered
success in CFTC-regulated entities for the past decade.
The Commission's almost complete reversion to a prescriptive
regulatory approach converts its role from an oversight agency,
responsible for assuring self regulatory organizations comply with
sound principles, to a front line decision maker that imposes its
business judgments on the operational aspects of derivatives trading
and clearing. This reinstitution of rule-based regulation will require
a substantial increase in the Commission's staff and budget and impose
indeterminable costs on the industry and the end-users of derivatives.
Yet there is no evidence that this will be beneficial to the public or
to the functioning of the markets. In keeping with the President's
Executive Order to reduce unnecessary regulatory cost, the CFTC should
be required to reconsider each of its proposals with the goal of
performing those functions that are mandated by DFA.
Further, the principles-based regime of the CFMA has facilitated
tremendous innovation and allowed U.S. exchanges to compete effectively
on a global playing field. Principles-based regulation of futures
exchanges and clearing houses permitted U.S. exchanges to regain their
competitive position in the global market. Without unnecessary, costly
and burdensome regulatory review, U.S. futures exchanges have been able
to keep pace with rapidly changing technology and market needs by
introducing new products, new processes and new methods by certifying
compliance with the CEA. Indeed, U.S. futures exchanges have operated
more efficiently, more economically and with fewer complaints under
this system than at any time in their history. The transition to an
inflexible regime threatens to stifle growth and innovation in U.S.
exchanges and thereby drive market participants overseas. As further
discussed below, this will certainly impact the relevant job markets in
the United States.
We support the overarching goals of DFA to reduce systemic risk
through central clearing and exchange trading of derivatives, to
increase data transparency and price discovery, and to prevent fraud
and market manipulation. Unfortunately, DFA left many important issues
to be resolved by regulators with little or ambiguous direction and set
unnecessarily tight deadlines on rulemakings by the agencies charged
with implementation of the Act. In response to the aggressive schedule
imposed by DFA, the Commodity Futures Trading Commission (``CFTC'' or
``Commission'') has proposed hundreds of pages of new or expanded
regulations.
In our view, many of the Commission's proposals exceed the
boundaries of its authority under DFA, are inconsistent with DFA, not
required by DFA, and/or impose burdens on the industry that require an
increase in CFTC staff and expenditures that could never be justified
if an adequate cost-benefit analysis had been performed. I will discuss
below the Commission's failure to comply with the Congressionally
mandated cost-benefit process, the need to sequence Dodd-Frank
rulemaking appropriately, and the potential negative impact on U.S.
markets of regulatory proposals.
A. Lack of Consideration of Costs of Regulatory Proposals
The Commission's rulemaking has been skewed by its failure to
follow the plain language of Section 15 of the Commodity Exchange Act
(``CEA''), as amended by DFA, which requires the Commission to consider
the costs and benefits of its action before it promulgates a
regulation. In addition to weighing the traditional direct costs and
benefits, Section 15 directs the Commission to include in its
evaluation of the benefits of a proposed regulation the following
intangibles: ``protection of market participants and the public,''
``the efficiency, competitiveness, and financial integrity of futures
markets,'' ``price discovery,'' ``considerations of sound risk
management practices,'' and ``other public interest considerations.''
The Commission has construed this grant of permission to consider
intangibles as a license to ignore the real costs.
The explicit cost-benefit analysis included in the more than thirty
rulemakings to date and the Commission's testimony in a number of
Congressional hearings indicate that those responsible for drafting the
rule proposals are operating under the mistaken interpretation that
Section 15(a) of the CEA excuses the Commission from performing any
analysis of the direct, financial costs and benefits of the proposed
regulation. Instead, the Commission contends that Congress permitted it
to justify its rule making based entirely on speculation about
unquantifiable benefits to some segment of the market. The drafters of
the proposed rules have consistently ignored the Commission's
obligation to fully analyze the costs imposed on third parties and on
the agency by its regulations.
Commissioner Sommers forcefully called this failure to the
Commission's attention at the CFTC's February 24, 2011, Meeting on the
Thirteenth Series of Proposed Rulemakings under the Dodd-Frank Act.
``Before I address the specific proposals, I would like to talk
about an issue that has become an increasing concern of mine--
that is, our failure to conduct a thorough and meaningful cost-
benefit analysis when we issue a proposed rule. The proposals
we are voting on today, and the proposals we have voted on over
the last several months, contain very short, boilerplate `Cost-
Benefit Analysis' sections. The `Cost-Benefit Analysis' section
of each proposal states that we have not attempted to quantify
the cost of the proposal because Section 15(a) of the Commodity
Exchange Act does not require the Commission to quantify the
cost. Moreover, the `Cost-Benefit Analysis' section of each
proposal points out that all the Commission must do is
`consider' the costs and benefits, and that we need not
determine whether the benefits outweigh the costs.''
Commissioner Sommers reiterated her concern with the lack of cost-
benefit analysis performed by the Commission in her March, 30, 2011
testimony before the Subcommittee on Oversight and Investigations of
the House Committee on Financial Services. Commissioner Sommers noted
that ``the Commission typically does not perform a robust cost-benefit
analysis at either the proposed rule stage or the final rule stage''
and noted that ``while we do ask for comment from the public on the
costs and benefits at the proposal stage, we rarely, if ever, attempt
to quantify the costs before finalizing a rule.''
B. Sequencing of Rulemakings Under Dodd-Frank
Chairman Gensler has recently disclosed his plan for the sequencing
of final rulemakings under DFA. He has divided the rulemakings into
three categories: early, middle and late. We agree that sequencing of
the rules is critical to meaningful public comment and effective
implementation of the rules to implement DFA. Many of the rulemakings
required by DFA are interrelated. That is, DFA requires many
intertwined rulemakings with varying deadlines. Market participants,
including CME cannot fully understand the implications or costs of a
proposed rule when that proposed rule is reliant on another rule that
is not yet in its final form. As a result, interested parties are
unable to comment on the proposed rules in a meaningful way, because
they cannot know the full effect.
We agree with many, but not all aspects of the Chairman's proposed
sequencing agenda and have recently proposed an alternative sequencing
agenda to the Commissioners. We recommend that in Phase 1 (early), the
Commission focus on rules that are necessary to bring the previously
unregulated swaps market into the sound regulatory framework that
exists for futures markets. This set of major rulemakings represents
the largest amount of change for the industry and cannot be
satisfactorily addressed in a timely manner if key elements of the
regulatory framework for swaps clearing are not determined until the
middle or late stages of the rulemaking process. Further, the
regulatory framework for reducing systemic risk in OTC derivatives was
the central focus of DFA and therefore should have the highest
priority.
We suggest that Phase II (middle) deal with exchange-trading
requirements for swaps, including the definition of and requirements
for swap trading facilities, business conduct standards for swap
dealers and requirements for swap data repositories. While we support
efforts to increase transparency in swaps markets, we believe these
rulemakings are less critical in time priority than the clearing
mandate and related clearing rules that will reduce systemic risk.
Finally, we recommend that the Commission leave those rulemakings
that deal with DCMs and position limits for Phase III (late). As I
mention throughout my testimony, the exchange-traded derivatives market
operated flawlessly during the financial crisis, and the proposed rules
affecting DCMs and position limits, which as discussed below, often
represent an overstepping of the Commission's authority under DFA,
represent incremental changes to an already robust regulatory scheme.
With respect to the phasing in of the mandatory clearing rules for
swaps, some have suggested that the clearing requirement first be
applied to dealer-to-dealer swaps and then later applied to dealer-to-
customer swaps. CME Group strongly disagrees with this approach insofar
as it may limit clearing competition and customer choice and because,
more importantly, it will disadvantage customers who are preparing for
central counterparty clearing of swaps but are unable to complete their
preparations due to the uncertainty associated with the lack of final
rules. Sell-side and buy-side participants may elect to support or
prefer different clearing solutions depending on how they are owned and
operated, the membership requirements associated with each clearing
house, and the risk management and default management features
associated with each clearing solution. Different clearing houses have
already adopted differing approaches to these features, enhancing
competition and the proliferation of different business models.
Sequencing dealer-to-dealer clearing prior to dealer-to-customer
clearing lacks any rational justification and simply limits the
availability of competing clearing models, potentially limiting
competition, which Congress expressly provided for in DFA.
The theory behind phasing in dealer-to-dealer swaps first is that
dealers will be prepared to begin clearing swaps before buy-side
participants are likewise prepared. This rationale, however, is not
based in fact. An overwhelming number of buy-side participants are
already clearing or ready to clear or will be ready to clear in the
near future. Ten buy-side firms are already clearing at CME Group.
Another 30 are testing with us and have informed us that they are
planning to be prepared to clear no later than July 15. Another 80 buy-
side firms are in the pipeline to clear with us and would like to be
ready to clear voluntarily approximately 3-6 months before mandated to
do so. Also, UBS recently conducted a comprehensive study (March 10,
2011) of OTC derivatives market participants to gauge the readiness on
the buy-side for this transition. Their study found that buy-side firms
are increasingly prepared to clear OTC derivatives, reporting that 73%
of firms are already clearing or preparing to clear, 71% expect to
begin clearing within 12 months, and 82% expect that the majority of
their OTC businesses will be cleared within 2 years. Claims that buy-
side participants are not ready to clear are simply false and will
disadvantage buy-side firms that wish to reduce bilateral clearing
risks by adopting central counterparty clearing as soon as possible.
We believe that the most efficient way to implement the clearing
mandate is to phase in the mandate on a product-class by product-class
basis. Once the CFTC defines ``class,'' it can mandate that large
classes of instruments, such as 10 year interest rate swaps, be cleared
regardless of the counterparties to the trade. This approach will (i)
preserve customer choice in clearing, (ii) bring the largest volume of
swaps into clearing houses as soon as possible, and (iii) allocate the
Commission's limited resources in an efficient manner. CME Group's
letter to Chairman Gensler, which discusses our position on both
sequencing of rulemaking and sequencing of implementation of the
clearing mandate in greater detail, is attached for your reference as
Exhibit A.
The Commission should avoid creating an un-level playing field
among large swap market participants--both in terms of freedom to
choose among competing clearing offerings and in terms of their ability
to reduce bilateral credit risks in a timely fashion. Congress wisely
recognized that major swap participants that are not swap dealers can
also pose systemic risks to the marketplace; hence the Commission
should sequence rules applying to swap dealers and major swap
participants at the same time.
This Congress can mitigate some of the problems that have plagued
the CFTC rulemaking process by extending the rulemaking schedule so
that professionals, including exchanges, clearing houses, dealers,
market makers, and end-users can have their views heard and so that the
CFTC will have a realistic opportunity to assess those views and
measure the real costs imposed by its new regulations. Otherwise, the
unintended adverse consequences of those ambiguities and the rush to
regulation will impair the innovative, effective risk management that
regulated exchanges have provided through the recent financial crisis
and stifle the intended effects of financial reform, including the
clearing of OTC transactions.
C. Impact of Regulatory Proposals on U.S. Markets
Several Commissioners clearly recognize the potential unintended
consequences and the potential detrimental effects of a prescriptive,
rather than principles-based, regime upon the markets. Commissioner
Dunn, for example, expressed concern that if the CFTC's ``budget woes
continue, [his] fear is that the CFTC may simply become a restrictive
regulator. In essence, [it] will need to say `No' a lot more . . . No
to anything [it does] not believe in good faith that [it has] the
resources to manage'' and that ``such a restrictive regime may be
detrimental to innovation and competition.'' \1\ Commissioner O'Malia
has likewise expressed concern regarding the effect of proposed
regulations on the markets. More specifically, the Commissioner has
expressed concern that new regulation could make it ``too costly to
clear.'' He noted that there are several ``changes to [the] existing
rules that will contribute to increased costs.'' Such cost increases
have the effect of ``reducing the incentive of futures commission
merchants to appropriately identify and manage customer risk. In the
spirit of the Executive Order, we must ask ourselves: Are we creating
an environment that makes it too costly to clear and puts risk
management out of reach'' \2\
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\1\ Commissioner Dunn stated: ``Lastly, I would like to speak
briefly about the budget crisis the CFTC is facing. The CFTC is
currently operating on a continuing resolution with funds insufficient
to implement and enforce the Dodd-Frank Act. My fear at the beginning
of this process was that due to our lack of funds the CFTC would be
forced to move from a principles based regulatory regime to a more
prescriptive regime. If our budget woes continue, my fear is that the
CFTC may simply become a restrictive regulator. In essence, we will
need to say `No' a lot more. No to new products. No to new
applications. No to anything we do not believe in good faith that we
have the resources to manage. Such a restrictive regime may be
detrimental to innovation and competition, but it would allow us to
fulfill our duties under the law, with the resources we have
available.'' Commissioner Michael V. Dunn, Opening Statement, Public
Meeting on Proposed Rules Under Dodd-Frank Act (January 13, 2011)
http://www.cftc.gov/PressRoom/SpeechesTestimony/
dunnstatement011311.html.
\2\ In Facing the Consequences: ``Too Costly to Clear,''
Commissioner O'Malia stated: ``I have serious concerns about the cost
of clearing. I believe everyone recognizes that the Dodd-Frank Act
mandates the clearing of swaps, and that as a result, we are
concentrating market risk in clearinghouses to mitigate risk in other
parts of the financial system. I said this back in October, and
unfortunately, I have not been proven wrong yet. Our challenge in
implementing these new clearing rules is in not making it `too costly
to clear.' Regardless of what the new market structures ultimately look
like, hedging commercial risk and operating in general will become more
expensive as costs increase across the board, from trading and
clearing, to compliance and reporting.''
``In the short time I have been involved in this rulemaking
process, I have seen a distinct but consistent pattern. There seems to
be a strong correlation between risk reduction and cash. Any time the
clearing rulemaking team discusses increasing risk reduction, it is
followed by a conversation regarding the cost of compliance and how
much more cash is required.''
``For example, there are several changes to our existing rules that
will contribute to increased costs, including more stringent standards
for those clearinghouses deemed to be systemically significant. The
Commission staff has also recommended establishing a new margining
regime for the swaps market that is different from the futures market
model because it requires individual segregation of customer
collateral. I am told this will increase costs to the customer and
create moral hazard by reducing the incentive of futures commission
merchants to appropriately identify and manage customer risk. In the
spirit of the Executive Order, we must ask ourselves: Are we creating
an environment that makes it too costly to clear and puts risk
management out of reach?'' Commissioner Scott D. O'Malia, Derivatives
Reform: Preparing for Change, Title VII of the Dodd-Frank Act: 732
Pages and Counting, Keynote Address (January 25, 2011)
http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-3.html.
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Additionally, concern has been expressed regarding unduly stringent
regulation driving major customers overseas; indeed, we have already
seen this beginning to happen with only the threat of regulation. For
example, Commissioner Sommers has noted that she was troubled by the
lack of analysis of swap markets and of whether the proposal would
`cause price discovery in the commodity to shift to trading on foreign
boards of trade,' and that ``driving business overseas remains a long
standing concern.''
Conclusion
Attached to my testimony are just a few examples where the
Commission has proposed rules inconsistent with DFA or that impose
unjustified costs and burdens on both the industry and the Commission.
As previously noted, CME Group has great concern about the number of
unnecessary and overly burdensome rule proposals aimed at the regulated
futures markets. The goal of Dodd-Frank was to bring transparency,
safety and soundness to the over-the-counter market, not re-regulate
those markets which have operated transparently and without default.
However, given the CFTC has determined to issue numerous rules above
and beyond what is statutorily required by DFA, we ask this Congress to
extend the rulemaking schedule under DFA to allow time for industry
professionals of various viewpoints to fully express their views and
concerns to the Commission and for the Commission to have a realistic
opportunity to assess and respond to those views and to realistically
assess the costs and burdens imposed by the new regulations. To this
end, we urge the Congress to ensure that the Commission performs a
proper cost-benefit analysis, taking into account real financial costs
to market participants, before the proposal or implementation of rules
promulgated under DFA. The imposition of unnecessary costs and
restrictions on market participants can only result in the stifling of
growth of the U.S. futures industry, send market participants to
overseas exchanges, and in the end, result in harm to the U.S. economy
and loss of American jobs. We urge the Congress to ensure that
implementation of DFA is consistent with the Congressional directives
in the Act and does not unnecessarily harm hedging and risk transfer
markets that U.S. companies depend upon to reduce business risks and
increase economic growth.
Appendix
Concerns Regarding Specific Rulemakings
We are concerned that many of the Commission's proposed rulemakings
go beyond the specific mandates of DFA, and are not legitimately
grounded in evidence and economic theory. I will now address, in turn,
several proposed rules issued by the Commission that illustrate these
problems.
1. Advance Notice of Proposed Rulemaking on Protection of Cleared Swaps
Customers Before and After Commodities Broker Bankruptcies \3\
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\3\ 75 Fed. Reg. 75162 (proposed Dec. 2, 2010) (to be codified at
17 CFR pt. 190).
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In its Advanced Notice of Proposed Rulemaking (``ANPR'') regarding
segregation of customer funds, the Commission notes that it is
considering imposing an ``individual segregation'' model for customer
funds belonging to swaps customers. Such a model would impose
unnecessary costs on derivatives clearing organizations (``DCOs'') and
customers alike. As noted in the ANPR, DCOs have long followed a model
(the ``baseline model'') for segregation of collateral posted by
customers to secure contracts cleared by a DCO whereby the collateral
of multiple futures customers of a futures commission merchant
(``FCM'') is held together in an omnibus account. If the FCM defaults
to the DCO because of the failure of a customer to meet its obligations
to the FCM, the DCO is permitted (but not required), in accordance with
the DCO's rules and CFTC regulations, to use the collateral of the
FCM's other futures customers in the omnibus account to satisfy the
FCM's net customer futures obligation to the DCO. Under the baseline
model, customer collateral is kept separate from the property of FCMs
and may be used exclusively to ``purchase, margin, guarantee, secure,
transfer, adjust or settle trades, contracts or commodity option
transactions of commodity or option customers.'' \4\ A DCO may not use
customer collateral to satisfy obligations coming out of an FCM's
proprietary account.
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\4\ See, Reg. 1.20(a).
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In its ANPR, the Commission suggests the possibility of applying a
different customer segregation model to collateral posted by swaps
customers, proposing three separate models, each of which requires some
form of ``individual segregation'' for customer cleared-swap accounts.
Each of these models would severely limit the availability of other
customer funds to a DCO to cure a default by an FCM based on the
failure of a customer to meet its obligations to the DCO. The
imposition of any of these alternative models first, is outside of the
Commission's authority under DFA and second, will result in massive and
unnecessary costs to DCOs as well as to customers--the very individuals
such models are allegedly proposed to protect.
CME Group recognizes that effective protection of customer funds
is, without a doubt, critical to participation in the futures and swaps
markets. This fact does not, however, call for a new segregation
regime. The baseline model has performed this function admirably over
the years, with no futures customers suffering a loss as a result of an
FCM's bankruptcy or default. There is no reason to believe it will not
operate as well in the swaps market. DFA did nothing to change this
segregation regime as applied to futures, and a focus of Dodd-Frank is
to bring the OTC swaps market into a regulatory scheme similar to that
which allowed the futures markets to function flawlessly throughout the
financial crisis. To this end, it is nonsensical that Congress would
intend to require a different scheme of segregation of customer funds
and as a result, a different margining and default model than that
currently used in the futures markets. Imposing such a conflicting
model would complicate the function of DCOs intending to clear both
futures and swaps. Indeed, the statutory language adopted in Section
724 of DFA does nothing to compel such a result.
The imposition of a different customer segregation system could
undermine the intent behind DFA by imposing significantly higher costs
on customers, clearing members, and DCOs intending to clear swaps and
injecting moral hazard into a system at the customer and FCM levels. A
change from the baseline model would interfere with marketplace and
capital efficiency as DCOs may be required to increase security
deposits from clearing members. That is, depending on the exact
methodology employed, DCOs may be forced to ask for more capital from
clearing members. Based on CME Group's initial assessments, these
increases in capital requirements would be substantial. For example,
CME Group's guarantee fund would need to double in size. Aside from
these monetary costs, adoption of a segregation model would create
moral hazard concerns at the FCM level. That is, the use of the new
proposed models could create a disincentive for an FCM to offer the
highest level of risk managements to its customers if the oversight and
management of individual customer risk was shifted to the clearing
house and continue to carry the amount of excess capital they do today.
Imposition of the suggested systems could increase costs and
decrease participation in the CFTC-regulated cleared-swaps market
because customers may be unable or unwilling to satisfy resultant
substantially increased margin requirements. FCMs would face a variety
of increased indirect costs, such as staffing costs, new systems and
compliance and legal costs and direct costs such as banking and
custodial fees. FCMs would likely, in turn, pass these costs on to
customers. Additionally, smaller FCMs may be forced out of business,
larger FCMs may not have incentive to stay in business, and firms
otherwise qualified to act as FCMs may be unwilling to do so due to the
risk and cost imposed upon the FCM model by individualized segregation.
This could lead to a larger concentration of customer exposures at
fewer FCMs, further increases to margin and guarantee fund
requirements, and further increased costs to customers. All of these
consequences would lead to decreased participation in U.S. futures and
swaps exchanges and result in loss of jobs in the United States.
2. Proposed Rulemaking on Position Limits \5\
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\5\ 76 Fed. Reg. 4752 (proposed Jan. 26, 2011) (to be codified at
17 CFR pts. 1, 150-51)
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A prime example of a refusal to regulate in strict conformance with
DFA, is the Commission's proposal to impose broad, fixed position
limits for all physically delivered commodities. The Commission's
proposed position limit regulations ignore the clear Congressional
directives, which DFA added to Section 4a of the CEA, to set position
limits ``as the Commission finds are necessary to diminish, eliminate,
or prevent'' ``sudden or unreasonable fluctuations or unwarranted
changes in the price of'' a commodity.\6\ Without any basis to make
this finding, the Commission instead justified its position limit
proposal as follows:
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\6\ My December 15, 2010, testimony before the Subcommittee on
General Farm Commodities and Risk Management of the House Committee on
Agriculture includes a more complete legal analysis of the DFA
requirements.
The Commission is not required to find that an undue burden on
interstate commerce resulting from excessive speculation exists
or is likely to occur in the future in order to impose position
limits. Nor is the Commission required to make an affirmative
finding that position limits are necessary to prevent sudden or
unreasonable fluctuations or unwarranted changes in prices or
otherwise necessary for market protection. Rather, the
Commission may impose position limits prophylactically, based
on its reasonable judgment that such limits are necessary for
the purpose of ``diminishing, eliminating, or preventing'' such
burdens on interstate commerce that the Congress has found
result from excessive speculation. 76 Federal Register 4752 at
4754 (January 26, 2011), Position Limits for Derivatives.
---------------------------------------------------------------------------
(emphasis supplied).
At the December 15, 2010, hearing of the General Farm Commodities
and Risk Management Subcommittee of the House Agriculture Committee on
the subject of the implementation of DFA's provisions respecting
position limits, there was strong bipartisan agreement among the
Subcommittee Members with the sentiments expressed by Representative
Moran:
``Despite what some believe is a mandate for the Commission to
set position limits within a definite period of time, the Dodd-
Frank legislation actually qualifies CFTC's position-limit
authority. Section 737 of the Dodd-Frank Act amends the
Commodity Exchange Act so that Section 4A-A2A states, `The
Commission shall, by rule, establish limits on the amount of
positions as appropriate.' The Act then states, `In
subparagraph B, for exempt commodities, the limit required
under subparagraph A shall be established within 180 days after
the date of enactment of this paragraph.' When subparagraphs A
and B are read in conjunction, the Act states that when
position limits are required under subparagraph A, the
Commission shall set the limits within 180 days under paragraph
B. Subparagraph A says the position-limit rule should be only
prescribed when appropriate.
``Therefore, the 180 day timetable is only triggered if
position limits are appropriate. In regard to the word
`appropriate,' the Commission has three distinct problems.
First, the Commission has never made an affirmative finding
that position limits are appropriate to curtail excessive
speculation. In fact, to date, the only reports issued by the
Commission or its staff failed to identify a connection between
market trends and excessive speculation. This is not to say
that there is no connection, but it does say the Commission
does not have enough information to draw an affirmative
conclusion.
``The second and third issues relating to the appropriateness
of position limits are regulated to adequacy of information
about OTC markets. On December 8, 2010, the Commission
published a proposed rule on swap data record-keeping and
reporting requirements. This proposed rule is open to comment
until February 7, 2011, and the rule is not expected to be
final and effective until summer at the earliest. Furthermore,
the Commission has yet to issue a proposed rulemaking about
swap data repositories. Until a swap data repository is set up
and running, it is difficult to see how it would be appropriate
for the Commission to set position limits.''
CME is not opposed to position limits and other means to prevent
market congestion; we employ limits in most of our physically delivered
contracts. However, we use limits and accountability levels, as
contemplated by the Congressionally-approved Core Principles for DCMs,
to mitigate potential congestion during delivery periods and to help us
identify and respond in advance of any threat to manipulate our
markets. CME Group believes that the core purpose that should govern
Federal and exchange-set position limits, to the extent such limits are
necessary and appropriate should be to reduce the threat of price
manipulation and other disruptions to the integrity of prices. We agree
that such activity destroys public confidence in the integrity of our
markets and harms the acknowledged public interest in legitimate price
discovery and we have the greatest incentive and best information to
prevent such misconduct.
It is important not to lose sight of the real economic cost of
imposing unnecessary and unwarranted position limits. For the last 150
years, modern day futures markets have served as the most efficient and
transparent means to discover prices and manage exposure to price
fluctuations. Regulated futures exchanges operate centralized,
transparent markets to facilitate price discovery by permitting the
best informed and most interested parties to express their opinions by
buying and selling for future delivery. Such markets are a vital part
of a smooth functioning economy. Futures exchanges allow producers,
processors and agribusiness to transfer and reduce risks through bona
fide hedging and risk management strategies. This risk transfer means
producers can plant more crops. Commercial participants can ship more
goods. Risk transfer only works because speculators are prepared to
provide liquidity and to accept the price risk that others do not.
Futures exchanges and speculators have been a force to reduce price
volatility and mitigate risk. Overly restrictive position limits
adversely impact legitimate trading and impair the ability of producers
to hedge. They may also drive certain classes of speculators into
physical markets and consequently distort the physical supply chain and
prices.
Similarly troubling is the fact that the CFTC's proposed rules in
this and other areas affecting market participants are not in harmony
with international regulators. International regulators, such as the
E.U., are far from adopting such a prescriptive approach with respect
to position limits. Ultimately, this could create an incentive for
market participants to move their business to international exchanges
negatively impacting the global leadership of the U.S. financial
market. Furthermore, exporting the price discovery process to overseas
exchanges will likely result in both a loss of jobs in the U.S. and
less cost-efficient hedging for persons in business in the U.S. As an
example, consider the two major price discovery indexes in crude oil:
West Texas Intermediate, which trades on NYMEX, and Brent Oil, which
trades overseas. If the Commission places heavy restrictions in areas
such as position limits on traders in the U.S., traders in crude oil,
and with them the price discovery process, are likely to move to
overseas markets.
3. Proposed Rulemaking on Mandatory Swaps Clearing Review Process \7\
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\7\ 75 Fed. Reg. 667277 (proposed Nov. 2, 2010) (to be codified at
17 CFR pts. 1, 150, 151).
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Another example of a rule proposal that could produce consequences
counter to the fundamental purposes of DFA is the Commission's proposed
rule relating to the process for review of swaps for mandatory
clearing. The proposed regulation treats an application by a DCO to
list a particular swap for clearing as obliging that DCO to perform due
diligence and analysis for the Commission respecting a broad swath of
swaps, as to which the DCO has no information and no interest in
clearing. In effect, a DCO that wishes to list a new swap would be
saddled with the obligation to collect and analyze massive amounts of
information to enable the Commission to determine whether the swap that
is the subject of the application and any other swap that is within the
same ``group, category, type, or class'' should be subject to the
mandatory clearing requirement.
This proposed regulation is one among several proposals that impose
costs and obligations whose effect and impact are contrary to the
purposes of Title VII of DFA. The costs in terms of time and effort to
secure and present the information required by the proposed regulation
would be a significant disincentive to DCOs to voluntarily undertake to
clear a ``new'' swap. The Commission lacks authority to transfer the
obligations that the statute imposes on it to a DCO. The proposed
regulation eliminates the possibility of a simple, speedy decision on
whether a particular swap transaction can be cleared--a decision that
the DFA surely intended should be made quickly in the interests of
customers who seek the benefits of clearing--and forces a DCO to
participate in an unwieldy, unstructured and time-consuming process to
determine whether mandatory clearing is required. Regulation Section
39.5(b)(5) starkly illustrates this outcome. No application is deemed
complete until all of the information that the Commission needs to make
the mandatory clearing decision has been received. Completion is
determined in the sole discretion of the Commission. Only then does the
90 day period begin to run. This process to enable an exchange to list
a swap for clearing is clearly contrary to the purposes of DFA.
4. Conversion from Principles-Based to Rules-Based Regulation \8\
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\8\ See, 75 Fed. Reg. 80747 (proposed Dec. 22, 2010) (to be
codified at 17 CFR pts. 1, 16, 38).
---------------------------------------------------------------------------
Some of the CFTC's rule proposals are explained by the ambiguities
created during the rush to push DFA to a final vote. For example,
Congress preserved and expanded the scheme of principles-based
regulation by expanding the list of core principles and granting self
regulatory organizations ``reasonable discretion in establishing the
manner in which the [self regulatory organization] complies with the
core principles.'' Congress granted the Commission the authority to
adopt rules respecting core principles, but did not direct it to
eliminate the principles-based regulation, which was the foundation of
the CFMA. In accordance with CFMA, the CFTC set forth ``[g]uidance on,
and Acceptable Practices in, Compliance with Core Principles'' that
operated as safe harbors for compliance. This approach has proven
effective and efficient in terms of appropriately allocating
responsibilities between regulated DCMs and DCOs and the CFTC.
We recognize that the changes instituted by DFA give the Commission
discretion, where necessary, to step back from this principles-based
regime. Congress amended the CEA to state that boards of trade ``shall
have reasonable discretion in establishing the manner in which they
comply with the core principles, unless otherwise determined by the
Commission by rule or regulation.'' See, e.g., DFA 735(b), amending
Section 5(d)(1)(B) of the CEA. But the language clearly assumes that
the principles-based regime will remain in effect except in limited
circumstances in which more specific rules addressing compliance with a
core principle are necessary. The Commission has used this change in
language, however, to propose specific requirements for multiple Core
Principles--almost all Core Principles in the case of DCMs--and
effectively eviscerate the principle-based regime that has fostered
success in CFTC-regulated entities for the past decade.
The Commission's almost complete reversion to a prescriptive
regulatory approach converts its role from an oversight agency,
responsible for assuring self regulatory organizations comply with
sound principles, to a front line decision maker that imposes its
business judgments on the operational aspects of derivatives trading
and clearing. This reinstitution of rule-based regulation will require
a substantial increase in the Commission's staff and budget and impose
indeterminable costs on the industry and the end-users of derivatives.
Yet there is no evidence that this will be beneficial to the public or
to the functioning of the markets. In keeping with the President's
Executive Order to reduce unnecessary regulatory cost, the CFTC should
be required to reconsider each of its proposals with the goal of
performing those functions that are mandated by DFA.
Further, the principles-based regime of the CFMA has facilitated
tremendous innovation and allowed U.S. exchanges to compete effectively
on a global playing field. Principles-based regulation of futures
exchanges and clearing houses permitted U.S. exchanges to regain their
competitive position in the global market. Without unnecessary, costly
and burdensome regulatory review, U.S. futures exchanges have been able
to keep pace with rapidly changing technology and market needs by
introducing new products, new processes and new methods by certifying
compliance with the CEA. Indeed, U.S. futures exchanges have operated
more efficiently, more economically and with fewer complaints under
this system than at any time in their history. The transition to an
inflexible regime threatens to stifle growth and innovation in U.S.
exchanges and thereby drive market participants overseas. This, I noted
earlier, will certainly impact the relevant job markets in the United
States.
(a) Proposed Rulemaking under Core Principle 9 for DCMs
A specific example of the Commission's unnecessary and problematic
departure from the principles-based regime is its proposed rule under
Core Principle 9 for DCMs--Execution of Transactions, which states that
a DCM ``shall provide a competitive, open and efficient market and
mechanism for executing transactions that protects the price discovery
process of trading in the centralized market'' but that ``the rules of
a board of trade may authorize . . . (i) transfer trades or office
trades; (ii) an exchange of (I) futures in connection with a cash
commodity transaction; (II) futures for cash commodities; or (III)
futures for swaps; or (iii) a futures commission merchant, acting as
principle or agent, to enter into or confirm the execution of a
contract for the purchase or sale of a commodity for future delivery if
that contract is reported, recorded, or cleared in accordance with the
rules of the contract market or [DCO].''
Proposed Rule 38.502(a) would require that 85% or greater of the
total volume of any contract listed on a DCM be traded on the DCM's
centralized market, as calculated over a 12 month period. The
Commission asserts that this is necessary because ``the price discovery
function of trading in the centralized market'' must be protected. 75
Fed. Reg. at 80588. However, Congress gave no indication in DFA that it
considered setting an arbitrary limit as an appropriate means to
regulate under the Core Principles. Indeed, in other portions of DFA,
where Congress thought that a numerical limit could be necessary, it
stated so. For example, in Section 726 addressing rulemaking on
Conflicts of Interest, Congress specifically stated that rules ``may
include numerical limits on the control of, or the voting rights'' of
certain specified entities in DCOs, DCMs or SEFs.
The Commission justifies the 85% requirement only with its
observations as to percentages of various contracts traded on various
exchanges. It provides no support evidencing that the requirement will
provide or is necessary to provide a ``competitive, open, and efficient
market and mechanism for executing transactions that protects the price
discovery process of trading in the centralized market of the board of
trade,'' as is required under Core Principle 9. Further, Core Principle
9, as noted above, expressly permits DCMs to authorize off-exchange
transactions including for exchanges to related positions pursuant to
their rules.
The imposition of the proposed 85% exchange trading requirement
will have extremely negative effects on the industry. It would
significantly deter the development of new products by exchanges like
CME. This is because new products generally initially gain trading
momentum in off-exchange transactions. Indeed, it takes years for new
products to reach the 85% exchange trading requirement proposed by the
Commission. For example, one suite of very popular and very liquid
foreign exchange products developed and offered by CME would not have
met the 85% requirement for 4 years after it was initially offered. The
suite of products' on-exchange trading continued to increase over 10
years, and it now trades only 2% off exchange. Under the proposed rule,
CME would have had to delist this suite of products.\9\
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\9\ More specifically, the product traded 32% off-exchange when it
was first offered in 2000, 31% off exchange in 2001, 25 % in 2002, 20%
in 2003, finally within the 85% requirement at 13% off-exchange in
2004, 10% in 2005, 7% in 2006, 5% in 2007, 3% in 2008, and 2% in 2009
and 2010.
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Imposition of an 85% exchange trading requirement would also have
adverse effects on market participants. If instruments that are most
often traded off-exchange are forced onto the centralized market,
customers will lose cross-margin efficiencies that they currently enjoy
and will be forced to post additional cash or assets as margin. For
example, customers who currently hold open positions on CME
Clearport' will be required to post a total of approximately
$3.9 billion in margin (at the clearing firm level, across all clearing
firms).
(b) Proposed Comparable Fee Structures Under Core Principle 2 for DCMs
In the case of certain proposed fee restrictions to be placed on
DCMs, the Commission not only retreats needlessly from principles-based
regulation but also greatly exceeds its authority under DFA. DCM Core
Principle 2, which appears in DFA Section 735, states, in part, that a
DCM ``shall establish, monitor, and enforce compliance with rules of
the contract market including . . . access requirements.'' Under this
Core Principle, the Commission has proposed rule 38.151, which states
that a DCM ``must provide its members, market participants and
independent software vendors with impartial access to its market and
services including . . . comparable fee structures for members, market
participants and independent software vendors receiving equal access
to, or services from, the [DCM].''
The CFTC's attempt to regulate DCM member, market participant and
independent software vendor fees is unsupportable. The CFTC is
expressly authorized by statute to charge reasonable fees to recoup the
costs of services it provides. 7 U.S.C. 16a(c). The Commission may not
bootstrap that authority to set or limit the fees charged by DCMs or to
impose an industry-wide fee cap that has the effect of a tax. See,
Federal Power Commission v. New England Power Co., 415 U.S. 345, 349
(1974) (``[W]hole industries are not in the category of those who may
be assessed [regulatory service fees], the thrust of the Act reaching
only specific charges for specific services to specific individuals or
companies.''). In any event, the CFTC's overreaching is not supported
by DFA. Nowhere in the CEA is the CFTC authorized to set or limit fees
a DCM may charge. To the extent the CFTC believes its authority to
oversee impartial access to trading platforms may provide a basis for
its assertion of authority, that attempt to read new and significant
powers into the CEA should be rejected.
5. Provisions Common to Registered Entities \10\
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\10\ 75 Fed. Reg. 67282 (proposed Nov. 2, 2010) (to be codified at
17 CFR pt. 40).
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The CFMA streamlined the procedures for listing new products and
amending rules that did not impact the economic interests of persons
holding open contracts. These changes recognized that the previous
system required the generation of substantial unnecessary paperwork by
exchanges and by the CFTC's staff. It slowed innovation without a
demonstrable public benefit.
Under current rules, before a product is self-certified or a new
rule or rule amendment is proposed, DCMs and DCOs conduct a due
diligence review to support their conclusion that the product or rule
complies with the Act and Core Principles. The underlying rationale for
the self-certification process which has been retained in DFA, is that
registered entities that list new products have a self-interest in
making sure that the new products meet applicable legal standards.
Breach of this certification requirement potentially subjects the DCM
or DCO to regulatory liability. In addition, in some circumstances, a
DCM or DCO may be subject to litigation or other commercial remedies
for listing a new product, and the avoidance of these costs and burdens
is sufficient incentive for DCMs and DCOs to remain compliant with the
Act.
Self-certification has been in effect for 10 years and nothing has
occurred to suggest that this concept is flawed or that registered
entities have employed this power recklessly or abusively. During 2010,
CME launched 438 new products and submitted 342 rules or rule
amendments to the Commission. There was no legitimate complaint
respecting the self-certification process during this time. Put simply,
the existing process has worked, and there is no reason for the
Commission to impose additional burdens, which are not required by DFA,
to impair that process.
Section 745 of DFA merely states, in relevant part, that ``a
registered entity may elect to list for trading or accept for clearing
any new contract, or other instrument, or may elect to approve or
implement any new rule or rule amendment, by providing to the
Commission a written certification that the new contract or instrument
or clearing of the new contract or instrument, new rule, or rule
amendment complies with this Act (including regulations under this
Act).'' DFA does not direct the Commission to require the submission of
all documents supporting the certification nor to require a review of
the legal implications of the product or rule with regard to laws other
than DFA. Essentially, it requires exactly what was required prior to
the passage of DFA--a certification that the product, rule or rule
amendment complies with the CEA. Nonetheless, the Commission has taken
it upon itself to impose these additional and burdensome submission
requirements upon registered entities.
The new requirements proposed by the CFTC will require exchanges to
prematurely disclose new product innovations and consequently enable
foreign competitors to introduce those innovations while the exchange
awaits CFTC approval. This, again, inhibits the ability of U.S.
exchanges to compete, drives market participants overseas and impairs
job growth in the United States. Moreover, given the volume of filings
required by the notice of proposed rulemaking, the Commission will
require significant increases in staffing and other resources.
Alternatively, the result will be that these filings will not be
reviewed in a timely manner, further disadvantaging U.S. exchanges.
Again, we would suggest that the Commission's limited resources should
be better aligned with the implementation of the goals of DFA rather
than ``correcting'' a well-functioning and efficient process.
First, the proposed rules require a registered entity to submit
``all documentation'' relied upon to determine whether a new product,
rule or rule amendment complies with applicable Core Principles. This
requirement is so vague as to create uncertainty as to what is actually
required to be filed. More importantly, this requirement imposes an
additional burden on both registered entities, which must compile and
produce all such documentation, and the Commission, which must review
it. It is clear that the benefits, if any, of this requirement are
significantly outweighed by the costs imposed both on the marketplace
and the Commission.
Second, the proposed rules require registered entities to examine
potential legal issues associated with the listing of products and
include representations related to these issues in their submissions.
Specifically, a registered entity must provide a certification that it
has undertaken a due diligence review of the legal conditions,
including conditions that relate to contractual and intellectual
property rights. The imposition of such a legal due diligence standard
is clearly outside the scope of DFA and is unnecessarily vague and
impractical, if not impossible, to comply with in any meaningful
manner. An entity, such as CME, involved in product creation and design
is always cognizant that material intellectual property issues may
arise. This requirement would force registered entities to undertake
extensive intellectual property analysis, including patent, copyright
and trademark searches in order to satisfy the regulatory mandates,
with no assurances that any intellectual property claim is discoverable
through that process at a particular point in time. Again, this would
greatly increase the cost and timing of listing products without
providing any corresponding benefit to the marketplace. Indeed, the
Commission itself admits in its NOPR that these proposed rules will
increase the overall information collection burden on registered
entities by approximately 8,300 hours per year.\11\
---------------------------------------------------------------------------
\11\ 75 Fed. Reg. at 67290.
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Further, these rules steer the Commission closer to the product and
rule approval process currently employed by the SEC, which is routinely
criticized and about which those regulated by the SEC complained at the
CFTC-SEC harmonization hearings. Indeed, William J. Brodsky of the
Chicago Board of Options Exchange testified that the SEC's approval
process ``inhibits innovation in the securities markets'' and urged the
adoption of the CFTC's certification process.
6. Requirements for Derivatives Clearing Organizations, Designated
Contract Markets, and Swap Execution Facilities Regarding
Mitigation of Conflicts of Interest \12\
---------------------------------------------------------------------------
\12\ 75 Fed. Reg. 63732 (proposed October 18, 2010) (to be codified
at 17 CFR pts. 1, 37, 38, 39, 40).
---------------------------------------------------------------------------
The Commission's proposed rules regarding the mitigation of
conflicts of interest in DCOs, DCMs and SEFs (``Regulated Entities'')
also exceed its rulemaking authority under DFA and impose constraints
on governance that are unrelated to the purposes of DFA or the CEA. The
Commission purports to act pursuant to Section 726 of DFA but ignores
the clear boundaries of its authority under that section, which it
cites to justify taking control of every aspect of the governance of
those Regulated Entities. Section 726 conditions the Commission's right
to adopt rules mitigating conflicts of interest to circumstances where
the Commission has made a finding that the rule is ``necessary and
appropriate'' to ``improve the governance of, or to mitigate systemic
risk, promote competition, or mitigate conflicts of interest in
connection with a swap dealer or major swap participant's conduct of
business with, a [Regulated Entity] that clears or posts swaps or makes
swaps available for trading and in which such swap dealer or major swap
participant has a material debt or equity investment.'' (emphasis
added) The ``necessary and appropriate'' requirement constrains the
Commission to enact rules that are narrowly-tailored to minimize their
burden on the industry. The Commission failed to make the required
determination that the proposed regulations were ``necessary and
proper'' and, unsurprisingly, the proposed rules are not narrowly-
tailored but rather overbroad, outside of the authority granted to it
by DFA and extraordinarily burdensome.
The Commission proposed governance rules and ownership limitations
that affect all Regulated Entities, including those in which no swap
dealer has a material debt or equity investment and those that do not
even trade or clear swaps. Moreover, the governance rules proposed have
nothing to do with conflicts of interest, as that term is understood in
the context of corporate governance. Instead, the Commission has
created a concept of ``structural conflicts,'' which has no recognized
meaning outside of the Commission's own declarations and is unrelated
to ``conflict of interest'' as used in the CEA. The Commission proposed
rules to regulate the ownership of voting interests in Regulated
Entities by any member of those Regulated Entities, including members
whose interests are unrelated or even contrary to the interests of the
defined ``enumerated entities.'' In addition, the Commission is
attempting to impose membership condition requirements for a broad
range of committees that are unrelated to the decision making to which
Section 726 was directed.
The Commission's proposed rules are most notably overbroad and
burdensome in that they address not only ownership issues but the
internal structure of public corporations governed by state law and
listing requirements of SEC regulated national securities exchanges.
More specifically, the proposed regulations set requirements for the
composition of corporate boards, require Regulated Entities to have
certain internal committees of specified compositions and even propose
a new definition for a ``public director.'' Such rules in no way relate
to the conflict of interest Congress sought to address through Section
726. Moreover, these proposed rules improperly intrude into an area of
traditional state sovereignty. It is well-established that matters of
internal corporate governance are regulated by the states, specifically
the state of incorporation. Regulators may not enact rules that intrude
into traditional areas of state sovereignty unless Federal law compels
such an intrusion. Here, Section 726 provides no such authorization.
Perhaps most importantly, the proposed structural governance
requirements cannot be ``necessary and appropriate,'' as required by
DFA, because applicable state law renders them completely unnecessary.
State law imposes fiduciary duties on directors of corporations that
mandate that they act in the best interests of the corporation and its
shareholders--not in their own best interests or the best interests of
other entities with whom they may have a relationship. As such,
regardless of how a board or committee is composed, the members must
act in the best interest of the exchange or clearinghouse. The
Commission's concerns--that members, enumerated entities, or other
individuals not meeting its definition of ``public director'' will act
in their own interests--and its proposed structural requirements are
wholly unnecessary and impose additional costs on the industry--not to
mention additional enforcement costs--completely needlessly.
7. Prohibition on Market Manipulation \13\
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\13\ 75 Fed. Reg. 67657-62 (proposed Nov. 3, 2010) (to be codified
at 17 CFR pt. 180).
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The Commission's proposed rules on Market Manipulation, although
arguably within the authority granted by DFA, are also problematic
because they are extremely vague. The Commission has proposed two rules
related to market manipulation: Rule 180.1, modeled after SEC Rule 10b-
5 and intended as a broad, catch-all provision for fraudulent conduct;
and Rule 180.2, which mirrors new CEA Section 6(c)(3) and is aimed at
prohibiting price manipulation. See 75 Fed. Reg. at 67658. Clearly,
there is a shared interest among market participants, exchanges and
regulators in having market and regulatory infrastructures that promote
fair, transparent and efficient markets and that mitigate exposure to
risks that threaten the integrity and stability of the market. In that
context, however, market participants also desire clarity with respect
to the rules and fairness and consistency with regard to their
enforcement.
As to its proposed rule 180.1, the Commission relies on SEC
precedent to provide further clarity with respect to its interpretation
and notes that it intends to implement the rule to reflect its
``distinct regulatory mission.'' However, the Commission fails to
explain how the rule and precedent will be adapted to reflect the
differences between futures and securities markets. See 75 Fed. Reg. at
67658-60. For example, the Commission does not provide clarity as to if
and to what extent it intends to apply insider trading precedent to
futures markets. Making this concept applicable to futures markets
would fundamentally change the nature of the market, not to mention all
but halting participation by hedgers, yet the Commission does not even
address this issue. Rule 180.1 is further unclear as to what standard
of scienter the Commission intends to adopt for liability under the
rule. Rule 180.2 is comparably vague, providing, for example, no
guidance as to what sort of behavior is ``intended to interfere with
the legitimate forces of supply and demand'' and how the Commission
intends to determine whether a price has been affected by illegitimate
factors.
These proposed rules, like many others, have clearly been proposed
in haste and fail to provide market participants with sufficient notice
of whether contemplated trading practices run afoul of them. Indeed, we
believe the proposed rules are so unclear as to be subject to
constitutional challenge. That is, due process precludes the government
from penalizing a private party for violating a rule without first
providing adequate notice that conduct is forbidden by the rule. In the
area of market manipulation especially, impermissible conduct must be
clearly defined lest the rules chill legitimate market participation
and undermine the hedging and price discovery functions of the market
by threatening sanctions for what otherwise would be considered
completely legal activity. That is, if market participants do not know
the rules of the road in advance and lack confidence that the
disciplinary regime will operate fairly and rationally, market
participation will be chilled because there is a significant risk that
legitimate trading practices will be arbitrarily construed, post-hoc,
as unlawful. These potential market participants will either use a
different method to manage risk or go to overseas exchanges, stifling
the growth of U.S. futures markets and affecting related job markets.
8. Anti-Disruptive Practices Authority Contained in DFA \14\
---------------------------------------------------------------------------
\14\ 75 Fed. Reg. 67301 (proposed November 2, 2010) (to be codified
at 17 CFR pt. 1).
---------------------------------------------------------------------------
Rules regarding Disruptive Trade Practices (DFA Section 747) run
the risk of being similarly vague and resulting in chilling market
participation. The CFTC has recently issued a Proposed Interpretive
Order which provides guidance regarding the three statutory disruptive
practices set for in DFA Section 747.\15\ CME Group applauds the
Commission's decision to clarify the standards for liability under the
enumerated disruptive practices and supports the Commission's decision
to refrain from setting forth any additional ``disruptive practices''
beyond those listed in the statute. We believe, however, that in
several respects, the proposed interpretations still do not give market
participants enough notice as to what practices are illegal and also
may interfere with their ability to trade effectively.
---------------------------------------------------------------------------
\15\ 76 Fed. Reg. 14943 (proposed March 18, 2011).
---------------------------------------------------------------------------
For example, the Commission interprets section 4c(a)(5)(A),
Violating Bids and Offers, ``as prohibiting any person from buying a
contract at a price that is higher than the lowest available offer
price and/or selling a contract at a price that is lower than the
highest available bid price'' regardless of intent.\16\ However,
certain existing platforms allow trading based on considerations other
than price. Without an intent requirement, these platforms do not
``fit'' under the regulations, and presumably will be driven out of
business. Similarly, market participants desiring to legitimately trade
on bases other than price will presumably be driven to overseas
markets.
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\16\ 76 Fed. Reg. 14946 (proposed March 18, 2011).
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Further, the Commission states that section 4c(a)(5)(B), Orderly
Execution of Transactions During the Closing Period, applies only where
a participant ``demonstrates intentional or reckless disregard for the
orderly execution of transactions during the closing period.'' However,
the Commission goes on to state that ``market participants should
assess market conditions and consider how their trading practices and
conduct affect the orderly execution of transactions during the closing
period.'' In so stating, the Commission seems to impose an affirmative
obligation on market participants to consider these factors before
executing any trade. This, first, directly conflicts with the scienter
requirements also set forth by the Commission and thus interferes with
the ability of market participants to determine exactly what conduct
may give rise to liability. Second, such an affirmative obligation will
interfere with the ability of market participants to make advantageous
trades, especially in the context of a fast-moving, electronic trading
platform. The end result of both these issues is that, if the
Interpretive Order goes into effect as written, market participation
will be chilled, participants will move to overseas markets and jobs
will be lost in the U.S. futures industry.
Section 747 of DFA, which authorizes the Commission to promulgate
additional rules if they are reasonably necessary to prohibit trading
practices that are ``disruptive of fair and equitable trading,'' is
exceedingly vague as written and does not provide market participants
with adequate notice as to whether contemplated conduct is forbidden.
If the Interpretive Order does not clearly define ``disruptive trade
practices,'' it will discourage legitimate participation in the market
and the hedging and price discovery functions of the market will be
chilled due to uncertainty among participants as to whether their
contemplated conduct is acceptable.
9. Effects on OTC Swap Contracts
DFA's overhaul of the regulatory framework for swaps creates
uncertainty about the status and validity of existing and new swap
contracts. Today, under provisions enacted in 2000, swaps are excluded
or exempt from the CEA under Sections 2(d), 2(g) and 2(h) of the CEA.
These provisions allow parties to enter into swap transactions without
worrying about whether the swaps are illegal futures contracts under
CEA Section 4(a). DFA repeals those exclusions and exemptions effective
July 16, 2011. At this time, it is unclear what if any action the CFTC
plans to take or legally could take to allow both swaps entered into on
or before July 16, and those swaps entered into after July 16 from
being challenged as illegal futures contracts. To address this concern,
Congress and the CFTC should consider some combination of deferral of
the effective dates of the repeal of Sections 2(d), 2(g) and 2(h),
exercise of CFTC exemptive power under Section 4(c) or other
appropriate action. Otherwise swap markets may be hit by a wave of
legal uncertainty which the statutory exclusions and exemptions were
designed in 2000 to prevent. This uncertainty may, again, chill
participation in the swap market and impair the ability of market
participants, including hedgers, to manage their risks.
The Chairman. Thank you, Mr. Duffy.
Mr. Scott for 5 minutes.
STATEMENT OF HAL S. SCOTT, J.D., DIRECTOR, COMMITTEE ON CAPITAL
MARKETS REGULATION; NOMURA PROFESSOR AND DIRECTOR, PROGRAM ON
INTERNATIONAL FINANCIAL SYSTEMS, HARVARD LAW SCHOOL, CAMBRIDGE,
MA
Mr. Scott. Thank you, Chairman Conaway, Ranking Member
Boswell, and Members of the Subcommittee, for permitting me to
testify before you today.
I am testifying in my own capacity and do not purport to
represent the views of the Committee on Capital Markets
Regulation. My testimony is focused on the implementation of
the Dodd-Frank Act, with emphasis on the CFTC.
The 44 rules that the CFTC--it was 46, actually, given
yesterday--has promulgated so far and the rules that are yet to
come will work a total revolution on the regulation of the
over-the-counter derivatives market. I think we should
understand the massive nature of the regulatory effort that we
are engaged in here.
The CFTC has finished proposing most of its rules, and we
are just 3 months away from the July deadline, by which time
many of the most important rules must be finalized.
Unfortunately, the proposals have come out in a somewhat
scattershot order. And, before we move forward toward
finalizing and implementing the rules, we need to have a more
comprehensive and rational approach.
Once all of the rules have been proposed, CFTC should
develop a public published statement as to how all of its rules
fit together and in what order the final rules should be
issued. The joint CFTC and SEC roundtable on implementation,
planned for May 2 and 3, is a first step in that direction but
only a first step.
After it has put all this together, it then should do a re-
proposal of the entire package of rules and permit another
round of comment on the substance of this package, which should
include, as I said, plans for implementation.
The Federal Reserve should play a key part in this
rulemaking process, as it plays a large role in regulating the
risk of the major participants in the derivatives
clearinghouses as well as the clearinghouses themselves. A
failure of a clearinghouse would be a major systemic shock to
the financial system. Indeed, for this reason, in my view, the
Fed should approve the substance and implementation of the
plans of these Commissions.
I should also emphasize the importance of the SEC and CFTC
conducting proper cost-benefit analyses before finalizing these
rules. Although neither agency is subject to the Executive
Order President Obama issued in January, requiring review of
the cost-benefit analysis by the Office of Information and
Regulatory Affairs, OIRA, within the Office of Management and
Budget, the heads of both of these Commissions have said they
will comply with its principles. Neither has, however, in my
view, come close.
Without better cost-benefit analysis, these rules risk
overturn in the D.C. Circuit. The D.C. Circuit has overturned
other regulatory rules for lack of proper foundation. And it is
not enough to consider cost and benefits. They have to be
analyzed, and conclusions have to be made.
I also want to talk a little bit about the international
situation. As you know, other jurisdictions, and in particular
the European Union, are working on a very similar regulatory
overhaul of their over-the-counter derivatives regulation.
Now, although the E.U. proposal is similar to the U.S.
system, or system of proposals, with respect to its emphasis on
central clearing, there are many important differences. For
example, the European Union places less emphasis on exchange
trading, on price transparency, and creates a broader end-user
exemption.
So, to some extent, these differences are a matter of the
statutes, Dodd-Frank versus what this proposed directive of the
E.U. is. But the CFTC does have the power to bring its
regulation of clearinghouse risks closer to that of Europe.
Both Europe and the U.S. will recognize a foreign clearinghouse
for participation by the firms that it is regulating, but only
if that clearinghouse is subject to similar requirements of
those in its home country. So the E.U. is going to look at our
rules and say, are they basically equivalent to the E.U. rules?
And we are going to look at their rules and say, are they
basically equivalent to our rules?
Now, if they diverge too much, we are going to have a
stalemate situation. Our firms aren't going to be able to be in
the E.U. because those rules are not equivalent, and their
firms aren't going to be able to be here because they are not
equivalent. This is a very undesirable outcome. It would be,
actually, better if we had a complete arbitrage than to have a
stalemate. So, the point being that, in this whole
consideration of the re-proposal, in my view, more has to be
done to coordinate our approach with the E.U.
Finally, I agree with Mr. Duffy that, overall, the approach
of the CFTC, now and shortly, has been micro-management. I
think what we need is more of a principles-based approach. And
I actually congratulate the SEC on sticking to that approach.
Thank you.
[The prepared statement of Mr. Scott follows:]
Prepared Statement of Hal S. Scott, J.D., Director, Committee on
Capital Markets Regulation; Nomura Professor, and Director, Program on
International Financial Systems, Harvard Law School,\1\ Cambridge, MA
---------------------------------------------------------------------------
\1\ Biography with disclosures on compensated activities available
at http://www.law.harvard.edu/faculty/hscott.
---------------------------------------------------------------------------
Thank you, Chairman Conaway, Ranking Member Boswell, and Members of
the Subcommittee for permitting me to testify before you today on the
implementation of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank Act).\2\ I am testifying in my own capacity
and do not purport to represent the views of any organizations with
which I am affiliated, although much of my testimony is based on the
past reports and statements of the Committee on Capital Markets
Regulation.
---------------------------------------------------------------------------
\2\ Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.
L. No. 111-203, 124 Stat. 1376 (hereinafter Dodd-Frank Act).
---------------------------------------------------------------------------
I will focus my remarks on the regulatory implementation of the
portions of the Dodd-Frank Act relating to derivatives, with emphasis
on the role of the Commodity Futures Trading Commission (CFTC). As you
know, these rules will have a profound long-term impact on our
financial system. It is important to get them right the first time, or
else we risk making the U.S. financial system more risky and less
competitive internationally.
The Dodd-Frank Act requires many of its most important rules to be
finalized by late July 2011, just over 3 months away. The CFTC has the
major role in writing the rules governing derivatives and Chairman
Gensler has stated that the CFTC is almost finished issuing its
proposals--albeit some important ones remain. On the other hand, the
CFTC has yet to issue a major final rule about derivatives and at least
some major rules will likely slip past the July finalization deadline.
I do not fault the CFTC for missing deadlines. In fact, in testimony I
delivered in January before the Committee on Financial Services, I
said, ``the most important objective should be to get the rules right,
not to act quickly.'' \3\ I still believe this is the case.
---------------------------------------------------------------------------
\3\ Promoting Economy Recovery and Job Creation: The Road Forward:
Hearing Before the H. Comm. On Finc. Servs., 112th Cong. 14-15 (Jan.
26, 2011) (testimony of Hal S. Scott) (hereinafter January Testimony).
---------------------------------------------------------------------------
The proposed rulemaking process has unfortunately been scattershot.
It was difficult for the public or markets to understand how the
issuance of 44 proposed rules over 5 months would fit together. Before
finalizing these rules the CFTC (as well as the SEC) should re-propose
all of these rules and describe how they fit together to achieve their
objectives, along with an analysis of their costs and benefits. It
should then permit another round of comment on the rules as a whole. It
should also make sure that the Federal Reserve concurs with its
proposals and that they are coordinated with those of the SEC and other
major countries. The CFTC should then, with the collaboration of the
other agencies, sequence the implementation of these rules in a way to
minimize transition costs.
I. The CFTC Implementation Process
Of the 31 major rulemaking areas the CFTC identified, it has
proposed rules in 28 areas. Appendix A shows the CFTC's rulemaking
progress to date. Before it begins to finalize and implement these
rules, however, it is important to consider whether any lessons can be
drawn from the process the CFTC used to propose the rules over the last
several months.
Unlike the SEC, the CFTC has not published a clear timetable
outlining which rules would be proposed when, and it is not obvious
that much thought was given to which proposed rules should come first.
I call this the scattershot approach. This has left the public in the
dark about what was coming down the pipeline. The public and markets
could not understand how the rules fit together before filing comments.
Some of the CFTC's earliest proposed rules turned on important terms
that had yet to be defined, such as ``major swap participant.'' It also
issued optional proposals, not required by Dodd-Frank, such as those on
segregation of collateral, before it proposed some of the major
mandatory rules.\4\ It was also concerned with the governance of
clearinghouses before addressing the relatively more important issue of
risk management.
---------------------------------------------------------------------------
\4\ See, e.g., Protection of Cleared Swaps Customers Before and
After Commodity Broker Bankruptcies, 75 Fed. Reg. 75162 (Dec. 2, 2010);
see also Sixth Series of Proposed Rulemakings Under the Dodd-Frank Act:
Opening Statement of Comm'r Jill E. Sommers Before the U.S. Commodity
Futures Trading Comm. (Dec. 1, 2010), http://www.cftc.gov/pressroom/
speechestestimony/sommersstatement120110.html (``a number of the
regulations that we have already considered, and a number of
regulations that we are considering today, are not required by Dodd-
Frank. Commission staff has spent months and months drafting proposed
regulations that are purely voluntary'').
---------------------------------------------------------------------------
Another general problem with the proposal process has been the lack
of sufficient understanding of the industry in formulating the
proposals. Showcase ``roundtable'' discussions and meetings with firms
are not enough. Regulators need to gather information from the markets
as to how they operate and then discuss their understanding of this
information with industry and outside experts. The rush to propose
rules generally did not allow this to happen. When the rules were
proposed comment periods were far too short, usually only 30 days for
the earliest proposals until the agencies yielded to pressure to extend
the comment periods. This process can be compared to the deliberate and
multi-year deliberation process the SEC went through before deciding in
2007 that foreign companies could issue shares in the United States
under international financial reporting standards without reconciling
their statements to U.S. GAAP,\5\ a decision of relatively less
importance than the entire transformation of the regulation of OTC
derivatives.
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\5\ See, Acceptance From Foreign Private Issuers of Financial
Statements Prepared in Accordance With International Financial
Reporting Standards Without Reconciliation to U.S. GAAP, 73 Fed. Reg.
986 (Jan. 4, 2008).
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Although the CFTC did not appropriately prioritize its rulemakings
during the proposal stage, it now has the opportunity to prioritize the
two most important parts of the rulemaking process, final rules and
implementation. Chairman Gensler calls the CFTC's rules a ``whole
mosaic.'' \6\ Once all of the rules have been proposed, the CFTC should
pause and develop a public, published plan for how that mosaic fits
together and in what order the final rules should be issued. It should
then permit another round of comment on the rules as a whole. This is
essential given the shortcomings of the piecemeal proposal process.
---------------------------------------------------------------------------
\6\ Implementing the Dodd-Frank Act: Remarks of Chairman Gensler
Before FIA's Annual International Futures Industry Conference (Mar. 16,
2011), http://www.cftc.gov/PressRoom/SpeechesTestimony/opagensler-
73.html.
---------------------------------------------------------------------------
The CFTC should then give careful consideration to the sequence of
implementation. Chairman Gensler has already outlined a helpful broad
tentative order.\7\ He has suggested that the final rules be grouped
into three broad categories, beginning in the spring and ending in the
early fall. While this timetable is too aggressive, some of the
ordering is quite sensible: the rules involving definitions,
registration, and mandatory clearing should come first. In other cases,
however, the schedule is less justified. For example, Chairman Gensler
mentions capital and margin as part of the last group, even though
those rules are among the most important for risk management.
---------------------------------------------------------------------------
\7\ See, id.
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The Federal Reserve should play a key part in the rulemaking
process. The Fed should review and approve the substance and
implementation of the Commission's plans. Under the Dodd-Frank Act, the
Fed has a major role to play in monitoring and managing the systemic
risk of clearinghouses, so it is important to have the Fed sign off on
the rules before they are finalized. First and foremost, the Fed
supervises the large dealer banks that do most of the derivatives
trading, as well as other systemically important nonbank financial
institutions that may be designated by the Financial Stability
Oversight Council (FSOC). The Fed also plays a central role in the
regulation of risk in systemically important clearinghouses.
Furthermore, the Fed can extend discount window privileges to a
clearinghouse in ``unusual or exigent circumstances'' \8\ subject to
any conditions it prescribes, which could include conditions relating
to risk management systems. The Fed may also object to the SEC and
CFTC's rules concerning systemically important clearinghouses, in which
case FSOC has the authority to resolve the conflict.\9\ Considering the
major role of the Fed, the SEC and CFTC should make sure the Fed agrees
with their final rules before they are implemented.
---------------------------------------------------------------------------
\8\ Dodd-Frank Act 806(b).
\9\ Dodd-Frank Act 804(a); see also Letter from Hal S. Scott to
Chairman Gensler Regarding The Federal Reserve's Authority Over
Clearinghouses 1 (Aug. 25, 2010), http://www.capmktsreg.org/pdfs/
2010.09.15_Genser_Letter_Release.pdf.
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With respect to implementation sequencing, a primary objective
should be, as recommended by the Committee on Capital Markets
Regulation, avoiding disrupting the markets.\10\ For example, rules
concerning the threshold for publicly reporting details of block trades
should be phased in so the Commissions can be certain that the rules
will not dry up liquidity. The Commissions can start with broad,
principles-based rules while they monitor the markets and collect the
data necessary to determine whether implementation of more specific and
limiting rules are necessary. This sequencing schedule should be
disclosed to the public, and, ideally should itself be subject to
comment. Although the proposed rules came out in an order that was more
haphazard than necessary, the CFTC can avoid repeating that mistake in
the coming months.
---------------------------------------------------------------------------
\10\ See Comm. on Capital Mkts. Regulation, comment to Commodity
Futures Trading Comm'n Notice of Proposed Rulemaking, Real-Time Public
Reporting of Swap Transaction Data, 75 Fed. Reg. 76140 (filed Jan. 18,
2011); Comm. on Capital Mkts. Regulation, comment to Securities
Exchange Comm'n, Regulation SBSR--Reporting and Dissemination of
Security Based Swap Information, 75 Fed. Reg. 75208 (filed Jan. 18,
2011).
---------------------------------------------------------------------------
II. Cost-Benefit Analysis
In my January testimony to the House Financial Services Committee,
I emphasized the need for the independent regulatory agencies to
perform sound cost-benefit analysis before proposing rules. The CFTC is
required by statute to ``consider the costs and benefits'' of its
rules, and the SEC is generally required to consider whether its rules
``will promote efficiency, competition, and capital formation.'' \11\
In January, the President issued an Executive Order that reaffirmed the
importance of conducting cost-benefit analysis when writing new
regulations.\12\ Although the Executive Order does not apply to
independent agencies such as the CFTC and SEC, the heads of both
agencies have suggested they will comply with its principles.\13\
---------------------------------------------------------------------------
\11\ 7 U.S.C. 19(a) (CFTC); 15 U.S.C. 78c(f) (SEC); see also 15
U.S.C. 78w(a)(2) (SEC required to consider burden on competition).
\12\ Exec. Order No. 13563, 1(b), 76 Fed. Reg. 3821 (Jan. 21,
2011).
\13\ See Public Hearing to Review Implementation of Title VII of
the Dodd-Frank Wall Street Reform and Consumer Protection Act: Hearing
Before the H. Comm. On Agric., 112th Cong. (Feb. 10, 2011) (testimony
of Chairman Gary Gensler), http://www.cftc.gov/PressRoom/
SpeechesTestimony/opagensler-68.html (CFTC Chairman Gary Gensler: ``the
CFTC's practices are consistent with the Executive Order's
principles.''); Testimony of Chairman Mary Schapiro Before the Subcomm.
on Fin. Servs.: Hearing Before the H. Appropriations Comm., 112th
Congress (Mar. 15, 2011), http://appropriations.house.gov/_files/
031511SECFY12Budget TestimonyFINAL.pdf (SEC Chairman Mary Schapiro:
``while the Executive Order doesn't apply to us, we're trying to act as
though it does.'').
---------------------------------------------------------------------------
The new Executive Order and the one that came before it subject
agencies' cost-benefit analysis to review by the Office of Information
and Regulatory Affairs (OIRA) within the Office of Management and
Budget.\14\ OIRA has published, with an interagency group, a set of
``best practices'' to guide those agencies bound by the Executive
Order.\15\ Neither the CFTC nor the SEC comes close to observing this
guidance.
---------------------------------------------------------------------------
\14\ See Exec. Order No. 12866, 6(a)(3), 58 Fed. Reg. 51735 (Oct.
4, 1993); Exec. Order No. 13563, 1(b), 76 Fed. Reg. 3821 (Jan. 21,
2011).
\15\ Office of Management and Budget, Economic Analysis of Federal
Regulations Under Executive Order 12866 (Jan. 11, 1996), http://
www.whitehouse.gov/omb/inforeg_riaguide (hereinafter OIRA CBA Guide).
---------------------------------------------------------------------------
The CFTC typically begins its cost-benefit analysis with
boilerplate text explaining that under its interpretation of its
statutory mandate, it is not required to quantify costs and
benefits.\16\ It then usually devotes only a few paragraphs to
identifying some costs and benefits of the proposed rules. Yet even
this qualitative analysis falls short. Yesterday the Committee on
Capital Markets Regulation filed a comment letter with the SEC and CFTC
regarding its proposed rules on reporting by private funds (Form
PF).\17\ In that letter, the Committee listed the three ``costs'' the
CFTC identified in the single paragraph devoted to the subject. It
identified the ``costs'' as: (1) ``Without the proposed reporting
requirements . . . FSOC will not have sufficient information''; (2)
``the proposed reporting requirements, once finalized will provide the
CFTC with better information''; and (3) ``the proposed reporting
requirements will create additional compliance costs.'' \18\ The first
two points are asserted benefits, not costs. The reference to
compliance costs is perfunctory and so general as to be meaningless.
---------------------------------------------------------------------------
\16\ See, e.g., Reporting by Investment Advisers to Private Funds
and Certain Commodity Pool Operators and Commodity Trading Advisors on
Form PF, 76 Fed. Reg. 8068, 8087 (Feb. 11, 2011).
\17\ Comm. on Capital Mkts. Regulation, comment to Commodity
Futures Trading Comm'n and Securities Exchange Comm'n Joint Proposed
Rules, Reporting by Investment Advisers to Private Funds and Certain
Commodity Pool Operators and Commodity Trading Advisors on Form PF, 76
Fed. Reg. 8068 (filed Apr. 12, 2011).
\18\ Reporting by Investment Advisers on Form PF, supra note 16, 76
Fed. Reg. at 8087.
---------------------------------------------------------------------------
Sound cost-benefit analysis measures costs and benefits against a
baseline. The OIRA guide of best practices instructs agencies to set
the baseline as the world without the proposed regulation.\19\ Yet in
most proposals the CFTC evaluates the overall costs and benefits of the
system required by the Dodd-Frank Act, rather than the particular
implementation the agency proposed. Likewise, OIRA instructs agencies
to evaluate alternatives to the proposed regulations.\20\ This is
especially important when, as in the case of rules requiring reporting
of information, many different systems could satisfy the statutory
requirement, perhaps with lower costs. Yet the agencies have not
identified alternatives. Nor do the agencies engage in incremental or
marginal analysis, which would consider whether the benefits of each
element of the proposed rule outweigh its costs. Instead, they
typically take a gestalt approach to the rules as a whole.
---------------------------------------------------------------------------
\19\ OIRA CBA Guide, supra note 15, III.A.1.
\20\ OIRA CBA Guide, supra note 15 III.A.2.
---------------------------------------------------------------------------
For the last 30 years, a period spanning nearly five Presidents, a
series of Executive Orders has required non-independent agencies to
comply with additional requirements to the rulemaking process, yet the
independent agencies have not been covered by these requirements.\21\
Cass Sunstein, presently the Administrator of OIRA, has long called for
subjecting the independent agencies to OIRA review.\22\ In my January
testimony, I proposed a moderate system of OIRA review that would avoid
any separation of powers issues involved with independent financial
agencies.\23\ This approach would have OIRA file comments with the
agency for important rulemakings. OIRA's comments would evaluate the
agency's cost-benefit analysis.\24\ Although OIRA's comments would not
be binding on the agencies, any final rules would still be subject to
review in court. I also called for extending and strengthening the
statutory provisions requiring the independent agencies to perform
cost-benefit analysis so that each of the financial regulators is
required to determine whether the costs of its rules exceed the
benefits.\25\ The rules proposed in the last 2 months have only
strengthened my opinion that the independent financial regulators,
particularly the CFTC and SEC, need stronger external requirements to
conduct sound cost-benefit analysis.
---------------------------------------------------------------------------
\21\ See Exec. Order No. 12866, 6(a), 58 Fed. Reg. 51735 (Oct. 4,
1993); Exec. Order No. 13563, 1(b), 76 Fed. Reg. 3821 (Jan. 21,
2011); 44 U.S.C. 3502(5).
\22\ See Robert W. Hahn & Cass R. Sunstein, A New Executive Order
for Improving Federal Regulation? Deeper and Wider Cost-Benefit
Analysis, 150 U. Pa. L. Rev. 1489, 1531-37 (2002); see also Richard H.
Pildes & Cass R. Sunstein, Reinventing the Regulatory State, 62 U. Chi.
L. Rev. 1, 4 (1995).
\23\ For a discussion of these issues see Hahn & Sunstein, id., 150
U. Pa. L. Rev. at 1531-37; Pildes & Sunstein, id., 62 U. Chi. L. Rev.
at 24-33; see also Elena Kagan, Presidential Administration, 114 Harv.
L. Rev. 2245, 2319-31 (2001).
\24\ January Testimony, supra note 3, 10.
\25\ January Testimony, supra note 3, 11.
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III. Coordination
In order to write the best rules possible and to avoid unnecessary
friction in the system, the Federal agencies should coordinate with
each other and with their foreign counterparts.
A. Domestic Coordination
The Dodd-Frank Act anticipates that the SEC and CFTC in particular
should work together to regulate the derivatives markets. So far they
have not coordinated as much as they should. In many of the proposed
rules, the CFTC and the SEC have taken different approaches to swaps
and security-based swaps, respectively. For example, the Commissions
took different approaches to rules concerning public reporting of swap
and security-based swap transactions,\26\ conflicts of interest in
ownership and governance of various swaps and security-based swap
clearinghouses,\27\ and risk management in clearinghouses.\28\ The
approaches of the CFTC and the SEC should diverge only when required by
real differences between the types of derivatives they are regulating.
If the Commissions do not take a unified approach, then they will
unnecessarily raise compliance costs as market participants who are
subject to two different regimes will have to comply with different
rules governing similar conduct. Furthermore, it will not always be
clear whether a swap falls with the jurisdiction of the CFTC or SEC--
different rules will encourage transactors to design derivatives to fit
into the rules they like best.
---------------------------------------------------------------------------
\26\ See, Real-Time Public Reporting of Swap Transaction Data, 75
Fed. Reg. 76140 (proposed Dec. 7, 2010) (CFTC); Regulation SBSR--
Reporting and Dissemination of Security-Based Swap Information, 75 Fed.
Reg. 75208 (proposed Dec. 2, 2010) (SEC). The Commissions use different
fields for the reporting systems.
\27\ See, Requirements for Derivatives Clearing Organizations,
Designated Contract Markets, and Swap Execution Facilities Regarding
the Mitigation of Conflicts of Interest, 75 Fed. Reg. 63732 (proposed
Oct. 18, 2010) (CFTC); Ownership Limitations and Governance
Requirements for Security-Based Swap Clearing Agencies, Security-Based
Swap Execution Facilities, and National Securities Exchanges with
Respect to Security-Based Swaps Under Regulation MC, 75 Fed. Reg. 65882
(proposed Oct. 26, 2010) (SEC). The SEC Proposed Rules mandate that a
higher percentage of board directors be independent but provides for
fewer mandatory committees.
\28\ See, Risk Management Requirements for Derivatives Clearing
Organizations, 76 Fed. Reg. 3698 (proposed Jan. 20, 2011) (CFTC);
Clearing Agency Standards for Operation and Governance, 76 Fed. Reg.
14472 (proposed Mar. 16, 2011) (SEC). The CFTC takes a much more
detailed approach to margin requirements.
---------------------------------------------------------------------------
The legislative solution to this coordination problem is real
structural reform. In 2009, the Committee on Capital Markets Regulation
called the financial regulatory structure ``an outmoded, overlapping
sectoral model,'' and called for its reorganization.\29\ I regard it as
dysfunctional. The Dodd-Frank Act did little to solve the problem.
Although it eliminated one agency, the Office of Thrift Supervision, it
created three more: FSOC, the Federal Insurance Office, and the Bureau
of Consumer Financial Protection.\30\ FSOC, the agency tasked with some
oversight and coordination roles, is not a solution to the large
structural problem. It has little direct supervisory authority and
power over other agencies, in part because many of its actions require
a \2/3\ supermajority vote.\31\ On the other hand, it is the only game
in town and Secretary Geithner, its Chairman, needs to be more
proactive in insuring agency coordination.
---------------------------------------------------------------------------
\29\ Comm. on Capital Mkts. Reg., The Global Financial Crisis: A
Plan for Regulatory Reform 1, 203 (May 2009).
\30\ See Dodd-Frank Act 312(b) (eliminating the Office of Thrift
Supervision), 111(a) (FSOC), 502 (Federal Insurance Office), 1011(a)
(Bureau of Consumer Financial Protection).
\31\ January Testimony, supra note 3, 18.
---------------------------------------------------------------------------
B. International Coordination
International coordination is equally important. Last September,
the European Union proposed regulations for its derivatives
markets.\32\ Although the E.U. proposal and the U.S. system are
similar, particularly with their joint emphasis on central clearing,
there are many important differences, most of which can only be changed
by bringing the U.S. and E.U. legislation closer. For example, the E.U.
proposal has a much more generous end-user exception and puts less
emphasis on exchange trading. Furthermore, the United States and
European Union differ significantly when it comes to the regulation of
trade repositories. The Dodd-Frank Act provides for detailed regulation
of trade repositories, including specific mechanisms for the disclosure
of information to U.S. and foreign regulators.\33\ The E.U. proposal,
on the other hand, provides general requirements for trade repositories
and does not specifically address disclosure of information to E.U. and
non-E.U. regulators.\34\
---------------------------------------------------------------------------
\32\ Proposal for a Regulation of the European Parliament and of
the Council on OTC derivatives, central counterparties and trade
repositories, COM (2010) 484 final (Sept. 15, 2010) (hereinafter E.U.
Proposal).
\33\ Dodd-Frank Act 728.
\34\ E.U. Proposal, Article 64.
---------------------------------------------------------------------------
But the regulation of clearinghouses provides a risk of conflict
that is not inherent in Dodd-Frank. Under the proposed E.U.
regulations, in order for a U.S. or other foreign clearinghouse to be
recognized by the European Union, the European Securities and Markets
Authority (ESMA) must determine that there is equivalent home state
regulation, authorization, and supervision provisions, as well as
cooperation arrangements with the ESMA.\35\ Similarly, under the Dodd-
Frank Act, U.S. regulators may exempt a foreign clearinghouse from
certain regulations only if the foreign organization is subject to
comparable and comprehensive home state regulation.\36\ These
equivalence determinations may be difficult if E.U. and U.S. regulation
divide on major matters like risk management and governance. Will the
European Union permit E.U. firms to use U.S. clearinghouses that admit
members with less capital than is required for E.U. clearinghouses?
\37\ I am not suggesting that the CFTC abandon its approach to member
capital, but rather that it detail how the clearinghouses can be
structured to be as safe with such lowered capital requirements for
members. Conversely, will the CFTC permit U.S. firms to use dealer-
owned clearinghouses in the European Union while insisting that there
be limitations on dealer ownership in the United States? \38\ This
would be unwise. Yet, not doing so could lead the major dealers to use
European rather than U.S. clearinghouses. Or will the Fed permit U.S.
banks to use E.U. clearinghouses that do not have access to the ECB
discount window when the Fed permits such access here, albeit under
unusual and exigent circumstances? These important issues must be
resolved before going live with the new rules.
---------------------------------------------------------------------------
\35\ E.U. Proposal, Article 23.
\36\ Dodd-Frank Act 738(a).
\37\ See, Risk Management Requirements for Derivatives Clearing
Organizations 39.12, 76 Fed. Reg. 3698, 3719 (proposed Jan. 20, 2011)
($50 million requirement).
\38\ See Dodd-Frank Act 726(a); Requirements for Derivatives
Clearing Organizations, Designated Contract Markets, and Swap Execution
Facilities Regarding the Mitigation of Conflicts of Interest 39.25,
75 Fed. Reg. 63732, 63750 (proposed Oct. 18, 2010) (imposing limits on
ownership).
---------------------------------------------------------------------------
IV. Micromanagement
Overall the SEC seems to embrace the principles-based approach of
the Dodd-Frank Act more than the CFTC, which has tended to propose
rules that would micro-manage the industry. For example, the CFTC
proposed a detailed rule concerning block trades, while the SEC took a
simpler approach.\39\ Similarly, the CFTC's rules about margin in
clearinghouses are far more specific than the SEC's.\40\ When
developing its rules for Swap Execution Facilities, the CFTC described
a Request for Quote system that required sending requests to at least
five members, while the SEC gave more freedom.\41\ In general, a broad,
principles-based approach is preferable to an approach of
micromanagement, unless there are specific reasons to think that a
detailed rule is necessary. A broad approach is particularly important
when, as here, dozens of rules will reshape an industry in ways that
cannot be predicted. As I have described, a staged implementation
approach could begin with broad, principled rules and gradually phase
in more specific rules when they are necessary and after the
Commissions can be more confident that they will not unnecessarily
disrupt the market.
---------------------------------------------------------------------------
\39\ See, Real-Time Public Reporting of Swap Transaction Data
43.5, 75 Fed. Reg. 76140, 76174-76 (proposed Dec. 7, 2010) (CFTC);
Regulation SBSR--Reporting and Dissemination of Security-Based Swap
Information 242.902, 75 Fed. Reg. 75208, 75285 (proposed Dec. 2,
2010) (SEC); see also Letter from the Comm. on Capital Mkts. Reg. to
David Stawick, Sec'y of the Comm'n, Commodity Futures Trading Comm'n
and Elizabeth Murphy, Sec'y, Sec. and Exch. Comm'n 4 (Jan. 18, 2011),
http://www.capmktsreg.org/pdfs/
2011.01.18_Swaps_Reporting_Comment_Letter.pdf.
\40\ See, Clearing Agency Standards for Operation and Governance
240.17Ad-22(b)(2), 76 Fed. Reg. 14472, 14538 (proposed Mar. 16, 2011)
(SEC); Risk Management Requirements for Derivatives Clearing
Organizations 39.13(g), 76 Fed. Reg. 3698, 3720 (proposed Jan. 20,
2011) (CFTC).
\41\ Registration and Regulation of Security-Based Swap Execution
Facilities 242.801, 76 Fed. Reg. 10948, 11054 (proposed Feb. 28,
2011) (SEC); Core Principles and Other Requirements for Swap Execution
Facilities, 37.9(a)(ii)(A), 76 Fed. Reg. 1214, 1241(proposed Jan. 7,
2011) (CFTC).
---------------------------------------------------------------------------
Thank you and I look forward to your questions.
Appendix A
---------------------------------------------------------------------------
\42\ This table does not contain interim rules, corrections,
extensions, or other variations.
CFTC Proposed Rules to Date Concerning Derivatives under the Dodd-Frank
Act 42
------------------------------------------------------------------------
Proposed
Date CFTC Category Rule
------------------------------------------------------------------------
10/14/2010 VII: DCO Core Principle Financial Resources
Rulemaking, Interpretation & Requirements for
Guidance Derivatives Clearing
X: Systemically Important DCO Organizations
Rules Authorized Under Title
VIII
10/18/2010 IX: Governance & Possible Requirements for
Limits on Ownership & Derivatives Clearing
Control Organizations, Designated
Contract Markets, and Swap
Execution Facilities
Regarding the Mitigation
of Conflicts of Interest
10/26/2010 XIX: Agricultural Swaps Agricultural Commodity
Definition
10/27/2010 XXX: Fair Credit Reporting Business Affiliate
Act and Disclosure of Marketing and Disposal of
Nonpublic Personal Consumer Information Rules
Information
10/27/2010 XXX: Fair Credit Reporting Privacy of Consumer
Act and Disclosure of Financial Information;
Nonpublic Personal Conforming Amendments
Information Under Dodd-Frank Act
11/2/2010 XXIX: Reliance on Credit Removing Any Reference to
Ratings or Reliance on Credit
Ratings in Commission
Regulations; Proposing
Alternatives to the Use of
Credit Ratings
11/2/2010 XXVI: Position Limits, Position Reports for
including Large Trader Physical Commodity Swaps
Reporting, Bona Fide Hedging
Definition & Aggregate
Limits
11/2/2010 VIII: Process for Review of Process for Review of Swaps
Swaps for Mandatory Clearing for Mandatory Clearing
11/2/2010 XXIV: Disruptive Trading Anti-disruptive Practices
Practices Authority Contained in the
Dodd-Frank Wall Street
Reform and Consumer
Protection Act
11/2/2010 XV: Rule Certification & Provisions Common to
Approval Procedures Registered Entities
(applicable to DCMs, DCOs,
SEFs)
11/3/2010 XXIX: Reliance on Credit Investment of Customer
Ratings Funds and Funds Held in an
Account for Foreign
Futures and Foreign
Options Transactions
11/3/2010 XXIII: Anti-Manipulation Prohibition of Market
Manipulation
11/17/2010 IV: Internal Business Conduct Implementation of Conflicts
Standards of Interest Policies and
Procedures by Futures
Commission Merchants and
Introducing Brokers
11/19/2010 IV: Internal Business Conduct Designation of a Chief
Standards Compliance Officer;
Required Compliance
Policies; and Annual
Report of a Futures
Commission Merchant, Swap
Dealer, or Major Swap
Participant
11/19/2010 XIV: New Registration Registration of Foreign
Requirements for Foreign Boards of Trade
Boards of Trade
11/23/2010 IV: Internal Business Conduct Regulations Establishing
Standards and Governing the Duties
of Swap Dealers and Major
Swap Participants
11/23/2010 IV: Internal Business Conduct Implementation of Conflicts
Standards of Interest Policies and
Procedures by Swap Dealers
and Major Swap
Participants
11/23/2010 I: Registration Registration of Swap
Dealers and Major Swap
Participants
12/3/2010 VI: Segregation & Bankruptcy Protection of Collateral of
for both Cleared and Counterparties to
Uncleared Swaps Uncleared Swaps; Treatment
of Securities in a
Portfolio Margining
Account in a Commodity
Broker Bankruptcy
12/6/2010 XXV: Whistleblowers Implementing the
Whistleblower Provisions
of Section 23 of the
Commodity Exchange Act
12/7/2010 XVIII: Real Time Reporting Real-Time Public Reporting
of Swap Transaction Data
12/8/2010 XVII: Data Recordkeeping & Swap Data Recordkeeping and
Reporting Requirements Reporting Requirements
12/9/2010 XVII: Data Recordkeeping & Reporting, Recordkeeping,
Reporting Requirements and Daily Trading Records
Requirements for Swap
Dealers and Major Swap
Participants
12/13/2010 VII: DCO Core Principle General Regulations and
Rulemaking, Interpretation & Derivatives Clearing
Guidance Organizations
12/15/2010 VII: DCO Core Principle Information Management
Rulemaking, Interpretation & Requirements for
Guidance Derivatives Clearing
Organizations
12/17/2010 XVII: Data Recordkeeping & Reporting Certain Post-
Reporting Requirements Enactment Swap
Transactions
12/21/2010 II: Definitions, such as Swap Further Definition of
Dealer, Major Swap ``Swap Dealer,''
Participant, Security-Based ``Security-Based Swap
Swap Dealer, and Major Dealer,'' ``Major Swap
Security-Based Swap Participant,'' ``Major
Participant, to be Written Security-Based Swap
Jointly with SEC Participant'' and
``Eligible Contract
Participant''
12/22/2010 III: Business Conduct Business Conduct Standards
Standards with for Swap Dealers and Major
Counterparties Swap Participants With
Counterparties
12/22/2010 XII: DCM Core Principle Core Principles and Other
Rulemaking, Interpretation & Requirements for
Guidance Designated Contract
Markets
12/23/2010 XVI: Swap Data Repositories Swap Data Repositories
Registration Standards and
Core Principle Rulemaking,
Interpretation & Guidance
12/23/2010 XI: End-user Exception End-User Exception to
Mandatory Clearing of
Swaps
12/28/2010 IV: Internal Business Conduct Confirmation, Portfolio
Standards Reconciliation, and
Portfolio Compression
Requirements for Swap
Dealers and Major Swap
Participants
1/6/2011 IX: Governance & Possible Governance Requirements for
Limits on Ownership & Derivatives Clearing
Control Organizations, Designated
Contract Markets, and Swap
Execution Facilities;
Additional Requirements
Regarding the Mitigation
of Conflicts of Interest
1/7/2011 XIII: SEF Registration Core Principles and Other
Requirements and Core Requirements for Swap
Principle Rulemaking, Execution Facilities
Interpretation & Guidance
1/20/2011 VII: DCO Core Principle Risk Management
Rulemaking, Interpretation & Requirements for
Guidance Derivatives Clearing
Organizations
1/26/2011 XXVI: Position Limits, Position Limits for
including Large Trader Derivatives
Reporting, Bona Fide Hedging
Definition & Aggregate
Limits
2/3/2011 XIX: Agricultural Swaps Commodity Options and
Agricultural Swaps
2/8/2011 IV: Internal Business Conduct Orderly Liquidation
Standards Termination Provision in
Swap Trading Relationship
Documentation for Swap
Dealers and Major Swap
Participants
2/8/2011 IV: Internal Business Conduct Swap Trading Relationship
Standards Documentation Requirements
for Swap Dealers and Major
Swap Participants
2/11/2011 XXVII: Investment Adviser Reporting by Investment
Reporting Advisers to Private Funds
and Certain Commodity Pool
Operators and Commodity
Trading Advisors on Form
PF
2/11/2011 XXVII: Investment Adviser Commodity Pool Operators
Reporting and Commodity Trading
Advisors: Amendments to
Compliance Obligations
3/3/2011 XXXI: Conforming Amendments Amendments to Commodity
Pool Operator and
Commodity Trading Advisor
Regulations Resulting From
the Dodd-Frank Act
3/9/2011 XXXI: Conforming Amendments Registration of
Intermediaries
3/10/2011 VII: DCO Core Principle Requirements for
Rulemaking, Interpretation & Processing, Clearing, and
Guidance Transfer of Customer
Positions
------------------------------------------------------------------------
The Chairman. Thank you, Mr. Scott.
And now, Dr. Overdahl, your comments for 5 minutes.
STATEMENT OF JAMES A. OVERDAHL, Ph.D., VICE PRESIDENT, NATIONAL
ECONOMIC RESEARCH ASSOCIATES,
WASHINGTON, D.C.
Dr. Overdahl. Thank you for the invitation to appear here
today and offer my perspective on the role of economic analysis
in the rulemaking process of the CFTC. Because of the CFTC's
important role in implementing Dodd-Frank, understanding this
process is also important.
My perspective is based on my experience as a former chief
economist at the CFTC, as well as the SEC. My remarks today are
my own and do not reflect the views of NERA or its clients.
Several statutes include provisions that require some form
of economic analysis or cost-benefit analysis in the CFTC's
rulemaking process. First, Section 15(a) of the Commodity
Exchange Act requires the Commission to, consider, cost and
benefits in the rulemaking process. Second, the Paperwork
Reduction Act also requires cost-benefit analysis; however,
this analysis applies only to a rule's paperwork burden and
does not include a broader analysis of the economic effects of
the rule.
Third, like other Federal regulatory agencies, the CFTC's
rulemaking process is governed by the Administrative Procedure
Act, which requires the Commission to justify its exercise of
rulemaking authority and to avoid actions that are arbitrary or
capricious. Recent court decisions citing the APA have turned
on the adequacy of economic analysis considered by regulators
when adopting new rules. The message from the courts is that
regulators' economic arguments need to be adequately supported
and that vigorous assertion is not a substitute for rigorous
economic analysis.
In sum, the statutory requirements for conducting economic
analysis are fairly minimal and easily satisfied. In this
respect, the CFTC is similar to other independent regulatory
commissions across the Federal Government.
Economic analysis can be used for more than just satisfying
procedural requirements. It can help improve regulatory
decision-making. I have found that data-driven economic
analysis enhances the ability of Commissioners to ask better
questions, better understand the tradeoffs and consequences
associated with the proposed rule, and to make more informed
decisions.
In my view, economic analysis goes beyond what is readily
quantifiable and includes consideration of unintended
consequences and potential effects of regulatory actions,
including identifying potential changes in behavior of market
participants. It also is helpful at the very earliest stages of
the rulemaking process by helping frame the problem that is
being addressed by the proposed regulatory action.
Internally, the CFTC requires the rulemaking divisions to
consult with the Office of the Chief Economist. However,
rulemaking divisions are not required to obtain formal sign-off
from the office before proposing a rule. As a result, the
economic staff is often used in the rulemaking process in a
behind-the-scenes consulting role.
One obstacle to effectively apply economic analysis to the
rulemaking process is the lack of relevant data. The CFTC has
often relied on public comments to supply data and analysis.
Although these comments can be extremely valuable, they rarely
include the type of data and analysis that can serve as a
substitute for the Commission conducting its own thorough
analysis.
In closing, I would like to offer a few suggestions on how
economic analysis can be better utilized at the CFTC.
First, I believe that some type of formal requirement is
necessary to institutionalize economic analysis at the CFTC.
Such a requirement could be adopted by the agency itself
through its own internal policies and procedures and add to
consistency in the process not only across the rulemaking
agenda but across time.
Second, economic analysis needs to be included in the
rulemaking process at an early stage, both for the proposed
rules but also for the problem that the rule is aimed at
addressing.
Third, the process of collecting data for analyzing
proposed rules needs to be improved.
Fourth, I believe it would be helpful for regulatory
agencies like the CFTC to have some very specific agency-
specific guide to help guide the process of using economic
analysis in its rulemaking process, similar to what Britain's
FSA uses.
Fifth, experience has shown that the discipline, rigor, and
overall quality of economic analysis improves when regulators
know that their analysis will be reviewed by others. For
Executive Branch agencies, OMB review serves this role. For
independent agencies like the CFTC, there is no hardwired
ongoing review of their analyses, and perhaps there should be.
Economic analysis is necessary because it enhances the
ability of the Commission to make informed decisions. An added
benefit is it will help improve the overall transparency and
accountability of the process. And for these reasons, economic
analysis in the rulemaking process should be a high priority.
Thank you, and I look forward to your questions.
[The prepared statement of Dr. Overdahl follows:]
Prepared Statement of James A. Overdahl, Ph.D., Vice President,
National Economic Research Associates, Washington, D.C.
Chairman Conaway, Ranking Member Boswell, and other Members of the
Subcommittee. I appear before you today in my current role as a Vice
President of National Economic Research Associates, or NERA, and as a
former Chief Economist of the Commodity Futures Trading Commission
(CFTC). I thank you for allowing me a chance to share my observations
about the role of economic analysis in the rulemaking process at the
CFTC.
In my testimony today I will address three topics. First, I will
describe the current role and importance of economic analysis in the
rulemaking process at the CFTC. Second, I will describe some of the
obstacles limiting the effective application of economic analysis to
the process. Lastly, I will offer suggestions on how economic analysis
can be better utilized to help craft cost-effective regulations, help
enhance the accountability of regulatory agencies to the public, and
help improve the overall transparency of the rulemaking process.
I. The Current Role of Economic Analysis in the Rulemaking Process at
the CFTC
The economics program at the CFTC is administered in the Office of
the Chief Economist and staffed by approximately a dozen economists.
Economists within this office perform the bulk of the Commission's
analytical work with respect to policy and regulatory initiatives.
Although these economists play a role in the Commission's rulemaking
process, they perform other roles too such as providing litigation
support in enforcement proceedings, gathering data and conducting
analysis about emerging market issues, and responding to abnormal
market events, such as the 2008 financial crisis, or last year's
``flash crash.'' Outside of the Office of the Chief Economist, another
four dozen or so industry economists are employed within the CFTC's
operating divisions, primarily in the Division of Market Oversight,
performing the day-to-day tasks of market surveillance.
Determining priorities and allocating the resources of the
economics program at the CFTC is the job of the Chief Economist, who
must consider the Chairman's priorities, the complexity of analysis
required, the urgency of the rulemaking calendar, litigation risks, and
the staff-to-staff working relationship with the drafters of the rule.
These considerations have contributed to the inconsistent application
of economic analysis across the rulemaking agenda at the CFTC.
The CFTC does not have a formal requirement for including economic
analysis in the rulemaking process, aside from the requirements of the
Regulatory Flexibility Act and the cost-benefit requirements of the
Paperwork Reduction Act (PRA). However, the analysis required in the
PRA applies only a rule's paperwork burden, and does not include an
analysis of broader economic effects of a rule. The CFTC's authorizing
statute, the Commodity Exchange Act, contains a provision in Section
15(a) requiring that the Commission ``consider'' costs and benefits in
the rulemaking process. Section 15(a) requires that ``[b]efore
promulgating a regulation . . . or issuing an order . . . the
Commission shall consider the costs and benefits of the action of the
Commission.'' In addition Section 15(a) requires that:
The costs and benefits of the proposed Commission action shall
be evaluated in light of (A) considerations of protection of
market participants and the public; (B) considerations of the
efficiency, competitiveness, and financial integrity of futures
markets; (C) considerations of price discovery; (D)
considerations of sound risk management practices; and (E)
other public interest considerations.
The CFTC, like other Federal regulatory agencies, is subject to the
Administrative Procedure Act (APA) which requires the Commission to
justify their exercise of rulemaking authority and avoid actions that
are ``arbitrary, capricious, an abuse of discretion, or otherwise not
in accordance with the law.'' Although this language falls short of a
formal requirement for the application of economic analysis to the
rulemaking process, recent court decisions have turned on the adequacy
of economic support considered by regulators before exercising
rulemaking authority under the APA. The prospect of scrutiny by the
courts has caused regulatory agencies like the CFTC to pay more
attention to the quality of their economic arguments when proposing new
rules--at least for those rules likely to be challenged in court.\1\
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\1\ See, Chamber of Commerce of U.S. v. S.E.C., 412 F.3d 133 (D.C.
Cir. 2005), and 443 F.3d 890 (D.C. Cir. 2006); Am. Equity Investment
Life Ins. Co. v. S.E.C., 572 F.3d 923 (D.C. Cir. 2009), and 2010 WL
2813600 (D.C. Cir. July 12, 2010); and NetCoalition v. S.E.C., 2010 WL
3063632 (D.C. Cir. August 6, 2010).
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Aside from requirements posed by statues and the courts for
consideration of costs and benefits when proposing new rules, the CFTC
has its own internal policies. Within the CFTC, Commission policy
requires operating divisions to ``consult'' with the Office of the
Chief Economist before proposing a new rule to the Commission. However,
operating divisions are not required to obtain formal sign-off from the
Office before proposing a rule.
In sum, the requirements for conducting economic analysis in the
rulemaking process are fairly minimal and easily satisfied. In this
respect, the CFTC is not unlike other independent regulatory
commissions (IRCs). A recent study of the economic analysis used by
IRCs finds that ``the analysis conducted . . . is generally the minimum
required by statute.'' The study also finds that:
In many instances the IRCs appear to be issuing major
regulation without reporting any quantitative information on
benefits and costs--apart from the paperwork burden--that would
routinely be expected for Executive Branch agencies covered by
E.O. 12866. Instead, there is only a qualitative discussion of
the benefits and costs. The IRCs present this discussion
without any formal review of alternatives. Their analyses
generally do not consider behavioral change. They also do not
estimate possible unintended effects. And perhaps most
importantly, with the exception of the estimates of paperwork
burden . . . their analyses of economic effects are not
prepared to comply with any identifiable standards for such
analysis.\2\
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\2\ Arthur Fraas and Randall Lutter ``On the Economic Analysis of
Regulations at Independent Regulatory Commissions,'' Discussion Paper,
Resources for the Future, April 2011.
Although the study does not directly address the CFTC (it is one of
several IRCs reviewed in the study) the results ring true based on my
experience at the CFTC. The CFTC has good economists and good
capability to formally analyze proposed rules, but the economics staff
is typically used in the rulemaking process only in a behind-the-scenes
consulting role.
Aside from the contribution economic analysis can have to
satisfying procedural and statutory requirements, its broader
contribution is to improving regulatory decision making. I found that
Commissioners at the CFTC welcomed independent, data-driven economic
analysis provided by the Commission economics staff. One reason for
this welcoming attitude, I believe, is because interested parties
constantly bombard Commissioners with iron-clad arguments on all sides
of all issues. Transparent analysis, combined with high-quality data
and rigorous analysis clearly enhanced the ability of Commissioners to
ask better questions, better understand the trade-offs and consequences
associated with a proposed rule, and make informed decisions. At times,
Commissioners made decisions that more heavily weighed considerations
outside the realm of economic analysis. Even in these cases, the
accountability and transparency of the process was improved by having
on-the-record economic analysis because it led Commissioners to
publicly consider the economic evidence and then provide a reasoned
basis for their decision.
Economic analysis can be useful at all stages of the rulemaking
process, including the very earliest stage of identifying, clarifying,
and framing the economic issues that can possibly be addressed by a
regulatory action. Once an issue is identified, economic analysis can
be helpful in evaluating alternative regulatory responses and in
determining whether these responses improve upon the existing situation
or dominate market-based solutions.
Within the regulatory process the role of what I am calling
``economic analysis'' is often referred to as ``cost-benefit analysis''
or ``regulatory impact analysis.'' As Professor Chester Spatt, has
observed, the meaning applied to these terms is not universally shared
among regulators.\3\ On the one hand, a narrow interpretation would
imply that economic analysis is limited to cases where regulatory
impacts can be quantified in dollars, such as out-of-pocket compliance
costs. Under this interpretation, the analysis would involve toting up
and comparing dollar costs and dollar benefits attributable to a
proposed rule. On the other hand, a broader interpretation goes beyond
what is readily quantifiable and includes qualitative factors
associated with a proposed rule. Under a broader interpretation,
economic analysis can enhance the regulator's understanding of the
trade-offs, potential effects and unintended consequences of their
actions, including identifying potential changes in behavior by market
participants. The value of economic analysis to the regulator derives
from its capacity to provide a clear, credible, and coherent framework
for articulating the reasoned basis for regulatory action.
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\3\ See Chester S. Spatt, ``Economic Analysis and Cost-Benefit
Analysis: Substitutes or Complements?'' March 15, 2007. Available at
http://www.sec.gov/news/speech/2007/spch031507css.htm.
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For the regulator, failure to adequately consider relevant economic
evidence leaves an adopted rule vulnerable to a court challenge on the
grounds that the agency's action lacked a reasoned basis under the
requirements of the APA. In recent years, the courts have identified
weaknesses in the application of economic analysis to SEC regulatory
decisions, resulting in rules being sent back for further
consideration. The message from the courts has been that regulators'
economic arguments need to be adequately supported--that vigorous
assertion is not a substitute for rigorous economic analysis. The SEC
experience is relevant to the CFTC since its rulemaking process is also
governed by the APA.
II. Obstacles Limiting the Effective Application of Economic Analysis
to the Rulemaking Process
Although there currently are no formal requirements for including
economic analysis in the rulemaking process at the CFTC, this has not
always been the case.\4\ At one time the CFTC had a Division of
Economic Analysis with full sign-off authority on proposed rules.
However, as part of the CFTC's restructuring following the enactment of
the Commodity Futures Modernization Act of 2000, the market
surveillance portion of the Division was placed in a new Division of
Market Oversight and the economic analysis function was spun-off into
an independent Office of the Chief Economist. Although full sign-off
authority for proposed rules resided with the new Division of Market
Oversight, this authority was not retained for the new Office of the
Chief Economist.
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\4\ At one point, in the early 1990s, three of the CFTC's five
Commissioners were Ph.D. economists, who presumably conducted their own
economic analysis of rules they proposed.
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Across time, individual CFTC Chairmen have created requirements for
the use of economic analysis in rulemaking, but these requirements were
not institutionalized. Since the requirements simply reflected the
preferences of individual chairmen, when these chairmen left, the
requirements were discontinued or simply forgotten. The absence of an
institutionalized role for economic analysis in the rulemaking process
has been one obstacle limiting its effective application at the CFTC.
Another obstacle to applying rigorous economic analysis to the
rulemaking process is that the rulemaking divisions of the CFTC have
never fully bought into the idea. In some cases, particularly in cases
where good working relationships existed between the economics staff
and the staff of the operating divisions, the process worked well.
Economists were routinely included at an early stage and their analyses
were welcomed and integrated into the process. In other cases, those in
the operating divisions who ``held the pen'' in drafting rules would
take a proprietary view and regard the rules as their turf. In other
instances the drafters of a rule would regard their product as an
unassailable good work that could only be diminished by economic
analysis. In these cases, intruders were not welcome until the process
was sufficiently far along so that the rule would be recommended to the
Commission with only superficial (and last minute) input from the
economics staff.
Another obstacle to effectively applying economic analysis to the
rulemaking process has been a lack of relevant data. In my view, this
problem is related to the fact that economists are often not consulted
in the rulemaking process with sufficient lead time to locate or
generate useful data. Without useful data, the power of economic
analysis is severely degraded.
Often, the CFTC has relied on public comments to supply data and
analysis. Although public comments can be extremely valuable to
providing some types of information, they rarely include the type of
data and analysis that can truly inform the process and serve as a
substitute for the Commission conducting its own analysis. Often, the
most useful information from public comments is that which addresses
compliance costs associated with proposed rules. To draw out this type
of data, the CFTC will often pose specific questions on these topics in
proposed rules. As with Commission staff, members of the public also
require sufficient lead time to locate useful data and conduct
meaningful analysis of proposed rules. The time constraints of the
public comment process often limit the ability of the public to provide
useful analysis for the record before the comment period expires.
Another problem in obtaining useful data and analysis from the
public are constraints imposed under the Paperwork Reduction Act (PRA)
that limit the ability of regulators to survey members of the public
who may possess useful data and information relevant to a proposed
rule. The PRA requires OMB approval of surveys involving more than nine
entities. The time required to gain OMB approval of a survey design
that would include a larger group of respondents can take nearly as
long as the Commission's rulemaking process itself. As a result, the
CFTC rarely uses surveys of more than nine people in forming cost
estimates for proposed rules. This limitation necessarily reduces the
quality of cost estimates. The CFTC will rely on the public comment
process to challenge the cost estimates published as part of the
proposed rule. A related problem involves the confidentiality of cost
data supplied to the regulator to inform the rulemaking process.
Businesses in a position to supply useful data and analysis often do
not do so because they do not want to publicly disclose information
that could deprive them of a competitive advantage.
I will note that there is evidence that the quality of information
supplied through the public comment process has started to improve in
response to recent court decisions. I have found that parties
potentially affected by proposed rules now regard the notice and
comment rulemaking process as if it was part of a legal proceeding.
Affected parties are increasingly viewing the comment process as an
opportunity to place on the public record factual information about
likely compliance costs and suggested alternative means of meeting the
objectives of regulators. Because of the potential for litigation,
parties commenting on proposed rules are directing their comments not
only to the members of the regulatory commission involved in adopting
rules, but also to the judges who may be reviewing the public record
for rules that are challenged through the courts. Because the outcome
of recent court challenges to Federal rules have turned on the adequacy
of the economic support considered by regulators when they adopted new
rules, parties submitting comments to the public record are paying
particular attention to the quality of their economic arguments.
III. Suggestions on How Economic Analysis Can Be Better Utilized to
Craft Regulations
In closing, I would like to offer a few suggestions on how economic
analysis can be better utilized to help craft cost-effective
regulations, help enhance the accountability of regulatory agencies to
the public, and help improve the overall transparency of the rulemaking
process.
First, economic analysis needs to be included in the rulemaking
process at an early stage. It is at the early stages where a rule's
``term sheet'' is developed by the rulemaking division. The term sheet
is a high level overview describing the proposed rule and identifying
the market problem the rule is designed to address. I believe it would
be useful at this stage to also include a high level economic review of
both the rule and the problem. This review would be performed before
the term sheet advances outside of the division proposing the rule.
This review should include some analysis indicating whether the rule is
likely to be a major or minor rule in terms of its economic impact.
Determining at an early stage whether a rule is likely to be major or
minor can help devote sufficient resources to those rules likely to
have a major economic impact. An early review would provide lead time
for the economics team to assess the complexity of the analysis
required and to begin gathering data that could be applied to analyzing
the proposed rule.
In my view, an early ``term sheet review'' will likely require a
formal policy adopted by the Commission to guide the rulemaking
process. A formal policy would add consistency to the process. Crafting
such a formal policy holds the potential for making an already
cumbersome process even more cumbersome. However, without sufficient
lead times, regulators cannot effectively use economic analysis to help
them identify and frame problems, evaluate alternatives, and have data-
driven analyses available to inform their deliberations.
Another way to improve the quality of economic analysis is to
improve the data collection process. One way to do this would be to
streamline the process by which regulators can survey firms for
information about potential compliance costs. Another way to do this is
to allow a process where firms could confidentially disclose to the
regulator cost information that would be useful in evaluating the
potential impact of a rule. Another way to gather data is for the
regulator, whenever possible, to run pilot programs that can generate
useful data for analysis. In the past, such pilot programs have proven
useful to the deliberations of regulators. One advantage of pilot
programs is that data generated from the program can be made available
to the academic community for analysis in addition to being available
for the regulator's own staff. Finally, those providing public comments
on proposed rules can improve the process by paying particular
attention to the quality of their economic arguments and by providing
data and analysis when appropriate.
Experience has shown that the discipline, rigor, and overall
quality of economic analysis considered by regulators as part of their
rulemaking process improves when the regulator knows that their
analysis will be reviewed by others.\5\ We see some evidence of this as
a result of recent court cases. Congressional oversight can also play
an important role. For executive branch agencies, OMB review serves
this role. But for independent regulatory agencies like the CFTC there
is no hard-wired, ongoing review of their analyses. It is not clear how
such a review could be implemented for independent agencies or if a
formal review structure is even desirable. One solution would be for
independent regulatory agencies like the CFTC to make their analyses
publicly available so that they can be reviewed and evaluated by
professional peers.
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\5\ See, for example, Richard D. Morgenstern, ``Reflections on the
Conduct and Use of Regulatory Impact Analysis at the U.S. Environmental
Protection Agency,'' Discussion Paper, Resources for the Future, April
2011.
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Even in a rulemaking process that includes rigorous economic
analysis, there will always be considerable uncertainty about a rule's
economic impact. Therefore, it may be helpful to have an ongoing post-
adoption review of rules to determine the actual economic impact of a
rule's implementation.
I believe it would be helpful for the CFTC to develop a guide for
the use of economic analysis in its rulemaking procedures. Britain's
Financial Services Authority (FSA) has produced such a guide that could
serve as a useful starting point for developing a similar guide for the
United States.\6\ I understand that the SEC has been working on
developing such a guide for its internal use. I believe that such a
guide would be more helpful that current OMB guidance or the guidance
offered in current or past Executive Orders that are difficult to apply
directly to financial market regulation. I believe that such guidance
can enhance consistency in the process both across the rulemaking
agenda and across time. Such guidance would need to be adopted in the
CFTC's internal policies and procedures.
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\6\ See Financial Services Authority Central Policy, ``Practical
Cost-Benefit Analysis for Financial Regulators'' June, 2000, available
online at: http://www.fsa.gov.uk/pubs/foi/cba.pdf.
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In the end, economic analysis is more than about satisfying
procedural requirements for regulatory rulemaking. Improving the power
and consistency of economic analysis at the CFTC is important because
it will enhance the ability of regulators to make informed decisions.
An added benefit is that it will also help enhance the overall
transparency and accountability of the rulemaking process.
I look forward to your questions.
The Chairman. Thank you, Doctor.
Ms. McMillan for 5 minutes.
STATEMENT OF KAREN H. McMILLAN, GENERAL COUNSEL, INVESTMENT
COMPANY INSTITUTE, WASHINGTON, D.C.
Ms. McMillan. Thank you, Chairman Conaway and
Representative Boswell, and thank you to the Subcommittee for
the opportunity to offer the views of the Investment Company
Institute on these important topics.
My name is Karrie McMillan, and I am the General Counsel of
the ICI. ICI is the national trade association of mutual funds
and other investment companies, and our members are entrusted
with managing $13 trillion on behalf of 90 million
shareholders.
The fund industry has long recognized that efficient,
effective, and evenhanded regulation is crucial to protecting
investors and the markets. We have a lot of experience with
regulation. Funds are regulated by all four of the Federal
securities laws.
Developing effective regulation, however, can be very
difficult. And that is clearly demonstrated by the rules that
the CFTC and the SEC are developing now to implement Dodd-
Frank's provisions on derivatives. ICI and other trade
associations have pointed out that the short and strict
deadlines imposed by Dodd-Frank have made it difficult to fully
analyze these very important rule proposals.
Coming into compliance with these proposals will be equally
challenging. If the rules are unclear or if they are overly
restrictive, market participants could withdraw from the
derivatives markets and have liquidity leave those markets, as
well.
A clear example of this sort of process is the agency's
decision to propose requirements for swap dealers and major
swap participants before even defining who those players are.
It is awfully hard to analyze and comment upon rules when you
don't know whether your business is in or out of the affected
groups.
The answer, we think, is for the agencies to take a
somewhat slower approach to ensure that there is time for the
thoughtful and comprehensive analysis that these important
rules deserve. And a slower approach should give affected
parties more time to comment on the proposals, and to comply
with them when they are finally adopted.
Surprisingly, though, the CFTC has chosen to make its own
workload heavier by taking an expansive new rulemaking that is
not mandated by Dodd-Frank nor, as far as we can see, based on
harm to investors or to the markets. I am speaking of the
CFTC's proposal to amend Rule 4.5, which currently exempts
funds regulated by the SEC from a second layer of regulation by
the CFTC if they use futures, options, and swaps as part of
their investment strategy.
The CFTC maintains that it needs to stop the practice of
registered investment companies offering futures-only product
without CFTC oversight. But the proposal goes far beyond the
handful of funds that could reasonably be described as futures-
only products. Instead, the amendments are sweeping and could
bring in hundreds, if not thousands, of funds.
Clearly, we object to the substance of these rules. As I
mentioned earlier, funds are already comprehensively regulated
with regulation that ensures thorough disclosure to investors,
limits their use of leverage, promotes diversification, ensures
the safe custody of fund assets, and governs conflicts of
interest.
It is important to emphasize that, if this rule were to go
forward, these two sets of regulation that would be imposed on
funds would be both duplicative and contradictory. And the
funds affected could include some as basic as S&P 500 stock
funds or tax-exempt bond funds that are used by investors
saving for retirement and other long-term goals, not the
speculators in futures and options markets.
So we have to ask, why now? Why, in the middle of this rush
to implement Dodd-Frank, is the CFTC diverting its resources,
and, honestly, those of funds in their shareholders, on a
proposal with so little justification? Why does the Commission
want to sweep hundreds of new registrants into an oversight
system that is already strained and add a second layer of
regulation?
We also have to ask how the CFTC can impose costly and
burdensome new regulation on funds with a cost-benefit analysis
that is cursory at best. As both Chairman Conaway and Chairman
Lucas previously observed, ``The CFTC is failing to adequately
conduct cost-benefit analysis,'' a concern also shared by some
Commissioners of the CFTC. This rule clearly falls into that
pattern.
Mr. Chairman, we recognize that the financial regulatory
agencies are facing an unprecedented task in developing rules
under Dodd-Frank. We commend them for their diligence and
dedication. But we would urge them to make their own burden
lighter by slowing down, getting the rules right, and not
embarking on excursions into areas that are not mandated by the
legislation.
Thank you, and I look forward to your questions.
[The prepared statement of Ms. McMillan follows:]
Prepared Statement of Karen H. McMillan, General Counsel, Investment
Company Institute, Washington, D.C.
Executive Summary
Registered investment companies, or ``funds,'' use swaps and
other derivatives in a variety of ways. ICI and its members
thus have a strong interest in ensuring that the new regulatory
framework for the derivatives markets supports and fosters
markets that are highly competitive, transparent, and liquid.
ICI commends the CFTC and SEC for their diligence and
dedication in the very difficult task of developing an
appropriate regulatory framework and avoiding unintended
consequences. We do, however, have concerns with the order in
which rules have been published for public comment and the
length of the respective comment periods. We also have urged
the CFTC and SEC to phase-in application of new regulatory
requirements over a reasonable period of time.
ICI is particularly concerned with the CFTC's decision in
late January to issue a sweeping proposal to revise or rescind
several of its rules, including Rule 4.5, which currently
provides an exclusion for funds and certain ``otherwise
regulated'' entities from regulation as commodity pool
operators. The proposal is not mandated or even contemplated by
the Dodd-Frank Wall Street Reform and Consumer Protection Act.
And its issuance at this time is most unfortunate, because it
has diverted attention away from the effort to implement the
provisions of the Dodd-Frank Act.
The proposed amendments to Rule 4.5 are premature and
insufficiently developed. For example, the CFTC proposes a key
trading restriction that would relate to margin levels on
derivatives positions. ICI and its members cannot assess the
full impact of this proposed restriction because it is not yet
known which swaps will be subject to central clearing, what the
margin requirements will be for cleared and uncleared swaps,
and whether foreign exchange forwards and foreign exchange
swaps will be exempted from the definition of ``swap.''
If adopted in their current form, the proposed amendments to
Rule 4.5 would subject funds--which are already subject to
comprehensive regulation under all four of the major Federal
securities laws--to duplicative and fundamentally inconsistent
regulatory requirements. The CFTC has failed to demonstrate the
need for imposing a second layer of regulation on funds.
Moreover, its cursory cost-benefit analysis is wholly
inadequate to justify the costly and burdensome regulation
contemplated by the proposed amendments.
Even if the proposed amendments to Rule 4.5 are
appropriately scaled back, there are likely to be some funds
(and their investment advisers) that would become subject to
CFTC regulation. It is essential that the CFTC work closely
with the SEC to reconcile the duplicative and conflicting
regulatory requirements to which these funds would become
subject, and to re-propose the harmonized regulations for
public comment.
I. Introduction
My name is Karrie McMillan. I am General Counsel of the Investment
Company Institute, the national association of U.S. investment
companies, including mutual funds, closed-end funds, exchange-traded
funds (ETFs), and unit investment trusts (UITs). For ease of
discussion, we refer in this testimony to all registered investment
companies as ``funds.'' Members of ICI manage total assets of $13.0
trillion and serve over 90 million shareholders.
ICI is pleased to offer its perspectives on rulemaking by the
Commodity Futures Trading Commission (CFTC or Commission) to implement
provisions of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (Dodd-Frank Act). We also provide our views on the CFTC's recent
decision to issue a sweeping proposal to modify or rescind several of
its exemptive and exclusionary rules, a proposal that is not mandated
(or even contemplated) by the Dodd-Frank Act. The proposed amendments
to one of those rules--CFTC Rule 4.5--are premature and insufficiently
developed. If adopted in their current form, those amendments would
subject a large segment of the fund industry--which is already subject
to comprehensive regulation--to duplicative and fundamentally
inconsistent regulatory requirements.
II. ICI Views on CFTC Rulemaking To Implement the Derivatives Reform
Provisions of the Dodd-Frank Act
Like many financial institutions, funds use swaps and other
derivatives in a variety of ways. They are a particularly useful
portfolio management tool in that they offer funds considerable
flexibility in structuring their investment portfolios. Uses of swaps
and other derivatives include, for example, hedging positions,
equitizing cash that a fund cannot immediately invest in direct equity
holdings (e.g., if the stock market has already closed for the day),
managing the fund's cash positions more generally, adjusting the
duration of the fund's portfolio (e.g., by seeking to maintain a bond
fund's stated duration of 7 years as its holdings in fixed-income
securities age or mature), managing bond positions in general (e.g., in
anticipation of expected changes in monetary policy or the Treasury's
auction schedule), or managing the fund's portfolio in accordance with
the investment objectives stated in its prospectus.
Implementation of the Dodd-Frank Act will dramatically change
financial regulation in the United States by, among other things,
establishing a new regulatory framework for the derivatives markets and
participants in those markets.\1\ ICI and its members have a strong
interest in ensuring that the derivatives markets are highly
competitive and transparent, and that the regulation governing them
encourages liquidity, fairness and transparency. ICI has therefore been
closely monitoring the work of the CFTC and the Securities and Exchange
Commission (SEC) as the agencies seek to develop this framework, and we
have provided comment on a number of their rule proposals.\2\
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\1\ ICI was an early supporter of Federal legislation to close this
regulatory gap. See, e.g., Investment Company Institute, Financial
Services Regulatory Reform: Discussion and Recommendations (March 3,
2009), available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf.
\2\ See, e.g., Letters from Karrie McMillan, General Counsel, ICI
to Elizabeth M. Murphy, Secretary, SEC, and David A. Stawick,
Secretary, CFTC, dated Sept. 20, 2010 and Feb. 22, 2011 (regarding the
definition of key terms in the Dodd-Frank Act related to the regulation
of swaps); Letters from Karrie McMillan, General Counsel, ICI to
Elizabeth M. Murphy, Secretary, SEC, dated Jan. 18, 2011 and to David
A. Stawick, Secretary, CFTC, dated Feb. 7, 2011 (regarding real-time
reporting of swap transaction data); Letters from Karrie McMillan,
General Counsel, ICI to David A. Stawick, Secretary, CFTC, dated Jan.
18, 2011 (regarding protection of customer collateral for cleared
swaps) and Feb. 1, 2011 (regarding protection of customer collateral
for uncleared swaps).
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Developing the appropriate regulatory framework for derivatives and
avoiding unintended consequences is a very difficult task. It is one
that requires thoughtful and comprehensive analysis, a deliberative
approach, coordination between the CFTC and SEC when possible and
appropriate, and careful consideration of comments and recommendations
from the public. From time to time, re-proposals of certain rules may
be necessary to ensure that they are workable and do not impose costs
that are not justified by their benefits.
Getting the rules right is critical for protecting the swaps
markets, market participants, and the broader financial system. And, in
our view, the agencies have a much harder time getting the rules right
if the public is limited in its ability to provide meaningful comment
on proposed rules because of overly short comment periods or the order
in which the rules are proposed.
Last December, ICI joined with nine other trade associations in
sending a joint letter to the CFTC and SEC on their efforts to
implement the derivatives provisions of the Dodd-Frank Act.\3\ The
letter began by commending the agencies ``for their diligence and
dedication with regard to this unprecedented rulemaking endeavor.'' It
noted, in particular, that the Dodd-Frank Act imposes ``short and
strict deadlines'' on each agency, and that many of the required rules
``concern activities and products that are complex and new to
regulatory oversight.''
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\3\ See Letter from American Bankers Ass'n, ABA Securities Ass'n,
The Clearing House Ass'n, L.L.C., Financial Services Forum, Financial
Services Roundtable, Institute of International Bankers, International
Swaps and Derivatives Ass'n, Investment Company Institute, Managed
Funds Ass'n and Securities Industry and Financial Markets Ass'n to
Elizabeth M. Murphy, Secretary, SEC, and David A. Stawick, Secretary,
CFTC, dated Dec. 6, 2010.
---------------------------------------------------------------------------
The joint letter did, however, raise concerns with aspects of the
rulemaking process being followed by the two agencies and recommended
certain changes. Among other issues, the letter expressed concern with
the order in which the rules have been published for public comment. A
prime example of this was the agencies' issuance of proposed
requirements for ``swap dealers'' and ``major swap participants''
before they had proposed how these Dodd-Frank Act terms should be
defined. Uncertainty regarding who might be covered by the proposed
requirements made it very difficult for firms to know whether and to
what extent the requirements might apply to them, and thus whether and
how to provide meaningful comment.
The joint letter also expressed concern that participants in the
derivatives markets ``would be asked to do too much in too short a
time'' in regard to implementing new rules. It cautioned that market
participants might be forced to refrain from derivatives transactions
for which compliance was not possible, which could in turn cause there
to be little or no liquidity in certain segments of the market. The
letter noted that the Dodd-Frank Act sets only a floor for the
effective date for implementing rules (i.e., ``not less than 60 days
after publication'') and, accordingly, called on the CFTC and SEC to
use their discretion in order to ``phase-in the application of new
regulatory requirements over a reasonable period of time, determined
through discussions with the market participants that the agencies
expect to be directly affected by those requirements.'' We are pleased
that Chairman Gensler recently acknowledged that Congress ``gave the
CFTC broad latitude in determining when final rulemakings under the
Dodd-Frank Act would become effective'' and that the agency ``may give
market participants more time'' to comply than the 60 day floor
described above.\4\
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\4\ See Gary Gensler, Chairman, CFTC, Remarks, Implementing the
Dodd-Frank Act, at the Futures Industry Association's Annual
International Futures Industry Conference, Boca Raton, FL (March 16,
2011).
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As this Committee continues to oversee the CFTC's implementation of
the Dodd-Frank Act, we urge you to encourage the agency to facilitate
meaningful public comment on these important rule proposals, to
consider those comments fully in their rule-writing effort and, once
those rules are finalized, to allow the private sector sufficient time
to come into compliance.
III. CFTC Proposal To Modify or Rescind Several Exemptive and
Exclusionary Rules, Including Rule 4.5
A. ICI Views on the Proposal Generally
In late January, the CFTC voted to issue a sweeping proposal to
revise or rescind several of its exemptive and exclusionary rules, as
well as adopt new disclosure requirements, in an effort to ``more
effectively oversee its market participants and manage the risks that
such participants pose to the markets.'' \5\ In particular, the
proposal would rescind the exemptions from regulation as a commodity
pool operator (CPO) on which sponsors of private investment funds
typically rely, significantly narrow the exclusion from CPO regulation
in Rule 4.5 under the Commodity Exchange Act as it relates to funds
(discussed in detail below), and impose new periodic reporting
requirements on all CPOs and commodity trading advisors registered with
the CFTC.
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\5\ See, Commodity Pool Operators and Commodity Trading Advisors:
Amendments to Compliance Obligations, 76 Fed. Reg. 7976 (Feb. 11, 2011)
(``Release'').
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Not surprisingly, a proposal of this nature and scope, if adopted,
would have significant implications for many asset management firms--
and this would be in addition to the many new obligations imposed on
these firms by the Dodd-Frank Act. Because of this, ICI and other
stakeholders have spent considerable time analyzing the proposal and in
particular, the amendments to Rule 4.5, and have developed some
recommendations for how it might be appropriately amended.
For many reasons, the timing of this proposal is most unfortunate.
The proposal is not mandated by the Dodd-Frank Act, although the CFTC
attempts to describe it as being ``consistent with the tenor'' of that
Act.\6\ Its publication for comment has required ICI and other
stakeholders to divert attention away from analyzing and commenting on
the many proposals from the CFTC, SEC and other agencies to implement
the Dodd-Frank Act.\7\ The proposal has likewise been a diversion for
the CFTC and its staff.
---------------------------------------------------------------------------
\6\ Id. at 7977.
\7\ The CFTC first published a petition for rulemaking from the
National Futures Association on September 17, 2010. See, Petition of
the National Futures Association, Pursuant to Rule 13.2, to the U.S.
Commodity Futures Trading Commission to Amend Rule 4.5, 75 Fed. Reg.
56997. ICI and others commented extensively on that petition. On
February 11, 2011, the CFTC published the proposal in question,
seemingly without taking into account the commenters' myriad concerns
raised during the first comment period.
---------------------------------------------------------------------------
It is also important to note that any adoption of the proposal in
its current form would have considerable long-term implications for the
CFTC. A host of new registrants would increase the agency's workload,
and regulatory oversight of these new registrants would strain its
limited resources, at a time when the agency acknowledges that it does
not have the staffing or budget to meet new responsibilities under the
Dodd-Frank Act.\8\ It likewise would strain the resources of the
National Futures Association (NFA), which serves as the frontline
regulator for CPOs.
---------------------------------------------------------------------------
\8\ See Testimony of Gary Gensler, Chairman, CFTC, Before the
Subcommittee on Agriculture, Rural Development, Food and Drug
Administration, and Related Agencies, Committee on Appropriations,
United States House of Representatives, on the CFTC's budget request
for FY 2012 (March 17, 2011) (stating that the Commission's current
funding level is ``simply not sufficient for the CFTC's expanded
mission to oversee both the futures and swaps markets.'').
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B. ICI Views on the Proposed Amendments to CFTC Rule 4.5
Rule 4.5 currently provides an exclusion for certain ``otherwise
regulated entities,'' including funds, from regulation as CPOs. The
proposed amendments would condition eligibility for the Rule 4.5
exclusion on compliance with certain trading and marketing
restrictions.\9\ Funds unable to satisfy these conditions would be
subject to regulation and oversight by the CFTC and the NFA. This would
impose a second layer of regulation on such funds, which already must
comply with comprehensive regulatory requirements under the Investment
Company Act of 1940 (Investment Company Act) and other Federal
securities laws.
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\9\ The topics covered in this section are discussed in extensive
detail in ICI's comment letter on the proposal. This letter was filed
with the CFTC on April 12, 2011, and we will submit a copy of this
letter to the Committee for inclusion in the hearing record.
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1. The CFTC Has Not Justified the Broad Scope of the Proposed
Amendments
The Release states that the amendments to Rule 4.5 are intended to
``stop the practice of registered investment companies offering
futures-only investment products without Commission oversight . . .''
\10\ The Release fails to explain, however, why the proposed amendments
are troublingly broader in reach. Specifically, the sweeping language
of the proposed trading and marketing conditions would implicate a
large number of funds that use futures, options and swaps simply as a
means to efficiently manage their portfolios, rather than as part of
operating a ``futures-only'' fund. It is difficult to justify this
result at a time when, as noted above, the CFTC Chairman has stated
that current funding levels for the agency are ``simply not
sufficient'' and is requesting substantial additional resources from
Congress.\11\
---------------------------------------------------------------------------
\10\ Release, supra note 5, at 7984.
\11\ See, supra note 8.
---------------------------------------------------------------------------
2. The CFTC Has Not Demonstrated the Need for Imposing a Second Layer
of Regulation on Funds
In its Release, the CFTC provides no evidence that a ``futures-
only'' fund--not to mention a fund using futures, options or swaps for
reasons other than providing exposure to the commodities markets--is
currently subject to inadequate regulation, or that investors or the
commodity markets generally have been harmed by their practices.
In fact, funds are already extensively regulated. They are the only
financial institutions that are subject to all of the four major
Federal securities laws. The Securities Act of 1933 and the Securities
Exchange Act of 1934 regulate the public offering of shares and ongoing
reporting requirements, respectively. Funds must provide comprehensive
disclosure to investors in plain English, including with regard to fees
and expenses, the fund's investment objectives, and the risks of
investing in the fund. The Investment Company Act regulates a fund's
structure and operations, and addresses fund capital structures
(including limits on use of leverage), custody of assets, investment
activities (particularly with respect to transactions with affiliates
and other transactions involving potential conflicts of interest), and
the composition and duties of fund boards. A fund's investment adviser
must register with the SEC and comply with the provisions of the
Investment Advisers Act of 1940. Funds and their advisers are subject
to antifraud standards. Finally, the Federal securities laws provide
the SEC with inspection authority over funds and their investment
advisers, principal underwriters, distributing broker-dealers and
transfer agents. The Financial Industry Regulatory Authority (FINRA)
also has oversight authority with regard to funds' principal
underwriters and distributing broker-dealers.
As a result, ICI questions why the CFTC believes it is necessary to
impose an additional, costly layer of regulation on these already
heavily regulated entities.
3. Because the Regulatory Regime for Swaps Is Still Being Developed,
the Fund Industry and Other Interested Parties Cannot
Adequately Assess the Impact of This Proposal
It is difficult at this time to assess the full impact of, and
meaningfully comment on, the proposed amendments to Rule 4.5. This is
because one of the key conditions would relate to margin levels on
derivative positions held by funds, and the regulators have not yet
made critical determinations that relate to swap margin levels.
Specifically, the CFTC and SEC have not finalized rules regarding which
swaps will be subject to central clearing requirements. In addition,
margin requirements have not been established for cleared or uncleared
swaps (which could end up varying significantly based on the type of
swap). Finally, we do not yet know whether the Department of the
Treasury will exempt foreign exchange forwards and foreign exchange
swaps from the definition of ``swap'' and, if no exemption is granted,
what the margin requirements would be for these instruments.
It is our strongly held view that the new regulatory framework for
swaps must be put in place and margin requirements for both centrally
cleared and uncleared swaps established before the Commission can
propose any amendments to Rule 4.5 that implicate the use of swaps.
4. The CFTC Has Not Adequately Analyzed the Potential Costs and
Benefits of Its Proposal
We believe that the CFTC's cursory analysis of the costs and
benefits of the proposed amendments to Rule 4.5 is wholly inadequate to
justify the costly and burdensome regulation they would impose on a
large portion of the fund industry. The CFTC does identify a few costs,
which it does not detail or quantify, but it fails to identify many of
the major costs the proposal would impose on funds, some of which would
inevitably get passed on to shareholders. The CFTC's analysis of
benefits is even more abstract and does not appear to be focused on the
proposed amendments to Rule 4.5. Importantly, the Commission fails to
acknowledge in its analysis that any benefits that fund shareholders
may receive as a result of these amendments would largely duplicate
many protections they currently enjoy as a result of the Investment
Company Act and other Federal securities laws.
We have deep concerns whether the CFTC's cost-benefit analysis
would satisfy the applicable requirements of the Commodity Exchange
Act,\12\ and we believe that the agency should not adopt any amendments
to Rule 4.5 without conducting a more comprehensive analysis. We
further question whether it is even possible for the CFTC to conduct an
adequate analysis until the status and margin issues regarding swaps,
mentioned above, have been resolved, as the resolution of those issues
could vastly impact the number of funds that may be swept into the
CFTC's jurisdiction.
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\12\ Section 15(a) of the Commodity Exchange Act requires the CFTC
to consider the costs and benefits of its actions before issuing rules,
regulations or orders. Section 15(a) requires the CFTC to evaluate the
costs and benefits in light of the following five areas: (1) protection
of market participants and the public; (2) efficiency, competitiveness
and financial integrity of futures markets; (3) price discovery; (4)
sound risk management practices; and (5) other public interest
considerations.
---------------------------------------------------------------------------
ICI is not alone in its concerns. The Chairman of this
Subcommittee, together with the Committee Chair, recently raised very
similar concerns in requesting that the CFTC's Inspector General
undertake an investigation of the adequacy of the Commission's cost-
benefit analysis.\13\ We particularly agree with their observations
that:
---------------------------------------------------------------------------
\13\ See Letter from Frank D. Lucas, Chairman, Committee on
Agriculture, and K. Michael Conaway, Chairman, Subcommittee on General
Farm Commodities and Risk Management, to A. Roy Lavik, Inspector
General, CFTC dated Mar. 11, 2011.
the CFTC is failing to adequately conduct cost-benefit
analysis--either as required by the [Commodity Exchange Act] or
the principles of the Executive Order [on Improving Regulation
and Regulatory Review]. . . . [p]articularly during tough
economic times, it is incumbent upon the CFTC to approach cost-
benefit thoroughly and responsibly to understand the costs, and
therefore the economic impact any proposed regulation will have
---------------------------------------------------------------------------
on regulated entities and markets.
Even members of the Commission have raised concerns about the manner in
which the agency conducts its cost-benefit analysis. Commissioner
Sommers, for example, has observed that:
the proposals we have voted on over the last several months []
contain very short, boilerplate `Cost-Benefit Analysis'
sections . . . . how can we appropriately consider costs and
benefits if we make no attempt to quantify what the costs
are? . . . Clearly, when it comes to cost-benefit analysis the
Commission is merely complying with the absolute minimum
requirements of the Commodity Exchange Act. That is not in
keeping with the spirit of the President's recent Executive
Order on `Improving Regulation and Regulatory Review.' We owe
the American public more than the absolute minimum.\14\
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\14\ See Jill E. Sommers, Commissioner, CFTC, Opening Statement,
Meeting on the Twelfth Series of Proposed Rulemakings under the Dodd-
Frank Act (Feb. 24, 2011).
---------------------------------------------------------------------------
5. The CFTC's Proposal Would Impose Inconsistent and Duplicative
Regulation on Funds
Finally, even if the restrictions in the proposed amendments to
Rule 4.5 are appropriately scaled back, there are likely to be cases in
which funds and their advisers would be unable to rely on the amended
rule and thus would become subject to regulation by both the CFTC and
the SEC. The Release specifically acknowledges that funds may have
difficulty complying with some of the CFTC's regulations, yet it does
not propose any solutions. As part of our analysis of the Commission's
proposal, ICI and its outside counsel have compared the CFTC and SEC
regulatory regimes under the Investment Company Act and the Commodity
Exchange Act, respectively. This analysis is summarized in a detailed
appendix to our April 12 comment letter.\15\ As this appendix
demonstrates, many of the CFTC's requirements would be duplicative of
the requirements to which funds and their advisers are already subject
under the Investment Company Act or other Federal securities laws.
Other of the CFTC's requirements would be fundamentally inconsistent
with the requirements to which funds and their advisers are subject.
---------------------------------------------------------------------------
\15\ See, supra note 9.
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For example, the SEC significantly limits the ability of a fund to
include in its prospectus performance information about other funds or
accounts managed by the fund's adviser.\16\ The CFTC rules, by
contrast, require disclosure of such information in certain
circumstances. A fund could not comply with the CFTC's requirements
without likely violating the SEC's (and FINRA's) requirements. As
another example, the CFTC rules regarding delivery and receipt of a
commodity pool disclosure document are fundamentally different than the
model under the Federal securities laws, and would not be practicable
for funds, which generally offer their shares publicly on a daily basis
though broker-dealers and other intermediaries.
---------------------------------------------------------------------------
\16\ FINRA, which has oversight over fund advertising, similarly
prohibits funds from advertising the adviser's other fund or account
performance.
---------------------------------------------------------------------------
The examples above illustrate why we believe it is absolutely
critical that the CFTC, before imposing an additional regulatory
requirement on funds, evaluate its regulatory purpose in doing so and
consider whether a regulation to which funds and their advisers are
already subject would be sufficient to satisfy that purpose.
More broadly, it is essential that the CFTC work closely with the
SEC before amending Rule 4.5 in order to reconcile the many duplicative
and conflicting regulations to which a fund and its adviser could
become subject. The harmonized regulations then should be re-proposed
for public comment.
IV. Conclusion
We appreciate this opportunity to testify before the Committee. The
regulatory proposals discussed in our testimony have important
implications for funds and the over 90 million shareholders who rely on
funds to meet their retirement and investment goals. Continued
Congressional oversight of the CFTC's work on these proposals is
critical to ensuring that the regulatory scheme for the derivatives
markets is appropriately established and that funds are not made
subject to duplicative and fundamentally inconsistent regulatory
requirements.
Attachment
April 12, 2011
David A. Stawick,
Secretary,
Commodity Futures Trading Commission,
Washington, D.C.
Re: Commodity Pool Operators and Commodity Trading Advisors: Amendments
to Compliance Obligations (RIN No. 3038-AD30)
Dear Mr. Stawick:
The Investment Company Institute \1\ appreciates the opportunity to
comment on the proposal by the Commodity Futures Trading Commission
(``Commission'' or ``CFTC'') to modify or rescind several of its
exemptive and exclusionary rules.\2\ Our comments focus on the proposed
amendments to CFTC Rule 4.5 that would apply solely to registered
investment companies (``Rule 4.5 Proposal'').
---------------------------------------------------------------------------
\1\ The Investment Company Institute is the national association of
U.S. investment companies, including mutual funds, closed-end funds,
exchange-traded funds (``ETFs''), and unit investment trusts
(``UITs''). ICI seeks to encourage adherence to high ethical standards,
promote public understanding, and otherwise advance the interests of
funds, their shareholders, directors, and advisers. Members of ICI
manage total assets of $13.0 trillion and serve over 90 million
shareholders.
\2\ Commodity Pool Operators and Commodity Trading Advisors:
Amendments to Compliance Obligations, 76 Fed. Reg. 7976 (Feb. 11, 2011)
(``Release'').
---------------------------------------------------------------------------
ICI and its members strongly object to the Rule 4.5 Proposal in its
current form. While we respect the Commission's authority to
``reconsider the level of regulation that it believes is appropriate
with respect to entities participating in the commodity futures and
derivatives markets,'' \3\ we do not believe the Commission has
demonstrated the need for a second level of regulation on registered
investment companies, which are already subject to comprehensive
regulation under the Federal securities laws. We further believe that
the Rule 4.5 Proposal is insufficiently developed and thus it is
premature to adopt it at this time. It does not appear to reflect
thorough consideration by the Commission of many critical issues,
including how registered investment companies participate in the
commodity futures and derivatives markets, the appropriateness of
including swaps in the Rule 4.5 Proposal, the extensive regulation to
which investment companies are subject under the Investment Company Act
of 1940 (the ``Investment Company Act'') and other Federal securities
laws, the overlapping and conflicting nature of many regulatory
requirements that registered investment companies would face if they
were regulated by both the Securities and Exchange Commission (``SEC'')
and the CFTC, and the potential costs and burdens of dual regulation.
---------------------------------------------------------------------------
\3\ Id. at 7977.
---------------------------------------------------------------------------
The Release states the Commission's belief that the text of the
proposed amendments to Rule 4.5 is ``an appropriate point at which to
begin discussions regarding the Commission's concerns.'' \4\ If, after
reviewing the comments on the Rule 4.5 Proposal, the Commission
nevertheless determines to proceed with amending Rule 4.5, we
respectfully urge that the agency develop and issue a new proposal to
amend the rule, taking into consideration the comments and
recommendations that it receives in response to this Release. To assist
the Commission in this endeavor, we have identified several critical
issues that should be addressed in any proposal to amend Rule 4.5, and
this letter sets forth our initial recommendations for how several of
those issues might be resolved.
---------------------------------------------------------------------------
\4\ Id. at 7984 (emphasis added).
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I. Executive Summary
Last summer, the National Futures Association (``NFA'') submitted a
petition for rulemaking that asked the CFTC to narrow significantly the
Rule 4.5 exclusion as applied to registered investment companies, by
requiring compliance with certain trading and marketing restrictions.
In late January, the CFTC proposed amendments to Rule 4.5 that not only
incorporate the trading and marketing restrictions suggested in the NFA
petition but also extend those restrictions to a fund's positions in
swaps. In the view of ICI and its members, the Rule 4.5 Proposal is
overly broad in scope and would cause many registered investment
companies to become subject to CFTC regulation, even though these funds
do not raise the Commission's stated concerns regarding ``futures-only
investment products.''
The CFTC has provided little rationale for its sweeping proposal,
including why it is necessary to impose a second, costly layer of
regulation on registered investment companies, which are already
subject to comprehensive regulation under the Investment Company Act
and other Federal securities laws. Moreover, the proposal is
insufficiently developed and adopting it without first resolving the
many critical issues it raises would be premature. As a result, ICI and
its members strongly recommend that, if the CFTC nonetheless determines
to move forward with the Rule 4.5 Proposal, it publish for comment a
revised version of the amendments that fully addresses these issues.
Our comments, concerns, and recommendations, which we describe
fully below, include the following:
Including Swaps in the Rule 4.5 Proposal is Premature: The
Commission's inclusion of swaps in the Rule 4.5 Proposal has
broad implications for a wide variety of registered investment
companies, which may find it difficult or impossible to meet
the proposed trading and marketing restrictions. While we do
not question the CFTC's jurisdiction over swaps, we nonetheless
believe it has an obligation under the Administrative Procedure
Act (``APA'') to explain the reasoning behind its decision to
require these users of swaps to register. We also strongly
believe that application of the Rule 4.5 Proposal to swaps is
premature because the CFTC and SEC have not yet adopted rules
specifying which swaps will be subject to central clearing and
margin requirements have not been established for cleared or
uncleared swaps. It also is still unclear whether foreign
exchange swaps and foreign exchange forwards will be considered
``swaps'' subject to CFTC oversight. As a result, commenters
are unable to provide meaningful input on this very critical
aspect of the proposal.
Cost-Benefit Analysis: We believe the CFTC's cursory cost-
benefit analysis of the Rule 4.5 Proposal is inadequate to
justify the costly and duplicative regulation that the proposal
would impose on a large portion of the investment company
industry. The analysis does not take into account many of the
significant costs the proposal would impose on investment
companies, and does not acknowledge the many protections
shareholders currently benefit from under the Investment
Company Act and other Federal securities laws. We question
whether the agency's analysis would satisfy applicable
statutory requirements, and urge the CFTC not to adopt any
amendments to Rule 4.5 without conducting a more comprehensive
analysis.
Clarification Regarding Which Entity Would Register as a
Commodity Pool Operator: The Release does not state which
entity would register as a commodity pool operator (``CPO'') if
a registered investment company is unable to meet the criteria
for exclusion under amended Rule 4.5. Because the investment
company's investment adviser is typically responsible for
establishing the company and operating it on a day-to-day
basis, we request that the CFTC concur with our view that the
adviser is the appropriate entity to serve as the company's
CPO.
Proposed Trading Restriction: The proposed five percent
limit on positions taken for non-bona fide hedging purposes,
especially as it would apply to swaps, futures, and options
used for non-speculative purposes, would result in a large
number of registered investment companies being unable to rely
on the Rule 4.5 exclusion. We believe that narrowing the scope
of the trading restriction would be more consistent with the
CFTC's regulatory goals, and offer the following suggestions:
(1) eliminating or significantly narrowing the application of
the proposed rule to swaps; (2) specifically referencing risk
management as an element of ``bona fide hedging'' in the
context of Rule 4.5; and (3) raising the threshold for
positions taken for non-bona fide hedging purposes. We note,
however, that it is not possible to comment on what the
specific threshold should be until margin levels for swaps are
determined.
Use of Wholly Owned Subsidiary Structure: The Rule 4.5
Proposal would require that any instruments held for non-
hedging purposes be held directly by the fund, and not through
a wholly owned subsidiary, as funds investing in commodities
often do today to avoid adverse tax consequences. We emphasize
that this subsidiary structure is used by funds for legitimate
tax purposes and not to evade regulation under the Investment
Company Act. To address any remaining concerns the Commission
may have, an investment company's adviser could make
representations that it would make the books and records of the
subsidiary available to the CFTC and NFA staff for inspection
upon request and provide transparency about fees, if any,
charged by the subsidiary.
Proposed Marketing Restriction: The proposed language
seeking to restrict the ability of registered investment
companies to market themselves as ``otherwise seeking
investment exposure to'' the commodity futures and options
markets is phrased broadly and could pick up a wide variety of
registered investment companies that have only a modest
exposure to commodity futures, commodity options, and swaps
(e.g., asset allocation funds). We strongly believe this
additional language in the marketing restriction is unnecessary
and should be eliminated. In addition, we request clarification
regarding the scope of the marketing restriction and
confirmation that it would not be read so broadly as to apply
to risk and other required disclosures in an investment
company's registration statement or marketing materials.
Areas of Conflict Between SEC and CFTC Regulation: Advisers
to those registered investment companies that would be unable
to meet the criteria for exclusion under proposed Rule 4.5
would be subject to both SEC and CFTC regulation, potentially
resulting in duplicative regulation in many areas, as well as
conflicting requirements in others (e.g., relating to
disclosure documents, delivery obligations, presentation of
performance data, and operational requirements). We strongly
believe that investment companies should not be subject to
duplicative regulation and that any conflicts between the
regulatory requirements should be resolved by the CFTC and SEC
before amendments to Rule 4.5 are adopted. In fact, to satisfy
the requirements of the APA, the CFTC must provide affected
entities with notice of how they would be expected to comply,
or how conflicting regulations would be resolved, and an
opportunity to provide comment before any amendments to Rule
4.5 are finalized.
II. The Proposed Amendments to Rule 4.5 are Insufficiently Developed,
and Adoption Would Be Premature
A. Background
The term CPO is broadly defined in the Commodity Exchange Act and
generally includes, among other things, any person engaged in a
business that is in the nature of an investment trust who receives
funds from others ``for the purpose of trading in any commodity for
future delivery on or subject to the rules of a contract market or
derivatives transaction execution facility.'' \5\ CFTC Rule 4.5
recognizes the breadth of this definition, and provides an exclusion
from CPO registration for certain persons operating ``qualifying
entities'' that are subject to a different regulatory framework,
including registered investment companies.\6\ Previously, the Rule 4.5
exclusion was conditioned upon the entity satisfying certain conditions
relating to its trading in commodity interests and the marketing of
shares/participations in the entity. After lengthy consideration in
2002-03 (which included an advance notice of proposed rulemaking and a
public roundtable on the regulation of CPOs and commodity trading
advisors (``CTAs'')), the CFTC determined to eliminate those conditions
from the rule. In so doing, it cited, among other things, the fact that
many qualifying entities avoided participation in the markets for
commodity futures and commodity options because the Rule 4.5 conditions
were ``too restrictive for many [of them] to meet'' and that
facilitating participation in the commodity markets by additional
collective investment vehicles and their advisers would have ``the
added benefit to all market participants of increased liquidity.'' \7\
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\5\ Section 1a(5) of the Commodity Exchange Act.
\6\ Entities seeking to rely on the Rule 4.5 exclusion must file a
notice of eligibility with the National Futures Association that
includes certain representations.
\7\ See, Additional Registration and Other Regulatory Relief for
Commodity Pool Operators and Commodity Trading Advisors, 68 Fed. Reg.
12622, 12626 (March 17, 2003) (``2003 Proposing Release''); Additional
Registration and Other Regulatory Relief for Commodity Pool Operators
and Commodity Trading Advisors: Past Performance Issues, 68 Fed. Reg.
47221 (Aug. 8, 2003) (``2003 Adopting Release'')
---------------------------------------------------------------------------
Last summer, the NFA submitted a rulemaking petition to the CFTC to
amend Rule 4.5.\8\ According to the petition, the NFA had concerns
about the marketing practices of three registered investment companies
offering so-called ``managed futures strategies.'' The NFA petition
proposed that the Rule 4.5 exclusion should be significantly narrowed
for all registered investment companies, leaving other ``qualifying
entities'' unaffected. Specifically, the petition recommended that
registered investment companies should be required to comply with
trading and marketing restrictions that are based upon those in the
rule prior to 2003, but are actually much broader in scope.
---------------------------------------------------------------------------
\8\ Petition of the National Futures Association, Pursuant to Rule
13.2, to the U.S. Commodity Futures Trading Commission to Amend Rule
4.5, 75 Fed. Reg. 56997 (Sept. 17, 2010).
---------------------------------------------------------------------------
Following publication of the NFA petition in the fall, the CFTC
received considerable feedback from individual companies and trade and
bar associations, including ICI (``October Letter'').\9\ Many of the
comment letters expressed serious concerns about the scope of the NFA's
proposed language, outlined the difficulties that registered investment
companies would face in trying to comply with overlapping and
conflicting requirements of the CFTC and SEC, and offered possible
solutions.
---------------------------------------------------------------------------
\9\ Letter from Karrie McMillan, General Counsel, ICI, to David A.
Stawick, Secretary, CFTC, dated Oct. 18, 2010.
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In late January, the CFTC voted to issue the Rule 4.5 Proposal. The
agency drew the proposed rule text almost verbatim from the NFA
petition, but significantly also applied the proposed trading and
marketing conditions to a registered investment company's positions in
swaps. The Release contains little explanation for the proposed
language, except to describe it as ``an appropriate point at which to
begin discussions regarding the Commission's concerns.'' \10\ The
Release also does not address the considerable comments the CFTC
received on the NFA petition, except to the extent it poses specific
questions for further public comment based on the responses it received
regarding the NFA petition.
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\10\ Release, supra note 2 at 7984.
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B. The CFTC Has Not Demonstrated the Need for Imposing a Second Layer
of Regulation on Registered Investment Companies
The CFTC provides little rationale in the Release for its sweeping
Rule 4.5 Proposal. It is not mandated by the Dodd-Frank Wall Street
Reform and Consumer Protection Act (``Dodd-Frank Act''), although the
CFTC describes the Rule 4.5 Proposal as being ``consistent with the
tenor'' of that Act.\11\ According to the Release, the proposed
restrictions under Rule 4.5 are intended to ``stop the practice of
registered investment companies offering futures-only investment
products without Commission oversight'' and that ``such restrictions
would limit the possibility of entities engaging in regulatory
arbitrage whereby operators of otherwise regulated entities that have
significant holdings in commodity interests would avoid registration
and compliance obligations under the Commission's regulations.''\12\
The CFTC provides no evidence, however, that such registered investment
companies are currently subject to inadequate regulation, or that
investors or the commodity markets generally have been harmed by their
practices. Nor does the agency explain why the Rule 4.5 Proposal is
troublingly broader in reach than ``futures-only investment products,''
as it potentially captures registered investment companies with
relatively little exposure to the commodity markets.
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\11\ Release, supra note 2 at 7977 (emphasis added). See Letter
from Scott Garrett, Chairman, Subcommittee on Capital Markets and
Government Sponsored Enterprises, to Gary Gensler, Chairman, CFTC,
dated March 3, 2011 (``Garrett Letter'') (Congressman Garrett recently
expressed concern regarding ``the CFTC in many cases . . . going even
beyond what the [Dodd-Frank Act] requires.'').
\12\ Release, supra note 2, at 7984.
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As we discussed in the October Letter, investment companies are
already extensively regulated under the Investment Company Act and
other Federal securities laws. The protections afforded under the
securities laws include, among others:
Limits on the use of leverage
Antifraud provisions
Comprehensive disclosure to investors, including with regard
to:
b Fees and expenses
b The investment objectives and strategies of the investment
company
b The risks of investing in the investment company
Independent board oversight
b Particular emphasis on potential conflicts of interest
Restrictions on transactions with affiliates
Requirements regarding custody of fund assets
Importantly, the existing regulatory scheme for registered
investment companies is, first and foremost, concerned with investor
protection, and is administered by the SEC, for which the protection of
investors is central to its mission. In addition, investment advisers
to registered investment companies must themselves be registered with
the SEC and be subject to regulation under the Investment Advisers Act
of 1940 and related SEC rules, which also include antifraud
protections. The Financial Industry Regulatory Authority (``FINRA'')
also has oversight authority over an investment company's principal
underwriter and distributing broker-dealers. Also, even though excluded
under current Rule 4.5, registered investment companies are subject to
CFTC large trader reporting requirements like any other trader, which
enables the CFTC to obtain information from those entities that it can
use to assess systemic risk.\13\ As a result, we continue to question
why the CFTC believes it is necessary to impose an additional, costly
layer of regulation on these already heavily-regulated entities.
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\13\ See Parts 15-19 and 21 of the CFTC's regulations.
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C. The CFTC Has Failed to Justify its Proposed Disparate Treatment for
Registered Investment Companies
Currently, the Rule 4.5 exclusion is available to a variety of
``otherwise regulated entities.'' The increased restrictions
contemplated by the Rule 4.5 Proposal, however, would apply only to one
type of entity that currently may rely on the rule--registered
investment companies. Under this proposal, the full range of CFTC and
NFA rules and oversight would be imposed only on registered investment
companies that engage in commodity trading and are unable to satisfy
the heightened criteria under Rule 4.5.
The Release offers no justification for imposing additional burdens
on registered investment companies that, ironically, are subject to far
more regulation and oversight than are other entities offered to, or
operated for the benefit of, retail investors that may continue to rely
on Rule 4.5 in its current form and thus be subject to only a single
regulatory scheme. Such disparate treatment is an invitation to
regulatory arbitrage, because there would be nothing in Rule 4.5 to
preclude other qualifying entities from offering a ``futures only''
investment pool without CFTC oversight. The creation of this regulatory
``gap'' would be wholly inconsistent with the tenor of the Dodd-Frank
Act. It also would be completely at odds with the Commission's stated
concerns in issuing the proposal.
Should the CFTC determine to modify Rule 4.5 to treat registered
investment companies differently than other regulated entities that
qualify for the Rule 4.5 exclusion, it must issue a re-proposal that
explain the basis for such disparate treatment as required by the
APA.\14\
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\14\ In The Connecticut Light and Power Company, et al. v. Nuclear
Regulatory Commission, 673 F.2d 525 (D.C. Cir. 1982) (``Connecticut
Light''), the Court of Appeals for the D.C. Circuit stated as follows:
The purpose of the comment period [required under the
Administrative Procedure Act] is
to allow interested members of the public to communicate information,
concerns, and criti-
cisms to the agency during the rule-making process. If the notice of
proposed rule-making fails
to provide an accurate picture of the reasoning that has led the
agency to the proposed rule,
interested parties will not be able to comment meaningfully upon the
agency's proposals. As
a result, the agency may operate with a one-sided or mistaken picture
of the issues at stake
in a rulemaking. . . . An agency commits serious procedural error
when it fails to reveal por-
tions of the technical basis for a proposed rule in time to allow for
meaningful commentary.
(Internal citations omitted).
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D. The Proposed Inclusion of Swaps Under Rule 4.5 is Premature
As noted above, the Release states that the language from the NFA
petition is ``an appropriate point at which to begin discussions,'' and
the text of the proposed amendments to Rule 4.5 is drawn almost
verbatim from the NFA petition. The text differs from the NFA's
language, however, in one key respect--by including swaps within the
scope of the proposed trading and marketing restrictions. While we
understand that the CFTC obtained jurisdiction over swaps as a result
of the Dodd-Frank Act, its expanded jurisdiction does not relieve the
agency of its obligation under the APA to explain the reasoning behind
its proposal, including a clear rationale as to why users of swaps need
to be registered.\15\ This includes the obligation to evaluate whether
particular uses of swaps raise the concerns that Rule 4.5 is intended
to address. Both analyses are entirely absent in the Release. As we
cautioned in our October Letter, and as explained more fully below, the
inclusion of swaps significantly expands the scope of the Rule 4.5
Proposal and would create a host of (presumably) unintended
consequences. Including swaps in the proposal also would increase
significantly the number of entities that would become subject to CFTC
regulation at a time when the Commission has expressed concern that its
resources are inadequate to meet its expanded regulatory
responsibilities for swaps under the Dodd-Frank Act.\16\
\15\ See, id. Section 553 of the APA requires that an agency
provide the public with adequate notice of the substance of a proposed
rule and an opportunity to provide meaningful comment. If it fails to
do so, the resulting rule may be struck down by courts on the basis
that it is not a ``logical outgrowth'' of the agency's proposal. See,
Kooritzky v. Reich, 17 F.3d 1509, 1513 (D.C. Cir. 1994) (court stated
that ``agencies must include in their notice of proposed rulemaking
`either the terms or substance of the proposed rule or a description of
the subjects and issues involved' . . . [a]nd they must give
`interested persons an opportunity to participate in the rule making
through submission of written data, views, or arguments.' The Labor
Department did neither.'' (internal citations omitted))
(``Kooritzky''); Shell Oil Co. v. EPA, 950 F.2d 741, 751 (D.C. Cir.
1992) (``an unexpressed intention cannot convert a final rule into a
`logical outgrowth' that the public should have anticipated. Interested
parties cannot be expected to divine the [agency's] unspoken
thoughts.'') (``Shell Oil'').
\16\ See Gary Gensler, Chairman, CFTC, Remarks, Implementing the
Dodd-Frank Act, at FIA's Annual International Futures Industry
Conference, Boca Raton, Florida (March 16, 2011) (``Our current funding
level of $169 million is simply not sufficient for the CFTC's expanded
mission to oversee both the futures and swaps markets. Though we will
work very closely with the National Futures Association, and they will
take on as many responsibilities as they can, including those related
to registration and examination of swap dealers, we will need
significant resources to properly oversee both the futures and swaps
markets.'') (``Gensler Remarks'').
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As described in more detail below, the Rule 4.5 Proposal includes a
condition that a registered investment company may use commodity
futures, commodity options or swaps solely for ``bona fide hedging
purposes.'' It may, however, hold certain instruments not for bona fide
hedging purposes, if the initial margin and premiums required to
establish those positions do not exceed five percent of the fund's
liquidation value.
As applied to swaps, this is a clear example of ``cart before the
horse'' rulemaking \17\ and could be subject to challenge under the
APA. The CFTC and SEC have not yet finalized rules regarding which
swaps will be subject to central clearing requirements. Margin
requirements have not yet been established for cleared or uncleared
swaps and, once they are established, could vary significantly based on
the type of swap. Similarly, we do not yet know whether the Department
of the Treasury will exempt foreign exchange forwards and foreign
exchange swaps from the definition of ``swap'' \18\ and, if no
exemption is granted, what the margin requirements will be for these
instruments. Given these uncertainties about swaps, it is simply not
possible for funds to evaluate in any meaningful way how they would
fare under the proposed five percent trading restriction, which is
calculated on the basis of initial margin, or to determine whether a
higher percentage threshold might be more appropriate. The new
regulatory framework for swaps must be put in place and margin
requirements for both centrally cleared and uncleared swaps established
before any amendments to Rule 4.5 that implicate the use of swaps can
be considered. Adopting the proposed amendments prior to that time
would not provide the public with adequate notice of the substance of
the rule the Commission intends to adopt, or an opportunity to provide
meaningful comment.\19\
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\17\ See Garrett Letter, supra note 11 (questioning the CFTC's
``cart before the horse'' approach to rulemaking, and whether it
``depriv[es] the public of the opportunity to provide meaningful
comment on the CFTC's proposals . . .'').
\18\ See Section 1a(47)(E) of the Commodity Exchange Act, as
amended by the Dodd-Frank Act.
\19\ See, Connecticut Light, supra note 14; Kooritzky, supra note
15; Shell Oil, supra note 15.
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E. Harmonizing the Regulations That Would Apply to a Registered
Investment Company Subject to CFTC Oversight Must Be Done
Through Public Notice and Comment
As we explain in detail later in this letter, adoption of the Rule
4.5 Proposal could subject a large number of registered investment
companies to regulation by the CFTC in addition to the SEC. As noted in
our October Letter, this would make funds subject to many directly
conflicting, or fundamentally inconsistent, requirements under the
Investment Company Act and the Commodity Exchange Act. The Release
states that dual regulation of registered investment companies ``may
result in operational difficulties'' and seeks comment regarding
``which rules and regulations are in conflict'' and ``how these could
be best addressed by the two Commissions.'' \20\
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\20\ Release, supra note 2, at 7984.
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While we are pleased that the CFTC recognizes the need to work
cooperatively with the SEC in order to determine how their respective
regulations should be harmonized for dual registrants, we are concerned
that the Commission provides no guidance in the Release on how that
might be accomplished. In order to meet the notice and comment
requirements of the APA, we strongly believe that the agency must re-
propose the rule to include a detailed proposal regarding how
registered investment companies will be expected to comply with the
CFTC's regulations, and how conflicting or inconsistent regulations
will be reconciled.\21\ To proceed otherwise would deprive registered
investment companies (and the broader public) of a meaningful
opportunity to comment on the new regulatory requirements that would be
placed on registered investment companies.\22\
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\21\ See, Kooritzky, supra note 15, at 1513 (``Something is not a
logical outgrowth of nothing.''); Shell Oil, supra note 15.
\22\ Id.; Connecticut Light, supra note 14.
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F. The CFTC Has Given Inadequate Consideration to the Potential Costs
and Benefits of the Proposed Amendments to Rule 4.5
In our view, the CFTC's cursory cost-benefit analysis of the Rule
4.5 Proposal is inadequate to justify the costly and duplicative
regulation that the proposal would impose on a large portion of the
investment company industry.\23\ In terms of costs, the agency
identifies only the following as being relevant to the Rule 4.5
Proposal: (1) failing to adopt revisions to Rule 4.5 that are
substantively similar to those proposed in the NFA's petition would
result in disparate treatment of similarly situated collective
investment schemes; \24\ (2) requiring the filing of an annual notice
to claim exemptive relief under Rule 4.5 enables the CFTC to better
understand the universe of entities claiming relief from its regulatory
scheme; and (3) the proposed changes ``may result in additional costs
to certain market participants due to registration and compliance
obligations.'' \25\ We strongly believe that the Rule 4.5 Proposal
would impose additional, significant costs on registered investment
companies. These costs--some of which would inevitably get passed on to
shareholders--would include, among others:
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\23\ Release, supra note 2, at 7988.
\24\ It is highly perplexing that the CFTC specifically lists this
as a cost, given that its Rule 4.5 Proposal fails to include all
``otherwise regulated'' entities that are able to rely on the rule.
\25\ Release, supra note 2, at 7988.
The cost of registering the CPO with the CFTC, and preparing
for and taking additional licensing examinations (fund
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distributors are already subject to licensing requirements);
The cost of preparing and distributing required disclosure
documents and reports to investors (funds already provide
substantial disclosures to their investors; what would be
required by the CFTC's proposal would be different in form and
timing, but for the most part would not provide meaningful
additional information that investors currently lack);
The cost of retaining counsel to attempt to reconcile and
satisfy inconsistent regulatory requirements;
The costs to upgrade systems to produce reports, coordinate
and potentially develop new systems for vendors that currently
assist in distributing investment company reports;
The costs of training salespeople;
The costs associated with the hiring and training of in-
house counsel and compliance professionals, and costs
associated with changes to fund compliance programs (both in
terms of time spent by in-house personnel and fees paid for
legal advice); and
Even for those entities able to comply with the new Rule 4.5
restrictions on trading and marketing, the costs of having to
establish the monitoring and compliance controls necessary to
ensure their ongoing compliance with any trading
restrictions.\26\
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\26\ Based on registered investment companies' experience with Rule
4.5 prior to its amendment in 2003, these controls would likely include
consultations with legal counsel to determine whether or not a
particular position would come within the applicable trading
restrictions.
With regard to benefits, the CFTC's analysis is equally
insufficient, appearing to focus more on benefits stemming from other
aspects of the Release rather than from the Rule 4.5 Proposal.
Specifically, it notes the anticipated benefits of the increased
information that proposed Forms CPO-PQR and CTA-PR would provide.\27\
These benefits do not make sense in the context of registered
investment companies, which are already heavily regulated by the SEC
and are required to provide extensive and detailed disclosure that is
available both to the public and to regulators. Moreover, the CFTC
fails to acknowledge in its analysis that any benefits that investment
company shareholders may receive as a result of the Rule 4.5 Proposal
would largely be duplicative of the many protections they currently
enjoy as a result of the Investment Company Act and other Federal
securities laws.
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\27\ The CFTC states that ``the proposed changes . . . will
[provide] the Commission and other policy makers with more complete
information about these registrants. . . . the Commission does not have
access to this information today and has instead made use of
information from other, less reliable sources.'' Release, supra, note
2, at 7988.
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For these reasons, we have deep concerns as to whether the CFTC's
analysis would satisfy the applicable requirements of the Commodity
Exchange Act, and we urge that the agency not adopt any amendments to
Rule 4.5 without conducting a more comprehensive analysis.\28\ We
further question whether it is even possible for the CFTC to conduct an
adequate analysis until the status and margin issues regarding swaps,
discussed above, have been resolved, as the resolution of those issues
could vastly impact the number of registered investment companies that
may be swept into the CFTC's jurisdiction.
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\28\ Section 15(a) of the Commodity Exchange Act requires the CFTC
to consider the costs and benefits of its actions before issuing rules,
regulations or orders. Section 15(a)(2) requires the CFTC to evaluate
the costs and benefits in light of the following five areas: (1)
protection of market participants and the public; (2) efficiency,
competitiveness and financial integrity of futures markets; (3) price
discovery; (4) sound risk management practices; and (5) other public
interest considerations. Both the CFTC's own Commissioners and Members
of Congress have recently raised concerns regarding the inadequacies of
the CFTC's cost-benefit analyses in its recent proposals. See, e.g.,
Commissioner Jill E. Sommers, Opening Statement, Meeting on the Twelfth
Series of Proposed Rulemakings under the Dodd-Frank Act (Feb. 24, 2011)
(``. . . the proposals we have voted on over the last several months [
] contain very short, boilerplate `Cost-Benefit Analysis' sections. . .
. how can we appropriately consider costs and benefits if we make no
attempt to quantify what the costs are? . . . Clearly, when it comes to
cost-benefit analysis the Commission is merely complying with the
absolute minimum requirements of the Commodity Exchange Act. That is
not in keeping with the spirit of the President's recent Executive
Order on `Improving Regulation and Regulatory Review.' We owe the
American public more than the absolute minimum.''); Letter from Frank
D. Lucas, Chairman, Committee on Agriculture, and K. Michael Conaway,
Chairman, Subcommittee on General Farm Commodities and Risk Management,
to A. Roy Lavik, Inspector General, CFTC, dated March 11, 2011 (``. . .
recent public comments indicate that the CFTC is failing to adequately
conduct cost-benefit analysis--either as required by the [Commodity
Exchange Act] or the principles of the Executive Order [on Improving
Regulation and Regulatory Review]. . . . Particularly during tough
economic times, it is incumbent upon the CFTC to approach cost-benefit
thoroughly and responsibly to understand the costs, and therefore the
economic impact any proposed regulation will have on regulated entities
and markets.'').
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III. The CFTC Must Address Many Complex and Interrelated Issues in
Developing a Proposal to Amend Rule 4.5
As is clear from our foregoing comments, we strongly object to the
CFTC's proceeding with the Rule 4.5 Proposal, as it has not
demonstrated a sufficient need to capture a broad swath of already
highly regulated entities and subject them to CFTC regulation. In the
event the CFTC determines to pursue this concept, however, we offer
below some suggestions for crafting the proposal to better fit the
agency's stated regulatory goal of protecting investors in pools
offering ``futures-only investment products.'' Any revisions to the
proposal to make it consistent with that goal would need to be
significant, and we respectfully request that the Commission provide
the public with a meaningful opportunity to comment on such a revised
proposal.
A. Clarification Regarding Which Entity Would Register as a Commodity
Pool Operator
The Proposal is silent regarding which entity would register as CPO
if a registered investment company is unable to meet the criteria for
exclusion under amended Rule 4.5. In light of the structure and
operations of registered investment companies, we request that the CFTC
concur with our view that the registered investment adviser to such an
investment company is the appropriate entity to serve as the company's
CPO, and not the investment company itself or its directors (for a
company organized as a corporation) or trustees (for a company
organized as a trust) (together, ``directors''). We believe having the
adviser register as CPO under these circumstances will satisfy the
CFTC's regulatory interest in ensuring that investors receive
appropriate disclosure and reports, and that adequate records are
maintained and available for regulatory inspection.\29\
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\29\ We note that while a registered investment adviser serving as
CPO for a registered investment company would also be the investment
company's CTA, regulations under the Commodity Exchange Act
specifically acknowledge that an investment pool's CPO and CTA can be
the same entity. See Rule 4.14(a)(4) under the Commodity Exchange Act
(exemption from registration as a CTA for a person that is registered
under the Commodity Exchange Act as a CPO, where the person's commodity
trading advice is directed solely to, and for the sole use of, the pool
or pools for which it is so registered).
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The CFTC has indicated that the following factors may be relevant
to determining who is acting as a CPO of a pool:
Who is promoting the pool by soliciting, accepting or
receiving from others, funds or property for the purpose of
commodity interest trading;
Who has the authority to hire (and to fire) the pool's CTA;
and
Who has the authority to select (and to change) the futures
commission merchant (``FCM'') that will carry the pool's
commodity interest trading account.\30\
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\30\ See, Commodity Pool Operators; Exclusion for Certain Otherwise
Regulated Persons From the Definition of the Term ``Commodity Pool
Operator''; Other Regulatory Requirements, 50 Fed. Reg. 15868 (Apr. 23,
1985) (``1985 Adopting Release'').
In applying these factors in the registered investment company
context, it is apparent that an investment company's adviser is the
primary force in establishing and operating the company and the most
logical person to serve as its CPO. A registered investment company has
no employees and relies on its adviser for the day-to-day management
of, and decisions regarding, the company. For example, it is typically
the adviser that makes the decision to establish the investment company
and, as the investment company's initial shareholder, typically selects
its initial board of directors. The adviser also selects and
recommends, for the board's approval, the investment company's service
providers, which may include sub-advisers, a principal underwriter,
custodians, a transfer agent, and an audit firm. It is the adviser that
has the authority to select and change the investment company's FCM.
Although employees of the adviser cannot, in their capacity as advisory
employees, solicit investors to invest in the investment company, this
function is typically served by the investment company's principal
underwriter, often an affiliate of the adviser.\31\ The adviser has a
fiduciary duty to the registered investment company, and is required to
act in the best interests of the company and its shareholders.\32\
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\31\ The principal underwriter is a registered broker-dealer. Its
employees that engage in solicitation activities are registered
representatives and hold appropriate licenses. As a result, an employee
of the adviser that is also a registered representative of the
principal underwriter can only engage in solicitation activities in his
or her capacity as a registered representative, and not an advisory
employee.
\32\ See Sections 36(a) and 36(b) of the Investment Company Act.
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By contrast, an investment company's directors do not perform
functions that should require them to register or be subject to
regulation as CPOs.\33\ They serve an oversight role and are not
responsible for the day-to-day management or operation of the
investment company. The CFTC and its staff have recognized that
registration of directors as CPOs may not be practicable or
necessary.\34\ The directors do not solicit investors for the
investment company. The board's role is to oversee the performance of
the investment company's adviser and other service providers under
their respective contracts and monitor potential conflicts of interest.
Under the Investment Company Act, an investment company's board of
directors must generally be comprised of a majority of ``independent''
directors. In order to be considered ``independent'' under the
Investment Company Act, these directors generally may not have a
significant business relationship with the fund's adviser, principal
underwriter, or affiliates.\35\ As the Supreme Court has recognized,
these independent directors are responsible for looking after the
interests of the fund's shareholders and serve as ``independent
watchdogs'' who ``furnish an independent check'' upon the management of
the fund.\36\ While the directors have the authority to approve and
terminate the investment company's agreement with its adviser,
termination is a drastic step. Such an action is not only costly and
disruptive, but also contrary to the investment company shareholders'
express intention to invest with a particular manager. Requiring
registration of directors would be fundamentally inconsistent with
their oversight role; subjecting them to the requirements applicable to
CPOs when they do not perform the functions of a CPO would be
unnecessary and would not further investor protection.
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\33\ See Letter from Dorothy A. Berry, Chair, IDC Governing
Council, to David A. Stawick, Secretary, CFTC (Apr. 12, 2011).
\34\ See, e.g., Commodity Pool Operators: Relief From Compliance
With Certain Disclosure, Reporting and Recordkeeping Requirements for
Registered CPOs of Commodity Pools Listed for Trading on a National
Securities Exchange; CPO Registration Exemption for Certain Independent
Directors or Trustees of These Commodity Pools, 75 Fed. Reg. 54794
(Sept. 9, 2010) (proposing exemptive relief from CPO registration for
directors of exchange traded commodity funds that were not registered
investment companies) (``Commodity ETF Release''); CFTC Staff Letter
No. 10-06 (March 29, 2010).
\35\ An independent director also cannot own any stock of the
investment adviser or certain related entities, such as parent
companies or subsidiaries. See Section 2(a)(19) of the Investment
Company Act.
\36\ Burks v. Lasker, 441 U.S. 471, 484 (1979).
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We also believe that it is not appropriate for the registered
investment company to register as CPO. The CFTC generally takes the
position that a CPO and its pool must be separate legal entities.\37\
As noted above, a registered investment company has no employees and
relies on its adviser for the day-to-day management of, and decisions
regarding, the company. It is the registered investment adviser, not
the investment company, which performs the functions that are key to
being deemed a CPO and is responsible for the investment company's
operations. It is appropriate, therefore, that the fund's adviser
should register solely with respect to the funds it manages. This
approach would be consistent with the CPO/pool model, in which it is
the pool's operator that registers with the CFTC, not the pool itself.
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\37\ See Rule 4.20(a) under the Commodity Exchange Act.
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If you concur with our view that the adviser to a registered
investment company is the entity that should register as CPO, only
those registered investment companies or other pools managed by the
adviser that are not eligible for exclusion under Rule 4.5 would become
subject to CFTC regulation.\38\ In addition, if the CFTC deemed it
appropriate, it could require an investment company adviser that must
register as a CPO to amend its advisory agreement at its next annual
contract renewal to state that the adviser will serve as the investment
company's CPO and to notify investment company shareholders of this
change in the investment company's next annual prospectus update.
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\38\ We note that the CFTC has recognized that separate funds
should be treated separately for purposes of determining whether the
criteria for exclusion under the rule have been met. See, e.g., 1985
Adopting Release, supra note 30, at II.B.
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The CPO registration process would provide the CFTC with additional
information about the adviser, its principals, including any principals
of the adviser that also serve as directors of investment companies
managed by the adviser, and any associated person(s). An adviser
registering as a CPO would include Form 8-Rs for its natural person
principals and associated persons, including those investment company
directors who are principals and/or associated persons of the adviser.
The adviser also would submit, on behalf of those persons, a
fingerprint card. We note that, under the Investment Company Act, all
of the investment company's directors, including the independent
directors, are subject to statutory disqualification provisions, which
are similar to those under the Commodity Exchange Act.\39\
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\39\ See Section 9 of the Investment Company Act.
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One of the adviser's executive officers would serve as the
associated person of the CPO. We believe it is appropriate for an
adviser CPO to have only one associated person for purposes of its CPO
registration because, as discussed above, the adviser cannot solicit
investors for the registered investment company. Instead, that function
is performed by registered representatives of the registered investment
company's principal underwriter, who hold Series 7 licenses.\40\ Rule
3.12(a) under the Commodity Exchange Act generally requires that any
person associated with a CPO be registered under the Commodity Exchange
Act as an associated person, which typically requires passing the
Series 3 examination. Rule 3.12(h)(1)(ii), however, provides that if
the pool is offered by registered representatives that are associated
with broker-dealers that are registered under the Securities Exchange
Act of 1934, the registered representatives are exempt from the Series
3 licensing requirement. The registered representatives of the fund's
principal underwriter would rely on this exemption to sell the fund's
shares. Because it is the fund's principal underwriter, and not the
adviser, that offers and sells the fund's shares, we believe it would
be appropriate for the associated person of the adviser to satisfy his
or her licensing requirement by passing the Series 31 examination
rather than the Series 3 examination, and plan to request such relief
from the NFA.\41\
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\40\ A Series 7 license is designed to ensure that the holder has
an understanding of the concepts relating to solicitation, purchase,
and/or sale of all securities products, including corporate securities,
municipal securities, municipal fund securities, options, direct
participation programs, investment company products, and variable
contracts.
\41\ We believe the Series 31 examination is better tailored to the
adviser's limited activities in this regard than the Series 3
examination, which requires knowledge of general commodity-related
topics.
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B. Scope of the Trading Restrictions in the Rule 4.5 Proposal
As indicated above, the overly broad nature of the Rule 4.5
Proposal in its current form would implicate many registered investment
companies beyond the ``futures-only'' funds referred to in the Release.
This point is illustrated by preliminary data from several ICI member
complexes, discussed below. In particular, the data suggest that many
types of registered investment companies use swaps, futures, and
options as a means to efficiently manage their portfolios, rather than
as part of operating a commodity fund. As a result, we believe that the
CFTC should revise the scope of the Rule 4.5 Proposal in a manner that
acknowledges that registered investment companies' use of these
instruments for non-speculative purposes does not raise the concerns
that the Rule 4.5 Proposal is designed to address.
We begin with a brief discussion of how registered investment
companies use futures, options and swaps. Next, we present the member
data described above. Finally, we offer several suggestions for how the
CFTC might appropriately narrow the scope of the trading restrictions
in the Rule 4.5 Proposal, including by: (1) eliminating or
significantly narrowing the application of the proposed rule to swaps;
(2) specifically referencing risk management as an element of ``bona
fide hedging'' in the context of Rule 4.5; and (3) raising the
threshold for the Non-Hedging Restriction.
1. Use of Commodity Futures, Commodity Options and Swaps by Registered
Investment Companies
Registered investment companies use commodity futures, commodity
options and swaps in a variety of ways to manage their investment
portfolios, and many of these uses are unrelated to speculation \42\ or
providing exposure to the commodity markets. Uses of these instruments
include, for example, hedging positions, equitizing cash that cannot be
immediately invested in direct equity holdings (such as if the stock
market has already closed for the day), managing cash positions more
generally, adjusting portfolio duration (e.g., seeking to maintain a
stated duration of 7 years as a fund's fixed income securities age or
mature), managing bond positions in general (e.g., in anticipation of
expected changes in monetary policy or the Treasury's auction
schedule), or managing the fund's portfolio in accordance with the
investment objective stated in the fund's prospectus (e.g., an S&P 500
index fund that tracks the S&P 500 using a ``sampling algorithm'' that
relies in part on S&P 500 or other futures).
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\42\ We use the term ``speculation'' to be consistent with the
commodity industry's common understanding of the term. Registered
investment companies, however, do not consider their investment
strategies to be ``speculative;'' the substantive provisions of the
Investment Company Act preclude their ability to engage in
``speculative'' behavior (see, e.g., Section 18 of the Investment
Company Act).
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Swaps are a particularly useful portfolio management tool because
they offer registered investment companies considerable flexibility in
structuring their investment portfolios. We offer two examples to
illustrate how a registered investment company might use swaps:
Total return swaps provide an efficient means to gain
exposure (e.g., to particular indices, to foreign markets for
which there is no appropriate or liquid futures contract, to
foreign markets where local settlement of securities
transactions may be difficult and costly). A registered
investment company might use a total return swap based on a
broad market index in order to gain market exposure on cash
flows to the investment company until such cash flow is fully
invested. It is important that registered investment companies
be able to put cash flows ``to work'' immediately, for the
benefit of their shareholders.
Interest rate swaps are commonly used by registered
investment companies that follow fixed income strategies. This
type of swap allows the investment company to adjust the
interest rate and yield curve exposures of the investment
company or to replicate a broadly diversified fixed income
strategy (which may be difficult to do solely through direct
purchases of bonds). For example, inflation protected funds are
now relatively common. To protect against inflation, these
strategies use Treasury inflation-protected securities
(``TIPS'') or an efficient substitute. Since the market for
TIPS is not especially deep, registered investment companies
may find it more efficient to achieve inflation protection
through interest rate swaps linked to the return on TIPS.
The Commission has failed to justify its broad inclusion of all
non-security based swaps in its proposal, despite the variety of ways
investment companies may use these instruments, many of which are far
afield of running a futures-only investment product. As previously
discussed, a far more nuanced analysis of swaps usage by registered
investment companies is necessary before this rule can proceed.
2. ICI Member Data Illustrates the Overly Broad Nature of the Rule 4.5
Proposal
As indicated above, the broad language of the proposed conditions,
together with the inclusion of swaps, would significantly expand the
scope of the Commission's Rule 4.5 Proposal to an extent the CFTC may
not have contemplated and well beyond the Commission's stated
objective, which is to preclude the offering of ``futures-only
investment products'' without CFTC oversight. The preliminary data
outlined below serve to illustrate these points.
Information provided by thirteen ICI member firms, which in total
advise 2,111 registered investment companies (including SEC-registered
open-end funds, closed-end funds (``CEFs''), and ETFs) whose assets
total $2.9 trillion indicates that these member firms have 1,154
separate funds that use or may use derivatives, of which an estimated
485 funds potentially would be unable to meet the criteria for
exclusion under proposed Rule 4.5 for various reasons (see Table 1).
Table 1: Use of Derivatives by Investment Companies Managed by Selected
ICI Member Firms 1
------------------------------------------------------------------------
------------------------------------------------------------------------
Number of fund complexes providing information 13
Total assets of open-end funds, CEFs, and ETFs managed by $2,899
these complexes ($ millions)
Number of open-end funds, CEFs, and ETFs managed by these 2,111
complexes
of which: 2
Funds that use or invest in derivatives 1,154
of which:
Funds that may be unable to rely on proposed Rule 4.5 485
of which, funds that primarily: 1
Pursue managed futures strategy 23
Seek exposure to physical commodities or other 6
commodity-related strategies
Are broad-based diversified funds 190
Are fixed-income funds or other funds using derivatives 160
to meet investment objectives
Use other strategies that could be implicated by 102
proposed Rule 4.5
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Source: ICI compilation of information provided by thirteen ICI member
firms.
1 Includes registered investment companies that are open-end mutual
funds, CEFs, and ETFs. All figures in the table refer exclusively to
long-term funds. Funds of funds are included in the number of funds
but are excluded from asset totals to avoid double counting total
assets in these funds.
2 Total does not add to 485 because certain fund complexes felt that
categorization was too uncertain in light of current lack of
specificity in Proposed Rule 4.5.
As Table 1 illustrates, of the 485 investment companies that may be
unable to meet the criteria for exclusion under the Rule 4.5 Proposal
for various reasons, only 29 investment companies seek returns
primarily based on a managed futures strategy or by providing exposure
to physical commodities or other commodity-related strategies. By
contrast, 190 investment companies are broad-based diversified funds,
such as index funds, asset allocation funds, target date funds,
inflation-protected funds, or other funds that have exposure to
physical commodities as a non-primary component in a broad-based
investment strategy. Another 160 of the 485 investment companies are
fixed-income or other funds that use financial futures or swaps to help
achieve their investment objectives. The remaining 102 investment
companies follow other strategies that could be implicated by the
proposed rule.
Our members' estimate of 485 investment companies in these 13
complexes that could potentially be implicated by the proposed rule is
based on a fair degree of uncertainty. As noted, the proposed rule at
present lacks critical details, such as precisely how swaps will be
treated, whether foreign exchange forwards and foreign exchange swaps
will be included, and others. Our member firms have thus made a good-
faith effort to interpret how the proposed rule may affect the
investment companies they advise. The total number of affected
investment companies, however, could be either considerably higher or
lower depending on the rule's final provisions. In addition, these
estimates are only for the thirteen member firms that provided
information. There are an additional 248 member complexes that either
were not asked to provide information or were unable to provide
information given the uncertainty inherent in the Rule 4.5 Proposal,
including a few of the very largest complexes. Thus, the estimates in
Table 1 should not be taken as an upper bound on the likely number of
investment companies that could be affected by the Rule 4.5 Proposal,
and likely understate the number of entities that could be subject to
dual registration and regulation by the SEC and CFTC under the Rule 4.5
Proposal. Nonetheless, the data clearly suggest that the rule, at least
as proposed, would likely affect a large number and variety of
investment companies, the vast majority of which pursue strategies
outside the CFTC's intended reach, as stated in the Release.
3. Suggestions for Narrowing the Scope of the Trading Restrictions in
the Rule 4.5 Proposal
The Rule 4.5 Proposal incorporates the trading restrictions from
the NFA petition with the addition, as discussed above, of swaps.
Specifically, a registered investment company would be required to
represent, in its notice of eligibility for the exclusion, that it will
use commodity futures, commodity options or swaps solely for ``bona
fide hedging purposes.'' It may, however, represent that it will hold
certain instruments not for bona fide hedging purposes, generally
subject to representations that the aggregate initial margin and
premiums required to establish those positions will not exceed five
percent of the liquidation value of the fund's portfolio (the ``Non-
Hedging Restriction''). We are concerned that the Non-Hedging
Restriction, especially as it would apply to swaps, futures, and
options used for non-speculative purposes, would result in a large
number of registered investment companies being unable to rely on
amended Rule 4.5 and becoming subject to registration with, and
regulation by, all of the SEC, the CFTC and NFA. We thus offer several
suggestions for how the CFTC might appropriately narrow the scope of
these proposed restrictions.
(a) The Non-Hedging Restriction Should Not Apply to Swaps, or Its
Application Should be Significantly Narrowed
Based on data and other information obtained from many of our
member firms, we have concluded that a wholesale inclusion of swaps in
the Rule 4.5 Proposal could result in advisers to a large number of
registered investment companies being unable to rely on the rule's
exclusion, burdening the CFTC and NFA with a large number of additional
registrants--entities already subject to comprehensive SEC regulation--
at a time when CFTC resources are severely constrained.\43\ Advisers to
these investment companies would become subject to CFTC and NFA
regulation, even if the investment company's uses of swaps would not
raise the concerns that CPO regulation is designed to address.
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\43\ See, e.g., Gensler Remarks, supra note 16.
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The Commission also has not provided any analysis that would
establish a basis for a wholesale inclusion of swaps in the Rule 4.5
Proposal, and the Proposal's consequent broad reach. While we
acknowledge the CFTC's jurisdiction over swaps as a result of the Dodd-
Frank Act, we believe its expanded jurisdiction does not relieve the
agency of the obligation to provide a clear rationale as to why users
of swaps need to be registered and to examine whether particular uses
of swaps raise the concerns that the Rule 4.5 Proposal is intended to
address. If the Commission does not eliminate or narrow the application
of the Rule 4.5 Proposal to swaps, as we suggest below, we are
concerned that some registered investment companies may choose to limit
their use of swaps in order to avoid this second layer of regulation,
with potential adverse effects on liquidity of the swaps markets.\44\
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\44\ See, e.g., Garrett Letter, supra note 11 (``. . . in none of
the relevant notices of proposed rulemakings is there any discussion of
the impact on liquidity.''); October Letter at n. 5 (stating that
``should the CFTC decide to move forward with a rulemaking to amend
Rule 4.5, we would urge the agency to consider carefully the effect
that its proposed changes would have on market liquidity.''). The
Commission's lack of discussion in the Release regarding the potential
effects of the Rule 4.5 Proposal on liquidity contrasts with its focus
on this issue in 2003 when it amended the rule to eliminate the trading
restrictions, in significant part because of concerns about the effects
they could have on market liquidity. See 2003 Adopting Release, supra
note 7.
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For these reasons, we respectfully urge the Commission to
eliminate, or at least narrow significantly, the application of the
Non-Hedging Restriction to swaps.\45\ We believe such a result would be
consistent with the fact that many registered investment companies use
swaps for a variety of purposes in connection with the efficient
management of their investment portfolios. Further, the use of swaps
for these purposes is unrelated to the Commission's stated objective,
which is to preclude the offering of ``futures-only investment
products'' without CFTC oversight.
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\45\ The CFTC could do so, for example, by excluding swaps that
provide exposure to the securities markets--markets over which the CFTC
has no jurisdiction--or interest rate swaps.
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(b) The Commission Should Specifically Reference Risk Management as an
Element of ``Bona Fide Hedging'' in the Context of Rule 4.5
We recommend that the Commission specifically reference, in any
amendments to Rule 4.5 that include a ``bona fide hedging'' test, risk
management transactions that would encompass contemporary uses of
swaps, futures, and options by investment company advisers, on behalf
of their funds, for non-speculative purposes. The CFTC has explicitly
recognized that hedging includes the concept of risk management and
distinguished it from speculative trading. Specifically, in a 1987
agency interpretation (``1987 Interpretation''), the Commission
provided for risk management exemptions for commodity exchanges from
speculative position limit rules.\46\ In the 1987 Interpretation, the
CFTC discussed different non-speculative derivatives trading
strategies, many of which are used by investment companies.\47\ More
recently, the CFTC has applied the concept of risk management in
proposing an exception from the mandatory clearing requirement for
swaps subject to conditions including, among others, that the entity be
using the swap to hedge or mitigate against commercial risk.\48\
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\46\ See, Risk Management Exemptions From Speculative Position
Limits Approved Under Commission Regulation 1.61, 52 Fed. Reg. 34633
(Sept. 14, 1987) (agency interpretation providing for risk-management
exemptions, in addition to current exemptions for hedging, from
speculative position limit rules of exchanges); see also Report of the
Financial Products Advisory Committee of the Commodity Futures Trading
Commission, The Hedging Definition and the Use of Financial Futures and
Options: Problems and Recommendations for Reform (June 15, 1987)
(``Committee Report'') (Committee's recommendations included, among
others, revising Rule 1.61 and issuing guidelines that permit exchanges
to exempt from speculative position limits transactions or positions
taken for risk-management purposes, revising Rule 1.3 to include a
definition of risk management, and revising Rule 4.5 to provide an
exclusion from CPO regulation for otherwise-regulated entities that use
futures and options for risk-management purposes).
\47\ While the 1987 Interpretation specifically did not address
Rule 4.5, it appears that may have been because the Committee Report
included separate, specific recommendations related to Rule 4.5 and
Rule 1.3(z). See 1987 Interpretation, supra note 46 at n. 3; Committee
Report, supra note 46 (recommending revising Rule 1.3(z) to include a
definition of risk management and revising Rule 4.5 to provide an
exclusion from CPO regulation for otherwise-regulated entities which
use futures and options for risk-management purposes).
\48\ See, End-User Exception to Mandatory Clearing of Swaps, 75
Fed. Reg. 246 (Dec. 23, 2010) (CFTC proposal for elective exception
from mandatory clearing requirement for swaps subject to conditions
including, among others, that the entity be using the swap to hedge or
mitigate against commercial risk) (``Swaps Proposal'').
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We therefore request that the Commission state specifically that
risk management will be considered as part of the bona fide hedging
test (or as an additional category) in connection with any amendments
to Rule 4.5. This would include transactions or positions taken by a
registered investment company in futures contracts, options contracts,
or swaps if used for the following purposes:
As alternatives or temporary substitutes for ``cash market''
positions;
To mitigate or offset changes in the value of ``cash
market'' positions owned by the investment company or non-
derivative liabilities of the investment company;
To facilitate the investment company's management of its
cash and/or reserves;
To adjust an investment company's duration; or
To efficiently adjust a fund's exposure to one or more asset
allocation categories.
Such a Commission statement would be consistent with current and prior
positions of the CFTC.\49\ Use of futures, options, or swaps in these
and other ways that allow investment company advisers to manage the
risks in their investment portfolios does not present the higher risks
to commodity markets and investors that may be raised by speculation,
and should not be subject to the Non-Hedging Restriction.
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\49\ See, e.g., id.; 1987 Interpretation, supra note 46; Committee
Report, supra note 46.
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(c) The Threshold for the Non-Hedging Restriction Should be Raised
The threshold for the Non-Hedging Restriction is proposed to be
five percent, the same threshold that was included in Rule 4.5 prior to
its amendment in 2003. We note, however, that current margin levels for
a number of derivative instruments in which registered investment
companies invest now exceed five percent of contract value. Almost a
decade ago, the CFTC acknowledged that margin levels for certain stock
index futures significantly exceeded five percent of contract value and
that margin levels for security futures contracts were 20 percent of
contract value, which had the effect of limiting their use for non-
hedging purposes as compared to instruments subject to lower margin
requirements.\50\ These concerns remain valid today, and would be
exacerbated by applying the Non-Hedging Restriction to swaps, as
contemplated by the Rule 4.5 Proposal.
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\50\ See 2003 Proposing Release, supra note 7. These concerns were
made moot by the CFTC's adoption of amendments to Rule 4.5 that
eliminated the Non-Hedging Restriction. See 2003 Adopting Release,
supra note 7.
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In the Release, the CFTC requests comment on whether a higher
threshold is appropriate. We believe it is, although due to the current
high level of uncertainty regarding the regulatory treatment of swaps
and the margin levels to which they will be subject, we are unable to
recommend what that higher threshold should be. If the threshold for
the Non-Hedging Restriction is not raised to reflect the realities of
the financial markets in which registered investment companies invest,
the result could be that investment companies may alter their
investment strategies specifically to avoid exceeding the Non-Hedging
Restriction, which would not be in the best interests of investors. We
stress that a full analysis of the correct threshold for the Non-
Hedging Restriction should be undertaken only after further opportunity
for public comment, following resolution of the regulatory issues
regarding the status of swaps, foreign exchange swaps, and foreign
exchange forwards.
C. Registered Investment Companies Should Continue To Be Permitted To
Use a Wholly Owned Subsidiary Structure
The Rule 4.5 Proposal would require that any positions in swaps,
commodity futures or commodity option contracts for non-hedging
purposes would need to be held ``by a qualifying entity only.'' This
language was added by the NFA Petition and was not included in Rule 4.5
as it existed prior to 2003. The language is apparently directed at
investment companies' use of wholly-owned subsidiaries to engage in a
limited amount of swaps, commodity futures, and commodity options
trading (i.e., no more than 25% of an investment company's investment
portfolio, as disclosed in its registration statement and as
specifically permitted by the Internal Revenue Service (``IRS'')) and
would effectively preclude a registered investment company from using
the subsidiary structure.
We emphasize, as we did in the October Letter, that this subsidiary
structure is used by registered investment companies for tax purposes
and not to evade regulation under the Investment Company Act, which is
focused on protecting investors. Under Subchapter M of the Internal
Revenue Code of 1986, as amended, each registered investment company is
required to realize at least 90 percent of its annual gross income from
investment-related sources, which is referred to as ``qualifying
income.'' \51\ Direct investments by a registered investment company in
commodity-related instruments generally do not, under IRS published
rulings, produce qualifying income. As a result, certain registered
investment companies sought and received private letter rulings from
the IRS that income from a wholly owned subsidiary that invests in
commodity and financial futures and options contracts, swaps on
commodities or commodity indexes and commodity-linked notes, fixed-
income securities serving as collateral for the contracts and
potentially cash-settled non-deliverable forward contracts constitutes
qualifying income.
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\51\ Income from investment-related sources includes income
specifically from dividends, interest, proceeds from securities
lending, gains from the sales of stocks, securities and foreign
currencies, or from other income (including, but not limited to, gains
from options, futures, or forward contracts) derived with respect to
its business of investing in such stock, securities, or currencies, or
income from certain types of publicly traded partnerships.
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If the CFTC has any remaining regulatory concerns about the
operations of these subsidiaries, we believe these concerns could be
addressed effectively through representations made by the investment
company's adviser that it would make the books and records of the
fund's subsidiary available to the CFTC and NFA staff for inspection
upon request and provide transparency about fees, if any, charged by
the subsidiary. We strongly recommend that the CFTC make explicit in
any re-proposal that use of the subsidiary structure as described above
would continue to be permitted.
D. Restriction on Marketing
In addition to the Non-Hedging Restriction, the Rule 4.5 Proposal
would require that an investment company seeking to rely on the Rule
4.5 exclusion represent that it will not be, and has not been,
marketing participations in the fund to the public as or in a commodity
pool or otherwise as or in a vehicle for trading in (or otherwise
seeking investment exposure to) the commodity futures, commodity
options, or swaps markets (the ``Marketing Restriction'') (emphasis
added). The italicized language was not part of the Marketing
Restriction in Rule 4.5 prior to 2003 but was introduced in the NFA
petition. The CFTC fails to explain why it believes this language is
necessary or to give any indication as to its intended scope, despite
concerns raised by ICI and other commenters in response to the CFTC's
earlier publication of the NFA's rulemaking petition. The NFA petition
similarly failed to address these issues.
As discussed in our October Letter, ICI and its members are very
concerned that this new language could be interpreted broadly, even
applying to registered investment companies whose investment portfolios
(whether directly or indirectly through a so-called ``fund-of-funds''
structure) have only a modest exposure to commodity futures, commodity
options, and swaps.\52\ The proposed language is also broad enough that
it could apply to an investment company's use of commodity futures,
options, or swaps for bona fide hedging purposes or within the Non-
Hedging Restriction, thereby rendering the trading exceptions within
the Rule 4.5 Proposal effectively moot. The language even appears broad
enough to capture registered investment companies that invest only in
securities and not commodities--entities clearly outside the CFTC's
jurisdiction--such as sector investment companies that invest in
securities of oil or mining companies, or other registered investment
companies that obtain commodity exposure through investments in
securities. Clearly, investments in these securities products cannot
result in CFTC registration. Finally, as drafted, the Marketing
Restriction could be triggered by basic disclosures in prospectuses and
marketing materials concerning the range of investments the investment
company may be entitled to make. We outline below several
recommendations intended to address these concerns.
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\52\ Many investment company complexes sponsor funds-of-funds for
retail investors. These funds-of-funds are in many cases intended to
provide retail investors with broad asset class diversification in a
single investment vehicle. As part of that diversification goal, funds-
of-funds often invest a portion of their assets in other investment
companies whose portfolios may include investments in non-traditional
asset classes such as commodities and commodity-related products.
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1. The Reference to ``Otherwise Seeking Investment Exposure'' Should Be
Deleted
We strongly recommend that the CFTC eliminate from the Marketing
Restriction the ``otherwise seeking investment exposure'' language. We
believe that this change would appropriately capture those registered
investment companies about which the CFTC may have concerns--funds that
are effectively holding themselves out as commodity pools. Adding the
investment exposure language only creates ambiguity and would result in
a significant number of registered investment companies that do not
provide meaningful commodity exposure being unable to satisfy the
exclusion and becoming subject to CFTC and NFA regulation, which
neither serves the interests of the regulators nor those of investors.
2. Two Tier Registration System
We recommend that advisers to registered investment companies that
do not market themselves as commodity pools, according to the revised
criteria we suggest above, but hold positions in commodity interests
that exceed the threshold under the Non-Hedging Restriction (as we
suggest it be amended) be, at most, required to register as CPOs, but
not otherwise be subject to the requirements applicable to CPOs under
Part 4 of the CFTC's rules. These investment companies, which may
include, among others, fixed-income funds, index funds, inflation-
protected funds, asset allocation funds and balanced funds, do not
raise the concerns the CFTC seeks to address in its Proposal.
Registration of the investment adviser as a CPO would require
membership with the NFA, and subject the adviser to examination by the
NFA.\53\ We do not believe it is appropriate to additionally subject
the advisers to these registered investment companies, which are
already subject to comprehensive regulation under the Federal
securities laws and rules, to the CFTC's Part 4 requirements, which are
designed for CPOs that market their commingled vehicles as commodity
pools or provide significant commodity interest exposure.
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\53\ Please see our analysis above, at Section III.A., regarding
CPO registration of the investment adviser.
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Because registered investment companies are subject to extensive
public disclosure and reporting requirements, the CFTC would have
access to comprehensive and detailed information about, among other
things, an investment company's risks, holdings, fees, performance
information, financial information, and service providers, as well as
detailed information about the investment company's adviser, all
without applying the CFTC's Part 4 requirements.\54\ Furthermore, the
SEC has proposed amendments to Form ADV that would expand even further
the information that is required by the form, including disclosure
about whether an adviser provides advice with respect to futures
contracts, forward contracts, or various types of swaps.\55\ We also
note that the CFTC would have antifraud and inspection authority over
an adviser that is deemed to be a CPO even without registration.
Imposing additional regulatory requirements on the advisers to these
registered investment companies would not provide meaningful additional
information to investors and, because of the inconsistent and
duplicative information requirements of the two regulatory regimes,
could instead cause confusion.
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\54\ Please see the examples of fund disclosure and reporting
requirements described in Appendix A to this letter. In addition, Part
1A of Form ADV, the registration form for investment advisers, provides
detailed information about the investment adviser and its business,
including information about the types of clients it has, its advisory
services, potential conflicts of interest, custody of client assets,
any disciplinary history, its owners and executive officers, and
information about certain service providers.
\55\ See, Rules Implementing Amendments to the Investment Advisers
Act of 1940, Investment Advisers Act Release No. 3110 (Nov. 19. 2010).
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3. Need for Clear Guidance
We are aware that others are exploring approaches to the Marketing
Restriction that would require registered investment companies to
consider a variety of factors, such as how the investment company holds
itself out to the public/its representations in materials provided to
investors; the composition of the investment company's assets; the
activities of its officers and employees; its historical development;
and perhaps other factors, to determine whether the investment
company's adviser should register as a CPO. If the CFTC determines to
adopt this or a similar test, we believe it is absolutely critical that
the agency provide clear guidance articulating what the relevant
factors are, how they will be weighted, and how the agency expects
industry participants to apply them. Certainty will be essential to the
usefulness of any such test, both to the industry and to
regulators.\56\ It is also critical that the public has an opportunity
to comment on any test that the CFTC determines to propose.\57\
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\56\ We also note that, to the extent applicability of the test is
unclear, advisers that do not register as CPOs based on a good faith
application of the enumerated factors nevertheless could be subject to
the hindsight analysis used in some private lawsuits claiming that, in
fact, the adviser should have registered.
\57\ See, Kooritzky, supra note 15, at 1513; Shell Oil, supra note
15, at 751.
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4. Other Clarifications
Finally, we respectfully request that the CFTC clarify certain
aspects of the Marketing Restriction. We specifically request
clarification that the Marketing Restriction would not preclude
registered investment companies from including in their registration
statements (including prospectuses and statements of additional
information), as well as in marketing materials, basic disclosure
concerning the range of investments the investment company may be
entitled to make as well as risk disclosures that may mention
investment in commodity futures, commodity options, and swaps. Our
requested clarification is consistent with the CFTC's past
interpretations of the marketing restriction.\58\ We further request
clarification that the Marketing Restriction would not preclude
disclosures concerning the range of investments or risks of a fund of
funds relating to its investments in underlying funds which may include
limited commodity exposure, when those investments are made as part of
an Investment Company Act-registered investment product, such as a
target date or asset allocation fund.
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\58\ The CFTC has previously stated that it will allow, within the
Marketing Restriction, ``any promotional material required by and
consistent with the policies of a qualifying entity's other Federal or
state regulator,'' as well as permit ``a [registered investment
company] to describe accurately in its sales literature the limited use
of its commodity interest trading and how it believes that use will be
beneficial.'' See 1985 Adopting Release, supra note 30, at C.3.
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IV. Registered Investment Companies Should Not Be Subject to
Overlapping and Conflicting Regulatory Requirements
As noted above, investment companies are already extensively
regulated under the Investment Company Act and other Federal securities
laws. The protections afforded under the securities laws include, among
others: limits on the use of leverage; antifraud provisions;
comprehensive disclosure to investors, including with regard to fees
and expenses, the investment objectives and strategies of the
investment company, and the risks of investing in the investment
company; oversight by an independent board of directors, particularly
with regard to potential conflicts of interest; restrictions on
transactions with affiliates; and requirements regarding custody of the
investment company's assets. As we discuss above, we believe strongly
that the Rule 4.5 Proposal is overbroad and would subject registered
investment company advisers to CPO regulation in cases where a second
layer of regulation is not necessary.
Even if the trading and marketing restrictions in the Rule 4.5
Proposal are appropriately scaled back, there are likely to be cases in
which advisers to registered investment companies would be unable to
rely on the amended rule and may have to comply with Part 4 of the
CFTC's rules. For this reason, we believe it is critical that the CFTC
work closely with the SEC before amending Rule 4.5 in order to
reconcile the many conflicting and duplicative CFTC and SEC regulations
to which these investment companies and their advisers would be
subject. The harmonized regulations then should be re-proposed for
public comment.
A. Reconciliation of Duplicative or Conflicting Regulatory Requirements
Registered investment companies are subject to extensive disclosure
and reporting requirements. Many of these are very similar to the
requirements to which CPOs are subject, including the requirement to
deliver disclosure documents to shareholders/participants in connection
with offers and sales to investors, and requirements to provide
periodic reports to shareholders/ participants, as well as reports to
regulators. We believe that, in those areas where SEC and CFTC
requirements are similar, requiring registered investment companies to
comply with both sets of regulatory requirements would be burdensome
and costly, as well as potentially confusing to investors; these
largely duplicative requirements also would not provide meaningful
improvement in the regulatory protections provided. Therefore, we
recommend that, as to those matters, the relevant SEC provisions should
apply. It is more efficient for registered investment companies to
comply with provisions to which they are currently subject, and to
which the other registered investment companies in their complexes
would be subject. Those provisions, based on the similarities to the
CFTC's requirements, would appear to satisfy the CFTC's regulatory
interest.
In other areas, the requirements under the Investment Company Act
and the Commodity Exchange Act are wholly inconsistent and would
require reconciliation or further guidance from the SEC and CFTC before
an adviser to a registered investment company could comply. While the
Commission requests comment in the Release regarding ``how these
[conflicts] could be addressed by the two Commissions,'' \59\ it
provides no guidance on how that might be accomplished. In order to
meet the notice and comment requirements of the APA, we strongly
believe the agency must re-propose the rule to include a detailed
proposal for how conflicting or inconsistent requirements will be
reconciled, or detailed discussion regarding the guidance it proposes
to provide.\60\
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\59\ See Release, supra note 2, at 7984.
\60\ See, Kooritzky, supra note 15; Shell Oil, supra note 15.
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We have compared the SEC and CFTC requirements that would be
applicable to CPOs of registered investment companies subject to Part 4
of the CFTC's regulations in Appendix A to this letter. In addition, we
discuss below several areas in which we specifically request relief
from the CFTC.
B. Areas in Which CFTC Relief is Necessary
1. Disclosure Document Delivery and Acknowledgment
The disclosure document delivery and acknowledgment requirements
applicable to commodity pools differ from the prospectus delivery
requirements applicable to registered investment companies.
Specifically, Rule 4.21(a) under the Commodity Exchange Act requires
that a CPO deliver a disclosure document to a prospective pool
participant ``by no later than the time it delivers to the prospective
participant a subscription agreement for the pool,'' and Rule 4.21(b)
states that the CPO may not accept money from a prospective pool
participant unless the CPO first receives from the prospective
participant a signed and dated acknowledgement stating that the
participant received the disclosure document describing the pool that
is required under the Commodity Exchange Act (the ``Disclosure
Document'').\61\ Registered investment companies are required to
deliver a prospectus to prospective investors no later than when a
transaction confirmation is delivered.\62\ Delivery or use of a
subscription agreement is not required for a registered investment
company, nor is receipt of a signed and dated acknowledgement.
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\61\ See Rules 4.21 and 4.24 under the Commodity Exchange Act.
\62\ See Section 5 of the Securities Act of 1933 (``1933 Act'') and
Rule 10b-10 under the Securities Exchange Act of 1934.
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The CFTC has recognized that the prospectus delivery requirements
under the Federal securities laws differ from CFTC regulations ``with
respect to timing and other aspects.'' \63\ The CFTC has proposed, and
its staff has granted, relief from the disclosure document delivery and
acknowledgement requirement of Rule 4.21 for commodity exchange traded
funds (``commodity ETFs''). As the CFTC has acknowledged for CPOs of
commodity ETFs, ``simultaneous compliance with both sets of
requirements [is] unnecessarily cumbersome, and would needlessly
interfere with the established procedures for conducting a registered
public offering of shares . . .'' \64\ The same would be true for
registered investment companies and their advisers. The compliance
difficulties are equally challenging regardless of whether a pool is
listing its shares on an exchange or otherwise offering them publicly.
We therefore request relief, on behalf of our members that could be
subject to the Part 4 regulations, from the Disclosure Document
delivery requirement of Rule 4.21(a) and from the signed
acknowledgement requirement of Rule 4.21(b) similar to that which the
CFTC recently proposed for commodity ETFs.\65\ In addition, we request
relief from the requirements in Rule 4.26(d)(1) and (2) under the
Commodity Exchange Act, which require a CPO to file the Disclosure
Document and amendments with the NFA prior to use. In particular, the
registered investment company's CPO would satisfy conditions analogous
to those proposed for CPOs of commodity ETFs, including: \66\
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\63\ See Commodity ETF Release, supra note 34.
\64\ Id. at 54795.
\65\ Because we are requesting relief based on conditions that the
CFTC has proposed but not yet adopted, we request the opportunity here
and below to revisit the conditions to the relief if the CFTC
subsequently adopts different conditions for commodity ETFs.
\66\ Proposed Rule 4.12(c)(2)(i)(A)-(D). Commodity ETF Release,
supra note 34, at 54800.
Causing the investment company's prospectus and statement of
information (``SAI'') to be readily accessible on an Internet
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website maintained by the adviser;
Causing the investment company's prospectus and SAI to be
kept current; \67\
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\67\ We would cause the investment company's prospectus and SAI to
be kept current in accordance with the requirements of the Federal
securities laws, rather than the rules under the Commodity Exchange
Act. Please see our request for relief below.
Informing prospective investment company investors of the
Internet address of the website and directing any broker,
dealer or other selling agent to whom the investment company's
principal underwriter sells shares of the investment company to
---------------------------------------------------------------------------
so inform prospective investors;
Complying with all other requirements applicable to pool
Disclosure Documents under Part 4 of the CFTC's regulations
except (1) those with which the investment company should be
deemed to already satisfy (as described in Appendix A), and (2)
those with which the investment company would be unable to
comply (absent the CFTC's reconciliation of conflicting CFTC
and SEC regulations or obtaining relief as requested in this
letter).
2. Updating of Prospectus and SAI
CPOs are required by the rules under the Commodity Exchange Act to
update a commodity pool's Disclosure Document every 9 months.\68\
Registered investment companies, however, are permitted under the
Federal securities laws to update their registration statements
(including their prospectuses and SAIs) annually.\69\ Requiring
registered investment companies to update their prospectuses every 9
months would increase costs for registered investment companies whose
advisers do not qualify for exclusion under Rule 4.5. Because the
registered investment company's audited financial statements would not
be completed when the 9 month update was due, the fund would be
required to file supplemental/post-effective amendments with the SEC to
add the audited financial statements. Such a requirement would also
place those investment companies managed by an adviser subject to Part
4 of the CFTC regulations on a different updating cycle than other
investment companies managed by the adviser, which would be costly and
inefficient. We therefore request that investment companies be
permitted to satisfy the Federal securities law standard for updating,
rather than being required to update every 9 months.\70\ We do not
believe that requiring that prospectuses be updated more frequently
would materially increase protections for investors, but would increase
costs to them.
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\68\ Rule 4.26(a)(2) under the Commodity Exchange Act provides that
``[n]o commodity pool operator may use a Disclosure Document . . .
dated more than 9 months prior to the date of its use.''
\69\ Section 10(a)(3) of the 1933 Act states that ``when a
Prospectus is used more than 9 months after the effective date of its
registration statement, the information contained therein shall be as
of a date not more than sixteen months prior to such use . . .''
\70\ See, Appendix A. In addition, we request relief, above, from
the requirement in Rule 4.26(d)(2) under the Commodity Exchange Act to
file amendments to the Disclosure Document with the NFA.
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3. Shareholder/Participant Reporting Requirements
The rules under the Commodity Exchange Act and the Investment
Company Act impose similar obligations as regards periodic reports to
be delivered to participants and shareholders, respectively. Both the
SEC and the CFTC require the delivery of annual reports to shareholders
containing audited financial statements.\71\ The SEC also requires the
delivery of semi-annual reports to shareholders containing unaudited
financial statements.\72\ The CFTC, however, requires that CPOs of
pools with net assets of more than $500,000 at the beginning of the
pool's fiscal year deliver to pool participants a monthly Account
Statement that includes an unaudited Statement of Operations and a
Statement of Net Assets.\73\ Complying with the monthly reporting
requirement would be unduly burdensome and costly for the CPO to a
registered investment company because registered investment companies
are not currently required to create monthly reports, most registered
investment companies redeem their shares on a daily basis, and shares
are often held in book-entry form.\74\
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\71\ See Rule 30e-1 under the Investment Company Act and Rule
4.21(c) under the Commodity Exchange Act.
\72\ See Rule 30e-1 under the Investment Company Act.
\73\ See Rule 4.22(a) under the Commodity Exchange Act. Also see
Appendix A for a detailed comparison of the reporting requirements.
\74\ Most registered investment companies would meet the rule's
$500,000 threshold.
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Accordingly, we request that investment companies that satisfy the
periodic reporting requirements under the Investment Company Act be
granted relief from the monthly Account Statement requirements under
the Commodity Exchange Act.\75\ Requiring registered investment
companies to create monthly reports only for those funds that would be
subject to Part 4 of the CFTC's regulations would be very costly and
burdensome. We believe that the semi-annual reporting requirements
under the Investment Company Act provide comparable protections to
investment company shareholders. We further note that rules under the
Investment Company Act require a registered investment company to file
a quarterly report 60 days after the close of the first and third
quarters that contains a schedule of investments and other
disclosures.\76\ This report is publicly available to investors.
---------------------------------------------------------------------------
\75\ We note that the CFTC has proposed, and its staff has granted,
relief from the Account Statement delivery requirement for commodity
ETFs. See Commodity ETF Release, supra note 34.
\76\ See Rule 30b1-5 under the Investment Company Act.
---------------------------------------------------------------------------
We agree that the relief would be subject to conditions analogous
to those proposed for CPOs of commodity ETFs, including: \77\
---------------------------------------------------------------------------
\77\ See Rule 4.23 under the Commodity Exchange Act.
Keeping the annual and semi-annual reports sent to
shareholders readily accessible on the adviser's website for a
period of 30 days following the date they are first posted on
---------------------------------------------------------------------------
the website;
Indicating in the investment company's prospectus or SAI
that the company's annual and semi-annual reports will be
readily accessible on the adviser's website; and
Including in the prospectus or SAI the Internet address
where the investment company's annual and semi-annual reports
are available.
4. Books and Records
CFTC rules require that a CPO maintain required pool books and
records at its main business address.\78\ Rules under the Investment
Company Act, by contrast, generally require that the books and records
of a registered investment company be preserved for specified periods
of time, with more recent books and records typically preserved in an
``easily accessible place.'' \79\ These rules also permit a registered
investment company to have a third party maintain the books and records
on its behalf, if the investment company and the third party enter into
a written agreement specifying that the records are the property of the
registered investment company and stating that such records will be
surrendered promptly on request.\80\ An investment adviser is also
required to specify on its Form ADV each entity that maintains its
books and records, including the location of the entity, and a
description of the books and records maintained at that location.\81\
It would be burdensome and inefficient for CPOs to registered
investment companies to develop different procedures and systems to
maintain solely those books and records relating to their commodity
trading.
---------------------------------------------------------------------------
\78\ See Rule 4.23 under the Commodity Exchange Act.
\79\ See Rule 31a-2 under the Investment Company Act.
\80\ See Rule 31a-3 under the Investment Company Act.
\81\ See Item 1(K) of Form ADV and Section 1.K. of Schedule D of
Form ADV.
---------------------------------------------------------------------------
We therefore request relief from Rule 4.23 on behalf of our members
to permit a registered investment company's CPO to maintain the CPO's
books and records required by the Commodity Exchange Act with
professional service providers as permitted by the Investment Company
Act. We note that the CFTC has proposed, and its staff has granted,
similar exemptive relief permitting CPOs to commodity ETFs to keep
books and records with certain professional service providers, rather
than at the CPO's main business address.\82\ We believe compliance with
the SEC books and records requirements would be fully consistent with
investor protection, and would provide the CFTC with any information it
may want about entities that maintain an investment adviser CPO's books
and records, as those entities will be identified (and the books and
records they maintain described) on the adviser's Form ADV.
---------------------------------------------------------------------------
\82\ See Commodity ETF Release, supra note 34, at 54796. We note
that professional services providers commonly used by registered
investment companies are not limited to those the CFTC has included in
its proposed exemptive relief (i.e., the pool's administrator, its
distributor, or a bank or registered broker or dealer that is providing
services to the CPO or the pool similar to those provided by an
administrator or distributor), and may also include professional
records maintenance and storage companies.
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5. Adviser CPOs Should Be Able to Provide SEC-Required Risk Disclosures
to Satisfy the CFTC's Proposed Swap Risk Disclosure Requirement
In the Release, the CFTC also proposes to amend the mandatory risk
disclosure statements under the Commodity Exchange Act for CPOs and
CTAs to require disclosure about certain risks specific to swaps
transactions.\83\ While we fully support strong risk disclosure to
investors, we also believe such disclosure must be accurate in order to
be effective.
---------------------------------------------------------------------------
\83\ See Rules 4.24(b) and 4.34(b) under the Commodity Exchange
Act.
---------------------------------------------------------------------------
We are concerned that the CFTC's proposed language fails to capture
the variety of ways in which registered investment company advisers
that are CPOs and CTAs may use swaps, which we describe above, and
that, as a result, the disclosure may provide investors with a
misleading impression of the risks presented by an investment company's
use of such instruments. We therefore recommend, in lieu of the
proposed language, that if an adviser is a CPO or CTA to a registered
investment company that engages in swaps transactions, the CFTC's
proposed risk disclosure requirement would be satisfied by the risk
disclosures that the SEC currently requires of registered investment
companies, which are comparable and allow an investment company to
tailor its disclosure to convey the particular risks presented by its
use of swaps.\84\
---------------------------------------------------------------------------
\84\ See Items 4 and 9 of Form N-1A under the Investment Company
Act, which require a registered investment company to disclose the
principal risks associated with investing in the company, as well as
Item 16 of the SAI, which requires additional information about the
risks of investing in the company.
---------------------------------------------------------------------------
Alternatively, we recommend that the CFTC require an adviser that
is a CPO or CTA to such a registered investment company to omit the
second paragraph of the proposed risk disclosure language. The second
paragraph provides that:
Highly customized swaps transactions in particular may increase
liquidity risk, which may result in a suspension of
redemptions. Highly leveraged transactions may experience
substantial gains or losses in value as a result of relatively
small changes in the value or level of an underlying or related
market factor.\85\
---------------------------------------------------------------------------
\85\ See Release at 7990-91.
This disclosure is inapposite to registered investment companies.
First, most registered investment companies issue redeemable securities
and are not permitted, under the Investment Company Act, to suspend
redemptions without obtaining an SEC order.\86\ Second, the Investment
Company Act does not permit registered investment companies to engage
in ``highly leveraged transactions,'' as investment companies are
subject to strict capital and asset coverage requirements.\87\
Requiring registered investment companies to make the disclosures
quoted above would be tantamount to requiring them to make materially
misleading statements.
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\86\ See Section 22(e) of the Investment Company Act and Rule 22c-1
under the Act. On rare occasions, the SEC has granted relief, either
under Section 22(e) or Rule 22c-1, to investment companies experiencing
``emergency situations'' that make it difficult to calculate their net
asset values in order to meet purchase or redemption requests.
Snowstorms, power outages, and similar events fall into this category.
\87\ See Section 18 of the Investment Company Act.
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C. Request for Clarification Regarding Series Investment Companies
We request clarification from the CFTC regarding the treatment of
series investment companies. For reasons of efficiency, a registered
investment company is frequently organized as a single corporation or
statutory trust that has multiple ``series,'' each of which represents
an interest in a separate pool of securities with separate assets,
liabilities, and shareholders. While the corporation or trust is the
entity that registers with the SEC, the registrant is required to amend
its registration statement each time it creates a new investment
company by issuing a new series. It is common practice for registered
investment companies to use the series form, and there are mutual fund
families that have single registered investment companies with over 100
series. The courts have treated series investment companies as separate
corporate entities for purposes of inter-series liability.\88\
---------------------------------------------------------------------------
\88\ See, Seidl v. American Century Companies, Inc., 713 F.Supp.2d
249, 257 (S.D.N.Y. 2010) (stating that ``[t]he individual series of a
registered investment company are, for all practical purposes, treated
as separate investment companies . . . and therefore any recovery in a
derivative suit would go to the shareholders of the [affected fund],
not to the shareholders of [the investment company's] other funds'');
and In re Mutual Funds Inv. Litig., 519 F.Supp.2d 580, 588-89 (D.Md.
2007) (stating that the practice of establishing individual series of a
registered investment company ``is entirely in accord with applicable
rules of the SEC, which has expressly pronounced that under such
circumstances each series is to be treated as a separate investment
company''); see also Stegall v. Ladner, 394 F.Supp.2d 358, 362-363
(D.Mass. 2005).
---------------------------------------------------------------------------
The CFTC, both historically and recently, has recognized pools
organized in series form as separate investment pools. The CFTC
explicitly recognizes series companies in its rules, and acknowledges
that each series should be treated as a separate pool if it has limited
liability.\89\ In addition, when the CFTC adopted the Rule 4.5
exclusion, it specifically stated that it would treat each separate
series of an investment company separately for purposes of determining
whether the series satisfied the criteria for exclusion from the rule.
In doing so, it noted approvingly its staff's statement from an
interpretive letter that:
---------------------------------------------------------------------------
\89\ See Rule 4.7(b)(2)(iv) and 4.7(b)(3)(i)(D) under the Commodity
Exchange Act (exemption for CPOs that offer or sell commodity pool
participations only to qualified eligible persons includes periodic
reporting relief and annual report relief that provides that, in the
case of a pool that is a series fund with limited liability, the
account statement or financial statements required are not required to
include consolidated information for all series of the pool).
. . . in light of the separate ownership in and identities of
the Fund's Portfolios--e.g., separate investment objectives,
net asset valuation and dividend policies--we believe it
consistent with the intent of proposed Rule 4.5 to treat as
separate entities each of the two Portfolios that intend to
engage in commodity interest trading for purposes of
determining whether the criteria of the proposal have been met.
Conversely, where such separate ownership and identities are
not present, we might find it more consistent with proposed
Rule 4.5 to aggregate all of the portfolios of a series
investment fund in determining whether the criteria have been
met.\90\
---------------------------------------------------------------------------
\90\ 1985 Adopting Release, supra note 30.
More recently, the CFTC has recognized series companies in its final
rules for periodic account statements and annual financial reports,
taking the position that series with limits on inter-series liability
should be treated as separate pools for account statement disclosure
purposes.\91\
---------------------------------------------------------------------------
\91\ See, Commodity Pool Operator Periodic Account Statements and
Annual Financial Reports, 74 Fed. Reg. 75785, 75786 (Nov. 9, 2009).
---------------------------------------------------------------------------
We are aware, however, that the CFTC staff has recently taken the
position that CPOs seeking to register new funds that are organized in
series form may not use standalone prospectuses for each separate
series but must instead include all the series in a trust in a single
prospectus. We believe such a result is inconsistent with treatment of
series investment companies both by the SEC, as discussed above, as
well as the CFTC's own rules and prior positions, and request that the
CFTC clarify that series investment companies should be treated the
same as investment companies that are not organized in series form.
This clarification would be fully consistent with CFTC positions, SEC
treatment of series investment companies, and the decisions of courts
that have considered the issue.\92\
---------------------------------------------------------------------------
\92\ See, id.; 1985 Adopting Release, supra, note 30; Seidl, supra
note 88.
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V. Request for Adequate Transition Period and Grandfathering
If the CFTC nonetheless determines to proceed with amendments to
Rule 4.5, we believe that, once any such amendments are adopted, it
will be critical for investment advisers and investment companies to
have adequate time to make the changes to their operations and policies
and procedures necessary to comply with the amended rule. Given the
many uncertainties about the rule at this time and the many changes
that could be required if it is adopted, especially if rules of the SEC
and CFTC are reconciled, we believe it will be essential for the
Commission to provide a substantial transition period for compliance
with any amended rule, although it is difficult at this time to
estimate what that period should be. The length of such a transition
period should be a specific request for comment in any re-proposal. As
a matter of fairness, we also request that those registered investment
companies that have previously claimed reliance upon current Rule 4.5
be exempted from compliance with any amendments to the rule, as these
funds are structured to rely on the exclusion in its current form.
* * * * *
As outlined above, we believe the Rule 4.5 Proposal is deeply
flawed and requires significant additional modification before adoption
is appropriate. We thus respectfully request that the CFTC fully and
carefully consider all of the concerns raised in our letter and by
other commenters and, if it continues to believe that amendments to
Rule 4.5 are necessary, to re-propose those amendments, taking into
consideration the views of commenters.
ICI and its members stand ready to assist the Commission in this
important and challenging effort. If you have questions or require
further information, please contact me at [Redacted], Sarah A. Bessin
at [Redacted], or Rachel H. Graham at [Redacted].
Sincerely,
Karrie McMillan,
General Counsel.
CC:
Hon. Gary Gensler, Chairman;
Hon. Michael V. Dunn, Commissioner;
Hon. Jill E. Sommers, Commissioner;
Hon. Bart Chilton, Commissioner;
Hon. Scott D. O'Malia, Commissioner;
Kevin P. Walek, Assistant Director;
Amanda Lesher Olear, Special Counsel;
Daniel S. Konar II, Attorney-Adviser, Division of Clearing and
Intermediary Oversight;
Hon. Mary L. Schapiro, Chairman, SEC;
Hon. Kathleen L. Casey, Commissioner, SEC;
Hon. Elisse B. Walter, Commissioner, SEC;
Hon. Luis A. Aguilar, Commissioner, SEC;
Hon. Troy A. Paredes, Commissioner, SEC;
Eileen Rominger, Director, Division of Investment Management, SEC.
appendix a
Comparison of Requirements Applicable to Registered Investment Companies and Commodity Pool Operators
----------------------------------------------------------------------------------------------------------------
SEC Requirement CFTC Requirement Recommended Result
----------------------------------------------------------------------------------------------------------------
Disclosure Requirements
----------------------------------------------------------------------------------------------------------------
Disclosure Document--Form N-1A sets Rules 4.21 and 4.24 together require Registered investment companies
forth the disclosure that a a CPO to provide a single should be deemed to have met CFTC
registered investment company must Disclosure Document to prospective requirements if they satisfy SEC
include in its registration participants that includes certain requirements and pre-clearance by
statement and is divided into three information describing the pool. the NFA should not be required.
parts--the Prospectus, the SAI and
the Wrapper/Part C. While the
Prospectus is generally the only
document that a registered
investment company must deliver to
prospective investors, the SAI,
which includes additional includes
certain additional information
describing the registered
investment company, is available to
investors upon request at no
charge. These documents are subject
to SEC pre-effective review.
Investment Program--Items 2, 4 and 9 Rule 4.24(h)(1) and (2) require a Registered investment companies
of Form N-1A require a registered CPO to provide a description of should be deemed to have met CFTC
investment company to state its ``the trading and investment requirements if they satisfy SEC
investment objective and to programs and policies that will be requirements.
disclose the principal investment followed by the offered pool.'' and
strategies that will be used to ``the types of commodity interests
seek to accomplish that objective. and other invests which the pool
The SAI requires additional will trade.''
information about the investment
company's investment program.
Principal Risks--Items 4 and 9 of Rule 4.24(g) requires a CPO to Registered investment companies
Form N-1A require a registered disclose ``the principal risk should be deemed to have met CFTC
investment company to disclose the factors of participation in the requirement if they satisfy SEC
principal risks associated with offered pool.'' requirement.
investing in the registered
investment company. The SAI
requires additional information
about the risks of investing in the
investment company.
Fee Disclosure--Item 3 of Form N-1A Rule 4.24(i) requires a CPO to These requirements are in many
requires a registered investment include in the Disclosure Document respects duplicative and, in
company to include in its for its pool ``a complete others, inconsistent. The formats
Prospectus a fee table and expense description of each fee, commission for disclosing fees are different.
example disclosing its fees and and other expense which the Requiring registered investment
expenses. The fee table generally commodity pool operator knows or companies to comply with both sets
discloses shareholder fees (maximum should know has been incurred by of requirements would be redundant
sales charge imposed on purchases, the pool for its preceding fiscal and confusing to shareholders. We
maximum deferred sales charge, year and is expected to be incurred therefore believe registered
maximum sales charge imposed on by the pool in its current fiscal investment companies should be
reinvested dividends, redemption year, including fees or other deemed to have met CFTC
fee, exchange fee and maximum expenses incurred in connection requirements if they satisfy SEC
account fee) and annual operating with the pool's participation in requirements.
fund expenses (management fees, investee pools and funds.'' The
distribution and/or service fees, rule includes a non-exhaustive list
other expenses) on a percentage of fees that must be described in
basis. Items 10 and 12 require the Disclosure Document, including
additional disclosure regarding management fees, brokerage fees and
management fees and sales expenses. commissions, fees paid in
Detailed narrative and historical connection with trading advice
expense disclosure is required in provided to the pool, incentive
the SAI, including total dollar fees, commissions that may accrue
amounts of advisory fees for each in connection with the solicitation
of the last 3 fiscal years, fees of participants in the pool,
paid to other service providers for professional and general
management-related services for administrative fees and expenses,
each of the last 3 years, organizational and offering
distribution-related fees paid expenses, clearance fees and any
during the last fiscal year and the other direct or indirect cost. The
purposes for which such payments disclosure must also include a
were made, aggregate brokerage break-even analysis that reflects
commissions for each of the last 3 all fees, commissions and other
fiscal years, brokerage commissions expenses of the pool.
paid to affiliates for each of the
last 3 fiscal years, compensation
paid to the investment company's
principal underwriter and director/
trustee compensation. Item 27(d)(1)
of Form N-1A also requires an
example of the effect of expenses
on a shareholder account, and must
appear in every annual and semi-
annual shareholder report.
Performance Disclosure--Item 4 of Rule 4.24(n) requires a pool to These requirements directly conflict
Form N-1A generally requires a include past performance of the and will need to be reconciled.
registered investment company to pool and in some cases of the CPO's Registered investment companies
include a bar chart showing the other pools, as set forth in Rule should be permitted to show only
investment company's annual total 4.25, which requires a significant the information required by Form N-
returns for each of the last 10 amount of performance data that is 1A and related SEC and SEC staff
calendar years, but only for different from that required or interpretations, including with
periods subsequent to the effective permitted under Form N-1A. In respect to performance of other
date of the registration statement. addition to performance data for pools and accounts. A registered
Following the chart, the investment the pool, the CPO must disclose investment company is permitted to
company must disclose the highest information for the performance of include in its registration
and lowest quarterly return during each other pool it operates (and by statement performance data for
the 10 years covered by the chart the trading manager if the offered other accounts only in
(or since inception if less than 10 pool has a trading manager) if the circumstances where the other
years). Form N-1A also requires an applicable pool has less than 3 account is managed in a
investment company to disclose its years of actual performance. substantially similar manner, among
average annual total returns for Further, if the CPO (or the trading other requirements. In addition,
the last 1, 5 and 10 years (or manager) has not operated for at FINRA rules generally prohibit
since inception if less than 10 least 3 years any pool in which 75% broker-dealers from using sales
years) and to compare its returns or more of the contributions to the literature for a registered
to a broad-based securities market pool were made by persons investment company that includes
index. An investment company is unaffiliated with the pool the performance of other accounts.
permitted to include in its operator, the trading manager, the This approach is different than
registration statement performance pool's CTAs or their respective that taken under Rule 4.25, which
data for other accounts only in principals, the CPO also must in certain cases requires
circumstances where the other disclose the performance of each performance of all pools (including
account is managed in a pool operated by and account traded privately offered pools) and
substantially similar manner, among by the trading principals of the accounts of the CPO or CTA, whether
other requirements. CPO. The performance of any or not they are managed in a
accounts (including pools) directed substantially similar manner.
by a major commodity trading Moreover, the inclusion of
adviser must also be disclosed. The performance information for a
CPO also must disclose the private fund in a prospectus for a
performance of any major investee publicly offered registered
pool. investment company, as may be
required under the CFTC's
performance disclosure
requirements, could jeopardize the
ability of the private fund to rely
on the private offering exemption
from registration that is provided
pursuant to Regulation D under the
1933 Act.
Management--Items 5 and 10 require a Paragraphs (e) and (f) of Rule 4.24 Registered investment companies
registered investment company to require the Disclosure Document to should be deemed to have met CFTC
disclose the name and experience of include, among other things, the requirement if they satisfy SEC
each investment adviser and name and business background of requirement.
portfolio manager for the each CPO, the pool's trading
investment company. The SAI manager, and each major commodity
requires additional disclosure trading adviser.
about investment advisers and
portfolio managers.
----------------------------------------------------------------------------------------------------------------
Disclosure Document Delivery and Updating Requirements
----------------------------------------------------------------------------------------------------------------
Disclosure Document Delivery-- Rule 4.21(a)(1) provides that ``each We request that the CFTC grant
Section 5 under the 1933 Act, the commodity pool operator . . . must exemptive relief to adviser CPOs
primary provision governing the deliver or cause to be delivered to subject to Part 4 (similar to the
receipt and timing of Prospectus a prospective participant in a pool relief that has been granted to
delivery, does not necessarily that it operates or intends to CPOs of commodity ETFs) to permit
require delivery of a Prospectus operate a Disclosure Document for advisers to make available fund
prior to investment and also does the pool prepared in accordance prospectuses and SAIs on their
not require delivery or use of a with [Rule] 4.24 by no later than websites. We believe that filing
subscription agreement. Rule 10b-10 the time it delivers to the with, and pre-clearance by, the NFA
requires broker-dealers to deliver prospective participant a should not be required.
confirmations of securities subscription agreement for the
transactions, and the Prospectus pool.'' (Emphasis added.) The
delivery requirements would ensure Disclosure Document also must be
that a Prospectus is delivered no filed with and pre-cleared by the
later than with the transaction NFA under Rule 426(d)(1).
confirmation.
Disclosure Document Updating-- Rule 4.26(a)(2) provides that ``[n]o We request exemptive relief so that
Section 10(a) of the 1933 Act commodity pool operator may use a registered investment companies may
effectively permits an investment Disclosure Document . . . dated update based on the SEC
company to update its registration more than 9 months prior to the requirements. We believe that
statement annually. In particular, date of its use.'' The updated filing with, and preclearance by,
Section 10(a)(3) states that ``when Disclosure Document also must be the NFA should not be required.
a Prospectus is used more than 9 filed with and precleared by the
months after the effective date of NFA under Rule 426(d)(2).
its registration statement, the
information contained therein shall
be as of a date not more than
sixteen months prior to such use .
. .''
Registered investment companies must Rule 4.26(c)(1) requires a CPO to Registered investment companies
supplement their Prospectuses and update its Disclosure Document to should be deemed to have met CFTC
SAIs to correct material correct any material inaccuracies requirement if they satisfy SEC
inaccuracies and omissions, but, to or omissions, and to deliver the requirement.
the extent supplements are mailed updated information to existing
to existing shareholders, the pool participants within 21
mailings typically are timed to calendar days of the date upon
coincide with other regular which the CPO first knows or has
mailings to manage costs. Some reason to know of the defect.
changes are so material that the
investment company may mail
supplements to shareholders
immediately. In certain cases, an
investment company may not deliver
supplements to existing
shareholders absent an additional
investment.
Disclosure Document Acknowledgment-- Rule 4.21(b) provides that ``[t]he We request that the CFTC grant
There is no requirement under the commodity pool operator may not exemptive relief to adviser CPOs
Federal securities laws that accept or receive funds, securities similar to the relief that has been
investment company investors or other property from a granted to CPOs of commodity ETFs.
acknowledge receipt of a prospective participant unless the Requiring an acknowledgment is
Prospectus. pool operator first receives from fundamentally inconsistent with the
the prospective participant an registered investment company
acknowledgement signed and dated by distribution model.
the prospective participant stating
that the prospective participant
received a Disclosure Document for
the pool.'' (Emphasis added.)
Additional Documents--The Federal Rule 4.26(b) generally requires a Registered investment companies
securities laws do not require an CPO to attach to its Disclosure should be deemed to have met CFTC
investment company to distribute Document the applicable pool's most requirement if they satisfy SEC
its shareholder reports with the current Account Statement requirements.
investment company Prospectus, but (discussed below) and Annual
require registered investment Report.
companies to disclose in the
Prospectus how shareholders can
obtain such documents at no charge.
----------------------------------------------------------------------------------------------------------------
Participant/Shareholder Reporting Requirements
----------------------------------------------------------------------------------------------------------------
Rule 30e-1 under the Investment Rule 4.21(c) requires each CPO to We request that the CFTC grant
Company Act requires a registered ``distribute an Annual Report to exemptive relief to adviser CPOs
investment company to send to its each participant in each pool that (similar to the relief that has
shareholders at least semiannually it operates . . . .'' The Annual been granted to CPOs of commodity
a report containing financial Report must include, among other ETFs) to permit advisers to make
statements and other required things, audited financial available annual and semi-annual
disclosures. The annual report must statements. shareholder reports required by
contain audited financial Rule 30e-1 on their websites.
statements. Rule 30b2-1 requires
that the reports to shareholders,
along with certain additional
information, be filed with the SEC
on Form N-CSR.
While the Federal securities laws do Rule 4.22(a) generally requires We request that the CFTC grant
not require a registered investment ``each commodity pool opera- tor . exemptive relief to adviser CPOs
company to distribute a monthly . . [to] distribute to each (similar to the relief that has
report or account statement to participant in each pool that it been granted to CPOs of commodity
shareholders, they require certain operates, within 30 calendar days ETFs) to permit advisers to make
interim reports in addition to the after the last date of the available annual and semi-annual
annual report noted above. For reporting period . . . an Account shareholder reports required by
example, Rule 30e-1 and Rule 30b2-1 Statement, which shall be presented Rule 30e-1 on their websites.
cited above require filing and in the form of a Statement of
delivery to shareholders of a semi- Operations and a Statement of
annual report, in addition to the Changes in Net Assets, for the
filing and delivery of the annual prescribed period.'' Rule 4.22(b)
report. In addition, Rule 30b1-5 states that the Account Statement
under the Investment Company Act must be distributed at least
requires a registered investment monthly in the case of pools with
company to file a quarterly report net assets of more than $500,000 at
on Form N-Q within 60 days after the beginning of the pool's fiscal
the close of the first and third year, and otherwise at least
quarters containing a schedule of quarterly.
investments and other disclosures.
----------------------------------------------------------------------------------------------------------------
Regulatory Reporting Requirements
----------------------------------------------------------------------------------------------------------------
Form N-SAR--Items 1-6 require Form CPO-PQR Schedule A, Part 1-- Registered investment companies
information regarding the name of Part 1 requests information that is should be deemed to have met CFTC
the investment company, its SEC comparable to that requested in requirement if they satisfy SEC
file numbers and address, among Form NSAR, Items 1-6 and 75. Part 1 requirement.
other things. Item 75 requires requires CPOs to report basic
information regarding assets under identifying information about the
management. CPO, including its name, NFA
identification number and assets
under management.
Form N-SAR requires the name of each Form CPO-PQR Schedule A, Part 2-- Registered investment companies
series of the registrant (Item 7); Part 2 would require a CPO to should be deemed to have met CFTC
the identification of key service report information regarding each requirement if they satisfy SEC
providers (Items 8-15); information of its commodity pools, including requirement. While there are some
regarding portfolio investments and the names and NFA identification differences between the
positions (Items 67-70); and numbers, position information for requirements of Form N-SAR and
information regarding subscription positions comprising 5% or more of proposed Form CPO-PQR, these
and redemption activity (Item 28). each pool's net asset value, and differences generally reflect the
Performance information is not the identification of the pool's fact that Form CPO-PQR is intended
specifically required by the form, key relationships with brokers, to obtain information relating to
but performance information is other advisers, administrators, systemic risk, a concern that in
available in other reports and custodians, auditors and marketers. our strongly held view is not
registration statements filed with Part 2 also would require raised by the activities of
the SEC. disclosure regarding each pool's registered investment companies
quarterly and monthly performance that are the subject of this
information and information letter. SEC proposed Form PF, which
regarding participant subscriptions the CFTC has stated solicits
and redemptions. information that is generally
identical to that sought by Form
CPO-PQR, is specifically designed
to address the potential systemic
risk raised by activities of
advisers to private funds, not
registered investment companies.
However, registered investment
companies are subject to CFTC large
trader reporting requirements like
any other trader, which enables the
CFTC to obtain information from
those entities that it can use to
assess systemic risk.
Investment companies must complete CPOs that have assets under Registered investment companies
the entire Form NSAR regardless of management equal to or exceeding should be deemed to have met CFTC
assets under management. In $150 million would be required to requirement if they satisfy SEC
addition, the form must be file Schedule B, which would requirement.
completed on a series by series require the CPO to report detailed
basis. In general, Form N-SAR information for each pool. The
requires the name of each series required information is comparable
(Item 7); information regarding to that required by the
each series' investment strategies corresponding provisions of Form N-
and positions (Items 62-70); SAR for funds and includes
liabilities from borrowings and information regarding each pool's
other portfolio management investment strategy, borrowings by
techniques (Item 74); and geographic area and the identities
information regarding brokerage of significant creditors, credit
transactions (Items 20-26). counterparty disclosure, and
entities through which the pool
trades and clears its positions.
Form N-SAR generally requires a Form CPO-PQR Schedule C, Parts 1 and Registered investment companies
registered investment company to 2--CPOs that have assets under should be deemed to have met CFTC
report investment and exposure management equal to $1 billion or requirement if they satisfy SEC
information on a series by series more would be required to file requirement. Registered investment
basis in all cases. It generally Schedule C. Part 1 would require companies are subject to CFTC large
does not require an investment certain aggregate information about trader reporting requirements like
company to report investment and the commodity pools advised by any other trader, which enables the
exposure information on an large CPOs, such as the market CFTC to obtain information from
aggregate basis or certain more value of assets invested, on both a those entities that it can use to
detailed information required by long and short basis, in different assess systemic risk. Accordingly,
Schedule C of Form CPO-PQR. types of securities and the more detailed information
derivatives, turnover in these requested by Form CPO-PQR, Schedule
categories of financial C should not be necessary for
instruments, and the tenor of fixed registered investment companies.
income portfolio holdings. Part 2
would require CPOs to report
detailed information regarding
individual pools with at least $500
million in assets under management,
including liquidity, concentration,
material investment positions,
collateral practices with
significant counterparties and
clearing relationships.
----------------------------------------------------------------------------------------------------------------
Books and Records
----------------------------------------------------------------------------------------------------------------
Rule 31a-2 requires a registered Rule 4.23 requires a CPO to maintain We request that the CFTC grant
investment company to preserve its required pool books and records at exemptive relief to adviser CPOs
books and records for specified its main business office. from Rule 4.23 if they satisfy the
periods of time, with more recent requirements of the Investment
books and records typically Company Act rules and Form ADV.
preserved in an ``easily accessible
place.'' Rule 31a-3 permits a
registered investment company to
use a third party to prepare and
maintain required records. Reliance
on the rule is conditioned upon
having a written agreement to the
effect that the records are the
property of the person required to
maintain and preserve them, and
that such records will be
surrendered promptly on request. In
addition, Item 1(K) of Form ADV
requires a registered investment
adviser to indicate whether it
maintains its required books and
records at a location other than
its principal office and place of
business, and Section 1.K. of
Schedule D of Form ADV requires the
adviser to specify each entity that
maintains its books and records,
including the location of the
entity, and a description of the
books and records maintained at
that location.
----------------------------------------------------------------------------------------------------------------
The Chairman. Thank you, Ms. McMillan.
Mr. Greenberger, 5 minutes.
STATEMENT OF MICHAEL GREENBERGER, J.D., PROFESSOR, UNIVERSITY
OF MARYLAND SCHOOL OF LAW, BALTIMORE, MD
Mr. Greenberger. Thank you very much, Chairman Conaway and
Ranking Member Boswell. I am deeply appreciative to have the
opportunity to talk to you today.
I think I come at this from a slightly different context,
and I may be so bold as to say a context that may be one of
your typical constituents.
We seem to, in this entire discussion, forget what we have
just been through. We have been through a process where we
deregulated a $100 trillion--over a $100 trillion industry, and
it collapsed. And that led to the meltdown.
The very reason this Committee so energetically and
thoughtfully put its weight behind the derivatives section of
Dodd-Frank was, everybody who is objective and honest said the
failure of the swaps market--failure in the sense that people
were placing bets, the casino never put money aside; when the
bets were called, the casino, like AIG and others, didn't have
money, the taxpayer had to make up the difference.
In betting, there is usually a winner and loser. In these
bets, there were two winners: the people who won the bets; the
people who lost the bets got money from the American taxpayer.
The American taxpayer, who wasn't part of the bets, ended up
paying everything. We paid trillions of dollars to rescue the
too-big-to-fail banks that are now reporting billions of
dollars of profits.
When you say, what is the cost-benefit analysis, talk to
your constituents. Do they think they paid a cost for what
happened back in September of 2008? They are either jobless,
they have job insecurity, their pensions are down, their houses
have lost value, they can't get loans from these banks even
though the banks are very profitable. There was a terrific cost
paid by the American taxpayer.
The purpose of Dodd-Frank is to make sure that never
happens again. And so, when you do your cost-benefit analysis,
remember your constituent whose kid is sitting on a couch with
a college degree and can't find a job with loans that can't be
repaid. That has to be part of the cost.
And, by the way, when the CFTC rules go into effect, it is
only the swaps that succeed those rules that become regulated.
The hundreds of trillions of dollars of swaps that are out
there now that are being entered into today are not going to be
regulated.
The reason there is a July 21st deadline for these rules
is, if we don't put some discipline into this system, history
is going to repeat itself. Why will history repeat itself?
European countries are facing sovereign defaults. Jamie Dimon
just advised a group of investors, ``Don't worry about the
municipalities. I only think about a hundred or so will default
on their bonds.'' That is going to cause systemic risk if that
happens. There is oil shock right now. We are talking about the
possible default of the United States Government.
That is going to trigger all the unregulated swaps out
there. People are going to say, ``Oh, I won my bet,'' to the
counterparty. ``Where is my money?'' And the money isn't going
to be there. And you know who is going to be asked to pay that
burden? The American taxpayer.
So we can--all of this stuff about cost-benefit analysis,
let's get all the rules out and have a new comment period--this
is what used to be called the four-corners offense to prevent
the agency from complying with its statutory mandate: to put
protections in, to ensure capital adequacy, provide
transparency, give pricing to the system to prevent the next
default, the next meltdown.
If any of these bad events take place--European default,
municipal default, oil price shock--there is going to be a
second dip recession, and people are going to say to you, ``How
come there are no rules?'' And we are going to say, well, we
wanted to have the Office of Management and Budget chief
economists bring in new data and everything else.
This is a bipartisan issue. Republicans and Democrats are
laying flat on their back today because regulation failed. The
CFTC should not only not be criticized--the people who work
there have been there in the Reagan Administration, H.W. Bush,
Clinton, W. Bush. These are career employees; they don't have
an agenda. They are killing themselves to comply and save the
American people from lack of capital that the taxpayer has to
make up and lack of transparency.
I just ask that the Committee please stand back and say,
what is going to happen if we are analyzing this like our
navels while the American public goes down for a second time
and there are no bullets left? There is no money for stimulus,
no money for TARP. And what did they say in September of 2008?
If we don't have stimulus, we are going to go into the Great
Depression. Well, if we have a second dip, there will be no
stimulus.
Thank you.
[The prepared statement of Mr. Greenberger follows:]
Prepared Statement of Michael Greenberger, J.D., Professor, University
of Maryland School of Law, Baltimore, MD
The Relationship of Unregulated OTC Derivatives to the Meltdown. It
is now accepted wisdom that it was the non-transparent, poorly
capitalized, and almost wholly unregulated over-the-counter (``OTC'')
derivatives market that lit the fuse that exploded the highly
vulnerable worldwide economy in the fall of 2008.\1\ Because tens of
trillions of dollars of these financial products were pegged to the
economic performance of an overheated and highly inflated housing
market, the sudden collapse of that market triggered under-capitalized
or non-capitalized OTC derivative guarantees of the subprime housing
investments. Moreover, the many undercapitalized insurers of that
collapsing market had other multi-trillion dollar OTC derivatives
obligations with thousands of financial counterparties (through
unregulated interest rate, currency, foreign exchange, and energy
derivatives). If a financial institution failed because it could not
pay off some of these obligations, trillions of dollars of
interconnected transactions would have also failed, causing a cascade
of collapsing banks throughout the world. It was this potential of
systemic failure that required the United States taxpayer to plug the
huge capital hole that a daisy chain of nonpayments by the world's
largest financial institutions would have caused, thereby heading off
the cratering of the world's economy.\2\
---------------------------------------------------------------------------
\1\ See Ben Moshinsky, Stiglitz says Banks Should Be Banned From
CDS Trading, Bloomberg.com (Oct. 12, 2009), http://noir.bloomberg.com/
apps/news?pid=newsarchive&sid=
a65VXsI.90hs; Paul Krugman, Op-Ed, Looters in Loafers, N.Y. Times, Apr.
18, 2010, available at http://www.nytimes.com/2010/04/19/opinion/
19krugman.html?dbk. See, generally Alan S. Blinder, The Two Issues to
Watch on Financial Reform--We Need an Independent Consumer Watchdog and
Strong Derivatives Regulation. Industry Lobbyists are Trying to Water
Them Down, Wall St. J., Apr. 22, 2010, available at http://
online.wsj.com/article/
SB10001424052748704133804575197852294753766.html; Henry T. C. Hu, Empty
Creditors and the Crisis, Wall St. J., Apr. 10, 2009, at A13; Michael
Lewis, The Big Short: Inside the Doomsday Machine (2010) [hereinafter
The Big Short]; Simon Johnson & James Kwak, 13 Bankers: The Wall Street
Takeover and the Next Financial Meltdown (2011) [hereinafter 13
Bankers]; Michael Hirsh, Capital Offense: How Washington's Wise Men
Turned America's Future Over to Wall Street (2010) [hereinafter Capital
Offense]; Bethany McLean & Joe Nocera, All The Devils Are Here: The
Hidden History of the Financial Crisis (2010) [hereinafter All The
Devils Are Here]; Inside Job (Sony Pictures Classics & Representational
Pictures 2010); Frontline: The Warning (PBS television broadcast Oct.
20, 2009) [hereinafter The Warning]; Financial Crisis Inquiry
Commission, The Financial Crisis Inquiry Report: Final Report of the
National Commission on the Causes of the Financial and Economic Crisis
in the United States xxiv (Jan. 2011), available at http://
www.fcic.gov/report [hereinafter FCIC Report].
\2\ See Moshinsky, supra note 1; Krugman, supra note 1; Blinder,
supra note 1; Hu, supra note 1; The Big Short, supra note 1.
---------------------------------------------------------------------------
An Example of the Multi-Trillion Dollar Derivative ``Bets'' That
Had to Be Paid by the U.S. Taxpayer. The then perfectly lawful ``bets''
that hedge fund manager John Paulson placed through this unregulated
OTC derivatives market provide but a single example of how that market
collectively misfired and--but for taxpayer bailouts--nearly imploded
the world economy.\3\ From 2006 to 2007, Mr. Paulson with, inter alia,
the assistance of swaps dealers, purchased synthetic collateralized
debt obligations (``CDOs''), which were nothing more than the purchase
of insurance on his selection of weak tranches of subprime residential
mortgage-backed securities that Mr. Paulson himself did not own.\4\ In
other words, through so-called ``naked credit default swaps (`CDS'),''
Mr. Paulson effectively bought insurance on his own selection of
subprime investments in which he had no ownership and for which he had
no risk, but which he believed would fail. Since the dawn of the 19th
century, it has not been legal to buy insurance on someone else's risk.
However, because these ``bets'' were categorized as OTC derivatives,
they were expressly deregulated as ``swaps'' by Congressional
enactment, and insurance laws were not applied.
---------------------------------------------------------------------------
\3\ Complaint at 2, Securities and Exchange Commission v. Goldman
Sachs & Co. and Fabrice Tourre, 2010 U.S. Dist. Ct. 3229 (S.D.N.Y. Apr.
16, 2010) (``Undisclosed in the marketing materials and unbeknownst to
investors, a large hedge fund, Paulson & Co. Inc. (`Paulson'), with
economic interests directly adverse to investors in the ABACUS 2007-AC1
CDO, played a significant role in the portfolio selection process.
After participating in the selection of the reference portfolio,
Paulson effectively shorted the RMBS portfolio it helped select by
entering into credit default swaps (`CDS') with [Goldman] to buy
protection on specific layers of the ABACUS 2007-AC1 capital structure.
Given its financial short interest, Paulson had an economic incentive
to choose RMBS that it expected to experience credit events in the near
future.'') (On July 15, 2010, Goldman Sachs entered into a settlement
without admitting or denying the SEC's allegations for the amount of
$550 million.)
\4\ Id.
---------------------------------------------------------------------------
When subprime mortgage borrowers (i.e., those with various degrees
of non-creditworthiness) defaulted and could not, as common sense would
have suggested, sustain their mortgages, the tranches that Mr. Paulson
insured (but did not own) failed, thereby triggering highly lucrative
payment obligations to Mr. Paulson pursuant to his synthetic CDOs and
naked CDS. Paulson ultimately made about $15 billion on these bets.\5\
---------------------------------------------------------------------------
\5\ Svea Herbst-Bayliss and Kevin Lim, Paulson reassures on Goldman
role, Reuters (April 21, 2010), available at http://www.reuters.com/
article/2010/04/21/us-goldman-paulson-redemptions-
idUSTRE63K0C620100421?pageNumber=1.
---------------------------------------------------------------------------
Even though the purchasers of synthetic CDOs, such as Mr. Paulson,
``profited spectacularly from the housing crisis . . . they were not
purchasing insurance against anything they owned. Instead, they merely
made side bets on the risks undertaken by others.'' \6\ In fact,
because synthetic CDOs mimicked insurance, those who were ``insured''
through synthetic CDOs were only required to sustain their multi-
trillion dollar bets with insurance-like ``premiums,'' i.e., they were
only required to pay about two percent of the total amount insured.\7\
---------------------------------------------------------------------------
\6\ FCIC Report, supra note 1, at 195.
\7\ See, The Big Short, supra note 1, at 51.
---------------------------------------------------------------------------
Moreover, as has been widely demonstrated, investors ``creating''
their synthetic bets that the subprime market would fail often
repeatedly insured against the same weak subprime tranches, i.e., many
weak subprime tranches were ``bet'' to fail multiple times.\8\ In
essence, therefore, once a borrower defaulted on a mortgage, the loss
in the real economy was exponentially multiplied by the many side bets
placed on whether that borrower would default.
---------------------------------------------------------------------------
\8\ See, id.
---------------------------------------------------------------------------
Mr. Paulson's investments are reflective of trillions of dollars
bet on the subprime market, and the astronomical amounts owed to the
holders of this unregulated ``insurance'' of the subprime market serve
as a microcosm of the worldwide financial crisis.\9\
---------------------------------------------------------------------------
\9\ See, generally, The Big Short, supra note 1; see also Inside
Job, supra note 1.
---------------------------------------------------------------------------
Most importantly, the ``insurers'' of the subprime market (some of
the most prominent financial institutions in the world) were not
required to have capital to sustain their insurance or to post
collateral to ensure their payments. (Had these investments been
governed by insurance or gaming laws, those betting that subprime
mortgages would be paid would have been required to have adequate
capital to ensure payments if the bet were lost.) And, when the
``insurers'' were ``surprised'' to find that those without
creditworthiness could not pay their mortgages, they did not have the
ability to pay off their indebtedness to the holders of synthetic CDOs.
However, what should have been a zero-sum game was converted from a
lose-lose game into a win-win situation, i.e., the Mr. Paulsons of this
world only got paid because ``insurers'' were subsidized by the
taxpayer so that the ``casinos'' could make payment on the bets. Unlike
regular gambling, no gambler lost--except the perfectly innocent
bystanders: the U.S. taxpayer.\10\
---------------------------------------------------------------------------
\10\ See, The Big Short, supra note at 1, at 256.
---------------------------------------------------------------------------
As it now stands, the world is attempting to dig itself out of the
worst financial crisis since the Great Depression of the 1930's--a task
now aggravated, inter alia, by the burden of escalating energy and food
commodity prices. Dozens of studies suggest that even those escalating
commodity prices may very well be aided by betting on the upward
direction of those prices through passive investments originated by
U.S. financial institutions using unregulated OTC derivatives.\11\
---------------------------------------------------------------------------
\11\ See, Commodity Markets Oversight Coalition, Evidence of the
Impact of Commodity Speculation by Academics, Analysts and Public
Institutions (2011), available at http://www.nefiactioncenter.com/PDF/
evidenceonimpactofcommodityspeculation.pdf; see also, Kenneth J.
Singleton, Graduate School of Business Professor, Stanford University,
Investor Flows and the 2008 Boom/Bust in Oil Prices (March 23, 2011),
available at http://www.stanford.edu/ kenneths/.
---------------------------------------------------------------------------
Dodd-Frank Provides the Tools to Protect the U.S. Taxpayer. Title
VII of the Dodd-Frank Act \12\ would make it very difficult to repeat
the kind of undercapitalized, non-transparent, and economy-busting
``betting'' mentioned above. That statute, if properly implemented, (1)
requires all major players to have adequate capital to enter the market
to sustain their potentially huge obligations; (2) requires that almost
all of these kinds of investments be collateralized by counterparties;
(3) requires almost all of these investments to be guaranteed and
properly margined by clearing facilities, which, in turn, are subject
to strict Federal regulation and oversight; (4) requires all of these
transactions to be publicly recorded and, in many instances, traded on
public exchanges or exchange-like environments; and (5) collectively
places the CFTC, the SEC, and the members of the Financial Stability
Oversight Council in a position to have full transparency of these
kinds of investments with an eye to preventing the kind of systemic
risk that threatened the world economy in the fall of 2008.
---------------------------------------------------------------------------
\12\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Pub. L. No. 111-203 (2010).
---------------------------------------------------------------------------
It must be emphasized that Title VII exempts from the clearing
requirement commercial end-users.\13\ Moreover, the CFTC and SEC have
repeatedly said that uncleared swaps used by commercial end-users will
be exempt from margin requirements both for the commercial end-user and
for the swap dealer selling the hedging vehicle.\14\
---------------------------------------------------------------------------
\13\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Pub. L. No. 111-203, 723(a)(3) (2010) (``Clearing Transition Rules--
(A) Swaps entered into before the date of the enactment of this
subsection are exempt from the clearing requirements of this subsection
if reported pursuant to paragraph (5)(A); (B) Swaps entered into before
application of the clearing requirement pursuant to this subsection are
exempt from the clearing requirements of this subsection if reported
pursuant to paragraph (5)(B).'').
\14\ Written Testimony of Gary Gensler, Chairman, Commodity Futures
Trading Commission, Hearing Before the U.S. House Committee on
Agricultural to Review Implementation of Title VII of the Dodd-Frank
Wall Street Reform and Consumer Protection Acton, February 10, 2011,
available at http://www.cftc.gov/pressroom/speechestestimony/
opagensler-68.html (``Transactions involving non-financial entities do
not present the same risk to the financial system as those solely
between financial entities. Consistent with this, proposed rules on
margin requirements should focus only on transactions between financial
entities rather than those transactions that involve non-financial end-
users.'') [hereinafter ``Gensler Testimony'']; Written Testimony of
Mary Schapiro, Chairman, Securities and Exchange Commission, Hearing
Before the U.S. House Financial Services Committee on Implementation of
Titles VII and VIII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act by the U.S. Securities and Exchange Commission, February
15, 2011, available at http://www.sec.gov/news/testimony/2011/
ts021511mls.htm (``in proposing margin rules, we will be mindful both
of the importance of security-based swaps as hedging tools for
commercial end-users and also of the need to set prudent risk rules for
dealers in these instruments.'') [hereinafter ``Schapiro Testimony''].
---------------------------------------------------------------------------
Moreover, the statute expressly exempts from regulation all swaps
in existence before the statute passed, as well as swaps executed
before final rules are put in place.\15\ That means until the CFTC
acts, hundreds of millions of dollars of swaps will continue to be
unregulated with no provision for capital adequacy or transparency.
This latter factor, in and of itself, justifies the timetable
established in Dodd-Frank for implementation of the statute, which the
CFTC is diligently attempting to follow. Until final rules are adopted,
the American taxpayer, consumer and retiree are exposed to the same
regulatory inadequacies that caused the fall 2008 credit crisis to
begin with.
---------------------------------------------------------------------------
\15\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Pub. L. No. 111-203, 739 (2010) (``Unless specifically reserved in
the applicable swap, neither the enactment of the Wall Street
Transparency and Accountability Act of 2010, nor any requirement under
that Act or an amendment made by that Act, shall constitute a
termination event, force majeure, illegality, increased costs,
regulatory change, or similar event under a swap (including any related
credit support arrangement) that would permit a party to terminate,
renegotiate, modify, amend, or supplement one or more transactions
under the swap.'').
---------------------------------------------------------------------------
One of the most important sections in Title VII of Dodd-Frank is
Section 737 on Position Limits.\16\ It is designed to ban excessive
speculation from the derivatives market, i.e., ban that speculation
which exceeds the need for liquidity by commercial hedgers in the
commodity markets. The CFTC, as Congressionally mandated, is currently
in the process of implementing Section 737 through the rulemaking
process and proposed rules on position limits on January 26, 2011.\17\
---------------------------------------------------------------------------
\16\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Pub. L. No. 111-203, 737 (2010).
\17\ Position Limits for Derivatives, 76 Fed. Reg. 4752 (January
26, 2011).
---------------------------------------------------------------------------
However, in attempting to properly implement Section 737, the CFTC
has faced massive opposition. Opponents have argued that Section 737 is
not necessary to prevent volatility in commodity prices. First, as I
have stated in my comment letter in response to the proposed position
limits rules,\18\ Section 737 does not afford the CFTC discretion
regarding the implementation of position limits. Rather, it imposes the
statutory obligation to set position limits with the goal of limiting
excessive speculation. In drafting this section, Congress purposefully
replace the word ``may'' in the House version of the Dodd-Frank Act
\19\ with ``shall,'' \20\ to ``strengthen confidence in trader position
limits on physically deliverable commodities as a way to prevent
excessive speculative trading.'' \21\
---------------------------------------------------------------------------
\18\ See Comment Letter by Michael Greenberger, Professor,
University of Maryland School of Law, Director, Center for Health and
Homeland Security, to David Stawick, Secretary, Commodity Futures
Trading Commission, Position Limits for Derivatives (March 28, 2011),
available at http://www.michaelgreenberger.com/files/
Greenberger_PL_comment_letter.pdf.
\19\ The Wall Street Reform and Consumer Protection Act of 2009,
H.R. 4173, 111th Cong. (2009).
\20\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Pub. L. No. 111-203, 737 (2010).
\21\ Official website of House Committee on Agriculture, House
Passes Peterson-Frank Amendment to Strengthen Regulation of Over-the-
Counter Derivatives, December 10, 2009, available at http://
democrats.agriculture.house.gov/press/PRArticle.aspx?NewsID=207.
---------------------------------------------------------------------------
Those who oppose position limits argue that there is a lack of
empirical data demonstrating that excessive speculation has
unnecessarily and dramatically increased the price of energy and
agricultural commodities. For example, Terry Duffy of the CME Group
stated during the March 3, 2011 hearing before the Senate Committee on
Agriculture, Nutrition and Forestry that ``there's been absolutely no
evidence that [speculators] have anything to do with the effect of
price whether it comes from an academic, whether it comes from a
government study or anything else. So just want to put that clear.''
\22\ This is simply incorrect. Even if, for argument's sake, the
imposition of position limits is discretionary, many company/commercial
end-users, including, inter alia, Starbucks, Hershey, Lindt &
Spruengli, and Delta Airlines, have now come forward demonstrating that
the futures market is in complete disarray because of excessive
speculation.\23\ The Commodity Markets Oversight Coalition, an
independent, non-partisan and nonprofit alliance of groups that
represents commodity-dependent industries, businesses and end-users,
has also adopted the position that commodity prices defy market
fundamentals due to excessive speculation.
---------------------------------------------------------------------------
\22\ See, Transcript of Implementation of Title VII of the Wall
Street Reform and Consumer Protection Act, Hearing Before the Senate
Committee on Agriculture, Nutrition & Forestry, 112th Cong. (March 3,
2011) (Statement of Terry Duffy, Executive Chairman, CME Group); see
also e.g., in the comment letter submitted by SIFMA Asset Management
Group, which is comprised primarily of Chief Operating Officers and
other senior executives at asset management firms, argued: ``The CFTC
should delay adoption of position limits until an `appropriateness'
determination can be made. Currently, there lacks insufficient evidence
to suggest that speculation is affecting commodities markets.'' Comment
Letter by Timothy W. Cameron, Esq., Managing Director, Asset Management
Group of Securities Industry and Financial Markets Association (SIFMA)
to David Stawick, Secretary, Commodity Futures Trading Commission,
Notice of Proposed Rulemaking--Position Limits for Derivatives, March
28, 2011, available at http://www.sifma.org/issues/item.aspx?id=24137
(emphasis added).
\23\ See, e.g., Howard Schultz, Chief Executive Officer of
Starbucks, Inc., recently stated: ``I've been in this business for 30
years. I can tell you unequivocally with every coffee farmer and
resource that we talk to in which we have decades of relationships, we
cannot identify a supply problem in the world where we're buying
coffee. So one question is, `why are coffee prices going up?' and in
addition to that, `why is every commodity price going up at the same
time?' Why is cotton, corn, wheat, why? And I think what's going on is
financial engineering; that financial speculators have come into the
commodity markets and drove these prices up to historic levels and as a
result of that the consumer is suffering.'' Josh Garrett, Starbucks CEO
Points to Speculation as Cause of Rising Commodity Prices,
heatingoil.com (April 6, 2011), available at
http://www.heatingoil.com/blog/starbucks-ceo-points-to-speculation-as-
cause-of-rising-commodity-prices0406/; see also e.g., The world's
largest chocolate maker, Hershey Co. have announced that they have
increased the price to ``offset the higher costs of ingredients such as
cocoa and sugar which has doubled in cost over the last year.''
Moreover, Lindt & Spruengli, the Swiss chocolate maker, said that
``they may well increase their prices to consumers in the second half
of the year to offset the higher costs of Cocoa prices that the company
have incurred after Cocoa costs rose following financial speculation
and post-election violence in the Ivory Coast.'' Edward Buckley,
Hershey's Raise Their Prices By Nearly 10% To Offset Rising Costs,
newsdailybrief.com (April 1, 2011), available at http://
newsdailybrief.com/hersheys-raise-their-prices-by-nearly-10-percent-to-
offset-rising-costs/353628/ (emphasis added); Jim Spencer and Dee
DePass, As we pay more at the pump, oil trading curbs still on hold,
Star Tribune (March 20, 2011) (quoting Ben Hirst, Chief Counsel, Delta
Air Lines: ``[S]peculators try to anticipate what other speculators are
going to do, and the market overreacts. It's not as though there's a
shortage of product that caused the price to move up. It's a casino
process with financial players betting on where the price is going to
go. But it has an effect on [current] prices.'').
---------------------------------------------------------------------------
Notably, during the March 31, 2011 hearing before the House
Committee on Natural Resources, three out of the four panelists (Bill
Graves, CEO and President of American Trucking Association and former
Republican Governor of Kansas, Don Shawcroft, President of Colorado
Farm Bureau, and Michael J. Fox, Executive Director of Gasoline &
Automotive Service Dealers of America, Inc.) supported the need to
regulate excessive speculation with strict aggregate position limits as
required by Section 737 across all derivatives markets and to provide
necessary funding to the CFTC to implement that strict anti-speculative
regime.\24\ In particular, Mr. Fox told the Committee: ``The fastest
way to $6 retail gasoline price is to not fully fund the CFTC and not
impose the Dodd-Frank regulations. That's the fastest way to get to $6
gasoline.'' \25\
---------------------------------------------------------------------------
\24\ See, Harnessing American Resources to Create Job and
Addressing Gasoline Prices: Impacts on Business and Families, Hearing
Before the H. Comm. on Natural Resources, 112th Cong. (March 31, 2011).
\25\ Id.
---------------------------------------------------------------------------
Overbroad exemptions from speculative position limits are wholly
unjustified, as it has been repeatedly proven that the swap dealer
exemptions have allowed those Too Big to Fail banks to enter into
excessive speculative transactions in the commodities market.
Specifically, the bipartisan Senate Permanent Subcommittee on
Investigations Report on Excessive Speculation in the Wheat Market,
which was released on July 24, 2009, found that ``four swap dealers
selling index-related swaps currently operate with hedge exemptions
that allow them to hold much larger positions on the Chicago wheat
futures market than would otherwise apply under the CFTC's speculative
position limits.'' \26\ Allowing these kinds of exemptions to continue
would drive excessive speculation in all commodity markets, which is
why we are in an inflationary food and energy bubble at this time.
---------------------------------------------------------------------------
\26\ Permanent Subcommittee on Investigations of the Committee on
Homeland Security and Governmental Affairs, Excessive Speculation In
The Wheat Market 37 (June 24, 2009) [hereinafter ``Wheat Report''].
---------------------------------------------------------------------------
We Are Not Home Free Yet. There is now a substantial question
whether Title VII of Dodd-Frank will be properly implemented because of
resistance by big banks and other financial institutions. According to
the Comptroller of the Currency, five big Wall Street banks have
controlled 98% of the existing (pre-Dodd-Frank) OTC derivatives market,
thereby necessitating, for example, the Antitrust Division of the
Department of Justice to intervene in one of the critically important
CFTC and SEC proposed rulemakings concerning ownership of the major new
financial institutions created by Dodd-Frank. The big banks want to
keep these institutions within their control. Needless to say, if
properly implemented, the huge profits of these and other banks will be
diminished by the competition that a transparent market brings, in the
words of Dodd-Frank, ``free and open access'' to what would be highly
competitive derivatives markets.
While each argument advanced by swaps dealers must be analyzed on
its own merits, there can be no mistake that a unifying rationale for
minimizing the impact of Dodd-Frank, either implicitly or explicitly,
is that we are now out of the financial crisis and there is no need for
change. Therefore, it is suggested that as much of the status quo ante
as can be preserved should now be left in place.
A subsidiary argument is that if Dodd-Frank is fully enforced, it
will be a job killer. However, as shown above, the undercapitalized
casino that unregulated derivatives fostered in the subprime housing
market was the ultimate job and pension killer. The misery created by
that unregulated market often gets lost in Wall Street talking points.
Moreover, the economic gambling infrastructure built before Dodd-Frank
around subprime mortgages exists, e.g., for prime mortgages, commercial
mortgages, student loans, auto and credit card debt.
We are presently in a jobless ``recovery.'' Moreover, the shock of
rapidly escalating energy and food prices, as well as threatened
defaults by municipalities and European Union sovereign states, can
either individually or collectively create economic dislocations akin
to that experienced in the fall of 2008. For example, there is almost
certainly an untold number of grossly undercapitalized naked CDS on
municipal and sovereign obligations. If there are widespread defaults
in those areas, an untold number of undercapitalized ``insurance''
guarantees will be triggered.
The loss of profits of ``Too Big to Fail'' financial institutions,
which have fully recovered and may be stronger and bigger now than
before the meltdown, must be balanced against the well being of the
American consumer, worker and taxpayer.\27\ Rejecting Dodd-Frank on the
assumption that all is now well is a dangerous strategy to follow
legislatively or at the regulatory level.
---------------------------------------------------------------------------
\27\ Karen Weise, Banks `Too Big to Fail' Could Get Bigger: Federal
agencies putting mortgage and derivative reforms into force are writing
rules that seem to have a big-bank bias, Bloomberg Businessweek (April
7, 2011), available at http://www.businessweek.com/magazine/content/
11_16/b4224025246331.htm.
---------------------------------------------------------------------------
There is another concern that the implementation of Dodd-Frank
would add significant operation costs to commercial end-users. However,
as shown above, the Act contains a statutory ``end-user'' exception to
ease the burden on businesses using swaps to mitigate risk associated
with their commercial activities.\28\ The legislative intent shows that
the drafters of the Act unequivocally share this goal as well.\29\
Furthermore Chairman Gensler and Chairwoman Schapiro have said
repeatedly that end-users will not have to post margin for uncleared
swaps and that the swaps dealer counterparty will not have to post
margin.\30\ Simply, this is a case of commercial end-users not taking
``yes'' for an answer to their worries about having to post collateral
for uncleared swaps.
---------------------------------------------------------------------------
\28\ See Dodd-Frank Wall Street Reform and Consumer Protection Act,
Pub. L. No. 111-203, 723 (2010).
\29\ See, Letter from Christopher Dodd, Chairman, Senate Committee
on Banking, Housing, and Urban Affairs & Blanche Lincoln, Chairman,
Senate Committee on Agriculture, Nutrition, and Forestry, to Barney
Frank, Chairman, Financial Services Committee & Colin Peterson,
Chairman, Committee on Agriculture, (June 30, 2010), available at
http://www.wilmerhale.com/files/upload/
June%2030%202010%20Dodd_Lincoln_Letter.pdf (explaining that the end-
user exception is ``for those entities that are using the swaps market
to hedge or mitigate commercial risk.'').
\30\ See, Gensler Testimony, supra note 14; see also Schapiro
Testimony, supra note 14.
---------------------------------------------------------------------------
Whatever new costs Dodd-Frank imposes (and those costs are greatly
exaggerated by those seeking to deflate regulation) are minimal
compared to the dire economic havoc that might be caused by under-
regulation, especially when Congress is now almost devoid of ``stimulus
bullets'' to repair future economic ills.
Funding for the CFTC and SEC. Severely hampering the CFTC's and
SEC's ability to implement Title VII of Dodd-Frank are their
challenging financial and staffing conditions. With regard to the CFTC,
that agency's gross under-funding makes performing its new and complex
functions under Dodd-Frank ``a Herculean task.'' \31\ Under the new
regulations, the CFTC must examine a voluminous amount of data and
information encompassing transactions that number in the millions.\32\
An $11 million slash in the technology budget has forced the agency to
cease developing a new program that would scan the overwhelming number
of trades to detect suspicious trading. Moreover, the potential long-
term effects of insufficient funding is severe; operating under its
current budget will mean that applications, findings, and enforcement
required by the new law would languish.\33\ As Commissioner Bart
Chilton aptly warns, ``Without the funding, we could once again risk
another calamitous disintegration.'' \34\ Lack of funds not only
shortchanges the Commission, but it also risks another widespread
financial crisis.
---------------------------------------------------------------------------
\31\ Ben Protess, Regulators Decry Proposed Cuts in C.F.T.C.
Budget, N.Y. Times (February 24, 2011) (quoting CFTC Commissioner
Michael Dunn), available at http://dealbook.nytimes.com/2011/02/24/
regulators-decry-proposed-c-f-t-c-budget-cuts/?ref=todayspaper.
\32\ Jean Eaglesham and Victoria McGrane, Budget Rift Hinders CFTC,
Wall St. J. (Feb. 25, 2011).
\33\ See, Transcript of the Congressional Hearing to Review
Implementation of Title VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act before the H. Comm. on Agriculture (Feb. 15,
2011) (statement of Terry Duffy, Executive Chairman, CEM Group).
\34\ See, Statement of Bart Chilton, Commissioner, Commodity
Futures Trading Commission, Risky Business (February 24, 2011),
available at http://www.cftc.gov/PressRoom/SpeechesTestimony/
chiltonstatement022411.html.
---------------------------------------------------------------------------
In this regard, the CFTC lacks an adequate number of personnel to
perform its increased regulatory duties. From 1999 to 2007, the agency
shrunk from 567 full-time equivalents (``FTEs'') to 437. By 2010, the
number of FTEs had risen to 650, only a 30% increase in the number of
personnel since the agency's establishment in 1975. Chairman Gary
Gensler estimates that he needs an additional 400 people to meet the
challenges of regulating the multi-trillion dollar derivatives
markets.\35\ As Barbara Roper of the Consumer Federation of America has
noted, for example, the ``Draconian cuts'' of the House of
Representatives' proposed budget would ``decimate that tiny agency
without making any meaningful inroads in the Federal deficit.'' \36\
Even the relatively fiscally conservative Financial Times has recently
editorialized that the SEC and CFTC deserve the funding levels that
were promised to prevent a future meltdown through proper
implementation of Dodd-Frank.
---------------------------------------------------------------------------
\35\ Ben Protess and Mac William Bishop, At Center of Derivatives
Debate, a Gung-Ho Regulator, N.Y. Times (Feb. 10, 2011), available at
http://dealbook.nytimes.com/2011/02/10/at-center-of-debate-over-
derivatives-a-gung-ho-regulator/.
\36\ See, Statement of Barbara Roper, Director of Investment
Protection, Consumer Federation of America, Feb. 14, 2011.
---------------------------------------------------------------------------
It is one thing to attack Dodd-Frank frontally by seeking
deregulatory action either through legislation or weakened rules. There
can be little doubt, however, that starving financial regulatory
agencies dependent upon appropriations is a de facto rescission of
Dodd-Frank. It asks Americans to face yet another crisis under the
guise of budget cuts--a crisis that may ``the next time'' drag the
United States and the world into the next Great Depression.
In making this point, I also want to commend the CFTC for its
heroic work in meeting the necessarily rigorous deadlines imposed by
Dodd-Frank for well over 60 new rules. I spent 25 years in a private
law practice heavily devoted to rulemaking advocacy, and then
involvement in the judicial review of those rules in virtually every
Federal circuit court of appeals in the country and in the United
States Supreme Court. I was also very proud of the many rules that were
promulgated by the CFTC while I was the Director of the Division of
Trading and Markets. However, the hard and productive work performed by
the CFTC in implementing Dodd-Frank, especially with its small staff,
is extraordinary. The quality of that work also meets the highest
standards of public service. This Subcommittee as one of the key
oversight bodies for the CFTC should be very proud of this effort. The
agency has more than demonstrated that it will be a vigilant protector
of the important markets it now oversees if it receives the financial
support it needs from this Congress.
This testimony is further supported in detail by my March 3, 2011
written testimony before the Senate Committee on Agriculture, Nutrition
and Forestry at pp. 6 to 25; \37\ my March 28, 2011 comment letter to
the CFTC on Position Limits for Derivatives; \38\ my published article
in the University of Maryland School of Law's Journal of Business and
Technology Law; \39\ and a series of my previously published articles
and testimony delivered to Congress and to the Financial Crisis Inquiry
Commission.\40\ Links to those documents may be found in the margin.
---------------------------------------------------------------------------
\37\ Written Testimony of Michael Greenberger, Hearing Before the
U.S. Senate Committee on Agriculture, Nutrition and Forestry Regarding
the Implementation of Title VII of the Wall Street Reform and Consumer
Protection Act (March 3, 2011), available at http://
www.michaelgreenberger.com/files/110303-
Greenberger_Senate_Ag_Testimony2.pdf.
\38\ Comment Letter by Michael Greenberger, Professor, University
of Maryland School of Law, Director, Center for Health and Homeland
Security, to David Stawick, Secretary, Commodity Futures Trading
Commission, Position Limits for Derivatives (March 28, 2011), available
at http://www.michaelgreenberger.com/files/
Greenberger_PL_comment_letter.pdf.
\39\ Overwhelming a Financial Regulatory Black Hole with
Legislative Sunlight: Dodd-Frank's Attack on Systemic Economic
Destabilization Caused by An Unregulated Multi-Trillion Dollar
Derivatives Market, 6 J. Bus. & Tech. L. 127 (April 2011), available at
http://works.bepress.com/michael_greenberger/41/.
\40\ Derivatives in the Crisis and Financial Reform, in The
Political Economy of Financial Crises, Oxford University Press Handbook
(Gerald Epstein & Martin Wolfson eds., forthcoming 2012); Is Our
Economy Safe? A Proposal for Assessing the Success of Swaps Regulation
under the Dodd-Frank Act, in The Future of Financial Reform: Will It
Work? How Will We Know? (Roosevelt Institute 2010), available at http:/
/works.bepress.com/michael_greenberger/34; Out of the Black Hole:
Regulatory Reform of the Over-the-Counter Derivatives Market, in Make
Markets Be Markets 99 (Roosevelt Institute 2010), available at http://
works.bepress.com/michael_greenberger/35/; Out of the Black Hole:
Reining in the Reckless Market in Over-the-Counter Derivatives,
American Prospect (2010), available at http://works.bepress.com/
michael_greenberger/37; and Written Testimony of Michael Greenberger,
Hearing Before the Financial Crisis Inquiry Commission Regarding The
Role of Derivatives in the Financial Crisis (June 30, 2010), available
at http://www.fcic.gov/hearings/pdfs/2010-0630-Greenberger.pdf.
The Chairman. Well, I thank the witnesses for your
comments. We will now go into the question period.
In spite of those comments, I do think that cost-benefit
analysis is an appropriate tool to use to make sure that we get
the regulations right.
So, Mr. Scott, Dr. Overdahl, do we need, looking forward--I
know we don't have it in place right now, but looking forward
with respect to the CFTC, do you recommend any specific
legislative changes to 15(a), or whatever it might be, to
require broader economic analysis of impact regulations would
have for the good or for the bad on the folks who have to
comply with those regulations?
Dr. Overdahl, do you want to start?
Dr. Overdahl. Sure.
I think the obligation under 15(a) to consider is one that
is pretty easily satisfied, and I can envision language that
would go beyond that. I guess my preference would be that it
would be a direction to the Commission to develop their own
internal procedures on how to analyze rules, how to implement
effective cost-benefit analysis.
I think if they are doing that, with help, perhaps, from
the OIRA at the OMB--the reason I mention them is because they
have a lot of experience dealing with Federal agencies that
have this very same type of requirement, that that could
improve the process.
And, if there was anything additional, it would be that
somehow their analysis be reviewed by somebody. I don't think
it really matters by whom, because just by the fact that
somebody is looking, I think, will improve that process.
The Chairman. Mr. Scott?
Mr. Scott. I agree with what Dr. Overdahl just said. I
think we need to impose a more demanding standard of cost-
benefit analysis on the CFTC--and, by the way, the SEC, as
well.
And I also agree that somebody should be looking at this
analysis to check it out. So my proposal is that OIRA, within
OMB, review the cost-benefit analysis of these independent
financial agencies and make comments. Unlike with the non-
independent agencies, their comments would not be binding.
Actually and technically, they are not even binding on the non-
independent agencies. But, practically speaking, since they are
part of the Administration, they are.
I think we need to respect the independent agencies and
their independence. So I would not make the Office of
Management and Budget's review binding on these agencies. But,
it would add a lot to the process if they reviewed the cost-
benefit analysis and articulated what their opinion was. This
would put pressure, obviously, on these agencies to do a better
job.
Dr. Overdahl. And could I just add one thing?
I think there needs to be some distinction between major
rules and minor rules. I don't think you would want to have the
same level of scrutiny for every possible rule. But, certainly,
for major rules I think it is a reasonable requirement.
Mr. Scott. Major versus others, is that the issue? I am not
sure.
Dr. Overdahl. Yes.
Mr. Scott. Well, of course, then we get into what is major
and what is not, so it is difficult.
But the spirit of your question is that the more important
the rule and the more potential economic impact that it has on
the country, the more stringent the analysis should be, because
it matters more.
So, in the operation of a cost-benefit analysis regime,
what you are suggesting will happen, but I wouldn't, kind of,
say major, yes, non-major, no----
The Chairman. I guess that the struggle here is to write a
principles-based requirement that is not so prescriptive that--
whatever. But that is the struggle we all run.
Mr. Duffy, on the position limits, a lot has been said
about that. We have a recent report from the Financial
Services--something--that they don't think position limits
work. I got folks on both sides of this.
Is it your sense, from an international standpoint--Mr.
Scott, you may want to pitch in on this, as well--that all
these international folks are just waiting with bated breath
for us to do position limits so they can flood in and do them
themselves? I mean, they are really wanting to do this, but
they are just waiting on the U.S. to lead in that regard?
Mr. Duffy. I don't believe that the position-limits issue
in Europe will take hold. They have basically said--I know that
the French want more strict limits, the U.K. wanted no limits,
so they came out with a compromise saying that if, in fact,
they find an issue where they need to impose certain limits,
they have the ability to do so. The study you are referring to,
I believe, was the Chairman of the U.K. FSA and two other
academics that came out and said they saw no correlation
between speculation and the price of any particular product.
And I do believe that they would love to see the United
States of America act, put on prescriptive position limits on
certain products and watch that business migrate over to London
and other parts of Europe. This is something that is very
attractive, very appealing.
And you have to also--and I know you know this, Mr.
Chairman. London is very much focused on financial services,
and it is a big part of their economic fabric. And if they lose
any market share, that puts them in a very difficult situation.
So, without a doubt, they will not make a move until the United
States of America does first.
The Chairman. Thank you.
Mr. Boswell for 5 minutes.
Mr. Boswell. Well, thank you.
Interesting points you have all made. Stimulating, for
sure. Let's see where we can go here.
But, Mr. Greenberger, you have heard your fellow panelists
and others advocate for delaying implementation of the
derivatives title of Dodd-Frank. Who do you think benefits the
most from delay?
Mr. Greenberger. There is no doubt that the big banks, who
now have to face regulation that they didn't have before, want
to see this delayed. Their profits are going to be cut. Does
that mean the financial services industry, which now makes 33
percent of all the profits of the United States, is going to be
cut? No. It means the big banks will have to share those
profits with banks in your jurisdiction. They won't hold an
oligopoly anymore.
They are desperate to, through budget cuts, procedural
delays, slow this thing down. And you run the risk that while
you are slowed down you are bareback; the protections are not
there. If there is another crisis--and, believe me, if you had
to bet whether there was or wasn't, from your instinct you got
to worry about it--your constituents are going to want to know,
where were you? This was your Subcommittee; why weren't the
rules put in place?
Mr. Boswell. I don't know about you, Mr. Chairman. My local
banks, I hear a lot of complaints--and I have some great local
banks, community banks, so don't misinterpret what I am saying.
But I have producers out there, been at it a long time, pretty
stable, that are having a hard time putting resources together.
Do you think that because of what this whole picture of
what we are talking about is what is running downhill, water
and other things run downhill, is that why they are being so
difficult to satisfy on any process of operational loans?
Mr. Greenberger. Look, credit is tight out there. Jamie
Dimon just got a $23 million bonus and a $600,000 payment for
moving expenses. Your constituents cannot borrow money. The
too-big-to-fail banks are too big to worry about loaning money
to the average American, the average student, the average
homeowner.
And what do they want to do? They want to do proprietary
trading. They want to deal with these swaps. They want to enter
into the AIG transactions where they bet that something is
going to happen. And when they lose and don't have the money,
they will turn around to you and say, ``Hey, if we go down,
everybody goes down. You had better rescue us.''
Lord Turner has been mentioned here. Lord Turner has made
the very famous statement that these big banks are societally
useless. They don't help your constituents. To the extent you
delay this rule, you are helping Jamie Dimon get a bigger bonus
next year, more than $23 million. You are not supporting the
average citizen in your constituency.
Mr. Boswell. I still have a few moments.
Mr. Scott, your testimony advocates consistency in
coordination among the regulators with regard to Dodd-Frank,
except when required by real differences. It appears the
prudential regulators believe end-users should be required to
post margin to better protect the banks overseen by their
prudential regulators. Do you believe this difference is
merited?
Mr. Scott. I am a little hard of hearing, Congressman, and
I didn't catch your question.
Mr. Boswell. Okay. Your testimony advocates consistency in
coordination among regulators with regard to Dodd-Frank except
when required by real differences. It appears prudential
regulators believe end-users should be required to post margins
to better protect the banks overseen by the regulators. Do you
believe this difference is merited?
Mr. Scott. Sorry, Congressman. It is my fault, not yours.
I guess the question is, when should there be differences
between the CFTC and the Fed in particular. I don't think there
should be differences. I think whatever the CFTC does should be
consistent with preventing systemic risk.
Mr. Greenberger talked about the crisis. A large part of
the losses in that crisis were due to systemic risk. And it is
the Fed's job, principally, under Dodd-Frank, to worry about
that.
So, there should be consistency, okay, not only between the
CFTC and the SEC, but also with the Fed.
Mr. Boswell. Thank you.
I yield back.
The Chairman. The gentleman yields back.
Mr. Neugebauer from Texas for 5 minutes.
Mr. Neugebauer. Thank you, Mr. Chairman.
And I was pleased to hear--what we are hearing is a common
theme. I had a hearing last week in Financial Services
Oversight Committee, and we heard a lot about people saying
that there wasn't appropriate cost-benefit analysis going on.
And when you look at Dodd-Frank, for example, 240 rulemaking
opportunities here, compared to Sarbanes-Oxley, which I think
had 16 or 17. And the volume and the speed about which a lot of
these were coming out is very concerning.
In fact, Commissioner Sommers was one of the witnesses. And
she said, ``we are voting on rules that contain very short,
boilerplate cost-benefit analysis. And I think when you look at
the size and the scope of the impact of a lot of these
proposals, a boilerplate, short analysis doesn't seem to
correspond with what the potential conflicts or potential
outcomes of some of these changes are.'' So I concur with many
on the panel that I think that process needs to take place.
I think the other thing, Mr. Scott, you mentioned, and this
is something else that I have actually said to Mr. Gensler, is
that after all of these regulations are promulgated that,
really, we need to then take a big-picture look at what--not
only just being able to execute those from an infrastructure
standpoint, but also the consequences of all of those
regulations and how they not only impact the marketplace but
also competitiveness, the cost, and, in fact, how much
incrementally did we improve the system.
A lot of people disagree that Dodd-Frank is the bill that
is going to save the world. What I would say is we are not
quite sure of that, because we didn't do the proper
investigation and oversight in going in and looking at what did
happen in the system before we implemented this very broad
piece of legislation. In many cases, we had regulators that
just weren't doing their job, not that they needed more
regulation.
Mr. Duffy, you talked a little bit about London. And,
certainly, that is one--in a global marketplace, that is one of
the places that we--but you didn't--and I apologize, I didn't
get to hear all of your testimony--but there are other places,
Asian markets, as well.
Can you elaborate, when you look at the landscape that is
going on now, European, because what I am beginning to hear is
that the infrastructure is building up in the Asian markets to
be very competitive.
Mr. Duffy. There is absolutely no question about it. One of
the largest competitors for CME's agricultural business is in
Dalian, China, today under the Dalian Exchange. They are
trading enormous amounts of grain products throughout--they are
discovering price throughout Asia under a different regulatory
regime.
Hong Kong has become more and more focused on financial
services. And, Singapore has become the haven for Asian
institutions to do their business. And they do it completely
different than we do here in the U.S.
We are competing with the world, Congressman, as you know.
I mean, our world has gotten so small, and it has no borders.
So if we get--and I will say it again--a regulatory arbitrage,
people will migrate to where they can do business in the most
cost-effective way. And the way you do that is to have
liquidity generate there in certain jurisdictions, and that is
how you move the business.
We are seeing a tremendous amount of liquidity throughout
Asia. We don't talk about it as much here in Washington; we
normally talk more about Europe. Asia is just, if not a bigger,
threat to the U.S. financial services, because liquidity is
building by the second over there. So we are very concerned
with our Asian competitors, but we do work and compete globally
over there also.
Mr. Neugebauer. Thank you.
Any other panelists want to comment on that issue?
Mr. Scott. Well, I agree again with Mr. Duffy. But I
articulated concern in my testimony that we could take measures
actually that makes this worse. If the CFTC took the attitude,
for instance, that European or Asian clearinghouses were not
adequately regulated in its view--maybe their membership
requirements were too high compared to Mr. Gensler's--then I
think the CFTC actually has the power under Dodd-Frank to
restrict use of those clearinghouses by U.S. firms, which would
be a terrible result, because the E.U. would, possibly,
retaliate, and then we would get into a conflict.
So, as I said, regulatory arbitrage would be a better
outcome than that kind of a stalemate. All to say that we
should be doing a lot more than we are doing. It is not enough
to go over to London and make a speech, okay? What you have to
do is sit down with the E.U., the staffs, and work out these
differences.
Mr. Neugebauer. Thank you, Mr. Chairman.
The Chairman. The gentleman yields back.
The gentleman from Illinois, Mr. Hultgren, for 5 minutes.
Mr. Hultgren. Thank you, Mr. Chairman.
Thank you, all of you, for being here.
Just a couple of questions. Mr. Duffy, I wondered if you
could just comment briefly on Chairman Gensler's proposal to
phase in the clearing requirements either according to the
parties to the swap or by asset class.
Mr. Duffy. Well, fading in the implementation, one of the
things that we think is critically important--and I hope I am
answering your question properly, sir--is there is a
requirement to bring dealer-to-dealer and dealer-to-client on
clearing of these products. What we feel is very important
under the Dodd-Frank law, it said, give the customer the choice
on where they want to clear their product. And if we just go
ahead and lead with just dealer-to-dealer, the client will have
no other alternative but to go to a particular clearinghouse.
So we would like to see the implementation of the clearing
coincide together, which we think makes the most amount of
sense, to be with the spirit of the law, and also let the
client make that choice.
I hope I am answering your question properly.
Mr. Hultgren. Yes, I think you are. Do you get the sense
that they are open to that, from comments of Chairman Gensler
and others? Are they----
Mr. Duffy. I don't have any indication that they are not
open to it, sir. I have been working with Chairman Gensler and
other Commissioners to make sure they understand that point. It
is a competitive issue amongst many different clearing
entities. And, of course, the law would suggest that the
customer has that right.
And so, yes, I do believe we are making some headway, but I
am concerned because of other things we have seen coming out of
the agency.
Mr. Hultgren. Yes.
Switching gears just a little bit, also, Mr. Duffy, an area
that hasn't been discussed at great length in the Committee are
the rules proposed--the proposals aimed at market manipulation
and anti-disruptive trading practices.
While we certainly want to ensure bad actors cannot engage
in manipulative or disruptive practices, we have heard concerns
that vague terms of the rules may have a freezing effect on the
market.
I wonder about your view on that, if these rules do go too
far. And, if so, how can the regulators strike that right
balance of protecting from bad actors while at the same time
protecting our markets?
Mr. Duffy. First of all, market manipulation is something,
obviously, we are very focused on. We are a publicly traded
company. We are a 156 year old institution. We have never had a
customer lose a penny due to a clearing member default, so we
have all these great things that we have to make sure we keep
ourselves at the highest standard. And if we don't have
credible markets, we don't have a credible company. So market
manipulation is something we spend a lot of time focusing and
watching, and we feel very comfortable there.
Anti-disruptive trading practices is something that, when
you create a law as it relates to what is considered anti-
disruptive trading practices--I traded for 23 years of my life,
sir, and the markets go up and they go down and they go fast
and they go furious. In the day of ``electronification'', they
go in milliseconds, not in 10 second time periods.
So these are laws or rules that are being promulgated,
putting forward, that could be so broad and vast that it would
actually take a transaction that is absolutely, 100 percent
legitimate that is done on the close of a trading session and
deem that to be anti-disruptive. Many participants like to
enter their orders on the close of business or the opening of
business because that gives them a mark for the next day and
they know where the market closed.
So if you were to enter into that and that order actually
moved the market, whether because of an illiquid time of the
trading, you could be deemed as anti-disruptive trading
practices. This is just too wide, too vast, and could
absolutely kill liquidity, move it more to the over-the-counter
market, move it to block, take it away from the central
marketplace. And all the things that Mr. Greenberger doesn't
want to see happen will happen if this rule goes into place.
Mr. Hultgren. And that is my fear, and I think many of our
fears, is that these broad responses here really could do
exactly the opposite of what our hope was with so much of this.
Last week, Chairman Gensler was asked about a letter he
received from the UK's Financial Services Authority expressing
concern about a CFTC proposal to cap the amount a capital
clearinghouse can require of potential clearing members at $50
million. FSA expressed concerns that the proposal may actually
inject more risk into the system.
I wonder if you could, Mr. Duffy, just respond quickly on
that idea of would that potentially inject more risk into the
system. And are there other CFTC proposals that you think might
result in more instead of less risk to the system?
Mr. Duffy. And I appreciate the question, sir.
On the clearing requirement minimums, there are
clearinghouses, as you know--how they work, they are
capitalized by the members of the firms. And when there is a
potential default or something goes wrong within one of the
clearing members, they all participate in assuming that
default.
So if you are trading 4,000 to 5,000 transactions a day
with a high notional value of over-the-counter swaps
transactions and you have people that are involved in your
clearinghouse for $50 million while the others are capitalized
at $1 billion and one of them defaults, how are you going to
get the $50 million participant to help in the default process?
They absolutely cannot.
Because what the Chairman is suggesting is, whatever you
trade, then you can put a small amount of money just up to that
limit, which would make sense from a perspective if the world
was perfect, but if there are defaults, like we saw Lehman,
like we saw Bear, like we saw all these other institutions,
people have to participate to come together to help make up the
difference. And if you have $50 million, I assure you will be
out of money before the first transaction happens. You won't be
able to help out in there.
So I understand what the dealers are talking about, and I
understand what the Chairman is talking about. I don't know if
there is a good mix. But you have to have everybody be able to
participate in the default process. That is what keeps the
system sound and safe.
Mr. Hultgren. Thank you.
Thank you all for being here. I do have other questions. I
am out of time, but hopefully we can present those to you. I
also felt bad that I missed the first part of the hearing. We
had some votes in another committee that I am on that I had to
be at. But I do appreciate the work that you are doing. This is
important right now for us to be discussing this.
So I yield back my time. Thank you, Mr. Chairman.
The Chairman. The gentleman's time has expired.
We will go another round.
I wanted to ask Ms. McMillan, you and I had a conversation
yesterday about the impact that some of these rules would have
on some disclosure requirements: the CFTC would force you to
disclose, and the SEC would prevent you from disclosing.
So can you talk to us a little bit more about this loss of
the exemption of Rule 4.5, what it does to your industry and
member companies? And what is your opinion that this proposed
action by the CFTC will do?
Ms. McMillan. Certainly. Thank you.
The proposed removal of the exemption of Rule 4.5 by the
CFTC would essentially require funds that are already regulated
by the SEC to have a second layer of regulation by the CFTC if
they trip over two different tests, which, the way that they
are drafted very, very broadly, they are likely to do.
One of the main reasons for that is that swaps are now part
of the CFTC's jurisdiction and are included in this proposal.
We don't think that the CFTC took adequate time to understand
how registered investment companies use swaps. They are more
for hedging, for risk management, not for what is typically
viewed in this Committee as being speculative purposes.
The other is that there is a marketing restriction that
could prohibit investment companies from putting in the
prospectus disclosure that they are required to put in by the
SEC or risk management or risk disclosure that they are also
required to put in if they engage even to a small extent in
future options or swaps.
The problem, then, is that if these companies then also
have to be regulated by the CFTC, these are largely disclosure
issues, and both agencies have different philosophies about how
that disclosure should be done. Some are similar and could be
reconciled fairly easily, but some are absolutely contradictory
and kind of go to the fundamental nature of how these agencies
think investors should get information.
One good example is that the SEC absolutely prohibits
registered investment companies from putting in performance of
the advisor with respect to other pools that it manages, on the
theory that that could mislead investors because the other
pools may be very different from the one that they are
investing in. The CFTC takes the opposite approach and says,
well, that is valuable information for an investor because they
should know how the advisors perform, particularly if the
advisor doesn't have a long track record.
If a company is required to comply with both rules, it is
going to violate one of them; it simply cannot go forward. And
while the CFTC in its proposal recognized that there are these
contradictions, they did not offer up any solution to that, so
the public doesn't have any opportunity of knowing what regime
it may have to live under and to provide comments. And we do
think that disclosure to investors of this and other issues are
very important and we should have the opportunity to comment on
it.
The Chairman. All right. Thank you, Ms. McMillan.
I yield back.
The gentleman from Iowa, Mr. Boswell, for another 5
minutes.
Mr. Boswell. Thank you, Mr. Chairman. I don't think I will
need that.
I think I owe an apology to Mr. Scott. Am I speaking
clearly? Can you hear me? No, I thank you very much for being
here. And I want to make sure I am clear in our discussion.
But prudential regulators, the Feds, say end-users should
post margin. The CFTC says no. I think you say Fed views should
trump CFTC views. Question: Do you agree with prudential
regulators that end-users should post margin to better protect
the banks?
Mr. Greenberger. If I can answer that question, I think
there has been a lot of misunderstanding about that. The FDIC
published a rule yesterday. In fact, Commissioner O'Malia said,
``Oh, the two Commissions couldn't be further apart.'' If you
read what the FDIC said, it says that commercial end-users who
have good credit do not have to post margin. And, as they said,
even before we had Dodd-Frank, under the old thing, in a self-
regulatory sense, banks will not extend counterparty credit if
the counterparty doesn't have good credit.
If you read these carefully, the FDIC, representing the
prudential regulators, and the CFTC both say they will not
require end-users with good credit ratings to post margin.
There is no difference between the two agencies. I can brief
you on that. In the FDIC, page 7-8 of their summary says, we
agree with Chairman Gensler and the CFTC staff; we want to do
what they are doing.
The end-user here is protected by statute, if it is a
commercial end-user. The agencies have said they will not
collect margin. There has been no issue that has been more
carefully drilled into and more reassurances offered that end-
users don't have to clear and they don't have to post margin.
And, as I keep saying, people don't want to take ``yes'' for an
answer. They are out from under.
Mr. Boswell. Well, thank you for that comment.
Mr. Scott, would you like to--I pose the question to you.
Mr. Scott. Well, maybe from Chairman Gensler's point of
view, they are out. But the bank regulators have a concern,
which I think was articulated in their proposal yesterday, that
a bank could get overexposed to a counterparty. And so they
want to set some limit on the unsecured exposure as net of the
collateral protection that their counterparty has, whether that
counterparty is financial or commercial.
I think, in practice, this isn't going to be a big deal
because the threshold will be set high. But to say that the
regulators of banks would be totally unconcerned with the
counterparty risk of commercial counterparties seems to me not
the right solution.
What the right solution is, is to recognize that commercial
counterparties are different, they pose different risks, and we
should have a very high risk limit; it shouldn't be infinite.
And I think that is basically what the bank regulators are
saying.
Mr. Boswell. Thanks for the comment.
Mr. Greenberger, do you have any response?
Mr. Greenberger. Yes, the only thing I am going to say is,
Mr. Scott said the Federal Reserve should be more involved in
this, and the statute requires both the SEC and the CFTC to
consult with the Federal Reserve. What we are beginning to see
is the Federal Reserve and the prudential regulators saying
they are going to be tougher than the CFTC.
So if we criticize the CFTC, if we put them down, ``They
aren't doing their job right,'' ``They aren't taking this
seriously,'' ``They are using boilerplate explanations,'' you
are going to so diminish them that two people are going to lose
in this battle. This Committee is going to end up seeing these
guys go over to prudential regulators, and they are going to
lose the protection of this Committee. If you beat the CFTC
down like this, you are just asking for someone to take them
over. As you well know, that has been up in the air.
I think the CFTC--they have not used boilerplate. They have
busted their rear ends on this. They are not ideological. Some
of those people were hired in the Reagan Administration, served
under Wendy Gramm. They are trying to do their best. We hear,
``They could do this. They could do that. They might do this.''
Let's see what they do.
Then we are told on judicial review they are going to get
killed. Judicial review is where this should all work out. If
they are not doing their job right, we are being told the
courts will reverse them. I have every confidence, because I
have handled many judicial reviews, all the way up to the
Supreme Court, that the CFTC will survive judicial review. They
are doing this carefully, thoughtfully.
And if their economic analysis is bad, as Mr. Scott has
said, they will be reversed in the D.C. Circuit. I don't think
they will be reversed; I think they can justify it.
You have to ask yourself, do you want to take the place of
a reviewing cost and unwind the 2,400 page statute or, as
normally happens, let this work its way out in the normal
process?
Mr. Boswell. Thank you.
I guess I should yield back.
The Chairman. The gentleman from Illinois for a second
round.
Mr. Hultgren. Thank you. A couple quick questions.
Dr. Overdahl, just a quick question. Do economists at the
CFTC write the cost-benefit sections of the rules?
Dr. Overdahl. When I was there, it certainly was not the
case. It was the drafters of the rule who are in the rulemaking
divisions, typically, the attorneys in those divisions that
wrote the cost-benefit analysis.
Mr. Hultgren. A quick question for Ms. McMillan. The CFTC's
proposal says that Rule 4.5 proposals are intended to stop the
practice of registered investment companies offering futures-
only investment products without Commission oversight.
I wonder if you can tell us what the problems have been
with those funds.
Ms. McMillan. To be perfectly honest with you, I am puzzled
as well. We have not seen those kinds of problems. They
actually were not alleged in the rule proposal.
We do understand that the CFTC has the right to take a look
at practices that it feels may come within its jurisdiction,
but the proposal that it has drafted goes well beyond even what
its stated intent was.
Mr. Hultgren. Thanks.
Last question. Mr. Scott, you have done quite a bit of
research and writing in the past as it relates to our financial
regulatory structure and the competitiveness of U.S. capital
markets. Many of your recommendations were focused on
modernizing the regulatory structure to better reflect today's
markets.
In your view, has Dodd-Frank modernized the regulatory
structure?
Mr. Scott. The short answer is ``no.'' We needed much more
than FSOC to rationalize our regulatory structure.
You always talk about CFTC and SEC. As you know, at some
point, the discussion of those agencies were up for merger
through the Paulson blueprint. That never occurred.
I think the fragmentation of our regulatory structure has
made it dysfunctional. I am depressed by the fact that the
biggest crisis since the Depression couldn't change it. It
actually made it more complicated. You have FSOC, Office of
Financial Research, Consumer Financial Protection Bureau. So I
am about to give up hope for serious reform, Congressman.
Mr. Hultgren. Just to wrap up, Mr. Duffy, I wonder, just
from your thoughts and your view, has Dodd-Frank modernized the
regulatory structure?
Mr. Duffy. You know, the jury is still out on that, sir. I
think we have to wait until all the rules get written, comments
are in, and the implementation happens. I think that is even
more reason to take pause and make sure we get it right. I
think, in order to answer that question, only time will tell.
So, hopefully everybody gets an opportunity to comment. I
am hearing the amount of comments that are coming into the
CFTC, the letters are staggering, in the thousands. And this is
something that needs to be completely worked out.
There are parts of Dodd-Frank that we are very, very
supportive of, and there are other parts that we are not. And I
am hopeful that Dodd-Frank can do what the CEA Modernization
Act of 2000 did for our industry. So I am very hopeful that can
happen, but, again, we have our concerns. But only time will
tell.
Mr. Hultgren. Yes. We do, as well.
Well, thank you very much. I appreciate it.
I yield back my time.
The Chairman. The gentleman yields back.
Before we adjourn, I will ask the Ranking Member if he has
any closing remarks.
Mr. Boswell?
Mr. Boswell. No.
The Chairman. Well, I want to thank our panel. Some diverse
views. We appreciate that.
I do think it is the role of this Committee, Subcommittee,
to continue to watch what is going on. And an attitude that we
are simply players in a Greek tragedy, that we can't affect our
fate, is inaccurate. The fact that we question what is going
on, we ask for things--that we are trying to get this thing
done correctly, I think is the appropriate role of this
Committee and this Subcommittee. It is one that we will
continue to explore vigorously as we work with Chairman
Gensler, with Dan Berkovitz, who testified earlier, to try to
get the best regulatory scheme we can that allows these markets
to continue to function in America, that allow American end-
users and producers across this country to get at the tools
they need to mitigate their risks and deal with those risks in
ways that make sense, and that allows the providers a scheme
that they can comply with that is cost-effective and it gets
done what we all want to have done.
So, with that, we will adjourn the hearing. Thank you very
much.
Under the rules of the Committee, the record of today's
hearing will remain open for 10 calendar days to receive
additional material, supplemental or written responses from the
witnesses to any questions proposed by a Member.
This meeting of the Subcommittee on General Farm
Commodities and Risk Management is adjourned.
[Whereupon, at 12:00 p.m., the Subcommittee was adjourned.]