[Senate Hearing 112-102]
[From the U.S. Government Publishing Office]
S. Hrg. 112-102
BUILDING THE NEW DERIVATIVES REGULATORY FRAMEWORK: OVERSIGHT OF TITLE
VII OF THE DODD-FRANK ACT
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
CONTINUING THE OVERSIGHT OF THE IMPLEMENTATION OF TITLE VII OF THE
DODD-FRANK ACT
__________
APRIL 12, 2011
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.fdsys.gov/
_____
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Charles Yi, Chief Counsel
Jeff Siegel, Senior Counsel
Brian Filipowich, Professional Staff Member
Andrew Olmem, Republican Chief Counsel
Hester Peirce, Republican Senior Counsel
Mike Piwowar, Republican Chief Economist
Dawn Ratliff, Chief Clerk
Levon Bagramian, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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TUESDAY, APRIL 12, 2011
Page
Opening statement of Chairman Johnson............................ 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 2
WITNESSES
Mary L. Schapiro, Chairman, Securities and Exchange Commission... 4
Prepared statement........................................... 40
Responses to written questions of:
Chairman Johnson......................................... 88
Senator Shelby........................................... 88
Senator Hagan............................................ 89
Gary Gensler, Chairman, Commodity Futures Trading Commission..... 5
Prepared statement........................................... 43
Responses to written questions of:
Chairman Johnson......................................... 90
Senator Shelby........................................... 90
Senator Reed............................................. 98
Senator Hagan............................................ 100
Daniel K. Tarullo, Member, Board of Governors of the Federal
Reserve System................................................. 6
Prepared statement........................................... 47
Responses to written questions of:
Chairman Johnson......................................... 101
Senator Shelby........................................... 101
Senator Reed............................................. 102
Senator Hagan............................................ 104
Mary J. Miller, Assistant Secretary for Financial Markets,
Department of the Treasury..................................... 8
Prepared statement........................................... 49
Responses to written questions of:
Senator Shelby........................................... 104
Senator Reed............................................. 106
Senator Hagan............................................ 118
Thomas C. Deas, Jr., Vice President and Treasurer, FMC
Corporation.................................................... 26
Prepared statement........................................... 52
Lee Olesky, Chief Executive Officer, Tradeweb Markets LLC........ 28
Prepared statement........................................... 54
Terrence A. Duffy, Executive Chairman, CME Group Inc............. 29
Prepared statement........................................... 59
Ian Axe, Chief Executive, LCH.Clearnet Group Limited............. 31
Prepared statement........................................... 73
Jennifer Paquette, Chief Investment Officer, Colorado Public
Employees' Retirement Association.............................. 33
Prepared statement........................................... 79
(iii)
BUILDING THE NEW DERIVATIVES REGULATORY FRAMEWORK: OVERSIGHT OF TITLE
VII OF THE DODD-FRANK ACT
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TUESDAY, APRIL 12, 2011
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 2:45 p.m., in room SD-538, Dirksen
Senate Office Building, Hon. Tim Johnson, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN TIM JOHNSON
Chairman Johnson. I would like to call this hearing to
order. Due to the length of this afternoon's hearing, we will
limit opening statements today to myself and Ranking Member
Shelby, and I would ask the other Members of the Committee to
please submit their opening statements for the record.
Today we will review the implementation of the new
regulatory framework for the OTC derivatives market required by
the Dodd-Frank Act. This is our Committee's first oversight
hearing on this issue since the passage of Dodd-Frank. While I
know there are many other issues that Senators may like to
raise with the regulators before us today, we should focus our
questions on the subject of this hearing.
The Dodd-Frank Act brings needed transparency and
accountability to our derivatives market and addresses problems
that greatly exacerbated the 2008 financial crisis. I commend
all of the regulators here today and their staffs for their
extraordinary work and long hours they have dedicated to these
important reforms.
Putting in a new framework to regulate the vast $600
trillion swaps market in this age of instantaneous global
capital movement is an enormously complicated task that demands
close cooperation with international regulators. We must create
new rules of the road to ensure that our financial markets
remain the envy of the world. Our regulators should follow
congressional intent to craft rules that are based on relevant
data that reflect the unique structure of the swaps market
while avoiding rulemaking for political expediency, and ask
Chairman Gensler and Chairman Schapiro and all our regulators
to work carefully to do what is necessary to get this right.
This effort will require strong coordination both within
and among regulators to review the full set of final rules in a
holistic way before they are finalized. The regulators must
also integrate meaningful public input into this review. I urge
our regulators to work together to craft a streamlined,
harmonized set of workable rules that protect the ability to
hedge risks in a cost-effective manner and minimize unintended
consequences that could send American jobs overseas.
With that, I turn to Senator Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman.
Today the Committee will examine the implementation of the
Dodd-Frank Act's new derivatives regulatory scheme. There is
particular need for oversight in this area because Dodd-Frank
has needlessly, I believe, created widespread uncertainty about
the regulation of derivatives and threatens to impose huge
costs on Main Street businesses as well as on our overall
economy.
The irony is that the proponents of Dodd-Frank told us that
the new law would bring certainty to the market and stimulate
economic growth. Instead, Dodd-Frank has set in motion a
massive regulatory rulemaking process that is on an unrealistic
timetable. Predictably, the result has been regulatory
confusion and market uncertainty.
Regulators are hastily proposing rules to meet the
extremely short deadlines without fully considering either
their economic impact or how they interact with the rules
proposed by other regulators. Meanwhile, market participants
are scrambling to understand how the numerous and complicated
rules will impact their businesses. In fact, they have filed
thousands of comments on the proposed rules.
The comments reveal the gravity of their concerns as well
as their confusion about how the rules will work in practice.
This process is a direct result of the poorly conceived
regulatory structure created by the Dodd-Frank legislation.
Although numerous studies have recommended consolidating our
financial regulators, Dodd-Frank actually dispersed authority
for derivatives regulation. Unfortunately, the danger of having
multiple regulators involved is a process marked by disorder
and confusion.
For example, although regulators have proposed numerous new
rules for derivatives, the CFTC and the SEC have still not
proposed rules that clarify the definition of a swap. This
omission alone has had serious ramifications for our markets
and the implementation process. After all, if regulators do not
know what the definition of a swap is, how can they finalize
their own rules governing swap dealers or major swap
participants since it is unclear exactly who is covered by
these rules? And if market participants do not know if they
will be classified as a swap dealer or a major swap
participant, how can they be expected to know when to submit
comments?
This is just one example of how Dodd-Frank has created a
confused derivatives rulemaking process that is not proceeding
in a logical order and creates significant uncertainty in our
markets.
The regulatory process is further hampered by the fact that
the Dodd-Frank Act was so poorly drafted. Here is just one
example, a simple example that illustrates my point.
One of the first Dodd-Frank rules promulgated by the CFTC
was an interim final rule for ``reporting pre-enactment swap
transactions.'' The stated purpose of the rule is to reconcile
two conflicted Dodd-Frank provisions: Sections 723 and 729.
The CFTC rule proposal specifically states, and I will
quote, ``The inconsistencies between these two reporting
provisions must be reconciled in order to eliminate uncertainty
with respect to the actual reporting requirements for pre-
enactment swaps.'' In other words, our regulators have been
forced to undertake additional rulemaking in an effort to
correct the inconsistencies and errors in the Dodd-Frank Act.
And although I am not sure how rules can alter statutory
requirements, it is clear that Dodd-Frank has some fundamental
flaws and should be revisited.
Today I look forward to hearing how the regulators plan to
improve this broken regulatory process, particularly how they
will consider and incorporate comments from the public.
Make no mistake. The unprecedented scale and scope of
agency rulemakings mandated by the Dodd-Frank derivatives title
make it impossible for regulators to engage in deliberative and
rational rulemaking and still meet the unrealistic deadlines
imposed by the act.
I am also concerned that the regulators are not fully
considering the costs and benefits of the rules and the effect
that these rules could have on our markets and job creation in
the country.
As the American economy continues to struggle, this may be
the most important facet of the current regulatory process. I
think it must not be overlooked.
Thank you, Mr. Chairman.
Chairman Johnson. I would like to welcome and introduce the
witnesses on our first panel:
The Honorable Mary Schapiro is Chairman of the U.S.
Securities and Exchange Commission. Previously, she was CEO of
FINRA. Ms. Schapiro also served as Commissioner of the SEC from
1988 to 1994 and Chairman of the Commodity Futures Trading
Commission from 1994 to 1996.
The Honorable Gary Gensler is Chairman of the Commodity
Futures Trading Commission. Mr. Gensler previously served in
the Treasury Department as Under Secretary of Domestic Finance
and Assistant Secretary of Financial Markets. He also served as
senior adviser to Chairman Paul Sarbanes.
Daniel Tarullo is a member of the Federal Reserve Board of
Governors. Prior to his appointment to the Board, Mr. Tarullo
was a professor at the Georgetown University Law Center. He
served as Assistant Secretary of State for Economic and
Business Affairs as well as Deputy Assistant to the President
for Economic Policy and Assistant to the President for
International Economic Policy in the Clinton administration.
Mary Miller is Assistant Secretary for Financial Markets in
the Department of the Treasury. In that role she advises the
Treasury Secretary on a variety of issues relative to domestic
finance, financial markets, and other important policy matters.
Previously, Ms. Miller worked as director of the Fixed Income
Division for the T. Rowe Price Group and served as a research
associate for the Urban Institute.
Chairman Schapiro, you may proceed.
STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN, SECURITIES AND
EXCHANGE COMMISSION
Ms. Schapiro. Good afternoon, Chairman Johnson, Ranking
Member Shelby, and Members of the Committee. Thank you for
inviting me to testify today on behalf of the Securities and
Exchange Commission regarding the implementation of Title VII
and Title VIII of the Dodd-Frank Act regarding a regulatory
framework for derivatives. It is a pleasure to appear with my
colleagues Chairman Gensler, Governor Tarullo, and Assistant
Secretary Miller.
As you know, Title VII and VIII are intended to bring
greater oversight and transparency to the derivatives markets
and to payment, clearing, and settlement systems and activities
and, with that, to increase the stability of our financial
markets.
While implementing these provisions is a complex and
challenging undertaking, particularly in light of our other
regulatory responsibilities, we recognize the importance of
this task, and we are very committed to getting it right.
These rules are intended, among other things, to reduce
counterparty risk by bringing transparency and centralized
clearing to security-based swaps, reduce systemic risk, protect
investors by increasing disclosure, and establish a regulatory
framework that allows OTC derivatives markets to continue to
develop in a transparent, efficient, accessible, and
competitive manner.
Since passage of the legislation, we have been very engaged
in an open and transparent implementation process, seeking
input on the various rules from interested parties even before
issuing formal rule proposals.
Our staff has sought meetings with a broad cross-section of
interested parties. We joined with the CFTC to hold public
roundtables and hearings, and we have been meeting regularly
with other financial regulators to ensure consistent and
comparable definitions and requirements across the rulemaking
landscape.
To date, the SEC already has proposed a number of security-
based swap-related rules. Among them are rules that would
address potential conflicts of interest at security-based swap
clearing agencies, security-based swap execution facilities,
and exchanges that trade security-based swaps; rules that would
specify who must report security-based swap transactions, what
information must be reported, and where and when it must be
reported; rules that would require security-based swap data
repositories to register with the SEC; rules that would define
security-based swap execution facilities and establish
requirements for their registration and ongoing operations;
rules that would specify information that clearing agencies
would provide to the SEC in order for us to determine if the
swaps must be cleared and specify the steps that end users must
follow to rely on the exemption from clearing requirements; and
rules that establish standards for the operation and governance
of clearing agencies. In addition, with the CFTC, we have
proposed rules regarding the definitions of several of the key
terms within the Dodd-Frank Act.
Our staff also is working closely with the Federal Reserve
Board and the CFTC to develop a common framework for
supervising financial market utilities, such as clearing
agencies, which are designated by the Financial Stability
Oversight Council as systemically important. In the coming
months, we expect to propose rules to establish registration
procedures for security-based swap dealers and major security-
based swap participants and rules regarding business conduct,
capital, margins, segregation, and record keeping requirements
for security-based swap dealers and major security-based swap
participants. We will also propose joint rules with the CFTC
governing the definitions of swap and security-based swap, as
well as the regulation of mixed swaps.
We recognize the magnitude and interconnectedness of the
derivatives market, and so we intend to move forward at a
deliberate pace, continuing to thoughtfully consider issues
before proposing and adopting specific rules and working
closely with our domestic counterparts and international
regulators.
The Dodd-Frank Act provides the SEC with important tools to
better meet the challenges of today's financial marketplace and
fulfill our mission to protect investors, maintain fair,
orderly, and efficient markets, and facilitate capital
formation. As we proceed with implementation, we look forward
to continuing to work closely with Congress, all the
regulators, and members of the financial community, and the
investing public.
Thank you for inviting me to share with you our progress on
and plans for implementation, and I look forward to answering
your questions.
Chairman Johnson. Thank you, Chairman Schapiro.
Chairman Gensler, please proceed.
STATEMENT OF GARY GENSLER, CHAIRMAN, COMMODITY FUTURES TRADING
COMMISSION
Mr. Gensler. Good afternoon, Chairman Johnson, Ranking
Member Shelby, and Members of this Committee. I thank you for
inviting me here today. I am pleased to testify on behalf of
the Commodity Futures Trading Commission, and I also thank my
fellow Commissioners and all of the staff at the CFTC for their
hard work and commitment in implementing the Dodd-Frank Act. I
am pleased to testify along with my fellow regulators Chairman
Schapiro and Governor Tarullo, who I had the honor to be
announced with by then President-elect Obama 2\1/2\ years ago,
so we get to be together, and Assistant Secretary Mary Miller.
We have known each other now for about 15 years, so it is great
to be here together.
The CFTC is working very closely with the SEC, the Federal
Reserve, and other regulators in the U.S. and overseas. We are
coordinating and consulting with international regulators to
harmonize oversight of the swaps market, and we have received
thousands of comments today both before we have made proposals
and after we have made proposals. At this point in the process,
the CFTC has proposed rules in 29 of the 31 areas that the
Dodd-Frank Act required us to do so, including proposing rules
this morning on margin, which, of course, as well the Federal
Reserve and other prudential regulators took up.
Consistent with what Congress did in exempting nonfinancial
end users from clearing, the proposed rule would not require
margin to be paid or collected on transactions involving
nonfinancial end users hedging or mitigating commercial risk.
Over the next several weeks, it is our goal to largely
complete the mosaic of proposed rules by proposing rules
relating to capital as well as the joint product definition
rule along with the SEC and segregation for cleared swaps. And
it is our goal to try to complete that in the next several
weeks.
One component that we have asked the public about is
phasing of implementation. We have not moved to any final rules
yet. The whole mosaic will be out there, but implementation is
very important. The SEC and the CFTC actually earlier today
jointly announced that we would ask the public more on this. We
have asked on every one of our rules, but we want to do it in a
coordinated way. So early in May we are going to hold 2 days of
public roundtables to hear about effective dates and
implementation schedules, which compliance should come later,
which may be earlier, how it should be phased, whether by asset
class, by market participant, or by other characteristics.
We have also put a dedicated comment file up on our Web
site today so that people can comment on this very important
issue.
We will be considering final rules only after staff can
analyze, summarize, and consider comments, after the
Commissioners themselves can provide feedback, and after we can
consult with other regulators not only here but around the
globe.
Before I conclude, I just want to briefly talk about
resources. I appreciate any and all that this Committee did now
that we are going to move forward and get some breathing room
and certainty in 2011 funding. But the CFTC is a good
investment, and it has been asked to take on a much more
significant role than just overseeing the futures marketplace.
The futures marketplace is about $40 trillion in notional size,
maybe about $2.50 to $3 in futures for every dollar in the
economy. But the swaps marketplace that we have been asked to
oversee is $300 trillion in size here in the U.S. Give or take,
$20 of swaps for every dollar in the economy. We share that
role with the SEC, but clearly it is 7 times the futures
marketplace.
We are a good investment, even with what it just looks like
Congress will be recommending this week, $202 million. It is
dwarfed by the size of the financial industry itself, which is
measured in the hundreds of billions of dollars in revenues. So
the President has put forward a plan for us at $308 million
next year. I look forward to working with this Committee and
the appropriators on both sides of the aisle and in both Houses
to see how we can assure that we have the resources to fulfill
the mission.
Thank you.
Chairman Johnson. Thank you, Chairman Gensler.
Governor Tarullo, please proceed.
STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF GOVERNORS OF
THE FEDERAL RESERVE SYSTEM
Mr. Tarullo. Mr. Chairman, Senator Shelby, and other
Members of the Committee, thank you for this opportunity to
provide the Federal Reserve Board's views on the implementation
of Title VII of Dodd-Frank. The Board's responsibilities fall
into three broad areas. The first relates to coordination and
consultation with other authorities, both domestic and foreign.
As to domestic consultation, Dodd-Frank requires that the
CFTC and the SEC consult with the Board on rules to implement
Title VII. In providing comments to the two market regulators,
we have tried to bring to bear our experience from supervising
dealers and market infrastructures and our familiarity with
markets and data sources.
There are also very important international coordination
activities related to derivatives. Most prominently, the Group
of 20, or G-20 leaders, sometime ago established commitments
related to reform of the OTC derivatives market that would form
a broadly consistent international regulatory approach. In an
effort to implement the various portions of that commitment,
the Committee on Payment and Settlement Systems is working with
the International Organization of Securities Commissions to
update international standards for systemically important
clearing systems, including central counterparties that clear
derivatives instruments, and trade repositories.
Even before the G-20 leaders initiative, the Basel
Committee on Banking Supervision had established capital
standards for derivatives. More recently, the committee has
strengthened those standards and has created leverage and
liquidity standards which will be applicable to them.
The goal of all of these efforts should be a level playing
field that will promote both financial stability and fair
competitive conditions to the fullest extent possible. And I
think for all of the agencies represented here today, the
pursuit of this end is going to need to remain a priority for
some time.
The second task given to the Federal Reserve under Title
VII relates to the strengthening of infrastructure. Central
counterparties are given an expanded role in the clearing and
settlement of swap and security-based swap transactions. If
properly designed, managed, and overseen, central
counterparties offer an important tool for managing
counterparty credit risk, and thus reducing risk to market
participants and to the financial system.
Title VII of the act complements the role of central
clearing by heightening supervisory oversight of systemically
important financial market utilities. This heightened oversight
is important because financial market utilities such as central
counterparties concentrate risk and thus have the potential to
transmit shocks throughout the financial markets.
As part of Title VIII, the Board was given new authority to
provide emergency collateralized liquidity in unusual and
exigent circumstances to systemically important financial
market utilities. We are at present carefully considering how
to implement this provision in a manner that protects taxpayers
and limits the rise in moral hazard.
The third task committed to the Board by Dodd-Frank is that
of supervision. Capital and margin requirements are central to
the prudential regulation of financial institutions active in
derivatives markets as well as to the internal risk management
processes of those firms. The major rulemaking responsibility
of the Board and the other prudential regulators is to adopt
capital and margin regulations for the noncleared swaps of
banks and other prudentially regulated entities that are swap
dealers or major swap participants.
The Board and the other U.S. banking agencies played an
active role in developing the enhanced capital leverage and
liquidity regime that I mentioned before. These requirements
will strengthen the prudential framework for OTC derivatives by
increasing risk-based capital and leverage requirements and
requiring banking firms to hold an additional buffer of high-
quality liquid assets to address potential liquidity needs
resulting from their derivatives portfolios.
The statute also requires the prudential regulators to
adopt rules imposing initial and variation margins on
noncleared swaps to which swap dealers or major swap
participants that they supervise are a party.
The statute directs that these margin requirements be risk-
based. In accordance with the statutory instruction, the Board
and other prudential regulators proposed to implement the
margin provisions in a way that recognizes the low systemic
risk posed by most end users. The proposed rule would not
specify a minimum margin requirement. Rather, it would allow a
banking organization that is a dealer or major participant to
establish a threshold based on a credit exposure limit that is
approved and monitored as a part of the normal credit approval
process, below which the end user would not have to post
margin.
Finally, I would note that the proposed regulation provides
that the margin requirement should be applied only to contracts
entered into after the new requirement becomes effective.
Thank you for your attention.
Chairman Johnson. Thank you, Governor Tarullo.
Assistant Secretary Miller, please proceed.
STATEMENT OF MARY J. MILLER, ASSISTANT SECRETARY FOR FINANCIAL
MARKETS, DEPARTMENT OF THE TREASURY
Ms. Miller. Chairman Johnson, Ranking Member Shelby, and
Members of the Committee, thank you for inviting me to testify
today about Treasury's role in implementing Dodd-Frank's
derivatives provisions.
As you know, the President signed the Dodd-Frank Act into
law almost 9 months ago. The act established a framework for
the country to build a stronger, safer, and more competitive
financial system. It creates safeguards to protect consumers
and investors, end taxpayer bailouts, and improve the
transparency, efficiency, and liquidity of U.S. markets. The
derivatives provisions are a critical part of that framework,
and the Administration strongly supports them. Dodd-Frank's
derivatives provisions will shed light on a market that
previously operated in the shadows. Central clearing, trade
execution, and reporting requirements and business conduct
standards will provide substantial benefits. The work that the
Administration is undertaking in partnership with our
colleagues at the CFTC, SEC, and Federal Reserve Board is vital
in preventing the harmful buildup of risk that contributed so
greatly to the financial crisis in 2008.
As other Treasury officials have previously testified,
several broad principles guide our implementation efforts.
First, we are moving quickly to meet the statute's deadlines,
but we are also moving carefully to make sure that as we
implement the act we get it right.
Second, we are bringing transparency to the process so that
as many stakeholders as possible have a seat at the table, the
American people know who is at that table, and anyone who wants
to provide input on requests for comment and proposed
rulemakings can do so.
We are creating a more coordinated regulatory process. The
Financial Stability Oversight Council is playing a key role by
bringing together the financial regulatory agencies to help
develop consistent and comparable regulations and supervisory
regimes.
Fourth, we are building a level playing field by setting
high standards in the United States and working diligently with
our international counterparts to follow our lead.
Fifth, we are crafting rules of the road that will provide
U.S. investors and institutions the conditions they need to
invest capital, develop innovative products, and compete
globally.
Finally, we are committed to regularly keeping Congress
informed about our progress. The Treasury Secretary has
specific statutory responsibilities with respect to derivatives
implementation and also has other responsibilities in his
capacity as the Chairman of the FSOC.
Starting with the specific, Congress gave the Secretary the
authority to determine whether foreign exchange swaps and
forwards should be exempt from the definition of swap in the
Commodity Exchange Act. The Secretary must consider the
statutory factors set forth by the Dodd-Frank Act, including
the impact regulating FX swaps and forwards swaps under the CEA
would have on systemic risk and financial stability; the
existing regulatory regime and supervision of FX swaps and
forward participants; and, finally, whether an exemption could
lead to evasion of other regulatory requirements.
We published a request for comments to solicit public input
on a wide range of issues relating to a potential exemption. We
received 30 comments in response, and Treasury staff has also
conducted an independent analysis, including extensive
discussions with a range of interested parties.
We know that market participants, other stakeholders, and
the Committee are closely following this issue. Regardless of
the decision the Secretary makes, market participants need to
be able to prepare for it. While we intend to move
expeditiously, it is also critical that we take enough time to
make the right decision for the safety and soundness of the
markets.
The Secretary also has derivatives implementation
responsibilities in his capacity as FSOC Chairman. The FSOC
recently approved the publication of a Notice of Proposed
Rulemaking regarding the designation of systemically important
financial market utilities. FMUs support and facilitate the
transfer, clearing, and settlement of financial transactions,
and they form a critical part of the Nation's financial
infrastructure. The notice was published on March 28th and will
be open for comments for 60 days.
One final area I would like to touch on is the importance
of comparable international standards, including derivatives
oversight. The United States will set high standards, but
today's financial system is highly interconnected, mobile, and
global. We must work not only to protect the competitiveness of
U.S. financial markets but also to ensure that the reforms we
implement here are not undermined by lax standards elsewhere.
We will continue to work at home and abroad to build a
regulatory framework for derivatives that will help our
financial system become safer and sounder and a platform on
which we can build strong financial markets that will fuel our
economic growth.
Thank you.
Chairman Johnson. Thank you, Assistant Secretary Miller. I
will start off the questions. Thanks for your testimony.
I will remind my colleagues that we will keep the record
open for statements, questions, and any other material you
would like to submit. As we begin questioning the witnesses, I
will put 5 minutes on the clock for each Member's questions.
Chairman Schapiro and Chairman Gensler, how do you plan to
reconcile the different SEC and CFTC proposed rulemakings
governing swap execution facilities, real time reporting, block
trades, and other infrastructure consistent with Dodd-Frank's
requirement to assure regulatory consistency and comparability
and treat functionally or economically similar products or
entities in a similar manner?
Ms. Schapiro. Mr. Chairman, I would be happy to start. We
are very, very focused, obviously, on the issues surrounding
the fact that in a number of areas, and you just articulated
several of them, we do have differences in our rule sets
between the SEC and the CFTC. Some of those differences may
actually be necessitated by the fact that the markets, while
they are both derivatives markets, the products may trade
differently, have different liquidity characteristics, and for
that reason, some differences may actually be appropriate in
order to continue to foster the development of these markets.
But we have asked for comment on whether our understanding in
that regard is correct.
But I would also say that we are continuing to work
extremely closely together through the proposing stage, and now
that for a number of rules comment periods have closed, we were
able to review the comments that have come in on our proposals
as well as those that have come in on the CFTC's proposals
where they have gone in a slightly different direction and we
are very committed to continuing to work through those
differences, and if they are not grounded in very good market
structure reasons because of the nature of the products, trying
to get them as consistent as we possibly can.
Where we have proposed after the CFTC, I would just add, on
some rules, we have actually sought explicitly to get comment
on their approach to see if that might be a better way to go
forward. So in a number of areas where we do have differences,
I believe because we are still at the proposing stage and not
at the adopting stage, we will be able to work through many of
those differences. And then, of course, through implementation,
it may be necessary for either or both of us to engage in some
interpretation of our rules in order to ease implementation and
make them consistent.
Mr. Gensler. I will keep it brief. I agree with what
Chairman Schapiro said. It is a lot of consultation and
coordination. It is also in the context of there are some
differences between the futures marketplace and the securities
marketplace that either have existed in statute or in rules or
just in market practice for decades, and so we are trying to be
as close as we can between swaps and securities-based swaps
while also not creating some regulatory arbitrage and undercut,
for instance, in our case, a futures marketplace that has
worked with a great deal of transparency and low risk to the
American public, and not undercut that marketplace through some
differences, as well. And I suspect the same issues on your
side.
Ms. Schapiro. If I could just add, it is critically
important to us, as well, that because securities-based swaps
can be economic equivalents to equity positions, that we want
to make sure that we do not create, while we are trying to be
more and more synched up with the swaps markets, between the
security-based swaps and swaps markets, that we are not
creating great distance between the security-based swap markets
and the equity markets, as well.
Chairman Johnson. Assistant Secretary Miller and Governor
Tarullo, how are Treasury and the Fed working to harmonize
international derivatives regulations through the G-20 and the
Financial Stability Board, especially given the different
international time frames for moving ahead on new rules? How
are your efforts in this area being coordinated with the CFTC
and the SEC to be sure that requirements for capital and other
rules are both appropriate and consistent?
Ms. Miller. Well, we are following this very closely,
because as I said, we are very interested in having good
harmonization globally on these rules. So in many settings,
Treasury staff are engaging with their counterparts in
different international groups. There are a number of working
groups on derivatives that are occurring through the Financial
Stability Board in Europe. We are also interested in things
that are going on in Asia. So we are following both the
rulemaking process in the U.S. and we are engaging regularly
with our counterparts in other countries.
Mr. Tarullo. Mr. Chairman, let me add a couple of thoughts
there. As you can tell from the testimony today, the other
rulemakings that the SEC and the CFTC have ongoing, dealing
with the international equivalents of Title VII and Title VIII,
are going to implicate a number of different regulatory
authorities in other jurisdictions.
So I think what was looked for by the G-20 was a framework
of agreement or commitment on a set of goals that would then be
pursued in the various appropriate international bodies. What
we have got now, I think, is a good bit of very productive work
on efforts to get agreement on central counterparties, on
electronic trading, on transparency for those counterparties,
on risk management standards. That is being done, I think,
through a lot of cooperation among agencies, but in particular,
the Fed and the SEC, because, in fact, we have got a Reserve
Bank President and a Commissioner of the SEC who are chairing
the key international committees on this point--President
Dudley of the New York Fed and Commissioner Casey of the SEC.
On capital, as I said in my prepared remarks, the Basel
Committee on Banking Supervision has a set of capital
requirements for derivatives in a part of its overall
internationally recognized capital standards. They have been
updated to take account of what was learned during the crisis,
but they are already agreed among all the Basel Committee
members, which constitutes not just the G-20 but some
additional countries beyond the G-20.
I think the one area where we probably need some more work
now is on margins for noncleared derivatives and noncleared
swaps. I think the fact that we, the prudential regulators and
the market regulators are now moving toward a proposal for the
U.S. is going to enable us to have a clear, coherent, and
unified position internationally to try to move along some
other countries which are actively, or in some cases not so
actively, considering putting these requirements in place.
With respect to coordination, I think it has been very
good. As you can tell from just my recitation of the different
committees, we need to have everybody involved because there
are different expertises here, and from all accounts that I get
from our staff and directly from talking to principals at other
agencies, I think this is one area where the convergence of
views and the cooperation among U.S. agencies has been quite
good.
Chairman Johnson. Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Assistant Secretary Miller, on our second panel today, we
will hear from the Treasurer of FMC, a large manufacturing
company here in the U.S., who has grave concerns, according to
his testimony, about the excessive regulations mandated by
Dodd-Frank. His testimony indicates that these regulations will
increase operating costs, making it more difficult for his
company to both create jobs and to manage risk. Do you believe
that FMC Manufacturing Company, the end user, is the type of
company that should be regulated under Dodd-Frank, and does
Treasury have any concerns about the potential consequences of
Dodd-Frank derivatives regulation on job creation? Have you
done any work in this area?
Ms. Miller. OK. Thank you for the question. We have heard a
great deal from end users, nonfinancial and financial in the
markets, and I think that there is sufficient flexibility in
the Dodd-Frank legislation to work with a company like FMC in
terms of providing flexibility under derivatives regulation.
Senator Shelby. In other words, a company that is an end
user that is managing risk but not in the pure financial
speculation, is that right?
Ms. Miller. Yes. We have not done any specific work on the
economic impact on job creation of this particular title.
Senator Shelby. Will you do some research, have Treasury do
some research into that area?
Ms. Miller. Well, we have worked----
Senator Shelby. Because this could have ramifications for
creating jobs, could it not, if it is----
Ms. Miller. There were many studies mandated by Dodd-Frank
and we have been diligently delivering the work that has been
delivered under the statute. So we have put out quite a bit on
the financial market ramifications.
Senator Shelby. Foreign exchange swaps and another area.
Treasury is charged with determining whether foreign exchange
swaps and forwards should be subject to extensive Government
regulation. In your testimony today, you stated that, quote--I
will quote you--``we want to move expeditiously with respect to
making the determination that the treatment of foreign
exchange--about the treatment of foreign exchange and swaps.''
When will Treasury make its determination, in your judgment?
Ms. Miller. So I regret that I do not have that decision to
give you today for the hearing. I think we are very close. We
have been working on that----
Senator Shelby. Would you furnish that for the record and
the other Committee Members when you get it?
Ms. Miller. We absolutely will, and we would be delighted
to come up and brief you on our decision either way.
Senator Shelby. Are you at Treasury aware of any market
failure in the foreign exchange market that would justify
further regulation?
Ms. Miller. There are many parts of the foreign exchange
market. The FX swaps and forwards part that you just mentioned
is one part of the foreign exchange market----
Senator Shelby. Are you aware of any failures in that area
that would justify further regulation?
Ms. Miller. I think there are many parts of that market
that were under severe stress during the financial crisis and
some parts of it will be subject to Dodd-Frank regulation.
Senator Shelby. To your knowledge, were any of the areas in
derivatives where you are managing risk and you are an end user
under extreme stress? I do not know of any.
Ms. Miller. I would be happy to reply to that question with
further research if you want specific examples----
Senator Shelby. Will you do that for the record?
Ms. Miller. Sure.
Senator Shelby. OK. Governor Tarullo, central
clearinghouses is an area which is very important. Last week,
Chairman Bernanke of the Federal Reserve gave a speech about
the importance of properly regulating clearinghouses. He noted
that one of the reasons that clearinghouses have not had
trouble to date is, quote, ``good luck.'' We cannot always
count on good luck, as you know. Beyond relying on luck, what
steps can we take, or can you take, to ensure that taxpayers
are never called upon to bail out clearinghouses because that
was a concern of a lot of us when we were debating the Dodd-
Frank legislation, as you will recall.
Mr. Tarullo. Right. I do recall your questions on that
topic, Senator, a year or two ago. So with respect to the
central clearing parties that are designated as systemically
important, there will be oversight by the appropriate market
regulator, but the Federal Reserve has a role to play there as
well. We have a consultative role. We hope to be involved in
the exams, bringing to bear, if I can put it this way, a
supervisory or prudential supervisory perspective on these
institutions. So we would hope that they will all be subject to
strong prudential requirements for credit risk, strong
liquidity buffers----
Senator Shelby. What does ``hope'' mean? Now, you said you
would hope----
Mr. Tarullo. The mechanism here is one--the primary
regulators are the market regulators.
Senator Shelby. I know. We know.
Mr. Tarullo. We have a consultative role----
Senator Shelby. Oversight role.
Mr. Tarullo. We have an oversight role, that is correct,
and in that capacity, I think we will hope to contribute to the
perspective on the supervision of these organizations. I
suspect that there will be convergence among the agencies on
the kind of standards that are important, and, as I said, I
think we are going to draw on our experience not just with
market entities, which we do have, but also supervising from a
prudential point of view, looking to safety and soundness and
not simply market operations.
Senator Shelby. In the same type area, the United Kingdom's
Financial Services Authority wrote a comment letter in response
to a rule proposed by the CFTC on risk management requirements
for clearinghouses. The FSA, the United Kingdom's Financial
Services Authority, warned the CFTC that lax eligibility
requirements for firms to be members of clearinghouses could
create new risk to the financial system. Do you agree with
FSA's comments, or are you concerned about that, too?
Mr. Tarullo. Senator, I have not seen the FSA comment on
the proposed CFTC rule. I would say that an effective member
qualification and default set of standards is very important to
the integrity of any central clearing party.
Senator Shelby. Should not you or we, we altogether, should
not we do everything we possibly can do to ensure that there is
no bailout of a clearinghouse?
Mr. Tarullo. Absolutely, Senator. I think that is why we
all, everybody up there, everybody at the table here, share an
interest in having rigorous and effectively enforced standards
for the central clearing parties.
Senator Shelby. Can I get Chairman Gensler's comments on
that, because that is in his area.
Mr. Gensler. It is a big yes. I think that central
clearinghouses need robust oversight. I view it as a
partnership with the Federal Reserve, even we might be the
front line and, of course, the SEC has their clearinghouses, as
well. I think they should not have central bank liquidity,
though Dodd-Frank did allow for it in emergency exigent
circumstances when the Secretary and the Board of Governors
decide that. But I think that should be an absolute rare
occurrence. It should not happen.
Clearinghouses have not failed in this country. We have
survived two World Wars and we have survived great crises. I
think the clearinghouses have to have collection of margin.
They have to have it on a daily basis. They have to be able to
have proper default management and so forth----
Senator Shelby. They have to make sure everything clears,
do they not?
Mr. Gensler. They absolutely have to make sure everything
clears, and that which clears has available pricing, available
liquidity. And I think also with regard to the comment letter
that you referred from the----
Senator Shelby. From the U.K.----
Mr. Gensler. ----from the U.K., it is very important that
these clearinghouses have open membership, that the access to
the clearinghouse is not just so narrow--clearinghouses have
greater risk if it is only narrow membership. But if it is
broadened out, markets work best when they are open and
competitive.
Senator Shelby. Since there are international implications
to derivatives and derivatives trading and everything, should
we not listen to our counterparts in Europe, like the United
Kingdom and FSA and others who have similar concerns that we
should have?
Mr. Gensler. Absolutely, and we are listening. We are
consulting with sharing all our drafts, our term sheets, our
memos with not just the FSA, but ESMA and the European
Commission and the like. So their comment is very helpful, but
we also believe that membership should be opened up, but the
smaller members can only scale into that membership and not be
like the large members. Right now, the clearinghouse they are
thinking about has sort of an exclusive club deal and I think
Congress spoke to that in the statute, saying there is supposed
to be open access.
Senator Shelby. Yes. Exclusive clubs are dangerous things
sometimes.
Mr. Gensler. Yes, and that is what occurs in swaps clearing
today, not in futures clearing. Futures clearing is much more
open. Securities clearing is much more open. Swaps clearing
today has been more exclusive, but Dodd-Frank actually said it
had to be more open and competitive.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Johnson. Senator Reed.
Senator Reed. Thank you very much, Mr. Chairman.
Let me begin by associating myself with the comments
Senator Shelby made about the utility of clearing platforms to
dissipate the risk vis-a-vis bilateral transaction, but the
inherent danger of not-well-regulated trades create, and I know
everyone at this table is acutely focused on that and I urge
you, as Senator Shelby did, to keep your focus on that issue.
But Secretary Miller, following up on another line of
questioning of Senator Shelby about forex contracts, were these
contracts part of the Lehman bankruptcy, i.e., were there
losses incurred when Lehman failed because they could not
fulfill forex contracts, and would those losses have been
avoided if the contracts were traded or cleared?
Ms. Miller. There were open contracts with Lehman Brothers
when they failed. Those contracts were settled, so they were
able to be settled.
Senator Reed. And they were settled how?
Ms. Miller. A large number of them moved through a payment
versus payment settlement system. I cannot give you the precise
percentage that were settled that way, but it is my
understanding that all of the open contracts through Lehman
Brothers were settled.
Senator Reed. Governor Tarullo, did the Federal Reserve in
any way support the forex market during the months, the late
months of 2008?
Mr. Tarullo. Well, it was not support for the foreign
exchange market as such, Senator. There was liquidity provided
in the form of dollar liquidity, both through the discount
window directly to institutions operating in the United States
and to central banks of some other countries. But this was not
in pursuit of settling foreign exchange swaps. This was as a
byproduct of the general liquidity squeeze that----
Senator Reed. But part of their exposure was the foreign
exchange contracts?
Mr. Tarullo. I do not think it was--I think it was much
more a funding problem, a dollar funding problem. It was not a
matter of failing on a contract but not having access to
wholesale funding in dollars when you had obligations in
dollars.
Senator Reed. But there is a possibility, if these
contracts are exempt, that there could be another situation
where--a liquidity freeze where it is not a question of
settlement, they just cannot get the money to settle, and the
Fed is prepared or will enter into supporting this sector?
Mr. Tarullo. Well, Senator, under Dodd-Frank, we are not
permitted to offer institutions specific assistance except
obviously for the discount window or through the FMU provisions
here. I think--and Secretary Miller alluded to this--I think
most people who have studied this issue think that the problems
in the foreign exchange market have largely concentrated on
settlement. There is a quite short duration of most forex
forwards. As you may know, all the international work on
foreign exchange transactions began after the 1974 failure of
Herstatt Bank, which produced these kinds of settlement
problems.
So I think that is where most of the attention has been
focused, and today, there are, I would not say perfect or all
comprehensive mechanisms for making sure that foreign exchange
transactions settle, but there has been a substantial amount of
improvement over the last 36 years.
Senator Reed. I have approximately a minute and a half, so
Governor Tarullo, you can explain to me the interaction between
the capital requirements of the Volcker Rule for companies that
have derivative activities and Basel III and the general
prudential guidelines for capital that you are developing for
financial security, and the clock is ticking.
[Laughter.]
Mr. Tarullo. So, I am sorry, what are the three areas
again?
Senator Reed. Under Dodd-Frank, the Volcker Rule has some
specialized language with respect to companies, financial
companies trading derivatives. There is also the Basel III
requirements that talk about derivatives. And then there is
just the general prudential safeguards for capital that the Fed
can insist on a case-by-case basis----
Mr. Tarullo. Oh, sure.
Senator Reed. ----a general basis. So in your mind, are
these separate categories, or does this blend into one sort of
gut feeling about how much capital a company should have?
Mr. Tarullo. Well, now it is not going to be a gut feeling.
There will be an analytic backdrop for it, and I think there
already is. We devoted a lot of attention even before the Basel
III process to improving the market risk part of the general
capital standards and derivatives were one of the focuses for
attention, including important upgrades to counterparty risk,
evaluation and capital set-asides, and also to making sure that
you stressed the potential exposures as opposed to just a
random test through a normal market environment.
I think with respect to any capital authority that we have,
our aim will be to have a set of rules, backstopped by specific
supervisory oversight, which ensure that those activities are
not creating risk to the institution that does not have an
adequate set-aside. That is what existed in the precrisis
period. There were opportunities for arbitrage that were
readily taken by firms. I think there was inattention to
counterparty risk, both at the firm level and among regulators.
Those are the kind of changes that need to be put in place, and
those are the kind of changes that are in the rules that we are
promulgating under Basel III but with an eye to the specifics
of a firm, not just to sort of a gut feeling about that firm.
Senator Reed. Thank you, Mr. Chairman. Thank you, Governor.
Thank you, Mr. Chairman.
Chairman Johnson. Senator Corker.
Senator Corker. Thank you, Mr. Chairman, and I thank all of
you for being here, as usual.
I think the notion of a clearinghouse was something that--
or focusing on clearing trades was something that was very
bipartisan in nature. Obviously, you move into details and
there ends up being some differences, especially on the end
user piece. But for what it is worth, among market
participants, and we, obviously, like you, are talking to many
among those on the buy side and the sell side, and those who
strongly supported Dodd-Frank and those who obviously oppose
it, I think there is a concern about the rapidity that these
rules are being put in place and even more so on their
prescriptive nature, OK, and just being overly prescriptive.
So with that, Mr. Gensler, I am going to focus on a few
things with you. I noticed that people have to have five quotes
now, for instance. Even a large institutional trader that might
have a relationship with one institution has to have five
quotes, and I am wondering, who is it you are trying to help or
save, or what is the point behind that?
Mr. Gensler. Senator, I think you are referring to the swap
execution facility----
Senator Corker. That is right. That is right.
Mr. Gensler. ----in the proposed rule, and in that regard,
Congress said that those transactions that are cleared and made
available for trading would be brought to swap execution
facilities. That is a mandate and it is transparency. Congress
in the statute said that it would be to promote pretrade
transparency.
These are trades that are not large blocks. The blocks are
excepted. So it might be a $5 or $10 million trade, not a $500
million trade, and it is one that is cleared so it is
anonymous. There is no credit risk.
On those trades, what Congress suggested we do and what we
think we are doing in the rule is promoting transparency where
multiple participants have an ability to execute against other
multiple participants. In the futures marketplace, when a
request for quote goes out, it goes out to the whole
marketplace. It does not even go just to five. It goes out to a
broader group in the marketplace, and the quotes that come back
in are seen by the marketplace. So there is far more liquidity.
What we are proposing is actually less transparency than the
futures marketplace.
Senator Corker. So on the large block trades, they are
excluded----
Mr. Gensler. They are excluded.
Senator Corker. ----and do you think this was something
wise that we asked you to do, just briefly, yes or no?
Mr. Gensler. Yes.
Senator Corker. OK.
Mr. Gensler. Yes.
Senator Corker. The real-time reporting, I noticed you have
come up with a 15-minute time frame. I am just curious about
what was magic about that. I know numbers of people think that
is not long enough, especially in larger transactions.
Mr. Gensler. Well, I am glad you asked. Congress said that
real-time reporting after the trade should be as soon as
technologically practicable on the smaller trades, and then on
the blocks, we could have a delay. So we looked at what delay
do we have in the futures marketplace. It is about 5 minutes
now. We proposed 15 minutes if it is on a swap execution
facility. If it is bilateral, we asked a lot of questions and
sought comment. In the securities world, Chairman Schapiro
could speak better, but I think their delay is 90 seconds now.
So we looked at this and said it is three times the futures
world, about ten times the securities world. We are going to
get comments. The proposal will change once we get to a final
rule, but that was the thinking.
Senator Corker. So on the larger trades, it may be much
longer. It may be end of day. It may be something----
Mr. Gensler. Well, I----
Senator Corker. ----the block----
Mr. Gensler. The larger trades that are on a swap execution
facility, we proposed 15 minutes.
Senator Corker. Right.
Mr. Gensler. If it is a bilateral, we did not propose a
specific time. We just asked a lot of questions.
Senator Corker. And is it your vision--a lot of people
think that it is, so I will give you that editorial comment,
but do you think the derivatives market and equity markets
should be very similar when you finish all of these activities?
Mr. Gensler. I think that markets work best when they are
transparent, open, and competitive, and those three core
factors, whether it be futures or securities, or derivatives,
ultimately help end users, investors, and I think it helps the
economy grow. It does shift some of the information advantage
to the tens of thousands of users away from the most
sophisticated----
Senator Corker. So that is a yes?
Mr. Gensler. I think it is a yes----
Senator Corker. I think there are a lot of concerns because
people view the two instruments as being very different and I
think there is some concern out there that that is your vision
and it is not taking into account the differences between the
instruments.
Mr. Gensler. Senator, I think you asked about equities and
derivatives and we regulate futures. I think markets work best,
whether they are futures, equities, or swaps, when they are
transparent. When they are competitive, people get the benefit
of that competition in contrast to a closed or dark market.
Senator Corker. If derivatives are moving out to electronic
platforms, is there any concern about a growth of high-
frequency trading taking place in that area?
Mr. Gensler. It is something that captivates our commission
every day in the futures marketplace, when 85 to 90 percent of
the marketplace is now electronic. It is something that we
think is very much on our mind as we think about regulation in
the swaps marketplace.
Senator Corker. And we look forward to having you in our
office, and I am sorry we have not.
If I could ask one more question to Mr. Tarullo or Ms.
Miller, either one, you know, we had a lot of discussions, I
remember, in the hearing room when Mr. Volcker came in and
started talking about the Volcker Rule, sort of a flower in the
middle of regulation. It ended up being a part of Dodd-Frank.
And I am out, as I know all of you are, and certainly my
colleagues. We talk with banks throughout our country, small
community banks and others, about the Examiner in Charge, and
the Examiner in Charge that comes into their institution,
basically, their attitude, their understanding of whatever
regulator it is they are working with changes pretty
dramatically how their bank's status is interpreted, OK. The
Examiner in Charge is basically king.
As you look at the Volcker Rule, again, Mr. Volcker, who I
respect greatly and I think everybody up here does, could not
really describe to us what propped trading was. You just know
it when you see it. How are you all going to sort of
institutionalize the whole Volcker issue when, again, you have
these examiners, EICs, that are out amongst these various
institutions that have judgment? I do not see how you do that
properly and I would love to have any help with understanding
that.
Mr. Tarullo. Senator, I think there are a couple of things.
First, when you are talking about 7,000 financial institutions
as you are with some of the very basic prudential standards,
the balance is always as between allowing for the local
knowledge of the examiner-in-charge, because he or she is going
to understand the institution they are in better than anybody,
on the one hand, and on the other hand, assuring a consistency
in treatment across everybody in the United States because
people deserve that.
When it comes to something like the Volcker Rule or a
number of the other provisions that we are talking about, you
are almost surely dealing with a much smaller subset of
institutions, and I think there, the kind of horizontal
approach to regulation and supervision that we have been taking
with respect to larger institutions is going to be particularly
important.
So once we, the prudential regulators, come up with the
regulations to implement the Volcker Rule, we are going to have
to have a coordinated and coherent and unified approach to
implementing and overseeing the implementation of that rule,
and I would expect that as we have already done with some of
our activities over the last couple of years, beginning with
the stress tests in early 2009, we will have a process
internally to make sure that these things are being implemented
consistently, that the CPC teams, the leads of the teams that
are in place in the large institutions, have a common framework
of knowledge and training, and that we are making sure that the
regulatees have an opportunity to come to us, that is to the
Board, and to say, we are uncertain about what is going on here
or we are not sure we are being treated the same way.
So I think will it be a task? Yes. Will it be more
difficult, I think, than a lot of the other supervisory tasks
that we have now? I do not think so. That is not to understate
the attention it is going to require. But once we get those
rules in place, I think we do have a mechanism for making sure
they are applied in a consistent fashion--that people have
recourse to come to the Board to ask about the interpretation
of a rule.
Senator Corker. Thank you, Mr. Chairman.
Chairman Johnson. Senator Brown.
Senator Brown. Thank you, Mr. Chairman, and thank you, all
four of you, for your work on Dodd-Frank and getting the
legislation passed. Passing this bill last July in so many ways
was only the beginning of the effort to impose transparency and
accountability and unregulated in the opaque and unregulated
derivatives markets. It is pretty clear in newspaper reports
that the opponents of transparency and the opponents of
oversight lost the first fight, but they are working on budget
issues to try to restrict a lot of the things that you are
trying to do and trying to handcuff your efforts.
Just listening to your testimony today and looking at the
magnitude of the regulatory effort that you are undertaking I
think really illustrates the importance of that, so thank you.
Chairman Gensler, my questions are directed at you. I sent
a letter to you back in January about gas price speculation and
the importance of the CFTC's position limits rules in curbing
excessive speculation. I am concerned that excessive
speculation can once again perhaps seriously hurt our economy.
Every time there is a pipeline outage or a refinery fire or
trouble in the Middle East, it seems that one reaction of that
is speculators and oil companies move in to spike prices up,
using that as a typical excuse for that happening.
The Commodity Markets Oversight Coalition, a group of
commercial end users, pointed to 57 studies conducted in the
last 5 years showing the role of speculation in driving up
asset and commodity prices. In the 1990s, speculative interest
in commodities was about 15 to 30 percent typically. Today it
is closer to one-half to two-thirds of the market. Financial
companies account for over 51 percent of crude oil futures, an
increase of 5 percent just in the last month.
We know what this means to our economy potentially. We know
what it means to individual motorists, to small businesses
operating on small margins to truckers, to so many others. And
we have seen what speculation can do, similar price increases
in other commodity markets.
Last week, the CEO of Starbucks said financial speculators
have come into the commodity markets and drove those prices up
to historic levels, and as a result of that, the consumer is
suffering.
Chairman Gensler, talk to us about financial speculation,
its effect on prices, and then answer this question, if you
would. What authority under Dodd-Frank do you have now to
combat speculation? What do you need from us in terms of
additional tools to carry that out?
Mr. Gensler. Hedgers meet speculators in marketplaces. From
the earliest days in the derivatives marketplace, a farmer
planting corn or wheat or soy wanted to hedge a price and lock
in that price at harvest time, and it was generally a
speculator who was on the other side to assure that price.
When our agency's predecessors were formed, it was to make
sure that markets were transparent; a hundred percent of the
market had to come to a marketplace. Transparency is so
important, and it is important that we have the tools, legal
and other tools, to combat fraud and manipulation. Position
limits were part of that toolkit that we were given in the
1930s.
In Dodd-Frank, that was expanded. It was expanded not just
to be futures but also for economically equivalent swaps.
We are not a price-setting agency, but our agency is to
ensure that markets have a certain basic integrity, you can
have confidence in them, and they are not so concentrated. You
are accurate that speculators, if you might say, somebody who
is not in the physical marketing channel, somebody who is not
producing or using the oil or natural gas or the corn or wheat,
are a large part of the marketplace. They are well over half of
the marketplace usually in different parts of the market
statistics will show. We put these statistics out every Friday.
They are public.
So what we need to do, I believe, is complete a rule on
position limits. Position limits have been in place in the
agricultural products for decades and were in the energy
products in the 1980s and 1990s. We have a rule out and that
the comment period just closed. We actually got--and I
misstated it in my written testimony. We got 11,000 comments on
this position limit rule, on the energy and agricultural
limits. So we are going to need to sort through that. We are
going to take a number of months. That is a lot of comments to
sort through. Many of them are repetitive.
To your question, we also need to promote transparency in
this marketplace. I think the more transparent, the more market
participants can see the aggregates as well as the pricing,
that is a very important thing. And I think we need resources,
if I might say. This small agency I think is a good investment
to ensure the integrity of these markets.
Senator Brown. Thank you.
Chairman Johnson. Senator Toomey.
Senator Toomey. Thank you, Mr. Chairman, and thank you very
much to all of you for testifying.
I just cannot help but make one brief observation, which
is--gosh, it is just amazing to me. I have here in my hand the
CFTC rule on position limits for derivatives. It looks like it
is about a 4-point font. It is 25 pages long. And according to
CRS, Dodd-Frank calls for 330 rules.
It is not a criticism of this particular rule, but it
strikes me as an incredible cost to the financial institutions
that have to understand these, digest these, hire the manpower
to then comply with these. And it strikes me as something that
could approach a miracle if they are all perfectly consistent
and compatible and operate exactly as intended with no
unintended consequences. This is really a very, very difficult
undertaking, it seems to me, an enormous cost to the financial
institutions to comply with. I suppose the very large ones will
be able to afford it. Smaller ones, I am not so sure.
I would like to follow up with a question on the position
limits, Mr. Chairman, if I could.
One is my understanding of Dodd-Frank, which passed before
I got here, but my understanding is that the bill does provide
some flexibility in terms of how you go about imposing position
limits. And my further understanding is that thus far the
European regulators have not promulgated any rules whatsoever
regarding position limits.
Is there a danger that if we go ahead and impose position
limits and they do not, we simply have a migration of business
to other venues? Are you concerned about that at all?
Mr. Gensler. We are working closely with the European and
Asian regulators. I think capital and risk do not know any
geographic boundary, so whether it be position limits or other
rules, Senator, that is something that we are very conscious
of.
On position limits, I think after numerous hearings,
starting probably in 2007 and 2008 in the House and the Senate,
our authorities were not only broadened to include economically
equivalent swaps, but also something very important, the
exclusion from those position limits, called bona fide hedging,
was narrowed a bit. So we take congressional direction on this
as well.
Senator Toomey. I understand that, but are you concerned
that in the absence of comparable European regulation that we
have the opportunity for regulatory arbitrage across borders?
Mr. Gensler. I would have to say yes, but not just with
regard to position limits. That is why we have been so active
in Europe and elsewhere to try to harmonize where we can. But
in terms of position limits, what we are looking at in the
proposal is about futures and options on futures, where we have
set them for decades in agriculture. We did in energy in the
1980s and 1990s along with the exchanges, and the exchanges
took the lead. And it is looking to reimpose those, and we are
benefited because, as I said, we have 11,000 public comments in
the file right now. So this is one that the public is very
engaged in.
Senator Toomey. Well, I am concerned about this apparent
developing disparity between the regulatory regimes.
Another quickly question, if I could, on the real-time
reporting. We had a little discussion earlier about speculators
and the fact that speculators--and I completely agree with your
observation. Speculators provide a great deal of liquidity. It
is often the case that speculators also need to have a certain
amount of anonymity, and while transparency has many virtues
and can be very important, sometimes anonymity is important,
too.
My understanding is--and maybe you could correct me if I am
mistaken--that the CFTC's 15-minute disclosure requirement is
different than the SEC, which has a longer period of time
before a comparable transaction has to be disclosed. So is
there a difference between the two?
Ms. Schapiro. There is, Senator, a difference with respect
to block transactions, the larger transactions, which are the
ones that would give rise to the concern about whether too much
information was being revealed that might allow somebody to run
ahead of the hedge, for example, on the block.
Senator Toomey. Right.
Ms. Schapiro. We have not actually proposed yet standards
for how we will define a block transaction. We have asked for
comment on that, and then we will propose some specific
standards. But we have said that while we would recommend
disseminating the price of the transaction in real time, the
size of the transaction would not be disseminated for as long
as 8 to 26 hours after the transaction.
Senator Toomey. OK. And, Mr. Gensler, would your goal be to
have a harmonization with respect to the SEC's approach?
Mr. Gensler. We are working very closely together, not just
on real-time reporting, but to try to bring them together as
much as we can. Of course, there are differences in the
underlying markets. There are differences between futures and
securities, and the interest rate market, which is a vast and
large market, is different than the credit default swap market,
which is largely over at the SEC. So there will still be some
differences, but whether it be on the block role, the real-time
reporting role, the swap execution role, we are looking to try
to get as close as we can, but also respect that there are some
gaps between the underlying futures and securities markets.
Senator Toomey. Well, thank you very much. I see my time
has expired.
Thank you, Mr. Chairman.
Chairman Johnson. Senator Moran.
Senator Moran. Mr. Chairman, thank you very much.
Chairman Gensler, I would like to discuss the core
principles issue with you. First of all, I would say just
generally the complaint I get from the futures industry is that
the CFTC is working at such a furious pace. Difficult to keep
up with your rulemaking. I think there are 60 rulemaking
procedures ongoing. Difficult to conduct business and continue
to comment on the things that are happening at the CFTC. But
more troublesome to me is the implementation of a provision in
Dodd-Frank that seems unnecessary to me, and that is that the
CFTC has operated under a core principles regime, and I think
most observers would say survived the disaster of several years
ago in a very solid way, in a sound way. And yet as I recall,
you asked the House Agriculture Committee in my days there that
you have the authority to abandon the core principles and move
to a more SEC-type regulatory environment for the futures
industry. And I would just question you as to why you believe
that the core principles method of regulating the futures
industry, which at least in my view or the view of observers
that I read and hear, worked well and were moving in an
entirely different direction. And I recall this conversation in
the House Agriculture Committee with Chairman Peterson in which
we were assured that this is a backstop, if it becomes
necessary, the CFTC does not intend to go down this path of
changing the nature of its regulatory environment in the
futures industry. But that is certainly not the way it has
turned out to be.
Where would you characterize my understanding as wrong?
Mr. Gensler. I would never like to do that with a Senator,
but----
Senator Moran. I appreciate that attitude, but I know you
would be thinking it if you did not say it.
[Laughter.]
Mr. Gensler. No, I just want to give a little
clarification. The CFTC, as part of the Commodity Futures
Modernization Act, got core principles for two areas, but it
was not in all the areas. It was for clearing and for trading
platforms. We do not have today nor have we had it on oversight
of what is called intermediaries, the futures commission
merchants and the like. There are many rules there.
You are absolutely correct, Dodd-Frank gave us a little bit
greater ability on the clearing and the trading, and
particularly on clearing because now there is a mandate to move
what may be $200 to $300 trillion of derivatives into the
clearinghouses, that it was thought and I still believe it is
thought that this is a place that needs robust risk management,
and that we cannot as Americans just rely solely on the good
risk management standards of the clearinghouses themselves, but
that regulators and the whole Financial Stability Oversight
Council have a role and the Federal Reserve has an important
role to play advising us and joining in those examinations. So
I think in clearing very much so.
I could say, Senator, though Congress also set a 1-year
time limit to put out the rules, we have proposed rules--it is
actually 47 as of this morning. We have proposed rules, but we
have not finalized any. We are going to get the rest of the
proposals out hopefully in the next handful of weeks. The whole
mosaic will be out there. Though some comment files have
closed, we have discretion to continue to take comments, and
using that discretion we do continue to take comments. And we
are only going to move forward on final rules when we can
sufficiently summarize comments, get Commissioner feedback, get
regulatory feedback. We are not going to make the July
deadline. I know many people in the markets are probably
pleased to hear that. We are only going to do this according to
when we are ready to move over the spring, summer, and well
into the fall on the timing issue.
Senator Moran. Chairman, I have two responses to your
comments. One, do you have examples of where the regulatory
environment that the CFTC operated failed in regard to the
circumstances that we found our economy in that cause you to
have that sense. And then, second, just generally, your comment
about the mosaic, would it be your plan for the industry and
for Congress to be able to see the whole mosaic before any of
the rules are individually approved and implemented?
Mr. Gensler. I think to your second question, yes. As the
mosaic, we are hopeful to complete, as I said, in the next 3 to
5 weeks working with the SEC on one very important joint rule
and the capital rules and so forth.
Senator Moran. So we can see the big picture before we get
any ruling taking----
Mr. Gensler. That is right, and we are also doing some
joint meetings that we announced today with the SEC on
implementation phasing that we are going to be doing in early
May. We have an open comment file that we have put up on that
phasing as well.
I think in terms of your other question, I think that we
did not regulate--as a Nation, we did not regulate the swaps
marketplace, and it contributed to the crisis that we had in
2008. It was not the only reason, but all we need to do is
think about credit default swaps and AIG and the
interconnectedness of the financial system. So part of the
cost--and Senator Toomey referred to the cost the financial
industry is taking on, part of that cost is so that the
taxpayers do not have to bear as great a risk to bail out
financial institutions in the future.
Senator Moran. Thank you, Mr. Chairman.
Thank you, Mr. Chairman.
Chairman Johnson. Thank you all of our witnesses on our
first panel.
I would ask those on our second panel to take your place at
the witness table. While you get seated, I would like to
welcome and introduce the witnesses on our second panel.
Thomas Deas is vice president and treasurer of the FMC
Corporation, a Philadelphia-based company focused on ag,
industrial, and specialty markets. Mr. Deas has served in this
position since 2001 overseeing financing pension investments,
insurance, risk management, and other company functions.
Lee Olesky is chief executive officer of Tradeweb Markets,
a provider of online trading services for derivatives. Prior to
working for Tradeweb, Mr. Olesky was the CEO and founder of
BrokerTec, an electronic brokerage platform, and also worked at
Credit Suisse First Boston in a variety of positions.
Terry Duffy is executive chairman of the CME Group, which
operates several major futures and derivatives exchanges and
online trading platforms. Mr. Duffy has served in his current
position since 2006 and has been a member of CME's board since
1985.
Ian Axe is chief executive of LCH.Clearnet Group, which is
an independent clearinghouse group serving exchanges,
platforms, and OTC markets. Mr. Axe previously served as global
head of operations for Barclay's Capital.
Jennifer Paquette is chief investment officer of the Public
Employees' Retirement Association of Colorado. Ms. Paquette has
held this position since 2003. She oversees the investment
process for a public pension fund that provides benefits to
employees of the Colorado State government, Colorado
municipalities, public schools, universities, and colleges, and
other public entities.
Before we begin the testimony, I will recognize Senator
Toomey for some brief remarks.
Senator Toomey. Thank you very much, Mr. Chairman, for
giving me the opportunity in particular to welcome Mr. Thomas
Deas. Mr. Deas is the vice president and treasurer of FMC
Corporation, which is headquartered in Philadelphia. FMC is one
of the world's foremost diversified chemical companies with
leading positions in agriculture and industrial and consumer
markets. Mr. Deas has served as vice president and treasurer of
FMC since 2001. He has responsibilities for the worldwide
treasury function, including finance treasury operations,
pension investments and funding, and insurance and risk
management. He brings over 20 years of experience in this
field, and I have had the pleasure of having a number of
discussions with Mr. Deas, especially about the end user issue
as it applies to derivative use.
And I just wanted to welcome you today and thank you very
much for coming to testify.
Mr. Deas. Thank you, Senator.
Chairman Johnson. Mr. Deas, you may proceed.
STATEMENT OF THOMAS C. DEAS, JR., VICE PRESIDENT AND TREASURER,
FMC CORPORATION
Mr. Deas. Thank you, Mr. Chairman. Good afternoon to you
and to Ranking Member Shelby and the Members of the Committee.
In addition to my role in FMC Corporation, I am also
president of the National Association of Corporate Treasurers.
FMC and NACT are together members of the Coalition for
Derivatives End Users, representing thousands of companies
across the country that employ derivatives to manage day-to-day
business risk. I would like to express my gratitude to you, Mr.
Chairman, and to Ranking Member Shelby, for your bipartisan
efforts on behalf of derivative end users, and particularly to
Chairman Johnson for your work last week with the other
Committee Chairmen in support of end user margin exemption. We
also appreciate Senator Johanns' effort to extend the statutory
effective date for the proposed regulations, and I thank you,
Senator Toomey, and Ranking Member Shelby for your kind words
about FMC Corporation and your care and interest for
manufacturing companies of which we are a proud one.
In fact, FMC Corporation was founded almost 130 years ago
to provide spray equipment to farmers. Today, in addition
making agricultural chemicals that farmers apply to protect
their crops, our 5,000 employees have worked hard to make FMC a
leading manufacturer and marketer of a whole range of
agricultural, specialty, and industrial chemicals. We have
achieved this longevity by continually responding to our
customers' needs with the right chemistry delivered at the
right price. This year marks our 80th anniversary of listing on
the New York Stock Exchange. I had the valuable experience on a
newer financial market, one that we have been discussing today.
I had the opportunity to negotiate and execute some of the very
first derivatives--currency swaps--going back to 1984. I have
seen the derivatives market grow from its inception in the mid-
1980s to its current size by adapting and responding to market
participants' needs.
We support this Committee's efforts to redress the problems
with derivatives experienced during the financial crisis in
2008, but I want to assure you that FMC and other end users
were not and are not engaging in risky speculative derivatives
transactions. We use over-the-counter derivatives to hedge
risks in our business activity. We are offsetting risks, not
creating new ones.
FMC is the world's largest producer of natural soda ash,
the principal input in glass manufacturing, and we are one of
the largest employers in the State of Wyoming. We can mine and
refine soda ash products in southwestern Wyoming, ship them to
South Asia, and deliver them at a lower cost and with higher
quality than competing Chinese producers. We have achieved this
export success in part because of the derivatives we enter into
to hedge natural gas prices. These derivatives are done with
several banks, all of which are also supporting FMC through
their provision of almost $1 billion of committed credit. Our
banks do not require FMC to post cash margin, but they take
this risk into account as they price the transaction with us.
This structure gives us certainty so that we never have to post
cash margin while the derivative is outstanding.
But the current system, where end users and their
counterparties decide collaboratively whether and how margins
should apply is changing. Today the FDIC proposed a rule that
could in the future subject end users to margin requirements.
While we are still reviewing the details, it appears
regulators, not market participants, will now determine how
margin will be set. Regulators will have the final say over how
much cash an end user will have to divert to a margin account
where it will sit unavailable for productive uses.
In our world of finite limits and financial constraints,
posting cash margin would be a direct dollar-for-dollar
subtraction from funds that we would otherwise use to expand
our plants, build inventory to support higher sales, conduct
research and development activities, and ultimately sustain and
grow jobs.
In fact, a coalition survey of derivative end users
extrapolated the effects of margin requirements across the S&P
500, of which FMC is also a member, to predict the consequent
loss of 100,000 to 120,000 jobs, depending on these proposed
thresholds. The effect on the many thousands of end users
beyond the S&P 500 would be proportionately greater.
Although I have focused here on margin, end users are also
concerned about the more than 100 new rules that will determine
whether we can continue to manage business risk through
derivatives. We have heard also about capital requirements that
our counterparties would be required to hold, and we have heard
through the publication of rules today that uncleared over-the-
counter derivatives, the kind that we employ to hedge our
business risk, are singled out as high-risk transactions, which
will attract additional capital we are concerned could be
almost punitive and could end that ability of end users like
FMC to hedge their business risk with them.
Thank you very much for your attention. I would be happy to
answer your questions.
Chairman Johnson. Thank you, Mr. Deas.
Mr. Olesky, please proceed.
STATEMENT OF LEE OLESKY, CHIEF EXECUTIVE OFFICER, TRADEWEB
MARKETS LLC
Mr. Olesky. Mr. Chairman and Ranking Member Shelby and
Members of the Committee, good afternoon and thank you very
much for inviting me to participate in this hearing.
My name is Lee Olesky. I am the chief executive officer and
a founder of Tradeweb, and I appreciate the opportunity to
testify today about the regulatory framework for implementation
of Title VII of Dodd-Frank.
For the last 15 years, Tradeweb has been at the forefront
of building regulated electronic markets for the trading of OTC
fixed income securities and derivatives. Tradeweb's core
competency centers around leveraging technology to create more
transparent and efficient electronic markets that provide a
valuable service to the institutional buy-side and banks that
are our clients.
Before electronic markets like Tradeweb were established in
fixed income, institutional clients picked up the phone and
spoke to different dealers to obtain prices and trade U.S.
Government bonds. This phone-based trading model is how the OTC
derivatives market largely functions today.
In the late 1990s, due to technological advances and the
acceptance of the Internet, we saw an opportunity to provide
buy-side clients with greater pretrade price transparency and
execution efficiency in the U.S. Government bond market. In
1997, we established Tradeweb and created the first multibank
electronic Request for Quote marketplace for U.S. Treasury
securities. Our RFQ model gave clients the ability to run an
electronic auction among banks to get the best price and
automate a manual trading process.
Tradeweb's RFQ marketplace for U.S. Government bonds helped
transform a phone-based and largely opaque Government bond
market into a more transparent and competitive and efficient
market, with the added benefit of reducing operational risk. As
a result of this evolution, institutional clients such as asset
managers and pension funds now have access to regulated trading
systems that provide greater price transparency and more
efficient execution. Today on Tradeweb's global platform for
Government bonds, we trade on average approximately $40 billion
each day with 1,000 institutional clients located in every
financial center around the world. Among all of our platforms
and products, the daily volume on Tradeweb is in excess of $300
billion per day.
Tradeweb supports the goals of Dodd-Frank, which we believe
to be enhanced transparency and reduction of systemic risk.
However, it is vitally important to understand and give due
consideration to the needs of market participants in
promulgating rules for implementing Title VII. The aim must be
to achieve the goals of the act without materially disrupting
the market and the liquidity it provides to end users.
Market participants need confidence to participate in these
markets, and if careful consideration is not given to what the
rules say, we fear that this confidence could be materially
shaken.
The key for achieving the policy objectives for SEFs is to
provide for flexibility in the way market participants can
interact and trade swaps. Creating arbitrary or artificially
prescriptive limitations on the manner in which market
participants interact and trade could result in liquidity
drying up, increased costs to trade swaps, and market
participants seeking other, less efficient ways to manage their
risk.
Finally, there has been a great deal of discussion recently
about how best to implement the proposed rules. There is no
doubt that an overly hasty timetable for implementation could
directly impact the health of the derivatives market, given the
complexity of the system. Implementing these regulations in one
big bang is unrealistic, so phasing in the rules is a very
sensible approach.
However, market participants need clear guidance on when
the rules will be effective. This is particularly true for
firms such as Tradeweb that commit capital to build technology
to support these markets. We believe it is very important for
the SEC and CFTC to set clear time frames for when rules will
be effective as soon as practical, and we commend Chairman
Gensler for taking the initiative to discuss this in an open
forum in early May and take public comment on the time frames.
Furthermore, any difference in rules between the SEC and
CFTC should be largely eliminated. If there are material
differences between the two regulators' rules, the costs for
compliance and building technology will go up considerably. By
ensuring that the SEC and the CFTC rules retain sufficient
flexibility for market participants, clients can trade in a
manner that suits their trading strategies and risk profiles.
Some institutions may want to transact on live prices. Others
may want to use a disclosed RFQ model. And still others may
want to trade anonymously in an order book. Regulators should
not mandate that clients or platforms pick one model or offer
all models. Flexibility that allows for innovation among
technology providers is critical to attract the capital
necessary to fund the investments in these technologies.
In conclusion, we support the goals to reform the
derivatives market, and indeed we provide the very solutions
the regulation seeks to achieve. But we are concerned that the
Commissions may be overly prescriptive and, in doing so, create
unintended consequences for market participants and the
marketplace as a whole. We hope our experience in the
electronic markets can be helpful and instructive as Congress
and the regulators take on the great challenge of implementing
Title VII of Dodd-Frank.
Thank you.
Chairman Johnson. Thank you, Mr. Olesky.
Mr. Duffy, please proceed.
STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME GROUP
INC.
Mr. Duffy. Chairman Johnson, Ranking Member Shelby, Members
of the Committee, 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 four
exchanges, CME, CBOT, NYMEX, and 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.
In 2008, the 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. The CFTC is
attempting to change its role. It is an oversight agency whose
purpose has been to assure compliance with sound principles.
Now, it appears as if it is 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. It will
require doubling of the Commission's staff and budget. It will
impose astronomical costs on the industry and the end users of
derivatives. My written testimony includes numerous examples of
rulemaking that will have costly adverse consequences on
customers, intermediaries, exchanges, and the economy.
Obviously, the increased cost will have an indirect impact on
business and employment in the United States. Of equal concern,
the creation of international regulatory disparities will drive
business overseas. We recognize that the CFTC has been working
to induce international regulators to be equally prescriptive.
However, that effort seems to be failing, as other
jurisdictions capture U.S. business that the CFTC is driving
offshore.
The threat of prescriptive position limits and restrictions
on hedging in the United States are already driving business
overseas and into unregulated markets. The threat that margin
control will be used to influence prices of commodities will
even be more disastrous. Broad, undefined prohibitions on so-
called disruptive trading practices and strategies will not
only drive liquidity providers from the U.S. markets, but also
impair hedging and price discovery.
We are strong proponents of an adequate budget for our
regulator and support sufficient funding to modernize this
technology. However, we strongly object to the expansion of
Commission staff to enforce regulations that are uncalled for
by Dodd-Frank or that duplicate the duties now being performed
by SROs, which are self-regulatory organizations. This comes at
no cost to the Government.
Chairman Gensler cited earlier about the size of the
market. The Commission justifies its budget demands by pointing
to the growth of the notional value of the contracts it
oversees on regulated futures markets and the notional value of
the swaps market that it will be responsible for under Dodd-
Frank. But there is no valid relationship between the notional
value and the regulatory burden. The swaps market that the CFTC
will regulate involves only 4,000 to 5,000 transactions per day
and the parties are all sophisticated investors. The futures
market has grown to millions of transactions a day, but has
become a highly sophisticated electronic marketplace with a
perfect audit trail and high tech enforcement rules.
The CFTC's budget should reflect the positive impact of
technology and the necessary regulatory obligations imposed by
Dodd-Frank. Congress should encourage a full and fair cost and
benefit analysis for every proposal.
It also should extend Dodd-Frank's effective date to permit
a realistic opportunity to comment. Otherwise, we believe that
the well-regulated futures industry will be burdened by overly
prescriptive regulations. This is inconsistent with the sound
practices. Furthermore, it will make it more difficult to reach
Dodd-Frank's goal of increasing transparency and limiting risk.
I thank you for your time and look forward to your
questions.
Chairman Johnson. Thank you, Mr. Duffy.
Mr. Axe, please proceed.
STATEMENT OF IAN AXE, CHIEF EXECUTIVE, LCH.CLEARNET GROUP
LIMITED
Mr. Axe. Thank you, Mr. Chairman. Chairman Johnson, Ranking
Member Shelby, Members of the Committee, my name is Ian Axe and
I am Chief Executive of LCH.Clearnet Group Limited. On behalf
of the Group, I would like to thank the Committee for asking me
here today.
If I may, let me briefly introduce our company. We operate
two of Europe's leading clearinghouses and a fast-expanding
office in New York. We are 83 percent owned by members and 17
percent owned by exchanges, such as NYSE Euronext. We clear
interest rate, credit default, and energy swaps, bonds and
repos, equities, metals, and listed derivatives. We have been
clearing commodities for 120 years and pioneered the
development of swap clearing in 1999 with our SwapClear
service. This operates under a DCO license and has been subject
to CFTC regulation since 2001.
SwapClear clears over 50 percent of the global interest
rate swap market, with over $276 trillion in notional
outstanding, and last year it cleared over 120,000 swaps
trades, for U.S. counterparties with a notional value of $64
trillion. We recently extended our SwapClear service to include
a client clearing service for U.S. end customers. Twelve
members have since joined up to provide this service, and U.S.
end users have cleared swaps through them.
We have U.S. members on our sell and buy side committees
which meet monthly to discuss the development of our swap
service. Our buy side working group includes major U.S. asset
managers and hedge fund investors.
Our group played a critical role following the Lehman
Brothers collapse, successfully managing the world's largest
ever clearing member default. On its default, the firm had a
$12 trillion portfolio of risk at LCH.Clearnet, including a $9
trillion swap book. This was liquidated without loss or impact
on surviving members. On completion, we returned $850 million
of margin to U.S. bankruptcy administrators.
We are strong supporters of the Dodd-Frank Act goals and
believe that the legislation will improve stability in the
marketplace and greatly reduce systemic risk. In particular, we
welcome strong risk management and heightened financial service
standards for clearinghouses, a greater level of supervision
for clearinghouses, and mandatory clearing obligations.
We have followed the CFTC and SEC rulemaking process
closely and applaud the thoughtfulness of the agencies in this
task. We have participated in roundtables, attended open
meetings, responded to the proposed rulemakings, and met with
the Commissioners.
It is key that the legislation and rules emerging from the
U.S. and Europe are as closely aligned as possible. This will
reduce regulatory arbitrage, ensure consistent risk standards
internationally, and make certain that the G-20 commitments are
met. A lack of harmonization may impact the economy, jobs, and
the recovery.
I will set out three of the greatest areas of concern as
regards the difference between the U.S. and Europe in our
international oversight.
First, ownership and governance. We believe that Congress
correctly rejected aggregate ownership and voting caps for
clearinghouses during passage, and are concerned to see the
agencies might reintroduce such caps. Aggregate restrictions on
clearinghouse ownership or governance may limit innovation,
reduce competition, and increase costs.
Second, risk management and access rules for
clearinghouses. The CFTC risk management provisions at present
are aligned to the futures clearing business. Swaps need to be
reviewed as having different risk management techniques and
processes. We expect futures and swaps to converge over time,
but it is inappropriate now to impose futures clearing criteria
on swaps. We also believe access criteria for swap clearing
members must be proportionate to the risk introduced and
contingent on default management and risk underwriting
participation, such that the clearinghouse, its nondefaulting
members, and their clients are fully protected.
And third, customer protection. Security is key. Customers
clearing swaps, many of them pension funds and other long-term
saving institutions, must be protected from fellow customer
risk. The introduction of customer safeguards that deliver such
security would ensure that U.S. clients have the same
protection as clients in Europe.
In conclusion, we believe that the agencies' final rules
should afford individual customers the option of legal
segregation. Further, any final rules on clearinghouse
ownership or governance should be applied at an individual
level. Finally, access requirements should do nothing to
compromise the integrity of clearinghouses. We look forward to
extending our safeguards deeper into the U.S. marketplace and
to further growing our U.S. staff and operations in support of
the Act.
Thank you for inviting me here today. I am happy to take
any questions.
Chairman Johnson. Thank you, Mr. Axe.
Ms. Paquette, please proceed.
STATEMENT OF JENNIFER PAQUETTE, CHIEF INVESTMENT OFFICER,
COLORADO PUBLIC EMPLOYEES' RETIREMENT ASSOCIATION
Ms. Paquette. Thank you, Chairman Johnson and Ranking
Member Shelby, for holding this important hearing. I am
Jennifer Paquette, Chief Investment Officer of Colorado PERA.
I would like to share with you a school teacher's interest
in derivatives and share some concerns on proposed rulemaking.
A Colorado teacher told me years ago about a problem she had in
her classroom with a first grade boy. She required all the
students to read aloud in front of the class and this little
boy was very shy and could not do it. She allowed the student
to sit in the chair with his back to the class and whisper to
the blackboard instead, and over the course of the year, she
took the chair and moved it inch by inch, so that at the end of
the year, it faced the class. The chair was empty at the end of
the year and instead, the boy was standing in front of the
class reading aloud with great pride.
And when she told me the story, it struck me how much I had
in common with her. The care that she took with every student
in her class is the same care that we give to every single
investment that we oversee for her retirement plan. She would
not know how to invest a $39 billion institutional portfolio,
but I and my investment colleagues in Denver, we know how to do
that on her behalf. She would not know how to execute a total
return swap to mitigate risk, but we know how to do that. We
know how to employ futures to mitigate risk when we are doing
portfolio transitions.
The investment vehicles that we use matter to all of our
members. It is why I have come here for the honor of just a few
minutes before you.
Derivatives are tools we use for mitigating risk. While
derivatives are only a modest portion of our total market
value, they are very useful. You will find in my written
testimony we have concerns about how public plans may be
affected by CFTC proposed rules. CFTC's proposed rules include
public pension plans as a special entity. In order for us to
enter into a swap, the swap dealer would need to have a
reasonable basis to believe we have a representative that meets
certain requirements. We are concerned that there is a conflict
of interest for one party in a transaction to also be
responsible for determining who is qualified to represent the
other side of the transaction. We are also uncomfortable with
how this could potentially impair negotiations with a dealer.
We fear higher costs for executing transactions and are
concerned that strong counterparties may not want to do
business with us for reasons including potential liability.
Colorado PERA and a number of public pension funds whose
assets total over $700 billion have suggested a voluntary
alternative approach be created. I have included a letter in my
written testimony signed by these pension funds which describes
the approach. It would allow us to voluntarily undergo a
certification process to meet the independent representative
requirement. This would include passing a proficiency exam. I
think it supports the intent of protecting investors while
avoiding some potential conflicts and unintended consequences.
I have the utmost respect for the time and care you and
others are expending on these matters. We would like to
continue to access the swaps markets for the same portfolio
reasons we have used them effectively for years.
On behalf of almost half-a-million current and former
employees, public employees of Colorado PERA, I ask that you
and all those involved in this process consider our concerns. I
owe it to all of our Colorado PERA members and to that
particular teacher I told you about to advocate on this issue.
That little boy who was afraid to speak, who is not so little
anymore, I see every day, and he is my reminder to speak on
issues that matter to the investors that are our members.
Thank you for your time.
Chairman Johnson. Thank you, Ms. Paquette. I will start off
with a few questions. Thank you for your testimony.
I will remind my colleagues that we will keep the record
open for statements, questions, and any other material you
would like to submit. As we begin questioning the witnesses, I
will put 5 minutes on the clock for each Member's questions.
Mr. Olesky, how would the proposed CFTC rule on swap
execution facilities requiring five requests for quotes impact
market liquidity and potential earning? What would be the
impact on your company if the SEC and CFTC proposed rules for
SEFs are not reconciled?
Mr. Olesky. Thank you. Currently, Tradeweb trades interest
rate swaps in the U.S. and Europe and we have processed and had
about 75,000 interest rate swap transactions over the last
several years, and one of our concerns is that as the rules
have been proposed by the CFTC in this RFQ process, which is an
auction that customers, such as the clients that are at this
table, would run in order to get the best prices, that clients
would be forced to send out an inquiry to at least five
different dealers.
That is not the way the market operates today. In fact,
that is not the way the U.S. Government bond market operates
today. In our U.S. Government bond franchise, the average
inquiry goes out to just three banks and there are some very
good reasons for this. Clients need to assess how they are
going to get the best possible price in the marketplace, and at
times, that means going to just one or two dealers, not five.
So that is an example of a rule that has been proposed that is
not mindful of the way the market operates today and would
require a change. I am not sure what that change entirely would
be, but we, as a company that provides services to our clients,
are advocates for our clients, which are the large buy-side
firms, public pension funds, institutions that want to be able
to access liquidity in a way that makes the most sense to them.
Chairman Johnson. Mr. Duffy and Mr. Axe, how would applying
the Title VII clearing requirements to transactions with
foreign counterparties impact the competitiveness of U.S.
markets?
Mr. Duffy. I would be happy to start things. One of the
ways, Mr. Chairman, that that would impact us is if the CME had
a client that was in Europe and they wanted to do a
counterparty transaction with a party in the U.S., we would
have to make sure that the CME clearinghouse was registered in
the U.K. or in any other jurisdiction that that client--the
trade was coming from. This is a very long, burdensome process
throughout the U.K. In the U.S., it takes about 6 months to get
approved to become a clearing member. So this is absolutely a
very difficult thing for us to do going forward. So that is one
of the big competitive issues that we have.
I will let Ian make a comment, then----
Mr. Axe. Thank you, Mr. Chairman. We currently clear trades
both in the U.S. and in Europe, and to refer to my oral
testimony, I think the fear we have in terms of regulatory
arbitrage is if we don't ensure that we do have consistent
standards. We appreciate the ability to achieve licensed status
is one thing, but actually having different systems and
different regulatory systems across the different geographies
would create inconsistencies and would not be advisable in the
ideology of harmonization.
Chairman Johnson. Mr. Deas, from your perspective, how
would the proposed definition of swap dealers impact end users?
Mr. Deas. Chairman Johnson, the definition for swap
dealers, if it is not done properly, could pick up larger
companies who are still engaged in hedging underlying business
activities, and there is a fundamental difference between a
financial institution acting as a swap dealer and a large U.S.-
based company that is doing that.
End users are always hedging underlying business activity.
The derivative when valued together with that underlying
business exposure creates a neutral position. Swap dealers are
maintaining an open position. They are market makers. We
believe it is appropriate for them to centrally clear and
margin their trades, but because end users are always balanced,
if you impose margin on them because you have defined them
through this definition to be a swap dealer, then you take a
balanced pair of transactions that create a neutral position
and you actually impose a new and unwelcome risk, at least for
treasurers, that risk of having to fund periodic margin
payments with all the attendant uncertainty of that.
Chairman Johnson. Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Mr. Deas, in your testimony today, you warned that
regulators could impose costs on companies that would inhibit
their ability to produce goods and hire workers in the United
States. Chairman Gensler has begrudgingly, I would say, agreed
to make some accommodations for companies that use derivatives
to hedge their business risk, like yourself. But he also argues
that doing so, and I will quote, ``only benefits Wall Street
and does not benefit Main Street or the corporation that
provides service to America.'' Do you agree with Chairman
Gensler's assessment here?
Mr. Deas. No, sir, I do not. As I have indicated in my
testimony, we are manufacturing the goods that are consumed in
the U.S. and we have been able to export them successfully
overseas, and we do that----
Senator Shelby. It helps you compete, does it not?
Mr. Deas. Yes, sir, it does, and it helps us offset risks
that we cannot otherwise control.
Senator Shelby. And the consequences--I think you alluded
to it earlier. What would be the consequences of imposing
unnecessary regulatory burdens on companies like yourselves
ability to hedge your unique business risks? A lot of these
risks are tailored, are they not?
Mr. Deas. Yes, sir. One of the problems is, for instance, I
talked about our ability to export. If, as was questioned of
the Assistant Secretary of the Treasury, if the Secretary of
the Treasury declares that foreign exchange transactions are
swept up in this new mechanism, then it could force exporting
companies like FMC to incur higher costs, and one unfortunate
way to lower those costs would be for U.S.-based exporters to
move their manufacturing facilities offshore to the countries
where their customers are to achieve in that way a better match
between their costs and the currencies in which their customers
are paying them. I would hate to see that happen to U.S.-based
manufacturers, Senator.
Senator Shelby. Would requiring companies to use
standardized cleared products or forcing them to post margin,
as we have talked about here, increase risk in the financial
system or decrease it? Would it not increase risk for you
because it costs more?
Mr. Deas. Senator, it would increase risk in two ways.
First of all, as I have described, the over-the-counter
derivatives market became as--grew to the size it is today
because of its ability to respond and to provide customization.
The fact that these hedges are effective----
Senator Shelby. You are talking about tailoring your risk,
are you not?
Mr. Deas. Yes, sir, and the fact that we are able to
achieve that customization means that we have exactly offset
the business risk. Failure to make it match up exactly if we
were forced to use a standardized derivative would mean there
would be residual risk we would retain that could come home to
manifest itself in higher costs for us.
Senator Shelby. Mr. Duffy, Governor Tarullo--you were
here--explained that central clearinghouses concentrate risk
and thus have the potential to transmit shocks throughout the
financial markets. What would happen, for example, if CME--we
hope it never would--or another clearinghouse failed, and what
type of contingency plans has the CME prepared to make sure
that if it were to fail, that one of more of its members does
not threaten the entire financial system?
Mr. Duffy. Senator, that is a great question, and one of
the things we can go off of to start with is our record. In the
156 years, the CME has never had a customer----
Senator Shelby. I know.
Mr. Duffy. ----lose anything due to a clearing member
default. So that is the first thing.
The second thing is the way we do clearing at the CME
Group. We settle twice a day mark-to-market. So if the customer
does not have the funds up and the market runs away from them,
we either take them out of the market if the money is not
coming forward. So that is one of the things. We have the
ability to do that on an hourly basis. We hold over $100
billion of our customers' capital to make sure that these
transactions are protected. And so we have many, many
safeguards. Risk management is something that we spend a lot of
our time on at the CME Group and I think it is what has made us
what we are today.
Senator Shelby. That is good. I want to pronounce your name
right. Is it ``Paquette''? How do you say it?
Ms. Paquette. ``Paquette.''
Senator Shelby. Paquette. Ms. Paquette, the letter that you
and a number of other pension funds submitted to the
Commodities Futures Trading Commission noted that however well-
intentioned the goal of, quote, ``protecting vulnerable or
gullible parties in the swap market might be,'' the CFTC's
proposed business conduct standards may be so onerous that
pension plans are, quote, ``left to deal with less desirable
counterparties, if they could find any at all.'' If the CFTC's
proposal were adopted in its current form, would it make it
harder to manage the nearly $40 billion of retirement money for
which you are responsible to manage?
Ms. Paquette. Thank you, Ranking Member Shelby. If the
proposed rules were put in----
Senator Shelby. Were adopted in its current form----
Ms. Paquette. ----adopted in their current form, we think
it would be more challenging for us to manage our $40 billion--
--
Senator Shelby. And by ``challenging,'' it would be harder.
It would be more difficult, would it not?
Ms. Paquette. It would be more difficult in certain areas
of our portfolio, yes.
Senator Shelby. Thank you. Thank you, Mr. Chairman.
Chairman Johnson. Senator Moran.
Senator Moran. Mr. Chairman, thank you.
Mr. Duffy, earlier, I asked Chairman Gensler questions
about why he felt it was necessary to impose prescriptive rules
that override core principle regime that we have had at CFTC
previously, or currently, and the Chairman said it was because
the instruments like swaps, and that is why DCOs needed
prescriptive rules. However, to my knowledge, there were no
swap DCOs. The only clearing organizations pre- Dodd-Frank were
regulated exchanges. Clearing organizations seem to have
performed well in 2008. And furthermore, it seemed that the
prescriptive regulations have gone beyond DCOs and are actually
imparting the exchange--I mean, affecting--excuse me, impacting
exchanges, as well.
Can you characterize more specifically how the CFTC is
dismantling the core principle regime and how it would
negatively--let me be more unbiased--how it would impact CME's
exchanges and clearing organizations, and also, did any of the
DCOs fail in 2008 that would warrant Chairman Gensler's
concerns that have led him to override core principles for
DCOs?
Mr. Duffy. No, sir. None of them did fail. Prior to 2008
and 2007, CME cleared $1.2 quadrillion of notional value of
trade without one hiccup. So that is just for starters. And the
way Chairman Gensler is trying to roll back some of the
Modernization Act of 2000, for example, would be on product. If
we want to launch a new product, we have the ability to self-
certify that product. We innovate it. We should have the
ability to self-certify it so we can be first to market. Some
of these new rules would call for the CFTC to have days, weeks,
months to put this out for public comment again and give
everybody an opportunity to look at what CME is trying to
innovate. Well, there would be no incentive to innovate new
products. So that is one example.
Another example of that would be products we now currently
may trade in a block trade or an OTC fashion because there are
very few participants in the transaction, so we list it on a
facility just for a handful of participants and we still
essentially clear it. He is saying that within--if you do not
have 85 percent of that trade done, the volume done, you have
to delist the product or put it on a central limit order book.
So that would kill the product.
Euro-dollar contract is the largest contract in the world
today, and the short-term interest rates, and long-term
interest rates. When we listed that, if we went by the
prescriptive rules back then that they have in place today, we
would not have a Euro-dollar contract for folks to manage their
interest rate risk like they do today to protect their
pensions, mortgages, and other things. So these are just a
couple examples why I think the Chairman is wrong on this.
Senator Moran. The CME is a significant financial
institution. You also may have heard my raising the concern
that I have heard about the difficulties that the futures
industry is having in keeping up with the ongoing proposed
regulations, running their business and responding. My guess is
that it may be easier for the CME to meet that challenge than
it is the smaller exchanges. Am I missing something there? I do
not want you to--I do not expect you to say it is easy for you,
but I would worry also about, in my case, Kansas City, for
example, the ability just to keep up with the volume of
activity at the CFTC right now, to actually make intelligent
decisions about responses to proposed rules.
Mr. Duffy. We have a very large outside law firm. We have a
very large inside law firm. We cannot keep up with the comment
periods that are coming forward with all the new rules and do
it in a very thoughtful way. I have talked to the CEO of the
Kansas City Board of Trade, Jeff Borchardt. I know they are
having similar issues and they are a much smaller institution.
We do do business with them, so obviously we have an interest
in what their thoughts are on this, also. It is almost
impossible to keep up. So when the CFTC is proposing these
rules, trying to do them in a very short period of time, and
for us to digest and see what the consequences are with major
outside law firms and a large inside law firm, as a very large
institution and we cannot keep up with it, I am concerned how
others can.
Senator Moran. Your response to my question about
innovation, new product, would that then create a disadvantage
to being an American, a United States company? Will other
countries' exchanges be better capable of innovating than the
United States in bringing new products to market?
Mr. Duffy. Absolutely. If they can self-certify product
throughout the world and we do not get a first look at it like
they would get a first look at our product, you would put the
United States of America innovation in financial services right
down the drain.
Senator Moran. Mr. Duffy, thank you very much.
Chairman Johnson, thank you.
Chairman Johnson. Thank you.
As the rulemaking process moves forward, this Committee
will continue to provide robust oversight of the reforms to the
OTC derivatives market. Striking the right balance for how best
to regulate derivatives should not be a partisan issue and I
urge Senators on both sides of the aisle to continue working
with our regulators to build a stronger foundation for our
financial markets.
We did not reach a quorum today to vote on pending
nominations as was scheduled. We are going to look for a time
within the next 2 days to hold this vote off the Senate floor
after a roll call vote. My staff will send a notice when we
find an appropriate time.
Thank you again to all my colleagues and our panelists for
being here today.
This hearing is adjourned.
[Whereupon, at 4:58 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF MARY L. SCHAPIRO
Chairman, Securities and Exchange Commission
April 12, 2011
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee:
Thank you for inviting me to testify today on behalf of the
Securities and Exchange Commission regarding its implementation of
Titles VII and VIII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank Act'' or ``Act''), which primarily relate
to the regulation of over-the-counter (OTC) derivatives and the
supervision of systemically important payment, clearing, and settlement
systems. These titles require the SEC, among other regulators, to
conduct a substantial number of rulemakings and studies. Although this
task is challenging, particularly when viewed in the context of the
SEC's other Dodd-Frank Act rulemaking responsibilities, we are
committed to fulfilling the objectives of the Act in a responsible and
diligent manner, while seeking the broad public input and consultation
needed to get these important rules right. My testimony today will
briefly describe our progress and plans for implementing Titles VII and
VIII of the Dodd-Frank Act, with a particular focus on the regulation
of the OTC derivatives marketplace.
Background
OTC Derivative Marketplace
As has been frequently noted, the growth of the OTC derivatives
marketplace has been dramatic over the past three decades. From its
beginnings in the early 1980s, when the first swap agreements were
negotiated, the notional value of these markets has grown to almost
$600 trillion globally. \1\ However, OTC derivatives were largely
excluded from the financial regulatory framework by the Commodity
Futures Modernization Act of 2000. As a securities and capital markets
regulator, the SEC has been particularly concerned about OTC
derivatives products that are related to, or based on, securities or
securities issuers, and as such are connected with the markets the SEC
is charged with overseeing.
---------------------------------------------------------------------------
\1\ See, Bank of International Settlements, Positions in Global
Over-the-Counter (OTC) Derivatives Markets at End-June 2010, Monetary
and Economic Department (Nov. 2010), http://www.bis.org/publ/
otc_hy1011.pdf.
---------------------------------------------------------------------------
Dodd-Frank Act
The Dodd-Frank Act mandates oversight of the OTC derivatives
marketplace. Title VII of the Act requires that the SEC and CFTC write
rules that address, among other things, mandatory clearing, the
operation of security-based swap and swap execution facilities and data
repositories, capital and margin requirements and business conduct
standards for dealers and major participants, and regulatory access to
and public transparency for information regarding security-based swap
and swap transactions. This series of rulemakings should improve
transparency and facilitate the centralized clearing of security-based
swaps, helping, among other things, to reduce counterparty risk. It
should also enhance investor protection by increasing disclosure
regarding security-based swap transactions and helping to mitigate
conflicts of interest involving security-based swaps. In addition,
these rulemakings should establish a regulatory framework that allows
OTC derivatives markets to continue to develop in a more transparent,
efficient, accessible, and competitive manner.
Title VIII of the Act provides for increased oversight of financial
market utilities designated as systemically important and financial
institutions that engage in payment, clearing, and settlement
activities designated as systemically important by the Financial
Stability Oversight Council. The purpose of Title VIII is to mitigate
systemic risk in the financial system and promote financial stability.
Implementation Generally
The implementation of these titles is a substantial undertaking and
raises a number of challenges. Accordingly, we have been engaging in an
open and transparent implementation process, seeking input on the
various rulemakings from interested parties even before issuing formal
rule proposals. We will continue to seek input on each proposal with
the goal of producing effective and workable regulation of derivatives
activities and oversight of financial market utilities designated as
systemically important and financial institutions that engage in
payment, clearing, and settlement activities designated as systemically
important.
Public Consultation
We have enhanced our public consultative process by expanding the
opportunity for public comment beyond what is required by law. For
instance, we have made available to the public a series of e-mail boxes
to which interested parties can send preliminary comments before rules
are proposed and the official comment periods begin. These e-mail boxes
are on the SEC Web site, organized by topic. We also specifically
solicited comment, along with the CFTC, on the definitions contained in
Title VII of the Act.
In addition, our staff has sought the views of affected
stakeholders. This approach has resulted in meetings with a broad
cross-section of interested parties. To further this public outreach
effort, the SEC staff has held joint public roundtables and hearings
with the CFTC staff on select key topics. Through these processes, we
have received a wide variety of views and information that is useful to
us in proposing and, ultimately, adopting rules that are appropriate
for these markets.
Coordination With the CFTC and Other Regulators
In implementing Title VII, our staff is meeting regularly, both
formally and informally, with the staffs of the CFTC, Federal Reserve
Board, and other financial regulators. In particular, SEC staff has
consulted and coordinated extensively with CFTC staff in the
development of the proposed rules. Although the timing and sequencing
of the CFTC's and SEC's proposed rules may vary, they are the subject
of extensive interagency discussions. The SEC's rules will apply to
security-based swaps and the CFTC's rules will apply to swaps, but our
objective is to establish consistent and comparable requirements, to
the extent possible, for swaps and security-based swaps. Due in part to
differences in products, participants, and markets, some of our rule
proposals contain different approaches to various issues. Nonetheless,
as we move toward adoption, the objective of consistent and comparable
requirements will continue to guide our efforts.
In addition, as required by the Act, we are working with the CFTC
to adopt joint rules further defining key terms relating to the
products covered by Title VII and certain categories of market
intermediaries and participants. Joint rulemaking regarding key
definitions will promote regulatory consistency and comparability, and
thus help to prevent regulatory gaps that could foster regulatory
arbitrage and overlaps that could confuse, or impose unnecessary added
costs upon, market participants.
Finally, we recognize that other jurisdictions are also developing
regulatory frameworks that will address many of the areas covered by
Title VII. The manner and extent to which we and foreign regulators
regulate derivatives will affect both U.S. and foreign entities and
markets. Consequently, as we progress with the implementation of Title
VII, we will continue to consult with regulatory counterparts abroad in
an effort to promote robust and consistent standards and avoid
conflicting requirements, where possible. The SEC and CFTC are, in
fact, directed by the legislation to consult and coordinate with
foreign regulators on the establishment of consistent international
standards governing swaps, security-based swaps, swap entities, and
security-based swap entities. We believe that bilateral discussions
with foreign regulators, as well as our engagement in the IOSCO Task
Force on OTC Derivatives Regulation, which the SEC cochairs, and our
participation in other international forums will help us achieve this
goal.
In short, we remain committed to working closely, cooperatively,
and regularly with our fellow regulators to facilitate our
implementation of the regulatory structure established by the Dodd-
Frank Act.
Rulemaking
Actions Already Taken
The SEC has taken significant steps in implementing the rulemaking
required by Titles VII and VIII of the Act. To date, the SEC has
proposed a number of rulemakings required by these titles.
In October 2010, we proposed rules to mitigate conflicts of
interest involving security-based swaps. These proposed rules seek to
address conflicts of interest at security-based swap clearing agencies,
security-based swap execution facilities, and exchanges that trade
security-based swaps.
In November 2010, we proposed antifraud and antimanipulation rules
for security-based swaps that would subject market conduct in
connection with the offer, purchase, or sale of any security-based swap
to the same general antifraud provisions that apply to all securities
and reach misconduct in connection with ongoing payments and deliveries
under a security-based swap. We also proposed rules regarding trade
reporting, data elements, and real-time public dissemination of trade
information for security-based swaps. Those rules lay out who must
report security-based swap transactions, what information must be
reported, and where and when it must be reported. In addition, we have
proposed rules regarding the obligations of security-based swap data
repositories, which would require security-based swap data repositories
to register with the SEC and specify other requirements with which
security-based swap data repositories must comply.
In December 2010, we proposed rules relating to mandatory clearing
of security-based swaps. These rules would set out the way in which
clearing agencies would provide information to the SEC about security-
based swaps that the clearing agencies plan to accept for clearing. We
also proposed rules relating to the exception to the mandatory clearing
requirement for end users. These rules would specify the steps that end
users must follow, as required under the Act, to notify the SEC of how
they generally meet their financial obligations when engaging in
security-based swap transactions exempt from the mandatory clearing
requirement. In addition, we proposed joint rules with the CFTC
regarding the definitions of swap and security-based swap dealers, and
major swap and major security-based swap participants. These rules lay
out objective criteria for these definitions and are a first step in
helping the SEC appropriately address the market impacts and potential
risks posed by these entities.
Thus far in 2011, we have proposed rules regarding the confirmation
of security-based swap transactions, which would govern the way in
which certain security-based swap transactions are acknowledged and
verified by the parties who enter into them. We also proposed rules
regarding registration and regulation of security-based swap execution
facilities, which would define security-based swap execution
facilities, specify their registration requirements, and establish
their duties and core principles. And most recently, we proposed rules
to establish minimum standards concerning the operation, governance,
and risk management of clearing agencies. At the same time, we reopened
the comment period for our October proposal regarding conflicts of
interest at security-based swap clearing agencies, security-based swap
execution facilities, and exchanges that trade security-based swaps.
In addition, we adopted interim final rules in October 2010
regarding the reporting of outstanding security-based swaps entered
into prior to the date of enactment of the Dodd-Frank Act. These
interim final rules require certain security-based swap dealers and
other parties to preserve and report to the SEC or a registered
security-based swap data repository certain information pertaining to
any security-based swap entered into prior to the July 21, 2010,
passage of the Dodd-Frank Act and whose terms had not expired as of
that date.
Our staff also is working closely with the Federal Reserve Board
and the CFTC to develop, as required by Title VIII of the Act, a new
framework to supervise systemically important financial market
utilities, including clearing agencies registered with the SEC, that
are designated by the Financial Stability Oversight Council as
systemically important. For example, SEC staff has been actively
coordinating with the other agencies to develop rules regarding
submission of notices by designated financial market utilities with
respect to rules, procedures, or operations that could materially
affect the risks presented by such designated financial market
utilities. The SEC proposed these rules in December. In addition, in
March, the Financial Stability Oversight Council, of which the SEC is a
member, issued a notice of proposed rulemaking regarding the criteria
and analytical framework for designating financial market utilities
under Title VIII and the processes and procedures that would be used to
make such designations.
Our staff also has been actively coordinating with the other
agencies on the new authority granted to the SEC and CFTC to develop
standards for designated financial market utilities. Moreover, the SEC
and CFTC staffs have begun working with staff from the Federal Reserve
Board to jointly develop risk management supervision programs for
designated financial market utilities pursuant to Title VIII. The SEC,
CFTC, and Federal Reserve Board also are working together closely to
prepare a joint report to Congress required under Title VIII that will
make recommendations for improving consistency in the oversight of
designated clearing entities, promoting robust risk management, and
monitoring the effects of such risk management on the stability of the
financial system.
Upcoming Actions
In the coming months, we expect to propose rules regarding
registration procedures, business conduct standards, and capital,
margin, segregation, and record keeping requirements for security-based
swap dealers and major security-based swap participants. We also expect
to propose joint rules with the CFTC governing the definitions of
``swap'' and ``security-based swap,'' as well as the regulation of
``mixed swaps.''
The SEC has been carefully reviewing all the comments received
regarding the rules that already have been proposed and we are in the
process of considering those comments. We also are continuing
discussions with various market participants about their concerns and
ideas regarding the proposed rules. This information is invaluable as
we move toward consideration of final rules designed to further the
purposes of the Dodd-Frank Act and the SEC's mission to protect
investors, maintain fair, orderly, and efficient markets, promote the
prompt and accurate clearance and settlement of securities
transactions, and facilitate capital formation and provide effective
regulation of the security-based swap markets without imposing
unjustified costs or having unforeseen adverse consequences. We will,
of course, be engaged in the same process for our upcoming proposed
rulemakings, and I would like to take this opportunity to encourage
market participants and the public to continue submitting comments on
these upcoming proposed rulemakings.
Anticipated Completion of Rulemaking
We are working to complete the rulemaking proposal and adoption
process under Titles VII and VIII and are mindful of Congress'
deadlines for implementation. Nonetheless, this is a very challenging
task. The OTC derivatives markets are large and interconnected. The
issues are complex and do not lend themselves to easy solutions. We are
progressing at a deliberate pace, taking the time necessary to
thoughtfully consider the issues raised by the various rulemakings
before proposing specific rules. We are taking a similar approach as we
move toward consideration of final rules. As we do so, we are also
devoting careful thought to sequencing the implementation of final
rules in such a way that market participants will have sufficient time
to develop the infrastructure necessary to comply. We understand that
getting the rules right and implementing them in the right order is
important, and this will continue to guide our efforts in coming
months.
Impact of Rulemaking on Existing Markets
There are unique challenges involved in imposing a comprehensive
regulatory regime on existing markets, particularly ones that until now
have been almost completely unregulated. For example, 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. We
also need to carefully consider how our rules might impact preexisting
contracts. For example, in developing rules that concern the capital
and margin requirements for security-based swap dealers, we will need
to consider dealers' preexisting security-based swaps. The application
of new rules to existing security-based swaps could be very disruptive
and impose burdens on dealers or their counterparties that they did not
bargain for or anticipate. We discussed this issue, along with the end
user margin issue, with various stakeholders at a joint SEC-CFTC
roundtable in December, and are taking the input we received at the
roundtable and from other sources into account in writing proposed
rules.
Conclusion
The Dodd-Frank Act provides the SEC with important tools to better
meet the challenges of today's financial marketplace and fulfill our
mission to protect investors, maintain fair, orderly, and efficient
markets, promote the prompt and accurate clearance and settlement of
securities transactions, and facilitate capital formation. As we
proceed with implementation, we look forward to continuing to work
closely with Congress, our fellow regulators, and members of the
financial and investing public. Thank you for inviting me to share with
you our progress on and plans for implementation. I look forward to
answering your questions.
______
PREPARED STATEMENT OF GARY GENSLER
Chairman, Commodity Futures Trading Commission
April 12, 2011
Good afternoon Chairman Johnson, Ranking Member Shelby, and Members
of the Committee. I thank you for inviting me to today's hearing on
implementing Title VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act. I am pleased to testify on behalf of the
Commodity Futures Trading Commission (CFTC). I also thank my fellow
Commissioners and CFTC staff for their hard work and commitment on
implementing the legislation. I am pleased to testify alongside my
fellow regulators from the Securities and Exchange Commission (SEC),
Federal Reserve and Treasury Department.
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 Act was enacted to reduce risk, increase transparency and promote
market integrity within the financial system by, among other things:
1. Providing for the registration and comprehensive regulation of
swap dealers and major swap participants;
2. Imposing clearing and trade execution requirements on
standardized derivatives products;
3. Creating robust record keeping and real-time reporting regimes;
and
4. Enhancing the Commission's rulemaking and enforcement authorities
with respect to, among others, all registered entities and
intermediaries subject to the Commission's oversight.
The reforms mandated by Congress will reduce systemic risk to our
financial system and bring sunshine and competition to the swaps
markets. Markets work best when they are transparent, open and
competitive. The American public has benefited from these attributes in
the futures and securities markets since the great regulatory reforms
of the 1930s. The reforms of Title VII will bring similar features to
the swaps markets. Lowering risk and improving transparency will make
the swaps markets safer and improve pricing for end users.
Title VIII of the Dodd-Frank Act
The CFTC has overseen clearinghouses for decades. Title VIII of the
Dodd-Frank Act provides for enhanced oversight of these clearinghouses.
In close consultation with our fellow domestic and international
regulators, and particularly with the Federal Reserve and the SEC, the
CFTC proposed rulemakings on risk management for clearinghouses. These
rulemakings take account of relevant international standards,
particularly those developed by the Committee on Payment and Settlement
Systems and the International Organization of Securities Commissions
(CPSS-IOSCO).
The Dodd-Frank Act gives the Financial Stability Oversight Council
(FSOC) and the Federal Reserve Board important roles in clearinghouse
oversight by authorizing the Council to designate certain
clearinghouses as systemically important and by permitting the Federal
Reserve to recommend heightened prudential standards in certain
circumstances.
The FSOC proposed a rule last month that complements the CFTC's
rulemaking efforts. Public input will be valuable in determining how
the Council should apply statutory criteria to determine which
clearinghouses qualify for designation as systemically important.
Implementation
The Dodd-Frank Act is very detailed, addressing all of the key
policy issues regarding regulation of the swaps marketplace. To
implement these regulations, the Act requires the CFTC and the SEC,
working with our fellow regulators, to write rules generally within 360
days. At the CFTC, we initially organized our effort around 30 teams
who have been actively at work. We had our first meeting with the 30
team leads the day before the President signed the law.
A number of months ago we also set up a 31st rulemaking team tasked
with developing conforming rules to update the CFTC's existing
regulations to take into account the provisions of the Act.
The CFTC is working deliberatively and efficiently to promulgate
rules required by Congress. The talented and dedicated staff of the
CFTC has stepped up to the challenge and has recommended thoughtful
rules--with a great deal of input from each of the five Commissioners--
that would implement the Act. We have thus far proposed rulemakings or
interpretive orders in 28 of the 31 areas.
The CFTC's process to implement the rulemakings required by the Act
includes enhancements over the agency's prior practices in five
important areas. Our goal was to provide the public with additional
opportunities to inform the Commission on rulemakings, even before
official public comment periods. I will expand on each of these five
points in my testimony.
1. We began soliciting views from the public immediately after the
Act was signed and prior to approving proposed rulemakings.
This allowed the agency to receive input before the pens hit
the paper.
2. We hosted a series of public, staff-led roundtables to hear ideas
from the public prior to considering proposed rulemakings.
3. We engaged in significant outreach with other regulators--both
foreign and domestic--to seek input on each rulemaking.
4. Information on both staff's and Commissioners' meetings with
members of the public to hear their views on rulemakings has
been made publicly available at cftc.gov.
5. The Commission held public meetings to consider proposed
rulemakings. The meetings were webcast so that the Commission's
deliberations were available to the public. Archive webcasts
are available on our Web site as well.
Two principles are guiding us throughout the rule-writing process.
First is the statute itself. We intend to comply fully with the
statute's provisions and Congressional intent to lower risk and bring
transparency to these markets.
Second, we are consulting heavily with both other regulators and
the broader public. We are working very closely with the SEC, the
Federal Reserve, the Federal Deposit Insurance Corporation, the Office
of the Controller of the Currency and other prudential regulators,
which includes sharing many of our memos, term sheets and draft work
products. We also are working closely with the Treasury Department and
the new Office of Financial Research. As of Friday, CFTC staff has had
598 meetings with other regulators on implementation of the Act.
In addition to working with our American counterparts, we have
reached out to and are actively consulting and coordinating with
international regulators to harmonize our approach to swaps oversight.
As we are with domestic regulators, we are sharing many of our memos,
term sheets and draft work product with international regulators as
well. Our discussions have focused on clearing and trading
requirements, clearinghouses more generally and swaps data reporting
issues, among many other topics.
Specifically, we have been consulting directly and sharing
documentation with the European Commission, the European Central Bank,
the U.K. Financial Services Authority and the new European Securities
and Markets Authority. Three weeks ago, I traveled to Brussels to meet
with the European Parliament's Economic and Monetary Affairs Committee
and discuss the most important features of swaps oversight reform.
We also have 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 this consultation, we are working to bring consistency to
regulation of the swaps markets. In September of last year, the
European Commission released its swaps proposal. As we had in 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 all swaps to a trade repository. 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.
We also are soliciting broad public input into the rules and have
set up mailboxes for the public to comment directly prior to the
Commission's rulemaking process. As of yesterday, we had received 2,907
submissions from the public through the e-mail inboxes as well as 8,991
official comments in response to notices of proposed rulemaking.
For the vast majority of proposed rulemakings, we have solicited
public comments for a period of 60 days. On some occasions, the public
comment period lasted 30 days.
Additionally, many individuals have asked for meetings with either
our staff or Commissioners to discuss swaps regulation. As of
yesterday, we have had 675 such meetings. We are now posting on our Web
site a list of all of the meetings CFTC staff and I have with outside
organizations, as well as the participants, issues discussed and all
materials given to us.
At this point in the process, the CFTC has come to a natural pause
as we have now promulgated proposals in most of the areas. As we
receive comments from the public, we are looking at the whole mosaic of
rules and how they interrelate. We will begin considering final rules
only after staff can analyze, summarize and consider comments, after
the Commissioners are able to discuss the comments and provide feedback
to staff, and after the Commission consults with fellow regulators on
the rules. We hope to move forward in the spring, summer and fall with
final rules.
One component that we have asked the public about is phasing of
implementation. The Dodd-Frank Act gave the CFTC flexibility as to
setting implementation or effective dates of the rules to implement the
Dodd-Frank Act. For example, even if we finish finalizing rules in a
particular order, that doesn't mean that the rules will be required to
become effective in that order. 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 the entity or product
definitions rules.
The Commission has the authority to phase implementation dates
based upon a number of factors, including asset class, type of market
participant and whether the requirement would apply to market
platforms, like clearinghouses, or to specific transactions, such as
real time reporting. For example, a rule might become effective for one
asset class or one group of market participants before it is effective
for other asset classes or other groups of market participants. We are
looking to phase in implementation, considering the whole mosaic of
rules. We look forward to hearing from market participants and
regulators, both in the U.S. and abroad, regarding the phasing of
implementation.
End User Margin
One of the rules on which the CFTC is working closely with the SEC,
the Federal Reserve and other prudential regulators will address margin
requirements for swap dealers and major swap participants.
Congress recognized the different levels of risk posed by
transactions between financial entities and those that involve
nonfinancial entities, as reflected in the nonfinancial end user
exception to clearing. Transactions involving nonfinancial entities do
not present the same risk to the financial system as those solely
between financial entities. The risk of a crisis spreading throughout
the financial system is greater the more interconnected financial
companies are to each other. Interconnectedness among financial
entities allows one entity's failure to cause uncertainty and possible
runs on the funding of other financial entities, which can spread risk
and economic harm throughout the economy. Consistent with this,
proposed rules on margin requirements should focus only on transactions
between financial entities rather than those transactions that involve
nonfinancial end users.
Conclusion
Before I close, I will briefly address the resource needs of the
CFTC. The futures marketplace that the CFTC currently oversees is
approximately $36 trillion in notional amount. The swaps market that
the Act tasks the CFTC with regulating has a notional amount roughly
seven times the size of that of the futures market and is significantly
more complex. Based upon figures compiled by the OCC, the largest 25
bank holding companies currently have $277 trillion notional amount of
swaps.
The CFTC's current funding is far less than what is required to
properly fulfill our significantly expanded mission. Though we have an
excellent, hardworking and talented staff, we just this past year got
back to the staff levels that we had in the 1990s. To take on the
challenges of our expanded mission, we will need significantly more
staff resources and--very importantly--significantly more resources for
technology. Technology is critical so that we can be as efficient an
agency as possible in overseeing these vast markets.
The CFTC currently is operating under a continuing resolution that
provides funding at an annualized level of $168.8 million. The
President requested $261 million for the CFTC in his proposed fiscal
year (FY) 2011 budget. This included $216 million and 745 full-time
equivalent employees for prereform authorities and $45 million to
provide half of the staff estimated at that time needed to implement
the Act. Under the continuing resolution, the Commission has operated
in FY2011 at its FY2010 level. The President's FY2012 budget request
included $308 million for the CFTC and would provide for 983 full-time
equivalent employees.
Given the resource needs of the CFTC, we are working very closely
with self regulatory organizations, including the National Futures
Association, to determine what duties and roles they can take on in the
swaps markets. Nevertheless, the CFTC has the ultimate statutory
authority and responsibility for overseeing these markets. Therefore,
it is essential that the CFTC have additional resources to reduce risk
and promote transparency in the swaps markets.
Thank you, and I'd be happy to take questions.
______
PREPARED STATEMENT OF DANIEL K. TARULLO
Member, Board of Governors of the Federal Reserve System
April 12, 2011
Chairman Johnson, Ranking Member Shelby, and other Members of the
Committee, I appreciate this opportunity to provide the Federal Reserve
Board's views on the implementation of title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act). The Board's
responsibilities with respect to over-the-counter (OTC) derivatives
fall into three broad areas: consultation and coordination with other
authorities, both domestic and international; efforts to strengthen the
infrastructure of derivatives markets; and supervision of many
derivatives dealers and market participants.
Consultation and Coordination
The Dodd-Frank Act requires that the Commodity Futures Trading
Commission (CFTC) and the Securities and Exchange Commission (SEC)
consult with the Board on the rules they are crafting to implement
several provisions of title VII. Immediately after passage of the act,
the staff from the commissions and the Board met to fashion a process
for this consultation; at the Board, we identified members of the staff
with relevant expertise, both here and across the Federal Reserve
System. Our staff have commented on proposed rules of the commissions
at each stage of the development process to date. In providing
feedback, we have tried to bring to bear our experience from
supervising dealers and market infrastructure as well as our
familiarity with markets and data sources to assist the commissions.
Important coordination activities related to derivatives regulation
also are occurring within international groups. Most prominently, the
Group of Twenty (G-20) leaders have set out commitments related to
reform of the OTC derivatives markets that, when implemented by
national authorities, will form a broadly consistent international
regulatory approach. Work on the G-20 commitments is being done by
numerous groups of technical and policy experts, and staff members from
the Federal Reserve are actively participating in these groups.
More generally, the Board participates in many international groups
that serve as vehicles for coordinating policies related to the
participants and the infrastructure of derivatives markets. These
groups include the Basel Committee on Banking Supervision (Basel
Committee), which has recently enhanced international capital,
leverage, and liquidity standards for derivatives, and the Committee on
Payment and Settlement Systems, which is working with the International
Organization of Securities Commissions to update international
standards for systemically important clearing systems, including
central counterparties that clear derivatives instruments, and trade
repositories. Public consultation on these revised international
standards is currently under way.
The goal of all of these efforts is to develop a consistent
international approach to the regulation and supervision of derivatives
products and market infrastructures as well as to the sound
implementation of the agreed-upon approaches. Our aim is to promote
both financial stability and fair competitive conditions to the fullest
extent possible.
Infrastructure Issues
The Dodd-Frank Act addressed both the infrastructure of the
derivatives markets and the regulation and supervision of its dealers
and major participants. Central counterparties are given an expanded
role in the clearing and settling of swap and security-based swap
(hereafter referred to as ``swap'') transactions, and the Board
believes benefits can flow from this reform. Since 2005, Federal
Reserve staff members have worked with market participants to
strengthen the infrastructure for OTC derivatives, including developing
and broadening the use of central clearing mechanisms and trade
repositories. Market participants have already established central
counterparties that provide clearing services for some OTC interest
rate, energy, and credit derivatives contracts. If properly designed,
managed, and overseen, central counterparties offer an important tool
for managing counterparty credit risk, and thus they can reduce risk to
market participants and to the financial system. Both central
counterparties and trade repositories also support regulatory oversight
and policymaking by providing more-comprehensive data on the
derivatives markets. The Board is committed to continuing to work with
other authorities, both in the United States and abroad, to ensure that
a largely consistent international approach is taken to central
counterparties and trade repositories and that their risk-reducing
benefits are realized.
Title VIII of the act complements the role of central clearing in
title VII through heightened supervisory oversight of systemically
important financial market utilities, including systemically important
facilities that clear swaps. This heightened oversight is important
because financial market utilities such as central counterparties
concentrate risk and thus have the potential to transmit shocks
throughout the financial markets. The Financial Stability Oversight
Council is responsible for designating utilities as systemically
important. Through its role on the council, the Board helped develop
the designation process that was released for comment in March.
Separately, the Board is also seeking comment on proposed risk-
management standards that would apply to those designated utilities
supervised by the Board under title VIII. \1\ As part of title VIII,
the Board was given new authority to provide designated utilities with
access to Reserve Bank accounts, payment services, and emergency
collateralized liquidity in unusual and exigent circumstances. We are
carefully considering ways to implement this authority in a manner that
protects taxpayers and limits any rise in moral hazard.
---------------------------------------------------------------------------
\1\ Board of Governors of the Federal Reserve System (2011),
``Federal Reserve Seeks Comment on Proposed Rule Related to Supervision
of Designated Financial Market Utilities'', press release, March 30,
www.federalreserve.gov/newsevents/press/other/20110330a.htm.
---------------------------------------------------------------------------
Supervisory Issues
Although central counterparties will provide an additional tool for
managing counterparty credit risk, enhancements to the risk-management
policies and procedures for individual market participants will
continue to be a high priority for supervisors. As the reforms outlined
in the act are implemented, the most active firms in bilateral OTC
markets likely will become active clearing members of central
counterparties. As such, the quality of risk management at these firms
importantly affects the ability of the central counterparty to manage
its risks effectively and to deliver risk-reducing benefits to the
markets.
Capital and margin requirements are central to the prudential
regulation of financial institutions active in derivatives markets as
well as to the internal risk-management processes of such firms. Title
VII requires that the CFTC, the SEC, and prudential regulators adopt
capital and margin requirements for the noncleared swap activity of
swap dealers and major swap participants. The Board, the Office of the
Comptroller of the Currency, the Federal Deposit Insurance Corporation,
the Federal Housing Finance Agency, and the Farm Credit Administration
are responsible for adopting capital and margin requirements for swap
dealers and major swap participants that are banks or other
prudentially regulated entities. The commissions are responsible for
adopting capital and margin requirements for swap dealers and major
swap participants that are not supervised by a prudential regulator.
The prudential regulators and the commissions are consulting in
developing the rules, and all agencies must, to the maximum extent
practicable, adopt comparable standards.
Earlier today, the Board and the other prudential regulators
released for public comment a proposed rule on capital and margin
requirements. Our proposal will be open for public comment for 60 days,
and we look forward to receiving the public's comments.
For capital, our proposal relies on the existing regulatory capital
requirements, which already specifically address the unique risks of
derivatives transactions. Beyond the current requirements, the Board
and the other U.S. banking agencies played an active role in developing
the recent Basel III enhancements to capital requirements agreed to by
the Basel Committee in December 2010. Basel III will, among other
things, strengthen the prudential framework for OTC derivatives by
increasing OTC derivatives' risk-based capital and leverage
requirements and by requiring banking firms to hold an additional
buffer of high-quality, liquid assets to address potential liquidity
needs resulting from their derivatives portfolios.
Our proposal for margin imposes initial and variation margin
requirements on the noncleared swaps held by swap dealers or major swap
participants that have a prudential regulator. For swaps with a
nonfinancial end user counterparty, the proposed rule would not specify
a minimum margin requirement. Rather, it would allow a banking
organization that is a dealer or major participant to establish a
threshold, based on a credit exposure limit that is approved and
monitored as part of the credit approval process, below which the end
user would not have to post margin. For swaps with other
counterparties, the proposal would cap the allowable threshold for
unsecured credit exposure on noncleared swaps. In addition, the
proposal would only apply a margin requirement to contracts entered
into after the new requirement becomes effective.
A much discussed part of the act is the requirement that banks push
portions of their swap activity into affiliates or face restrictions on
their access to the discount window or deposit insurance. Under the
push-out provisions, banking organizations with deposit insurance or
access to the Federal Reserve's discount window will have to reorganize
some of their derivatives activity, pushing certain types of swaps out
of subsidiary banks and into distinct legal entities that will require
their own capitalization and separate documentation of trades with
existing customers. The act permits domestic banks to continue to
engage in derivatives activities that have been a traditional focus of
banks, including hedging activities and dealing in interest rate swaps,
currency swaps, certain cleared credit default swaps, and other swaps
that reference assets that banks are eligible to hold. However, because
of the specific language contained in the act, this exemption for
traditional bank derivatives activities does not apply to U.S. branches
of foreign banking firms that by law have access to the Federal
Reserve's discount window. A possibly unintended effect of the act's
push-out provision may be to require some foreign firms to reorganize
their existing U.S. derivatives activities to a greater extent than
U.S. firms. Proposed rules to implement this section are still under
development by the banking agencies.
Conclusion
As the implementation process for the act continues, the challenge
facing the Board is to enhance supervision, oversight, and prudential
standards of major derivatives market participants in a manner that
promotes more-effective risk management and reduces systemic risk, yet
retain the significant benefits of derivatives to the businesses and
investors who use them to manage financial market risks. The Board is
working diligently to achieve these goals.
______
PREPARED STATEMENT OF MARY J. MILLER
Assistant Secretary for Financial Markets, Department of the Treasury
April 12, 2011
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee, thank you for inviting me to testify today about Treasury's
role in implementing the derivatives provisions of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act).
As you know, the President signed the Dodd-Frank Act into law
almost 9 months ago. The Act established a framework for the country to
build a stronger, safer, and more competitive financial system. It
creates safeguards to protect consumers and investors, end taxpayer
bailouts, and improve the transparency, efficiency, and liquidity of
U.S. markets. The Dodd-Frank Act's derivatives provisions are an
important part of that framework.
During the 9 months since the Dodd-Frank Act became law, the
Treasury Department, other parts of the Administration, and independent
regulatory agencies have been working diligently to build out the
framework according to the directions provided by the statute. As we
implement the Dodd-Frank Act, we have focused on advancing the best
interests of consumers, investors, and taxpayers while also preserving
the best attributes of and improving upon a financial system that
encourages investment and promotes growth.
As other Treasury officials have previously testified before this
Committee, several broad principles guide our efforts:
1. We are moving as quickly as we can to carry out the intent of
Congress and meet the deadlines that the Dodd-Frank Act
established, but we are also moving carefully to make sure that
as we implement the Act, we get it right.
2. We are bringing full transparency to the process so that as many
stakeholders as possible have a seat at the table, so that the
American people know who is at that table, so that proposed
rules and even advance notices of proposed rulemakings and
requests for comments are published, and so that anyone who
wants to comment can do so.
3. We are creating a more coordinated regulatory process. We will
eliminate gaps that allowed risks to grow unchecked and
permitted a race to the bottom in certain areas. The Financial
Stability Oversight Council (FSOC) is playing a key role in
these efforts by bringing together the financial regulatory
agencies to help develop consistent and comparable regulations
and supervisory regimes across different agencies.
4. We are building a level playing field that treats market
participants equally, whether they are banks or nonbanks, and
whether they are domestic or foreign institutions. We are
setting high standards in the United States and working
diligently with our international counterparts to encourage
them to set similar standards.
5. We are crafting rules of the road that will provide U.S.
investors and institutions the confidence, the certainty, and
the incentives they need to invest capital, develop innovative
products and services, and compete globally.
6. Finally, we are committed to keeping Congress fully informed of
our progress on a regular basis.
Just as these guiding principles apply broadly to Dodd-Frank Act
implementation efforts, they also apply to implementation of the Dodd-
Frank Act's derivatives provisions in particular.
Our partners at the Commodity Futures Trading Commission (CFTC),
the Securities and Exchange Commission (SEC), and the Board of
Governors of the Federal Reserve System (Federal Reserve Board), all of
whom are represented here today, have been and will continue to be
instrumental in achieving the goals of the Dodd-Frank Act. As you will
hear from Chairman Gensler, Chairman Schapiro and Governor Tarullo,
their agencies' roles in implementing the Act's derivatives provisions
are particularly important.
While Treasury has a more limited role than the CFTC, SEC, and
Federal Reserve Board in building Dodd-Frank's new derivatives
regulatory framework, the Secretary of the Treasury (Secretary) does
have certain specific statutory responsibilities under the Dodd-Frank
Act and has other responsibilities in his capacity as the Chairman of
the FSOC.
Starting with the specific responsibilities under the Dodd-Frank
Act, Congress gave the Secretary the authority to determine whether
foreign exchange (FX) swaps and forwards should be exempted from the
definition of ``swap'' in the Commodity Exchange Act (CEA) (7 U.S.C.
ch. 1). Foreign exchange swaps and forwards generally are subject to
the requirements of the CEA. For these instruments, the most
significant requirements under the regulatory regime enacted by the
Dodd-Frank Act would be central clearing and exchange trading
requirements for foreign exchange swaps and forwards, unless the
Secretary determines that they ``(I) should not be regulated as swaps
under [the CEA]; and (II) are not structured to evade [the Dodd-Frank
Act] in violation of any rules promulgated by the [CFTC]'' pursuant to
the Dodd-Frank Act. \1\
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\1\ 7 U.S.C. 1a(47)(E)(i).
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The statute limits the scope of a determination to foreign exchange
swaps and forwards and does not allow the Secretary to exempt other
foreign exchange derivatives, such as foreign exchange options,
currency swaps, and nondeliverable forwards. These other foreign
exchange derivatives do not satisfy the narrow definition of a
``foreign exchange swap'' or ``foreign exchange forward'' and,
therefore, may not be exempted.
Under the CEA as amended by the Dodd-Frank Act, and for purposes of
the Secretary's determination, an FX swap is defined as ``a transaction
that solely involves--(A) an exchange of 2 different currencies on a
specific date at a fixed rate that is agreed upon on the inception of
the contract covering the exchange'' and ``(B) a reverse exchange of
[those two currencies] at a later date and at a fixed rate that is
agreed upon on the inception of the contract covering the exchange.''
\2\ Likewise, the CEA as amended narrowly defines an FX forward as ``a
transaction that solely involves the exchange of 2 different currencies
on a specific future date at a fixed rate agreed upon on the inception
of the contract covering the exchange.'' \3\
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\2\ 7 U.S.C. 1a(25).
\3\ 7 U.S.C. 1a(24).
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In determining whether to exempt foreign exchange swaps and
forwards, the Secretary must consider the following five statutory
factors set forth by the Dodd-Frank Act:
1. Whether the required trading and clearing of foreign exchange
swaps and foreign exchange forwards would create systemic risk,
lower transparency, or threaten the financial stability of the
United States;
2. Whether foreign exchange swaps and foreign exchange forwards are
already subject to a regulatory scheme that is materially
comparable to that established by the CEA for other classes of
swaps;
3. The extent to which bank regulators of participants in the
foreign exchange market provide adequate supervision, including
capital and margin requirements;
4. The extent of adequate payment and settlement systems; and
5. The use of a potential exemption of foreign exchange swaps and
foreign exchange forwards to evade otherwise applicable
regulatory requirements. \4\
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\4\ 7 U.S.C. 1b(a).
If the Secretary determines that foreign exchange swaps or forwards
should be exempted from the CEA's definition of ``swap,'' Treasury must
provide a written determination to Congress that contains: (1) ``an
explanation of why [FX] swaps and [FX] forwards are qualitatively
different from other classes of swaps in a way that would make the [FX]
swaps and [FX] forwards ill-suited for regulation as swaps;'' and (2)
``an identification of the objective differences of [FX] swaps and [FX]
forwards with respect to standard swaps that warrant an exempted
status.'' \5\
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\5\ 7 U.S.C. 1b(b).
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Consistent with Treasury's commitment to an open and transparent
process, on October 28, 2010, we published a Notice and Request for
Comments (Notice) in the Federal Register to solicit public comment on
a wide range of issues relating to whether foreign exchange swaps and
foreign exchange forwards should be exempt from the definition of the
term ``swap'' under the CEA. We received approximately thirty comments
in response to the Notice, and Treasury staff has also conducted its
own, independent analysis of the issue, including extensive discussions
with a range of regulators, end users, dealers, and other interested
parties.
We know that this is an issue that market participants and other
stakeholders are interested in, and we recognize that the Committee is
also closely following this issue. Like other areas of Dodd-Frank
implementation and consistent with the guiding principles identified
above, this is an area where we want to move expeditiously. Regardless
of the decision the Secretary pursues, market participants need to know
what the regulatory regime will look like and to be able to plan and
prepare for that regime. But it is also critical that we take enough
time to be confident that we are making the right decision for the
safety and soundness of the markets.
In addition to his specific duties under the Dodd-Frank Act, the
Secretary also has more general responsibilities with respect to the
Act's derivatives provisions in his capacity as Chairman of the FSOC.
In March, the FSOC held its fourth meeting and approved the publication
of a Notice of Proposed Rulemaking (NPRM) regarding the FSOC's
designation of financial market utilities (FMUs) as systemically
important.
FMUs exist in many financial markets to support and facilitate the
transfer, clearing, and settlement of financial transactions, and they
form a critical part of the Nation's financial market infrastructure.
FMUs' functions and interconnectedness with many parts of the market
can help manage and reduce risk, but if they are poorly operated could
also concentrate risk. Title VIII of systemic risks they might create
if not properly managed and supervised. To address the potential for
such risks, the Act seeks to enhance the regulation and supervision of
systemically important FMUs to promote robust risk management and
safety and soundness.
The FSOC published an advance notice of proposed rulemaking
regarding the criteria for designating systemically important FMUs on
December 21, 2010. After receiving, reviewing, and analyzing comments
received in response to the advance notice and performing additional
work, at its March meeting the FSOC approved the publication of the
NPRM. The NPRM was published in the Federal Register on March 28, 2011,
and the comment period will be open for 60 days for any interested
party to submit comments on the proposed rule.
Title VIII of the Dodd-Frank Act also gives the FSOC the
responsibility of designating systemically important payment, clearing,
and settlement (PCS) activities that occur at financial institutions
other than FMUs. These PCS activities could occur between financial
institutions transacting with each other or between a financial
institution and one of its customers. The FSOC's member agencies and
staff have started examining this issue as well, and the FSOC will
proceed in the coming months with the necessary rulemaking to establish
the criteria and procedures for the FSOC's designation of PCS
activities as systemically important.
One final area I would like to touch on is the importance of the
comparability of international standards that will apply to the
financial regulatory framework in general, including derivatives
regulation. The United States will set high standards and take the
steps that are necessary for the safety and soundness of our financial
system. But today's financial system is highly interconnected, mobile,
and global. It is important that we pursue as level an international
playing field as possible not only to protect the competiveness of U.S.
financial markets and institutions but also to ensure that the
critically important reforms we implement here cannot be evaded or
rendered ineffective by lax standards elsewhere.
With respect to the international derivatives regulatory framework,
significant globally coordinated work has already occurred, but more
remains to be done. Treasury and our international counterparts are
focused on making certain that critical over-the-counter derivative
market infrastructure is subject to appropriate oversight. A key
element of our current discussions is ensuring that we have cooperative
oversight frameworks in place to address the information needs of
supervisors in different jurisdictions.
We will continue to work at home and with our international
counterparts to build a regulatory framework for derivatives that will
help our financial system become safer and sounder and a sound platform
on which we can build strong financial markets that will fuel the
Nation's economic growth.
______
PREPARED STATEMENT OF THOMAS C. DEAS, JR.
Vice President and Treasurer, FMC Corporation
April 12, 2011
Good afternoon, I am Tom Deas, Vice President and Treasurer of FMC
Corporation and also President of the National Association of Corporate
Treasurers (NACT), an organization of treasury professionals from
several hundred of the largest public and private companies in the
country. FMC and NACT are also part of the Coalition for Derivatives
End Users (the ``Coalition''). Our Coalition represents thousands of
companies across the United States that employ derivatives to manage
basic business risks they face every day. Thank you very much for
giving me the opportunity to speak with you today about derivatives
regulation.
FMC Corporation was founded almost 130 years ago to provide spray
equipment to farmers. Today in addition to making agricultural
chemicals farmers apply to protect their crops, our 5,000 employees
have worked hard to make FMC a leading manufacturer and marketer of a
whole range of agricultural, specialty and industrial chemicals. FMC
has achieved this longevity by continually responding to our customers'
needs with the right chemistry delivered at the right price. This year
marks our 80th anniversary of listing on the New York Stock Exchange.
In 1931 FMC sought access to the U.S. equity market as the largest and
most available pool of capital to support our growing business. Today
in 2011 the most responsive financial market in the world is the over-
the-counter (OTC) derivatives market. I had the valuable experience of
negotiating and executing some of the very first derivatives--currency
swaps--going back to 1984. I have seen the market grow from its
inception in the mid-1980s to its current size by adapting and
responding to market participants' needs. The customization available
in the OTC derivatives market is key to FMC's and other end users'
ability to hedge business risks in a cost-effective way. The
standardized contracts available on existing and proposed derivatives
exchanges will not provide this customized match to our underlying
business exposures.
We support this Committee's efforts to redress the problems with
derivatives we experienced during the financial crisis in 2008. I want
to assure you that FMC and other end users were not and are not
engaging in risky speculative derivatives transactions from which some
of that turmoil arose. We are very concerned by the assertion several
regulators have made that the Act's requirement for swap dealers to
post margin should also be extended to end users. This would require us
to hold aside scarce cash and immediately available credit to meet
margin calls and would be a significant new economic burden. At the
time the Dodd-Frank Act was passed, end users understood we would be
exempt from having to post cash margin. I want to emphasize that FMC
and other end users employ OTC derivatives solely to manage underlying
business risks. We are offsetting risks--not creating new ones.
Please allow me to illustrate our use of derivatives with specific
examples. FMC is the world's largest producer of natural soda ash, the
principal input in glass manufacturing, and is one of the largest
employers in the State of Wyoming. We are also developing innovative
new environmental applications that scrub sulfur compounds from flue
gases of factories and power plants. We can mine and refine soda ash
products in southwestern Wyoming, ship them to South Asia, and deliver
them at a lower cost and with higher quality than competing Chinese
producers. Energy is a significant cost element in producing soda ash
and FMC protects against unpredictable fluctuations in future energy
costs with OTC derivatives to hedge natural gas prices. These
derivatives are done with several banks, all of which are also
supporting FMC through their provision of almost $1 billion of credit.
Our banks do not require FMC to post cash margin to secure mark-to-
market fluctuations in the value of derivatives, but instead price the
overall transaction to take this risk into account. This structure
gives us certainty so that we never have to post cash margin while the
derivative is outstanding. However, if we are required by the
regulators to post margin, we will have to hold aside cash and readily
available credit to meet those margin calls. Depending on the extent of
price movements, margin might have to be posted within the trading day
as well as at the close of trading. Because failure to meet a margin
call would be like bouncing a check, and would constitute a default,
our corporate treasury would act very conservatively in holding cash or
immediately available funds under our bank lines of credit to assure we
could meet any future margin call in a timely fashion and with a
comfortable cushion.
Adopting more conservative cash management practices might sound
like an appropriate response in the wake of the financial crisis.
However, end users did not cause the financial crisis. End users do not
contribute to systemic risk because their use of derivatives
constitutes prudent, risk mitigating hedging of their underlying
business. Forcing end users to put up cash for fluctuating derivatives
valuations means less funding available to grow their businesses and
expand employment. The reality treasurers face is that the money to
margin derivatives has to come from somewhere and inevitably less
funding will be available operate their businesses.
FMC and other members of the Business Roundtable estimated that
BRT-member companies would have to hold aside on average $269 million
of cash or immediately available bank credit to meet margin calls. In
our world of finite limits and financial constraints, this is a direct
dollar-for-dollar subtraction from funds that we would otherwise use to
expand our plants, build inventory to support higher sales, undertake
research and development activities, and ultimately sustain and grow
jobs. In fact, the study extrapolated the effects across the S&P 500,
of which FMC is also a member, to predict the consequent loss of
100,000 to 120,000 jobs. The effect on the many thousands of end users
beyond the S&P 500 would be proportionately greater. We would also have
to make a considerable investment in information systems that would
replicate much of the technology in a bank's trading room for marking
to market and settling derivatives transactions.
Let me give you a direct example of why our banks have agreed that
cash margin is not necessary for FMC's derivatives trades. Because we
are always hedging an underlying business risk, if a current valuation
of a derivative is underwater, then the risk we are hedging must be in
the money, resulting in a net neutral position. To illustrate, FMC
sells agricultural chemicals to farmers who need them at planting time,
but want to defer payment until harvest time. FMC agrees with the
farmer that he can pay in bushels of soybeans when he harvests his
crop. FMC then enters into a customized derivative with one of our
banks that exactly matches the amount and timing of the future delivery
of soybeans. As the price of soybeans fluctuates, the valuation of the
derivative changes by an equal and opposite amount in relation to the
bushels of soybeans. This results in no net gain or loss when the
derivative and the underlying exposure are valued together at any point
in the future. We benefit from not having unpredictable demands on our
liquidity. For this balanced structure, we agree to a small markup
payable at maturity of the soybean derivative transaction I've just
described. This is far cheaper in both financial and administrative
cost than if we had to keep idle cash or immediately available credit
to meet cash margin postings and undertake significant information
systems investments. Customized OTC derivatives allow us to expand
sales and provide added value to our customers, while reducing our
risk.
By forcing end users to post cash margin, the regulators will take
the balanced structure I've just described and impose a new risk.
Treasurers will have new and unpredictable demands on their liquidity.
Swap dealers are market makers who take open positions with derivatives
and we agree central clearing and margining is appropriate for them.
However, since end users are balanced, with derivatives exactly
offsetting underlying business risks, forcing them into the swap
dealers' margin rules adds the considerable risk for end users of
having to fund frequent cash margin payments. This will introduce an
imbalance and new risks onto transactions that are matched and will
settle with offsetting cash payments at maturity.
Let me take a moment to summarize some of our principal concerns
with the implementation of derivatives regulation:
First, we are concerned that the regulators will impose
margin on end user trades, diverting billions of dollars from
productive investment and employment into an idle regulatory
levy.
Second, even if the final regulations clearly exempt end
users from margin requirements, we still have the risk that the
regulators will require swap dealers to hold excessive capital
in reserve against uncleared over-the-counter derivatives--with
the cost passed on to end users as they manage their business
risks. We believe that swap dealers' capital requirements
should be appropriate to the actual loss experience of the
specific type of derivative. The unintended consequence of
punitive capital requirements could be for some end users to
cease hedging risks and for others to use foreign markets.
Finally, we are concerned that regulators will make
customized derivatives prohibitively expensive through margin
and increased capital requirements, with the effect of forcing
us into standardized derivatives from common trading facilities
that will not provide the exact match we seek with our
underlying business exposures. It is the customization
available with OTC derivatives that is so valuable to us and
makes the derivatives effective in hedging our exposures.
The cumulative effect of these regulations could mean that U.S.-
based manufacturers with substantial exports could no longer
economically hedge their foreign exchange risk with derivatives. As a
result they could be forced to move production offshore to match their
costs directly with the currencies of their customers. I urge you to
inquire into this looming problem that could increase the credit
spreads for OTC derivatives by a factor of five or more.
I know many people who suffered through the financial turmoil of
2008 are tempted to label all derivatives as risky bets that should be
curtailed. However, I hope these examples of prudent use of derivatives
by my company and other end users who form the backbone of our
country's economy have demonstrated the wisdom of the end user
exemptions that we believe to have been the legislative intent.
Chairman Gensler and other regulators have been very forthcoming
and open in soliciting input from us. We appreciate being involved, but
we have only a few weeks until the deadline for finalizing rules. The
end user exemption we thought was clear is still uncertain and only a
very few of the 105 rules required by July 15 have been published. I
urge you to extend the statutory date by which rules must be
promulgated until the remaining uncertainties can be clarified and we
can be assured the rules will operate effectively when taken together.
Thank you for your time. I would be happy to respond to any
questions you may have.
______
PREPARED STATEMENT OF LEE OLESKY
Chief Executive Officer, Tradeweb Markets LLC
April 12, 2011
Tradeweb Markets LLC (Tradeweb) appreciates the opportunity to
provide testimony to the Senate Committee on Banking, Housing, and
Urban Affairs (the ``Committee'') with respect to the regulatory
framework for and implementation of Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (the ``Dodd-Frank Act'' or
the ``Act'') under the proposed regulations from the Commodity Futures
Trading Commission (CFTC) and U.S. Securities and Exchange Commission
(``SEC'', together with the CFTC, the ``Commissions'').
I. Background on Tradeweb
Tradeweb is a leading global provider of electronic trading
platforms and related data services for the over-the-counter fixed
income and derivatives marketplaces. Tradeweb operates three separate
electronic trading platforms: (i) a global electronic multidealer to
institutional customer platform through which institutional investors
access market information, request bids and offers, and effect
transactions with, dealers that are active market makers in fixed
income securities and derivatives, (ii) an interdealer platform, called
Dealerweb, for U.S. Government bonds and mortgage securities, and (iii)
a platform for retail-sized fixed income securities. \1\
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\1\ Tradeweb operates the dealer-to-customer and odd-lot platforms
through its registered broker-dealer, Tradeweb LLC, which is also
registered as an alternative trading system (ATS) under Regulation ATS
promulgated by the SEC under the Securities Exchange Act of 1934.
Tradeweb operates its inter-dealer platform through its subsidiary,
Hilliard Farber & Co., Inc., which is also a registered broker-dealer
and operates Dealerweb as an ATS. In Europe, Tradeweb offers its
institutional dealer-to-customer platform through Tradeweb Europe
Limited, which is authorized and regulated by the U.K. Financial
Services Authority as an investment firm with permission to operate as
a Multilateral Trading Facility. In addition, Tradeweb Europe Limited
has registered branch offices in Hong Kong, Singapore, and Japan and
holds an exemption from registration in Australia.
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Founded as a multidealer online marketplace for U.S. Treasury
securities in 1997, Tradeweb has been a pioneer in providing market
data, electronic trading and trade processing in OTC marketplaces for
over 10 years, and has offered electronic trading in OTC derivatives on
its institutional dealer-to-customer platform since 2005. Active in 20
global fixed income, money market and derivatives markets, with an
average daily trading volume of more than $250 billion, Tradeweb's
leading institutional dealer-to-customer platform enables 2,000
institutional buy-side clients to access liquidity from more than 40
sell-side liquidity providers by putting the liquidity providers in
real-time competition for client business in a fully disclosed
electronic auction process. These buy-side clients comprise the
majority of the world's leading asset managers, pension funds, and
insurance companies, as well as most of the major central banks.
Since we began trading interest rate swaps in 2005, the notional
amount of interest rate derivatives traded on Tradeweb has exceeded
$6.5 trillion from more than 75,000 trades. Tradeweb has spent the last
5 years building on its derivatives functionality to enhance real-time
execution, provide greater price transparency and reduce operational
risk. Today, the Tradeweb system provides its institutional clients
with the ability to (i) view live, real-time IRS (in six currencies,
including U.S., Euro, Sterling, Yen), and Credit Default Swap Indices
(CDX and iTraxx) prices from swap dealers throughout the day; (ii)
participate in live, competitive auctions with multiple dealers at the
same time, and execute an array of trade types (e.g., outrights, spread
trades, or rates switches); and (iii) automate their entire workflow
with integration to Tradeweb so that trades can be processed in real-
time from Tradeweb to customers' middle and back offices, to third-
party affirmation services like Markitwire and DTCC Deriv/SERV, and to
all the major derivatives clearing organizations. Indeed, in November
2010, Tradeweb served as the execution facility for the first fully
electronic multidealer-to-customer interest rate swap trade to be
cleared in the U.S., and in February 2011, Tradeweb completed the first
fully electronic multidealer-to-customer credit default swap trade to
be executed and cleared in the U.S. Tradeweb's existing technology
maintains a permanent audit trail of the millisecond-by-millisecond
details of each trade negotiation and all completed transactions, and
allows parties (and will allow SDRs and DCOs) to receive trade details
and access post-trade affirmation and clearing venues. With such tools
and functionality in place, Tradeweb is providing the OTC marketplace
with a front-end swap execution facility.
As additional background, Tradeweb was established in 1997 with
financial backing from four global banks that were active in, and
interested in expanding and fostering innovation in, fixed income (U.S.
Government bond) trading. After 7 years of growth and expansion into 15
markets globally, in 2004, Tradeweb's bank-owners (which had grown from
four to eight over that time) sold Tradeweb to The Thomson Corporation,
which wholly owned it until January 2008. Although the original bank-
owners continued to be a resource for Tradeweb from 2004 to 2008, The
Thomson Corporation recognized that bank ownership was an important
catalyst of Tradeweb's development and sold through a series of
transactions a strategic interest in Tradeweb to a consortium comprised
of ten global bank owners. Today, Tradeweb is majority owned by Thomson
Reuters Corporation (successor to The Thomson Corporation) and minority
stakes are held by the bank consortium and Tradeweb management.
Accordingly, Tradeweb was launched by market participants and has
benefited from their investment of capital, market expertise and
efforts to develop and foster more transparent and efficient markets.
With the support of its ownership and its board comprised of market and
nonmarket participants, Tradeweb has, since its inception, brought
transparency and efficiency to the OTC fixed income and derivatives
marketplace.
II. Summary
Since 1998, Tradeweb has been operating a regulated electronic
marketplace for the OTC fixed income marketplace and has played an
important role in providing greater transparency and improving the
efficiency of the trading of fixed income securities and derivatives.
Indeed, Tradeweb has been at the forefront of creating electronic
trading solutions which support price transparency and reduce systemic
risk, the objectives of Title VII of the Dodd-Frank Act. Given that it
has the benefit of offering electronic trading solutions to the buy-
side and sell-side, Tradeweb believes that it can provide the Committee
with a unique and valuable perspective on the regulatory framework for
and the implementation of Title VII.
At the outset, Tradeweb is very supportive of the Dodd-Frank Act
and its stated goals. We believe that increased price transparency and
operational efficiency will lead to a reduction in systemic risk in
connection with the trading of derivatives. However, it is important
for this Committee, Congress as a whole, and the regulators to
understand and give due consideration to the needs of market
participants in promulgating rules for and implementing Title VII. The
aim must be to achieve the goals of the Act without materially
disrupting the market and the liquidity it provides to end users who
use derivatives to manage their varying risk profiles. Market
participants need confidence to participate in these markets and if
careful consideration is not given to what the rules say and how they
will ultimately be implemented, we fear that this confidence could be
materially shaken.
As part of the Dodd-Frank Act, Congress created a new type of
registered entity--known as a swap execution facility or ``SEF.''
Congress expressly created SEFs to promote the trading of swaps on
regulated markets, and provide a broader level of price transparency
for end users of swaps. While the definition of a SEF has been the
subject of much debate and speculation, the plain language of the Dodd-
Frank Act requires the Commissions to recognize the distinction between
SEF's on the one hand and designated contract markets (DCMs) or
exchanges on the other. There was a recognition by Congress that
alternatives to traditional DCMs and exchanges were necessary,
particularly in light of the current working market structure and
manner in which OTC derivatives trade. We applaud the direction of the
regulation, but want to ensure that the Commissions adopt rules that
are clear and allow for flexibility in the manner of execution for
market participants. \2\ This will give the end users choices,
confidence and liquidity, and will do so in a regulated framework that
promotes the trading of swaps, in an efficient and transparent manner
on regulated markets.
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\2\ The term ``swap execution facility'' has been defined in the
Dodd-Frank Act as a trading system or platform in which multiple
participants have the ability to execute or trade swaps by accepting
bids and offers made by multiple participants in the facility or
system, through any means of interstate commerce, including any trading
facility, that: (A) facilitates the execution of swaps between persons;
and (B) is not a designated contract market. The Dodd-Frank Act amends
Section 1a of the Commodities Exchange Act with a new paragraph (50,
and Section 761(a)(6) of the Dodd-Frank Act amends Section 3(a) of the
Securities Exchange Act of 1934 by adding a new paragraph (77)
(defining a ``security-based swap execution facility''). We refer to
both as a SEF in this submission.
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To that end, the rules relating to Title VII must be flexible
enough so as not to deter the trading of swaps on regulated platforms.
By ensuring that the rules retain sufficient flexibility to allow end
users to elect where and how they transact business, the Commissions
will provide for the most competitive execution of trades and encourage
the greatest liquidity in the market. Accordingly, the rules should not
unduly limit the choices of execution methods available for market
participants to manage their risks efficiently and effectively, or
overly prescribe the manner in which market participants can choose to
interact with each other to manage such risks (e.g., requiring a
Request for Quote (RFQ) to be transmitted to a minimum of five market
participants). If the rules regarding how market participants must
interact with each other from a trading perspective and accessing
liquidity are arbitrary and artificially prescriptive, and thus not
flexible enough to accommodate the varying methods of execution, market
participants simply will not participate and will seek alternative,
less efficient markets to manage their risk. We certainly do not
believe that is the ultimate goal of Title VII.
Further, the Dodd-Frank Act clearly contemplates that a SEF should
have broad, reasonable discretion to establish how it implements the
required regulatory framework. Overly prescriptive rules on the
registration and administration of SEFs and their compliance with the
Core Principles could place an unreasonable burden on existing swaps
trading platforms prior to the effective date of the final rules and
may also discourage new entrants into the swaps market. Congress and
the Commissions should thoughtfully implement the rules to provide
electronic swaps trading platforms with the flexibility required by the
Dodd-Frank Act.
Similarly, arbitrary or artificially prescriptive ownership limits
or governance requirements will deter investment of capital in new or
existing platforms. A careful balance needs to be reached between
safeguarding the system and encouraging private enterprise, which will
allow end users access to choose among robust trading venues and
clearing organizations. To be clear, we favor having an independent
voice on the Board of registered entities, but the rules should not go
so far as to make that the predominant voice--one that creates a
conflict of interest on the opposite extreme.
Because of the overlapping nature of the proposed rules from the
CFTC and SEC on each aspect of Title VII--including SEFs--we believe it
is imperative that the Commissions cooperate in developing final rules,
which should be aligned to the greatest extent possible. Bifurcated
rulemaking with respect to the swaps market will result in confusion
and lack of confidence in the marketplace and could potentially drive
participants away from the market altogether. It is also critically
important that there is a consistent approach between regulators
globally as overly rigid regulation in one jurisdiction will materially
impact how other regulators promulgate rules in an effort to maintain a
harmonized approach to overseeing the derivatives markets. The
potential result is a movement of the market outside the U.S., and that
would likewise be an unfortunate unintended consequence.
Finally, there has been a great deal of discussion recently about
how best to implement Title VII and the currently proposed rules. There
is no doubt that an overly hasty or ill thought-out timetable for
implementation could directly impact the health of the derivatives
markets by disenfranchising the interconnected members of this complex
ecosystem, and implementing these regulations in one ``big bang'' is
unrealistic. We believe the marketplace needs greater certainty in
terms of how and when these regulations will be implemented, and we
encourage Congress and the Commissions to seek public comment on these
issues.
Tradeweb is supportive of the goals to reform the derivatives
markets and indeed we provide the very solutions the regulation seeks
to achieve, but we are concerned that the Commissions may overreach in
their interpretation and implementation of Dodd-Frank, and in doing so
create unintended consequences for end users and the marketplace as a
whole.
III. Background on the OTC Rates and Credit Derivatives Marketplace
There are generally two institutional marketplaces for over-the-
counter (OTC) credit and rates derivatives: the dealer-to-customer
market (institutional) and the interdealer market (wholesale). In the
institutional market, certain dealers act as market makers and buy and
sell derivatives with their institutional customers (e.g., asset
managers, corporations, pension funds, etc.) on a fully disclosed and
principal basis. In the institutional market, the provision of
liquidity is essential for corporations, municipalities and Government
organizations (i.e., end users), which have numerous different asset
and liability profiles to manage. The need for customized risk
management solutions has led to a market that relies on flexibility--so
end users can adequately hedge interest rate exposure--and liquidity
providers, who have the ability to absorb the varied risk profiles of
end users by trading standard and customized derivatives. These market
makers then often look to the wholesale market--the market wherein
dealers trade derivatives with one another--to obtain liquidity or
offset risk as a result of transactions effected in the institutional
market or simply to hedge the risk in their portfolios.
In the wholesale or inter-dealer market, brokers (IDBs) act as
intermediaries working to facilitate transactions between dealers.
There is no centralized exchange (i.e., derivatives are traded over-
the-counter), and as a result, dealers look to IDBs to obtain
information and liquidity while at the same time preserving anonymity
in their trades. Currently, in the United States, these trades are
primarily accomplished bilaterally through voice brokering. By
providing a service through which the largest and most active dealers
can trade anonymously, IDBs prevent other dealers from discerning a
particular dealer's trading strategies, which in turn (i) reduces the
costs associated with the market knowing a particular dealer is looking
to buy or sell a certain quantity of derivatives, (ii) allows the
dealer to buy or sell derivatives in varying sizes, providing stability
to the marketplace, and (iii) enhances liquidity in the marketplace.
Both the wholesale and institutional derivatives markets trade
primarily through bilateral voice trading, with less than 5 percent of
the institutional business trading electronically. In these markets,
trades are often booked manually into back office systems and trades
are confirmed manually (by fax or other writing), and some (but not
all) derivatives trades are cleared.
With the implementation of the Dodd-Frank Act, we expect that most
of the interest rate and credit derivatives markets will be subject to
mandatory clearing, and therefore be traded on a regulated swap market.
Accordingly, with increased electronic trading, the credit and rates
derivatives markets will be much more transparent (with increased
pretrade price transparency) and efficient, and systemic risk will be
greatly reduced as the regulated swaps markets will have direct links
to designated clearing organizations (DCOs) and swap data repositories
(SDRs).
In light of the foregoing and with the forthcoming business conduct
standards, we believe the trading mandate was not intended to be and
does not need to be artificially and arbitrarily prescriptive to
achieve the goals of the Dodd-Frank Act. Indeed, to do so, would
undermine these goals. For example, by mandating a minimum of five
liquidity providers from which a market participant can seek prices
would likely reduce liquidity and effectively reduce the ability for
end users to adequately manage their risk. In short, regulated (i) swap
market trading (without regard to trading model but with the
appropriate transparency and regulatory oversight), (ii) clearing and
(iii) reporting is what will accomplish the policy goals without
hurting liquidity and disrupting the market. It is critical that the
Commissions do not propose rules that artificially and unnecessarily
hurt the market and undermine the goals of the Dodd-Frank Act.
IV. Key Considerations for SEF Rulemaking
SEFs
As noted above, it is imperative that the Commissions adopt rules
that are clear and allow for flexibility in the manner of execution for
market participants. This will give the market choices, confidence and
liquidity, and will do so in a regulated framework that promotes the
trading of swaps, in an efficient and transparent manner.
Consistent with the goals of the Dodd-Frank Act, for institutional
users, a SEF should (i) provide pretrade price transparency through any
appropriate mechanism that allows for screen-based quotes that provide
an adequate snapshot of the market (e.g., through streaming prices for
standardized transactions and competitive real time quotes for larger
or more customized transactions), (ii) incorporate a facility through
which multiple participants can trade with each other (i.e., must have
competition among liquidity providers), (iii) have objective standards
for participation that maintain the structure of liquidity providers
(like swap dealers) providing liquidity to liquidity takers
(institutional buy-side clients), (iv) have the ability to adhere to
the core principles that are determined to be applicable to SEFs, (v)
provide access to a broad range of participants in the OTC derivatives
market, allowing such participants to have access to trades with a
broad range of dealers and a broad range of DCOs; (vi) allow for equal
and fair access to all the DCOs and allow market participants the
choice of DCO on a per trade basis, and (vii) have direct connectivity
to all the SDRs.
In order to register and operate as a SEF, the ``trading system or
platform'' must comply with the enumerated Core Principles in the Dodd-
Frank Act applicable to SEFs. Regulators have the authority to
determine the manner in which a SEF complies with the statutory core
principles, and there is discretion for the Commissions to retain
distinct regulatory characteristics for SEFs versus DCMs. It is
critically important for the Commissions to apply the principles with
flexibility given the market structure in which swaps are traded.
Accordingly, regulators should interpret core principles in a way in
which SEF's can actually comply with them. While many of the SEF Core
Principles are broad, principle-based concepts--which make sense given
the potential for different types of SEFs and trading models--some of
the Core Principles are potentially problematic for SEFs that do not
operate a central limit order book or clearing.
Ownership and Governance
As noted above, Tradeweb was launched by market participants, and
has benefited from their investment of capital, market expertise, and
efforts to foster the development of more transparent and efficient
markets. With the help of its board, comprised of market and nonmarket
participants, Tradeweb has since its inception brought transparency and
efficiency to the fixed income and derivatives marketplace.
The success story of Tradeweb may not have been possible if overly
prescriptive governance and ownership limits had been imposed at the
time. It was highly unlikely that under those circumstances, any market
participants would have made an investment. Moreover, beyond the
initial seed capital, the banks' participation also allowed Tradeweb to
continue to invest in its infrastructure and evolve with the market--
thus building the robust and scalable architecture that has allowed it
to expand to 20 markets, survive 9/11 (Tradeweb's U.S. office was in
the North Tower of the World Trade Center), and develop connectivity
with over 2,000 institutions globally. Under the proposed rules of the
CFTC and the SEC, ownership and independent director limits will be
imposed on the different registered entities that will provide the
technological infrastructure to the swaps market--from trading to
clearing. Tradeweb believes that independent directors are a very good
idea, in terms of bringing an independent perspective to the governing
board, but their duties must be consistent with other board members.
However, artificial caps on ownership or excessive minimum voting
requirements for independent directors on the board (such as 51 percent
of the voting power) go too far. As a practical matter, ownership
limits will impair registered entities such as trading platforms and
clearing organizations, from raising capital, and overly expansive
independent director requirements will likewise hurt investment because
investors will lack a sufficient say in how their investment will be
governed. Moreover, Dodd-Frank provides other, more direct, ways in
which to mitigate conflicts of interest, and employing each of these
tools in a reasonable fashion will, in the aggregate, address the
potential conflicts of interest without negatively impacting investment
of capital and innovation in the marketplace.
For these reasons, we urge legislators and regulators to consider a
more reasoned approach to mitigating conflicts of interest.
Implementation
Because of its technological experience and expertise, Tradeweb
will be in a position to implement whatever trading rules are imposed
by the CFTC and SEC for SEFs shortly after registration. However, as we
note above, the implementation of Title VII of the Dodd-Frank Act will
require cooperation between regulators (both domestically and abroad)
in their rulemaking and implementation plan, as well as the cooperation
and investment of market participants. It is critical therefore that in
the first instance, the rulemaking is flexible but clear, and that each
facet is implementation is thought through--because a lack of
confidence in implementation will result in a lack of confidence in the
marketplace, the result of which would be a marketplace which would not
best serve the interests of the end user. We believe the marketplace
needs greater certainty in terms of how and when these regulations will
be implemented, and we encourage Congress and the Commissions to seek
public comment on these issues.
In sum, while we support the goals of the Dodd-Frank Act and
believe increased regulatory oversight is good for the derivatives
market, we want to emphasize that flexibility in trading models for
execution platforms are critically important to maintain market
structure so end users can manage their risks in a flexible manner. If
you have any questions concerning our comments, please feel free to
contact us. We welcome the opportunity to discuss these issues further
with the Committee and their Members.
______
PREPARED STATEMENT OF TERRENCE A. DUFFY
Executive Chairman, CME Group Inc.
April 12, 2011
Chairman Johnson, Ranking Member Shelby, 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 clearinghouse. 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
clearinghouses operated flawlessly. Futures markets performed all of
their essential functions without interruption and, despite failures of
significant financial firms, our clearinghouse 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 reregulate 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. 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 frontline 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 clearinghouses 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 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 30
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
clearinghouse, and the risk management and default management features
associated with each clearing solution. Different clearinghouses 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
percent of firms are already clearing or preparing to clear, 71 percent
expect to begin clearing within 12 months, and 82 percent 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 clearinghouses 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 unlevel 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, clearinghouses, 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.''
The CFTC's apparent decision to impose a multitude of prescriptive
rules on both DCMs and swap execution facilities (SEFs) may have a
detrimental effect on employment in the United States. The principles-
based regulation of futures markets had a transformative effect on U.S.
futures markets over the past decade. Since the Commodity Futures
Modernization Act of 2000 (CFMA), which converted the CEA from a rules-
based to principles-based regime, the futures markets have experienced
unparalleled growth and innovation and have been able to regain and
maintain a competitive position in the global market. The principles-
based regime has allowed U.S. futures exchanges to keep pace with
rapidly changing technology and market needs by introducing new
products, processes, and methods of compliance and avoiding stifling
regulatory review. The adoption by the CFTC of a prescriptive regime
will stifle this innovation, make U.S. futures markets less attractive
to traders, and in the end can only result in the loss of jobs as the
markets lose their ability to compete.
Most notably, the newly prescriptive regime, as well as other rules
proposed by the Commission, are not in harmony with international
regulators. This creates an incentive for market participants to move
their business to international exchanges where they may be subject to
less prescriptive regimes, threatening negative consequences for U.S.
exchanges. While the Commission has been working to induce
international regulators to be equally prescriptive, that effort seems
to be failing as other jurisdictions are alert to the value of snapping
up the business that the Commission will drive off shore. The threat of
prescriptive position limits and restrictions on hedging in the U.S.
are already driving business overseas or into unregulated markets.
Additionally, broad, undefined prohibitions on so-called ``disruptive''
trading practices and trading strategies will drive liquidity providers
from the U.S. markets and impair hedging and price discovery. The CFTC
should be careful not to adopt restrictions that tilt the competitive
playing field in favor of overseas markets. Such a tilt will result in
both a loss of jobs in the U.S. and less cost-efficient hedging for
persons in business in the U.S.
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 reregulate
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\
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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\3\ 75 Fed. Reg. 75162 (proposed Dec. 2, 2010) (to be codified at
17 C.F.R. pt. 190).
\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 clearinghouse
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\
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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\5\ 76 Fed. Reg. 4752 (proposed Jan. 26, 2011) (to be codified at
17 C.F.R. pts. 1, 150-151).
\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.
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(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
EU, 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\
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.
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\7\ 75 Fed. Reg. 667277 (proposed Nov. 2, 2010) (to be codified at
17 C.F.R. pts. 1, 150, 151).
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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\
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.
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\8\ See, 75 Fed. Reg. 80747 (proposed Dec. 22, 2010) (to be
codified at 17 C.F.R. pts. 1, 16, 38).
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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 frontline 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 clearinghouses 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
principal 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 percent 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 percent 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 percent 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 percent 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 percent 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 percent 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 percent off-exchange
when it was first offered in 2000, 31 percent off exchange in 2001, 25
percent in 2002, 20 percent in 2003, finally within the 85 percent
requirement at 13 percent off-exchange in 2004, 10 percent in 2005, 7
percent in 2006, 5 percent in 2007, 3 percent in 2008, and 2 percent in
2009 and 2010.
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Imposition of an 85 percent 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\
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.
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\10\ 75 Fed. Reg. 67282 (proposed Nov. 2, 2010) (to be codified at
17 C.F.R. pt. 40)
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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\
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\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\
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.
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\12\ 75 Fed. Reg. 63732 (proposed October 18, 2010) (to be
codified at 17 C.F.R. pts. 1, 37, 38, 39, 40).
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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\
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.
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\13\ 75 Fed.Reg. 67657-62 (proposed Nov. 3, 2010) (to be codified
at 17 C.F.R. pt. 180).
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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. Antidisruptive Practices Authority Contained in DFA\14\
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.
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\14\ 75 Fed. Reg. 67301 (proposed November 2, 2010) (to be
codified at 17 C.F.R. pt. 1).
\15\ 76 Fed. Reg. 14943 (proposed March 18, 2011).
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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.
______
PREPARED STATEMENT OF IAN AXE
Chief Executive, LCH.Clearnet Group Limited
April 12, 2011
Chairman Johnson, Ranking Member Shelby, Members of the Committee,
my name is Ian Axe and I am Chief Executive of LCH.Clearnet Group Ltd
(the ``Group''). On behalf of the Group, I would like to thank the
Committee for asking me here today.
LCH.Clearnet is the world's leading independent clearinghouse
group. Formed out of the merger of the London Clearing House Ltd and
Clearnet SA, we continue to operate two clearinghouses, LCH.Clearnet
Limited \1\ in London and LCH.Clearnet SA \2\ in Paris. Additionally we
have a fast-growing presence in the U.S. to support our rapidly
expanding U.S. swaps activity. We opened a New York office in late 2009
and staff numbers have since grown quickly. Our New York head count has
already doubled in the year to date.
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\1\ LCH.Clearnet Ltd. is regulated by, inter alia, the Financial
Services Authority of the United Kingdom and by the Commodity Futures
Trading Commission (as a ``Derivatives Clearing Organization'') of the
United States.
\2\ LCH.Clearnet SA is regulated as a Credit Institution and
Clearing House by a regulatory college consisting of, amongst others,
the market regulators and central banks from the jurisdictions of:
France, Netherlands, Belgium, and Portugal. It is also regulated as a
Recognized Overseas Clearing House by the U.K. Financial Services
Authority.
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We are a user-owned, user-governed organization, being 83 percent
owned by our clearing members, and 17 percent owned by exchanges such
as the NYSE Euronext group. We have been clearing commodities for 120
years, and LCH.Clearnet Limited has been registered with and regulated
by the Commodity Futures Trading Commission (CFTC) as a Derivatives
Clearing Organization (DCO) since 2001. We serve major international
exchanges and trading platforms, as well as a range of over-the-counter
(``OTC'' or ``swaps'') markets and we clear a broad range of asset
classes, including cash equities, exchange-traded derivatives, energy,
freight, interest rate swaps, and euro- and British pound-denominated
bonds and repos.
OTC Clearing Expertise
LCH.Clearnet Limited pioneered the development of OTC clearing in
1999 with our SwapClear and RepoClear services, respectively the
market-leaders in global interest rate swap and European repo clearing.
In addition, our London arm clears a range of OTC freight, energy, and
commodity products, while LCH.Clearnet SA clears European OTC index-
based credit default swaps and repo products.
LCH.Clearnet Limited currently clears over 50 percent of the global
interest rate swap market. This represents trades with a total notional
principal of over $276 trillion in 14 currencies with tenors out to as
far as 50 years. Last year SwapClear cleared over 120,000 trades
involving U.S. counterparties with a notional value in excess of $64
trillion. Of the total swaps portfolio cleared, approximately $91
trillion is in U.S. dollars.
We recently extended this capability to include a Futures
Commission Merchant (FCM) clearing service for U.S. end user clients.
We currently have 12 FCMs offering such services, and have since
successfully cleared our first trades under the FCM structure.
We are working closely with market participants to expand our
service in the U.S. and have set up formal working groups with FCMs and
buyside firms. Our Buyside Advisory Committee meets monthly to discuss
the development of the service. It comprises representatives from a
number of large U.S. firms, including Citadel, BlackRock, the D.E. Shaw
Group, the Federal Home Loan Banks, and Freddie Mac amongst others.
SwapClear is the largest swaps clearing service globally and is
widely recognized as a major contributor to financial stability. \3\
This important capability was put to the test during the collapse of
Lehman Brothers. LCH.Clearnet Limited was required to default-manage
Lehman Brothers' cleared portfolio of 66,000 interest rate swap trades
across five major currencies, with a notional value in excess of $9
trillion. Together with SwapClear clearing members, who are
contractually obligated to participate in the default management
process and to bid in the ensuing auctions, LCH.Clearnet Limited
successfully neutralized and sold off the entire swap portfolio.
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\3\ ``Deciphering the 2007-08 Liquidity and Credit Crunch'',
Markus K. Brunnermeier, Princeton University, Journal of Economic
Perspectives, May 2008: http://www.newyorkfed.org/research/conference/
2008/rmm/Brunnermeier.pdf.
``New Developments in Clearing and Settlement Arrangements for OTC
Derivatives'', Committee on Payment and Settlement Systems, BIS, Basel;
March 2007. Link: http://www.bis.org/publ/cpss77.htm.
---------------------------------------------------------------------------
The management of the default involved:
At default (Monday, 15 September 2008) SwapClear clearing
members seconded their experienced traders to work alongside
LCH.Clearnet Limited's risk management team to execute hedges
and to neutralize the market risk on the defaulter's portfolio.
All participants adhered to strict confidentiality rules.
Over the ensuing days, LCH.Clearnet Limited's risk position
was constantly reviewed and recalibrated, and additional hedges
were executed by the default management group in response to
the changing portfolio and volatile market.
From Wednesday, September 24 to Friday, October 3,
competitive auctions of the five hedged currency portfolios
were successfully completed and the group transferred all
66,000 trades to the successful bidders, all of whom were
surviving SwapClear clearing members.
The success of the default management process was largely due to
the strong commitment and contractual relationship between the
SwapClear clearing members and LCH.Clearnet Limited. The process was
wholly reliant on SwapClear clearing members' dedicated resources,
including key and experienced front office, risk, and operations
personnel who worked closely alongside the clearinghouse, in our
offices.
LCH.Clearnet Limited used only 35 percent of Lehman Brothers'
margin in managing the default and returned the remaining funds, in
excess of $850 million, to their administrators. No LCH.Clearnet
Limited counterparties incurred any loss as a result of the default,
and the clearing services operated by the Group continued to function
in full, with no disruption to member firms or clients, before, during
or after the Lehman Brothers' default. The Group thereby fulfilled its
commitment to its members, clients and the wider financial system by
ensuring market integrity and providing much-needed stability at a
critical juncture.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
The Group supported the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the ``Dodd-Frank Act'') because of the new law's
provisions in Title VII designed to reduce risk and increase
transparency in the OTC derivatives market through mandated clearing.
The Group strongly supports the policy goals underpinned by the
Dodd-Frank Act, and believes that this important piece of legislation
will do much to improve stability in the marketplace and much reduce
the risk of the taxpayer funding further bailouts.
In particular we welcome both stronger risk management and
heightened financial standards for clearinghouses; a greater level of
supervision for clearinghouses; mandatory clearing obligations and
trade reporting requirements.
We have been following the U.S. rulemaking process closely, and
applaud both the Commodity Futures Trading Commission (CFTC) and the
Securities and Exchange Commission (SEC) for the thoughtfulness and
openness with which they have approached these important matters. We
have been invited to participate in the Agencies' roundtables; have
attended their open meetings; responded to their proposed rulemakings
and met with their Commissioners.
At the same time we are directly involved in the legislative
proposals in Europe and are closely following the development of the
European Markets and Infrastructure Regulation (EMIR). The EMIR
proposal, which governs clearinghouses and trade repositories, was put
forward by the European Commission in September, and is now working its
way through the European Parliament and Council.
We believe it is of paramount importance that the legislation and
detailed rules emerging from the U.S. and EU, as well as the timetables
for implementation and adherence, are as closely aligned as possible.
This harmonization should ensure that: there is no opportunity for
regulatory arbitrage; capital is able to flow freely and that economic
recovery is not constrained.
Clearinghouses such as our own are global operations, supporting
global markets. Divergences in risk standards for clearinghouses
amongst key jurisdictions such as the U.S. and EU will likely lead to
the balkanization of clearing; such an outcome would result in a
significant increase in the amount of capital tied up in clearing and
be prejudicial for the economy, for jobs and for the recovery.
While we have generally supported the rules promulgated by the CFTC
and SEC and commend their efforts to remain in close dialogue with
supervisors in the EU, we have been concerned by the emergence of some
notable differences in their proposals to those under consideration in
Europe.
Our three greatest areas of concern in this regard include the
differences between the U.S. and Europe in rules governing: (1) the
Mitigation of Conflicts of Interest; (2) Risk Management Requirements;
and (3) Protection of Cleared Swaps.
Requirements Regarding the Mitigation of Conflicts of Interest
Sections 726(a) and 765 of the Dodd-Frank Act empower the CFTC and
SEC to adopt rules mitigating conflicts of interest with respect to any
DCO or Clearing Agency that clears swaps or security-based swaps. These
rules may include numerical limits on the control of, or the voting
rights with respect to, such a DCO or Clearing Agency by a specified
market participant (Enumerated Entity).
LCH.Clearnet has long recognized that there are potential conflicts
of interest in clearinghouses. Although LCH.Clearnet's substantial OTC
derivatives clearing book plainly evidences the contrary, it is
entirely possible that clearinghouse shareholders who deal in OTC
derivatives may have an interest in seeing that the clearinghouse does
not clear the instruments in which they deal. Equally, exchanges may
have an interest in ensuring that a clearinghouse in which they are
shareholders does not clear instruments traded on competing exchanges,
execution facilities or in the OTC market. End users shareholders may
meanwhile have an interest in ensuring that a clearinghouse keeps
margin requirements and other associated costs artificially low.
In recognition of the potential conflicts, LCH.Clearnet's corporate
charter prohibits any individual shareholder from exercising votes
representing more than five percent of the shares in issue, even if a
shareholder actually holds a number of shares amounting to more than 5
percent of the total number of shares in issue. This measure has
effectively ensured that neither a single shareholder nor a small group
of shareholders--whatever their origin or collective interests--has
been able to dominate management of LCH.Clearnet's clearinghouses and
determine their policies, such as which asset classes will be cleared.
At the same time, the direct involvement of market participants in
our clearinghouses has facilitated innovation. Their expertise has
directly contributed to our ability to develop complex and technically
challenging services such as those we offer to the OTC marketplace. For
this reason, we would caution that any regulation that limits the
aggregate involvement of Enumerated Entities in clearinghouses might
risk limiting innovation in OTC clearing, as well as stifling
competition and increasing the cost of business in the U.S.
During passage of the Dodd-Frank Act, Congress correctly rejected
the imposition of aggregate ownership and voting caps on
clearinghouses. We have therefore been concerned to see proposals
emerge from the Agencies \4\ that would re-introduce such caps. Any
such aggregate restriction on clearinghouse ownership or governance
would, in our view, lead to increased cost, with no commensurate
benefits. Rather, we believe that individual limitations on voting
rights such as those already in place at LCH.Clearnet, coupled with the
obligations to minimize and resolve conflicts of interest that
clearinghouses will be subject to, \5\ should be sufficient to allay
concerns about corporate governance within clearinghouses.
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\4\ RIN 3038 AD01, ``Requirements for Derivatives Clearing
Organizations, Designated Contract Markets, and Swap Execution
Facilities Regarding the Mitigation of Conflicts of Interest''. RIN
3235-AK7, ``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''.
\5\ CFTC Proposed Rule 39.25(a), 75 Fed.Reg. 63732, 63750 (October
18, 2010). There is a similar provision contained in SEC Proposed Rule
17Ad-25, 76 Fed.Reg. 14472, 14539 (March 16, 2011).
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Minimizing jurisdictional differences in rules such as those
mitigating conflicts in clearinghouses will be key to keeping costs low
and to reducing implementation challenges. In this regard we would
respectfully observe that in Europe, where we have been closely
tracking EMIR's progress through the legislature, there have been no
proposals to attempt to limit clearinghouse ownership or voting rights
by groups of entities--either from the European Commission, the
European Parliament, or the European Council. Indeed, the restrictions
on the ownership of shares or voting interests of the type proposed by
the Agencies would likely be deemed contrary to the fundamental
freedoms set out in the primary EU Treaty (the Treaty on the
Functioning of the European Union, ``TFEU''), in particular, those
protecting the freedom of establishment and the free movement of
capital. \6\
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\6\ The provisions of the TFEU relating to free movement of
capital provide that ``all restrictions on the movement of capital
between Member States and between Member States and third countries
shall be prohibited.'' The EU's Supreme Court (the European Court of
Justice, ``ECJ'') has consistently found that, for these purposes,
capital movements include ``direct investment in the form of
participation in an undertaking by way of shareholding or the
acquisition of securities on the capital market . . . and . . . the
possibility of participating effectively in the management of a company
or in its control.''
The free movement of capital and freedom of establishment are
fundamental tenets of the TFEU, and any exceptions to these rules would
needs therefore to be justified by overarching public policy
requirements. Moreover, the TFEU sets out that ``only the Council,
acting in accordance with a special legislative procedure, may
unanimously, and after consulting the European Parliament, adopt
measures which constitute a step backwards in Union law as regards the
liberalization of the movement of capital to or from third countries.''
Accordingly, such an amendment would require unanimity amongst Member
States.
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Risk Management Requirements
LCH.Clearnet acknowledges and endorses the Dodd-Frank requirement
that clearinghouses permit ``fair and open access.''
The Group employs open and transparent membership eligibility
criteria for each market that it clears. The criteria are approved by
both our clearinghouses. Risk Committees and Boards of Directors, all
of which are chaired by independent directors, and the criteria are
subject to subsequent regulatory approval. We are committed to
exploring all the ways in which we can expand our membership, whilst
maintaining the highest standards of risk management and ensuring the
safe and sound operation of our clearinghouses.
We have been concerned by the Agencies' proposed membership
requirements for clearinghouses offering OTC clearing services. \7\ The
Agencies propose to enforce the separation of participation in
clearinghouses from risk underwriting and default management
responsibilities.
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\7\ RIN 3038-AC98 Risk Management Requirements for Derivatives
Clearing Organizations, 21 January 2011.
RIN 3235-AL13 Clearing Agency Standards for Operation and
Governance, 3 March 2011.
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We have seen no such requirements in the European Commission's EMIR
Proposal, nor during its subsequent passage through the European
Parliament and European Council.
In our view, the SEC's and CFTC's proposed requirements for access
to clearinghouses, whilst founded on important policy considerations,
risk watering down our well-tested and proven default management
processes, upon which the integrity of our clearinghouses depend.
Absent clear default management rules that ensure the protection of
surviving members, clearinghouses such at our own would face
significant technical challenges that would put at risk our ability to
extend and develop our OTC clearing services. As such, the proposed
rules would seem to run contrary both to the Agencies' intent and to
their statutory and prudential responsibilities.
In undertaking to clear certain swaps products, particularly those
that are long-dated and less liquid than exchange-traded futures, a
clearinghouse needs to rely on clearing member participation in the
event of a default. We firmly believe that access criteria for OTC
clearing members must be proportionate to the risk each member
introduces into the system and should be contingent on default
management and risk underwriting participation, such that the integrity
of the clearinghouse is fully protected and there is no cost to or
impact on other members, their customers or the wider financial system.
CPSS-IOSCO, \8\ the global organization of securities and futures
regulators, has recently endorsed this view. The March 2011 report by
CPSS-IOSCO on Financial Market Infrastructures stipulates:
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\8\ Committee on Payment and Settlement Systems, Technical
Committee of the International Organization of Securities Commissions
(CPSS-IOSCO).
An OTC derivatives CCP may need to consider requiring
participants to agree in advance to bid on the defaulting
participant's portfolio and, should the auction fail, accept an
allocation of the portfolio. A CCP that employs such procedures
should carefully consider, where possible, the risk profile and
portfolio of the receiving participant before allocating
positions so as to minimize additional risk for the surviving
participant. \9\
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\9\ Principles for Financial Market Infrastructures CPSS-IOSCO
Consultative Report, March 2011 (p. 64).
In the interests of harmonization, we would also draw the
Committee's attention to the submission made by the U.K.'s Financial
Services Authority \10\ to the CFTC on this matter. The letter stated:
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\10\ http://comments.cftc.gov/PublicComments/
ViewComment.aspx?id=31986&SearchText=
Risk management standards for CCPs must be anchored in the
characteristics of the products being cleared, and the FSA
recognizes that different product types may require different
clearing models. This can extend to participant eligibility in
models where the clearing members are required to perform
specific actions to assist in a member default, for example
Interest Rate Swap clearing models that include an obligation
to bid for, or be allocated, portfolios from the defaulting
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clearing member.
SwapClear clearing members must be able to demonstrate that they
can support a swaps book from a front office, risk, technology, and
operations perspective. We rely on surviving clearing members: to be
able to hedge a defaulting member's swaps portfolio; to provide
liquidity for such hedging; to bid on hedged portfolios; and, if
necessary, to accept a forced allocation of swaps.
LCH.Clearnet regularly tests and confirms that its clearing members
maintain such a capability. This model was the basis upon which we
successfully managed the Lehman Brothers default.
Upon reviewing the Agencies' proposed rules for access, we have
asked ourselves whether the proposals would improve or reduce our
ability to manage a large member or client default, and have concluded
that such proposals still need work to ensure they would not be
detrimental to our ability to do so.
Our SwapClear membership is expanding continually, and now includes
50 direct clearing members from North America, Europe, and Asia. In
addition, we recently extended this capability to include an FCM
clearing service for U.S. end users, and have since successfully
cleared our first trades under the FCM structure. Firms that do not
meet our direct membership criteria, or do not wish to commit to the
risk underwriting and default management responsibilities, are thus
able to access the clearinghouse under the full protections of the
well-proven FCM structure.
We are open to keeping our SwapClear admission criteria under
constant review and to materially modifying the current entry
requirements for members. Provided that potential members prove they
have the required risk underwriting and default management capabilities
and commit to full participation in both, we will welcome their entry.
Futurization of Swaps
The Group has a number of concerns regarding the apparent
``futurization'' of Swaps in the provisions set out by the CFTC in its
Risk Management Requirements Rules for DCOs \11\ and other proposed
rulemakings.
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\11\ RIN 3038-AC98 Risk Management Requirements for Derivatives
Clearing Organizations, 21 January 2011.
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Among other requirements, the CFTC proposes that DCOs use a
margining methodology that is ill-suited and inefficient for swaps
clearing. Again there has been no evidence of such requirements in
Europe.
In this regard we would respectfully point to the recent report
from CPSS-IOSCO. This explicitly recognizes that swaps have unique
characteristics, which may require clearinghouses to employ different
risk management methods than they would for futures or cash
instruments.
The CPSS-IOSCO report said:
In addition to typical risk-management tools used by CCPs in
listed markets, CCPs in OTC derivatives markets may employ
other risk-management processes designed for the unique risks
of the cleared OTC derivatives product. Participant
requirements, margin requirements, financial resources and
default procedures are particular areas where a CCP may need to
consider additional tools tailored for OTC derivatives markets.
Protection of Cleared Swaps
The CFTC recently sought comment \12\ through an Advanced Notice of
Proposed Rulemaking (ANPR) on the most appropriate customer protection
regime for cleared swaps. In our view the introduction of a customer
protection model that insulates clients from such fellow-customer risk
would best uphold one of the key aims of the Act--that of protecting
consumers. It would also ensure that the protections and safeguards
afforded to the U.S. client base are at least as strong as those that
will be offered to customers in Europe, as required under EMIR. \13\
---------------------------------------------------------------------------
\12\ RIN 3038-AD99 Protection of Cleared Swaps Customers Before
and after Commodity Broker Bankruptcies, 2 December 2010.
\13\ http://ec.europa.eu/internal_market/financial-markets/docs/
derivatives/20100915_proposal_en.pdf, Article 37.
---------------------------------------------------------------------------
In the ANPR consultation the CFTC asked respondents which of four
client protection models would be most appropriate for customers
clearing swaps. \14\ As LCH.Clearnet stated in its response to the
ANPR, \15\ we believe that customers should above all be able to
preserve the collateral protections they are offered in the bilateral
uncleared swaps environment.
---------------------------------------------------------------------------
\14\ Option (1) Full Physical Segregation; Option (2) Legal
Segregation with Commingling; Option (3) Moving Customers to the Back
of the Waterfall; Option (4) Baseline Model.
\15\ http://comments.cftc.gov/PublicComments/
ViewComment.aspx?id=27157&SearchText=
---------------------------------------------------------------------------
Under current bilateral swaps market practice, some clients are
able to negotiate for individual segregation of collateral that they
post as margins. The collateral posted by clients that have made such
arrangements, although subject to other risks, is not subject to the
risk of the default of other market participants that have entered into
transactions with their swaps counterparts. These clients--many of them
pension funds, long-term savings institutions, Government and related
fiscal authorities and other real money investors--believe it is
inappropriate that they should be subject to an additional risk (that
of fellow-customers) when clearing their swaps positions.
At the specific request of customers in Europe, LCH.Clearnet has
developed a client clearing model that protects nondefaulting clients
from the risks of defaulting clients. We believe that this client-
clearing model is closely aligned to one of the models proposed by the
Commission in its ANPR, Option 2, or ``Legal Segregation With
Commingling.''
This model improves on the protections afforded in the bilateral
swaps marketplace, by enabling the clearinghouse to offer clients
portability of swaps margin-related collateral and market risk
positions in the event of a clearing member's default. It is structured
so as to enable the clearinghouse to identify and cover the risks
associated with an individual customer's portfolio as if the
clearinghouse were required to take on its management in isolation, as
could happen in the event of a member default. This construct also
enables the clearinghouse to monitor client profiles individually and
to maximize the likelihood of the transfer of such clients' risks and
positions in the event of their clearing member(s) defaulting.
Having implemented the above outlined model in Europe, the Group is
confident that it gives rise to no further costs than the CFTC's other
proposed models, either at the clearinghouse or at the clearing member
level.
Further, LCH.Clearnet can confirm that the implementation of this
clearing model has not changed the structure of resources that protect
the clearinghouse following a default; it has not required an increase
in margin collateral levels, nor has it caused the clearinghouse to
raise clearing member contributions to the default fund.
LCH.Clearnet looks forward to extending its existing SwapClear
client clearing service to U.S. end users under the well-proven FCM
structure. At the same time, we believe that the important client
protection mechanisms outlined above and described the CFTC in its ANPR
under ``Option 2, Legal Segregation with Comingling'' would best
preserve the interests of the investors and other clients clearing
swaps through FCMs. The introduction of such client-level protections
would also, we believe, ensure closer harmonization with those
protections afforded in Europe.
Conclusion
As stated at the start of this testimony, LCH.Clearnet is
supportive of the goals of the Dodd-Frank Act. We also believe that the
CFTC and SEC have approached the rulemaking process with care and
thoroughness, and commend the Commissioners and staff for their hard
work.
We applaud the Agencies for their engagement with the industry and
with authorities in the EU and further afield. Nonetheless, we do
believe that it would be helpful to reconcile the differences between
the U.S. and EU proposals, particularly with regard to: mitigation of
conflicts of interest; risk management requirements; and the protection
of cleared swaps, all of which we have outlined in this testimony.
We would respectfully urge the Committee to ensure that the final
rules promulgated by the Agencies are aligned as closely as possible
with those being finalized in the EU. Such a commonality of approach
should reduce the cost of business, the tendency for regulatory
arbitrage and the likelihood of flight of capital.
LCH.Clearnet looks forward to fulfilling its role in support of
this important statutory initiative and to growing our U.S. operations
so that more U.S. end users can benefit from the risk mitigation
provided through our clearing services.
In closing, LCH.Clearnet would like to thank the Committee for
inviting us to discuss the new derivatives regulatory framework. We
appreciate the opportunity and the Committee's interest in our
concerns.
______
PREPARED STATEMENT OF JENNIFER PAQUETTE
Chief Investment Officer, Colorado Public Employees' Retirement
Association
April 12, 2011
Thank you, Chairman Johnson and Ranking Member Shelby, for holding
this hearing on the derivatives regulatory framework. As investors that
utilize derivatives, we have a keen interest and I appreciate the
opportunity to testify.
Before I begin, it might be helpful to provide some background on
my investment experience and the organization I represent. I have
worked for large investment managers and broker dealers in research,
portfolio management, and institutional sales capacities. For the last
8 years, I have served as the Chief Investment Officer of the Colorado
Public Employees' Retirement Association (COPERA). My remarks will
include a brief overview of COPERA, our interest in the derivatives
market and concerns we have regarding the Commodity Futures Trading
Commission (CFTC) proposed rulemaking on Business Conduct Standards for
Swap Dealers and Major Swap participants with Counterparties, RIN 3038-
AD25.
COPERA and Derivatives
COPERA invests $39 billion in assets on behalf of almost half-a-
million former and current employees of Colorado State government,
public schools, universities, colleges, cities, and many units of local
government. We manage this diversified, institutional portfolio with a
long-term investment horizon which spans many decades. Investments
include global stocks, bonds, real estate, alternatives, timber, and
commodities and we use derivatives in a number of asset categories.
We employ derivatives in a number of ways. Global stock managers
will use currency forwards to mitigate currency risk. Stock index
futures are used to gain timely exposure to markets in support of our
strategic objectives and to reduce risk. Total return swaps are
utilized by bond managers to gain exposure to specific indexes and to
enhance diversification.
For example, a bond manager may enter into a total return swap. In
such a swap, COPERA would agree to pay a cash rate plus a spread in
exchange for receiving the total return of a bond index for a specific
time period. During that period, collateral would be posted as the
value of the swap changes with the market. For a reasonable cost,
COPERA would benefit from the diversification of a broad index without
incurring the transaction costs of purchasing all the underlying index
securities. A swap of this nature can help control risk in addition to
enhancing the expression of our portfolio strategy.
While derivatives investments are modest in size compared to our
overall market value, they are very helpful tools which we have used in
our portfolio management process for many years. Current rule making is
extensive and happening at a rapid pace. While I will share a few
general comments before concluding, I would like to focus my testimony
on proposed CFTC regulations on business conduct standards for swap
dealers and major swap participants with counterparties.
Business Conduct Standards
CFTC proposals include public pension plans as a Special Entity. We
are concerned that the proposed business conduct standards as they
apply to a Special Entity could adversely affect pension plans like
ourselves. In order for a Special Entity to enter into a swap, the swap
dealer would need to have a reasonable basis to believe that the
Special Entity has a representative that meets certain requirements.
The objective may be to protect vulnerable or gullible parties in the
swap market. While this may be well intentioned, it would create
significant issues.
We are concerned that there is a conflict of interest for one of
the parties to a transaction also being responsible for determining who
is qualified to represent the other side of a transaction. Should a
Special Entity be deemed to not have a qualifying representative, the
swap dealer would need to have this determination reviewed by its Chief
Compliance Officer. This appears to address concern that a Special
Entity could be deemed unqualified in error but the assessment still
remains with the Swap Dealer's organization. I am also concerned that
this determination will not happen quickly enough in the context of
trades that are sometimes done in a matter of hours. Finally, giving
swap dealers veto ability may impair negotiations regarding
transactions.
While it is difficult to know how this rule would work in practice,
we are concerned that our pension plan could be a less desirable market
participant due to potentially higher compliance costs and potential
liability. We may be left to deal with less desirable counterparties,
if we could find any at all to do business with.
In an effort to provide a constructive approach to the concerns
raised, a number of public plans, representing $720 billion in assets
under management, submitted a comment letter on February 18, 2011, to
the Commodity Futures Trading Commission. I have attached the letter as
an appendix for your consideration. In brief, the alternative approach
would provide another supplemental way to meet the independent
representative requirement. The Special Entity, or its advisor, would
be able to voluntarily elect to undergo a certification process which
would involve passage of a proficiency exam developed by the CFTC or by
another organization as deemed appropriate.
Public plans have resources and expertise to manage their
institutional assets. COPERA's team of investment professionals manage
complex portfolios internally and oversee external investment managers.
Like many of our peers, our investment staffs include those that have
earned professional designations, are well educated and have many years
of experience in the markets. We are knowledgeable about using
derivatives to hedge certain investments and mitigate risk. We believe
some modifications to the proposed rule as discussed in the letter
would be beneficial to the retirement security of our members.
Closing Remark
We value the efforts of this Committee, regulatory entities and
others involved in this comprehensive approach to improving derivatives
regulation. These efforts to reduce risk and promote a healthy
financial system are valuable and essential. Inviting and considering
public comment on rule making, in addition to adequately resourcing and
providing oversight to those charged with these important
responsibilities, is in our collective best interests. On behalf of
Colorado PERA, I thank you very much for the opportunity to speak with
you today.
EXHIBIT A
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON
FROM MARY L. SCHAPIRO
Q.1. How will market data provided through swap data
repositories be used to inform your rulemaking about
appropriate block trade rules and reporting requirements?
A.1. Response not provided.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM MARY L. SCHAPIRO
Q.1. Numerous public commenters have expressed their concerns
that there may be conflicting regulations related to similar
products. For example, the proposed block trade regulation is
different for CFTC-regulated swaps and SEC-regulated
securities-based swaps. The CFTC proposal included tests to
determine block trades, while the SEC proposal asks for public
comment on what the definition of a block trade should be. How
will you reconcile these differences? Should similar products,
such as index and single-name CDS, be treated differently?
A.1. Response not provided.
Q.2. At the hearing, you noted that some differences between
the two Commissions' rules may be appropriate given differences
in the nature of the products that you regulate. If the SEC and
CFTC were merged, as some have recommended, would product
differences necessitate two different regulatory frameworks for
swap execution facilities?
A.2. Response not provided.
Q.3. How is your agency leveraging human and information
technology resources from other domestic regulators? How is
your agency leveraging human and technology resources from
oversees regulators? How is your agency leveraging existing
private industry technologies?
A.3. Response not provided.
Q.4. A frequently stated concern is that the rulemaking process
has been very haphazard and uncoordinated. Market participants
feel limited in their ability to comment on particular rules
without understanding the bigger picture. Would it make sense
for the Securities and Exchange Commission and the Commodity
Futures Trading Commission to jointly propose and put out for
public comment a plan for reproposing and adopting rules?
A.4. Response not provided.
Q.5. Chairman Schapiro's testimony stated that ``As we move
toward adoption the objective of consistent and comparable
requirements will continue to guide our efforts [to coordinate
with the CFTC and other regulators].'' Given the fact that so
many of the SEC's proposed rules differ substantially from the
CFTC's proposed rules on the same issue, please explain how you
will accomplish this objective? Will harmonization require one
or both of your agencies tor repropose certain rules?
A.5. Response not provided.
Q.6. Does the Commission need additional statutory authority in
order to allow market participants to continue to legally
engage in swap transactions pending exemption of final rules?
A.6. Response not provided.
Q.7. Chairman Schapiro, you have been asked previously whether
you think that you need more time to adopt derivatives rules.
Neither you nor Chairman Gensler has clearly requested more
time, but both of you have indicated that you will not be able
to comply with the statute's July rulemaking deadline. Why
don't you simply ask Congress for more time? Would extending
the rulemaking deadline allow for easier coordination with the
Europeans, who are not attempting to hold themselves to the
same timeline?
A.7. Response not provided.
Q.8. How does your agency define the term ``clearing'' with
respect to swaps (or security-based swaps)? Which activities
are encompassed within that definition?
A.8. Response not provided.
Q.9. Swap data repositories and security-based swap data
repositories may not share information with regulators other
than their primary regulator unless they obtain an
indemnification agreement. Please describe how this provision
would work in practice. Are there any issues that would impede
the implementation of this provision?
A.9. Response not provided.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN
FROM MARY L. SCHAPIRO
Q.1. On April 12, the banking regulators released their
proposal on ``Margin and Capital Requirements for Covered Swap
Entities.'' The proposal requires dealer banks and significant
counterparties to post two way initial margin and to hold that
margin at third party custodian banks. This margin would be
limited to immediately available cash funds and high-quality,
highly liquid U.S. Government and agency obligations. Re-
hypothecation of such amounts would be prohibited. What are the
costs associated with tying up margin in segregated accounts at
custodian banks? Have you quantified the impact this
requirement will have on liquidity?
A.1. Response not provided.
Q.2. The margin and capital requirements proposal takes a risk-
based approach by distinguishing between four separate types of
derivatives counterparties. The proposal extends the definition
of financial end user to include any government of any foreign
country or any political subdivision, agency, or
instrumentality thereof in the world. How would margin and
capital requirements apply to the dealings of the foreign
subsidiary of a U.S. financial institution that enters into a
swap? What about a U.S. financial institution that enters into
a swap with a foreign government? Would the foreign subsidiary
of a U.S. institution that enters into a swap with a foreign
government be required to post margin in U.S. Treasuries?
A.2. Response not provided.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON
FROM GARY GENSLER
Q.1. How will market data provided through swap data
repositories be used to inform your rulemaking about
appropriate block trade rules and reporting requirements?
A.1. On December 7, 2010, the Commission proposed regulations
relating to the Real-time Reporting of Swap Transaction Data.
Under the proposed rule, swap data repositories would use a
two-pronged formula to calculate the appropriate minimum block
trade sizes for certain categories of swaps. Minimum block
trade sizes would be reevaluated on an annual basis based on
swap transaction data received over the previous year. Those
swaps that have a notional size above the minimum notional or
principal amount determined by a swap data repository would be
subject to a time delay in reporting. The Commission has
received public comments on the proposed rule and will move
forward to consider a final rule after staff has had the
opportunity to summarize them for consideration and after
Commissioners are able to discuss them and provide feedback to
staff.
Q.2. Will the margin rules proposed this morning (April 12,
2011) at the FDIC on behalf of the prudential regulators and at
the CFTC require commercial end users to post margin directly
to swap dealers beyond what would ordinarily be required by
current swap dealer practices of mitigating counterparty
exposure? If so, what role will the prudential regulators and
the CFTC play in both establishing and supervising these credit
thresholds going forward? Additionally, how do the prudential
regulators and the CFTC define noncash collateral that could be
used to satisfy end user margin requirements?
A.2. To ensure the financial integrity of swap dealers and
security-based swap dealers, Congress directed that prudential
regulators, the SEC, and the CFTC to establish capital and
margin requirements. The CFTC's proposed rule would not require
margin for uncleared swaps to be paid or collected on
transactions involving nonfinancial end users hedging or
mitigating commercial risk.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM GARY GENSLER
Q.1. How does your agency define the term ``clearing'' with
respect to swaps (or security-based swaps)? Which activities
are encompassed within that definition?
A.1. The Dodd-Frank Wall Street Reform and Consumer Protection
Act defines the term ``cleared swap'' to mean any swap that is,
directly or indirectly, submitted to and cleared by a
derivatives clearing organization (DCO) registered with the
Commodity Futures Trading Commission (CFTC). Under the
Commodity Exchange Act, a DCO enables each party to the
agreement, contract, or transaction to substitute the credit of
the DCO for the credit of the parties. The DCO also mutualizes
or transfers credit risk among DCO participants by providing,
on a multilateral basis, for the settlement or netting of
obligations resulting from such agreements, contracts, or
transactions.
Q.2. Swap data repositories and security-based swap data
repositories may not share information with regulators other
than their primary regulator unless they obtain an
indemnification agreement. Please describe how this provision
would work in practice. Are there any issues that would impede
the implementation of this provision?
A.2. Under the provision, domestic and foreign authorities, in
certain circumstances, would be required to provide written
agreements to indemnify SEC and CFTC-registered trade
repositories, as well as the SEC and CFTC, for certain
litigation expenses as a condition to obtaining data directly
from the trade repository regarding swaps and security-based
swaps. Regulators in foreign jurisdictions have raised concerns
regarding the potential effect of the provision. However, I
believe that the indemnification provision need not apply in
the case of a trade repository registered with the CFTC that is
also registered in a foreign jurisdiction and the foreign
regulator, acting within the scope of its jurisdiction, seeks
information directly from the trade repository. Under the
CFTC's proposed rules regarding trade repositories' duties and
core principles, foreign regulators would not be subject to the
indemnification and notice requirements if they obtain
information that is in the possession of the CFTC.
Q.3. Numerous public commenters have expressed their concerns
that there may be conflicting regulations related to similar
products. For example, the proposed block trade regulation is
different for CFTC-regulated swaps and SEC-regulated
securities-based swaps. The CFTC proposal included tests to
determine block trades, while the SEC proposal asks for public
comment on what the definition of a block trade should be. How
will you reconcile these differences? Should similar products,
such as index and single-name CDS, be treated differently?
A.3. Section 712(a)(7) of the Dodd-Frank Act recognized the
differences between CFTC- and SEC-regulated products and
entities. It provides that, in adopting rules, the CFTC and SEC
shall treat functionally or economically similar products or
entities in a similar manner, but are not required to treat
them in an identical manner. The Commissions work toward
consistency in the agencies' respective rules to the extent
possible through our close consultation and coordination since
the enactment of the Dodd-Frank Act. This close coordination
has benefited the rulemaking process and will strengthen the
markets for both swaps and security-based swaps.
Q.4. At the hearing, you noted that some differences between
the two Commissions' rules may be appropriate given differences
in the nature of the products that you regulate. If the SEC and
CFTC were merged, as some have recommended, would product
differences necessitate two different regulatory frameworks for
swap execution facilities?
A.4. The CFTC's proposed SEF rule will provide all market
participants with the ability to execute or trade with other
market participants. It will afford market participants with
the ability to make firm bids or offers to all other market
participants. It also will allow them to make indications of
interest--or what is often referred to as ``indicative
quotes''--to other participants. Furthermore, it will allow
participants to request quotes from other market participants.
These methods will provide hedgers, investors, and Main Street
businesses both the flexibility to execute and trade by a
number of methods, but also the benefits of transparency and
more market competition. The proposed rule's approach is
designed to implement Congress' mandates for transparency and
competition where multiple market participants can communicate
with one another and gain the benefit of a competitive and
transparent price discovery process.
The proposal also allows participants to issue requests for
quotes, whereby they would reach out to a minimum number of
other market participants for quotes. It also allows that, for
block transactions, swap transactions involving nonfinancial
end users, swaps that are not ``made available for trading''
and bilateral transactions, market participants can get the
benefits of the swap execution facilities' greater transparency
or, if they wish, would still be allowed to execute by voice or
other means of trading.
In the futures world, the law and historical precedent is
that all transactions are conducted on exchanges, yet in the
swaps world, many contracts are transacted bilaterally. While
the CFTC will continue to coordinate with the SEC to harmonize
approaches, the CFTC also will consider matters associated with
regulatory arbitrage between futures and swaps. The Commission
has received public comments on its SEF rule and will move
forward to consider a final rule only after staff has had the
opportunity to summarize them for consideration and after
Commissioners are able to discuss them and provide feedback to
staff.
Q.5. How is your agency leveraging human and information
technology resources from other domestic regulators? How is
your agency leveraging human and technology resources from
oversees regulators? How is your agency leveraging existing
private industry technologies?
A.5. The Commission and other regulators have been working
closely with the Office of Financial Research (OFR) to help
develop a strategy for managing initial data required by the
OFR to monitor and study systemic risk in the U.S. financial
markets. The CFTC also has coordinated with the OFR in the
development of a universal Legal Entity Identification standard
that is consistent with the Commission's and the SEC's
rulemakings. Through the Financial Stability Oversight Council
(FSOC), the CFTC is providing both data and expertise relating
to a variety of systemic risks, how those risks can spread
through the financial system and the economy, and potential
ways to mitigate those risks. Commission staff also coordinates
with Treasury and other Council member agencies on each of the
studies and proposed rules issued by the FSOC.
The Commission has memorandums of understanding with
foreign regulators that relate to sharing of information. The
Commission leverages private industry technologies through its
work with self-regulatory organizations. With regard to
specific upcoming technology needs, the agency has solicited
the input of industry experts through individual meetings and
staff roundtable meetings. In addition, the Commission's
Technology Advisory Committee chaired by Commissioner Scott
O'Malia includes members from industry and provides valuable
assistance to the Commission.
To leverage existing private industry technologies, CFTC
makes extensive use of Commercial Off-the-shelf products. The
eLaw (automated law office support for enforcement activities),
automated trade surveillance, and financial risk management
programs all rely primarily on such products. The Commission
also uses tools and services used by Self Regulatory
Organizations (SROs) and the National Futures Association (NFA)
for financial reporting and examinations.
The Commission also uses products and services of other
agencies whenever practical. For example the Department of
Transportation provides services for financial management and
the Department of Agriculture services payroll processing.
Q.6. A frequently stated concern is that the rulemaking process
has been very haphazard and uncoordinated. Market participants
feel limited in their ability to comment on particular rules
without understanding the bigger picture. Would it make sense
for the Securities and Exchange Commission and the Commodity
Futures Trading Commission to jointly propose and put out for
public comment a plan for reproposing and adopting rules?
A.6. To address these issues, the Commission reopened most of
its comment periods that had closed and extended some existing
comment periods so that the public could provide comments in
the context of the entire mosaic of proposed rules. That
extended comment period closed on June 3, 2011. In addition, on
May 2 and 3, CFTC and SEC staff held roundtable sessions to
obtain public input with regard to implementation dates of the
various rulemakings. Prior to the roundtable, on April 29, CFTC
staff released a document that set forth concepts that the
Commission may consider with regard to the effective dates of
final rules for swaps under the Dodd-Frank Act. The Commission
has also accepted written comments on that subject.
Q.7. Chairman Schapiro's testimony stated that ``As we move
toward adoption the objective of consistent and comparable
requirements will continue to guide our efforts [to coordinate
with the CFTC and other regulators].'' Given the fact that so
many of the SEC's proposed rules differ substantially from the
CFTC's proposed rules on the same issue, please explain how you
will accomplish this objective? Will harmonization require one
or both of your agencies tor repropose certain rules?
A.7. Section 712(a)(7) of the Dodd-Frank Act recognizes the
differences between CFTC- and SEC-regulated products and
entities. It provides that, in adopting rules, the CFTC and SEC
shall treat functionally or economically similar products or
entities in a similar manner, but are not required to treat
them in an identical manner. The Commissions work towards
consistency in the agencies' respective rules to the extent
possible through close consultation and coordination since the
enactment of the Dodd-Frank Act. This close coordination has
benefited the rulemaking process and will strengthen the
markets for both swaps and security-based swaps.
In approaching any final rule, the Commission will be
guided by an examination of whether the connection between the
proposed rule and the final rule is sufficient for the final
rule to be considered a logical outgrowth of the proposed rule.
Q.8. Does the Commission need additional statutory authority in
order to allow market participants to continue to legally
engage in swap transactions pending exemption of final rules?
A.8. On July 14, 2011, the CFTC issued an order that would
provide relief until December 31, 2011, or when the
definitional rulemakings become effective, whichever is sooner,
from certain provisions that would otherwise apply to swaps or
swap dealers on July 16. This includes provisions that do not
directly rely on a rule to be promulgated, but do refer to
terms that must be further defined by the CFTC and SEC, such as
``swap'' and ``swap dealer.''
The order also would provide relief through no later than
December 31, 2011, from certain CEA requirements that may
result from the repeal, effective on July 16, 2011, of some of
sections 2(d), 2(e), 2(g), 2(h), and 5d.
Q.9. The Department of Justice (DOJ) recently submitted a
letter (DOJ letter) on a proposed CFTC rule regarding ownership
limitations and governance requirements for designated clearing
organizations (DCOs), designated contract markets and swap
execution facilities. Were there any relevant communications,
written or oral, between the CFTC and DOJ's Antitrust Division
prior to submission of the DOJ letter? If so, please explain.
Please include a list all DOJ and CFTC individuals involved in
those communications and a description of the nature of those
communications. Please explain who initiated those
communications, whether anyone from the CFTC or from the White
House requested or directed anyone in the DOJ to send the
letter; and whether anyone from the CFTC or from the White
House reviewed and/or edited the letter before it was
submitted.
A.9. The Commission received the comments of the Department of
Justice on December 28, 2010. Prior to that submission, staff
from the Antitrust Division advised CFTC staff of the desire to
discuss topics relating to competition in derivatives trading.
Those topics implicated the work of 16 of the CFTC's rulemaking
teams. While these initial communications to schedule
discussions occurred prior to DOJ's comment submission,
substantive discussions between CFTC and DOJ staff took place
in a meeting on January 14, 2011.
Q.10. Swap customers have the choice to transact in the
jurisdiction offering the most attractive environment, in terms
of price, ease of settlement, legal and regulatory certainty,
among other factors. Explain how you are coordinating with
foreign regulators to ensure there is a set of harmonized rules
among well-regulated markets. Are you concerned that swap
transactions will migrate to markets that operate under a more
favorable regulatory environment? If that happens, what are the
threats to the financial stability of the United States?
A.10. The Commission is actively consulting and coordinating
with international regulators to promote robust and consistent
standards and avoid conflicting requirements in swaps
oversight. The Commission participates in numerous
international working groups regarding swaps, including the
International Organization of Securities Commissions Task Force
on OTC Derivatives, which the CFTC cochairs. Our discussions
have focused on clearing and trading requirements,
clearinghouses more generally and swaps data reporting issues,
among other topics.
As we do with domestic regulators, the CFTC shares many of
our memos, term sheets and draft work product with
international regulators. We have been consulting directly and
sharing documentation with the European Commission, the
European Central Bank, the U.K. Financial Services Authority,
the new European Securities and Markets Authority, the Japanese
Financial Services Authority and regulators in Canada, France,
Germany, and Switzerland. Two weeks ago, I met with Michel
Barnier, the European Commissioner for Internal Market and
Services, to discuss ensuring consistency in swaps market
regulation.
Both the CFTC and European Union are moving forward on
addressing the key objectives the G-20 set forth in September
2009, including clearing through central counterparties,
trading on exchanges or electronic trading platforms, record
keeping, reporting, and higher capital requirements for
noncleared swaps.
Through consultation, regulators are working to bring
consistency to oversight of the swaps markets. In September of
last year, the European Commission (EC) released its swaps
proposal. The European Council and the European Parliament are
now considering the proposal. Similar to the Dodd-Frank Act,
the European Commission proposal covers the entire product
suite, including interest rate swaps, currency swaps, commodity
swaps, equity swaps, and credit default swaps. It is important
that all standardized swaps--including exchange-traded swaps--
are subject to mandatory central clearing. The proposal
includes requirements for central clearing of swaps, robust
oversight of central counterparties, and reporting of all swaps
to a trade repository.
The EC 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.
Q.11. The CFTC recently proposed position limits that will
impose additional costs on OTC derivative market participants.
However a recent joint report by the U.K. Financial Services
Authority and HM Treasury warns ``The U.K. Authorities would
urge caution in the application of any specific position limit
power, and the expectation that these regulatory tools might
achieve the objective of reduced price volatility, or
manipulation, as there appears to be no conclusive evidence
that this may be the case.'' In other words, position limit
regulation imposes real costs, with little or no benefit. What
analysis has the CFTC done to examine the impact of position
limits on liquidity? What are the results of that analysis? How
can the CFTC justify imposing position limits on OTC derivative
market participants when a proper cost-benefit analysis could
show that the costs do not justify the benefits? If the United
States is the only jurisdiction to adopt aggressive position
limits, will OTC derivatives transactions simply migrate
oversees?
A.11. In its proposed rulemaking, the CFTC considered the
proposal's impact on liquidity. In addition, the Commission
sought public comment specifically with regard to expected
effects on liquidity. The Commission will thoroughly and
carefully review submitted public comments before proceeding to
consider final rules.
The Dodd-Frank Act mandates that the CFTC set aggregate
position limits for certain physical commodity derivatives
across the derivatives markets. The Act broadened the CFTC's
position limits authority to include aggregate position limits
on certain swaps and certain linked contracts traded on foreign
boards of trade in addition to U.S. futures and options on
futures. Congress also narrowed the exemptions traditionally
available from position limits by modifying the definition of
bona fide hedge transaction.
Position limits have served since the Commodity Exchange
Act passed in 1936 as a tool to curb or prevent excessive
speculation that may burden interstate commerce. When the CFTC
set position limits in the past, the agency sought to ensure
that the markets were made up of a broad group of market
participants with a diversity of views. Integrity is enhanced
when participation is broad and the market is not overly
concentrated.
The CFTC strives to include well-developed considerations
of costs and benefits in each of its proposed rulemakings.
Relevant considerations are presented not only in the cost-
benefit analysis section of the CFTC's rulemaking releases, but
additionally are discussed throughout the release in compliance
with the Administrative Procedure Act, which requires the CFTC
to set forth the legal, factual, and policy bases for its
rulemakings. With the proposed rule on position limits, the
Commission sought public comment regarding costs and benefits.
As part of the process, the Commission has received more than
12,000 comments, including comments from market participants,
public interest groups, and individuals. The Commission will
review these comments thoroughly and will respond to them in
developing a final rule.
Q.12. Chairman Gensler, in a recent speech, your colleague
Commissioner Sommers noted that the proposals issued by the
CFTC thus far ``contain cursory, boilerplate cost-benefit
analysis sections in which [you] have not attempted to quantify
the costs.'' Are your fellow Commissioner's comments valid? If
not, why not? As Chairman of the CFTC, do you believe that it
is important for the other Commissioners to have confidence in
the integrity of the CFTC's rulemaking process? If so, what
steps can you take to ensure that the CFTC's cost-benefit
analysis is improved and satisfies all of the CFTC's
Commissioners?
A.12. The CFTC strives to include well-developed considerations
of costs and benefits in each of its proposed rulemakings.
Relevant considerations are presented not only in the cost-
benefit analysis section of the CFTC's rulemaking releases, but
additionally are discussed throughout the release in compliance
with the Administrative Procedure Act, which requires the CFTC
to set forth the legal, factual, and policy bases for its
rulemakings.
In addition, Commissioners and staff have met extensively
with market participants and other interested members of the
public to hear, consider and address their concerns in each
rulemaking. CFTC staff hosted a number of public roundtables so
that rules could be proposed in line with industry practices
and address compliance costs consistent with the obligations of
the CFTC to promote market integrity, reduce risk and increase
transparency as directed in Title VII of the Dodd-Frank Act.
Information from each of these meetings--including full
transcripts of the roundtables--is available on the CFTC's Web
site and has been factored into each applicable rulemaking.
With each proposed rule, the Commission has sought public
comment regarding costs and benefits.
Q.13. Chairman Gensler, you were actively engaged in the
legislative drafting process. The Dodd-Frank Act contains
aggressive rulemaking deadlines. Knowing what you do now, do
you wish that you had advocated for more reasonable deadlines?
A.13. The Dodd-Frank Act had a deadline of 360 days after
enactment for completion of the bulk of our rulemakings--July
16, 2011. Both the Dodd-Frank Act and the Commodity Exchange
Act (CEA) give the CFTC the flexibility and authority to
address the issues relating to the effective dates of Title
VII. We have coordinated closely with the SEC on these issues.
On July 14, the CFTC granted temporary relief from certain
provisions that would otherwise apply to swaps or swap dealers
on July 16. This order enables the Commission to continue its
progress in finalizing rules.
Q.14. The CFTC proposed changes to Rule 4.5, which could have
meaningful implications for registered investment companies.
These changes were not required by Dodd-Frank. Why is the CFTC
contemplating a broad reach into the regulation of registered
investment companies, which are already heavily regulated by
the SEC?
A.14. The CFTC and the SEC proposed a joint rule to require
reporting by investment advisers to private funds that are also
registered as commodity pool operators or commodity trading
advisors with the CFTC. The joint proposed rule would require
private fund investment advisers with assets under management
totaling more than $150 million to provide the SEC with
financial and other trading information. Private fund
investment advisers with assets under management totaling more
than $1 billion would be subject to heightened reporting
requirements. Separately, the CFTC proposed a rule that would
bring similar reporting to CPOs and CTAs with assets under
management greater than $150 million that are not otherwise
jointly regulated. This is to ensure that similar entities in
the asset management arena are regulated consistently. The CFTC
proposed rule would repeal certain exemptions issued under Part
4 of the Commission's regulations so the Commission will have a
more complete picture of the activity of operators of and
advisors to pooled investment vehicles in the commodities
marketplace. The Commission is reviewing the comments received
on the proposal. In addition, Commission staff has held
discussions with SEC staff and plans to hold a public
roundtable discussion.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED
FROM GARY GENSLER
Q.1. In March, a Stanford Professor published a study noting
that index positions and managed-money spread positions had the
largest impact on futures prices. Specifically, the study noted
that ``increased in flows into index funds . . . predict higher
subsequent futures prices.'' What is the CFTC doing (or has it
done) to examine this issue? What implications does this issue
have on price? Are index and hedge funds having an increasing
impact on commodity market dynamics? If so, how?
A.1. The Commission obtains comprehensive data on futures
markets participants through its large trader reporting system.
The Commission's rule on large swap trader reporting, will add
to that data. Large trader data is collected for surveillance
and regulatory purposes. In addition, to enhance market
transparency, the Commission publishes reports with the data in
aggregated form and subdivided by trader type. It is clear that
the derivatives markets have changed significantly. The markets
have become much more electronically traded. Instead of being
traded in the pits, more than 80 percent of futures and options
on futures were traded electronically in 2010. In addition, the
makeup of the market has changed. In contrast with the early
days of the CFTC, swap dealers now comprise a significant
portion of the markets. Also, investors today treat commodities
as an asset class for passive index investment. Based on
published CFTC data, financial actors, such as swap dealers,
managed money accounts, and other noncommercial reportable
traders, make up a significant majority of many of the futures
markets.
For example, market data as of June 28, 2011, shows that
only about 13 percent of gross long positions and about 19
percent of gross short positions in the WTI crude oil market
were held by producers, merchants, processors, and users of the
commodity. Similarly, only about 10 percent of gross long
positions and about 39 percent of gross short positions in the
Chicago Board of Trade wheat market were held by producers,
merchants, processors, and users of the commodity. Finally,
based upon CFTC data, the vast majority of trading volume in
key futures markets--up to 80 percent in many markets--is day
trading or trading in calendar spreads. Thus, only a modest
proportion of average daily trading volume results in
reportable traders changing their net long or net short futures
positions for the day. This means that only about 20 percent or
less of the trading is done by traders who bring a longer-term
perspective to the market on the price of the commodity. The
Commission recently published on its Web site historical data
on directional position changes to enhance market transparency.
Q.2. Recently, the Los Angeles Times reported that more and
more Americans are engaging in foreign currency trading,
encouraged by the advertising of the two largest U.S. brokers,
FXCM Inc and Gain Capital Holdings, Inc., and they ``are losing
money in spectacular fashion.'' Gain and FXCM recently reported
that U.S. customers amounted to approximately $777 billion and
$667 billion in annual trading volume respectively. The LA
Times article also noted that between 72 percent and 79 percent
of these customers lost money each quarter last year. Are you
concerned about this emerging trend? What is the CFTC doing to
regulate this area? What additional regulation is needed?
A.2. On September 10, 2010, the CFTC published final rules to
provide for the regulation of off-exchange retail foreign
currency transactions. The rules implement provisions of the
Dodd-Frank Wall Street Reform and Consumer Protection Act and
the Food, Conservation, and Energy Act of 2008, which,
together, provided the CFTC with broad authority to register
and regulate entities wishing to serve as counterparties to, or
to intermediate, retail foreign exchange (forex) transactions.
These rules of the road are to help protect the American public
in the largest area of retail fraud that the CFTC oversees. All
CFTC registrants involved in soliciting and selling retail
forex contracts to consumers now have to comply with rules to
protect the investing public.
The final forex rules put in place requirements for, among
other things, registration, disclosure, record keeping,
financial reporting, minimum capital, and other business
conduct and operational standards. Specifically, the
regulations require the registration of counterparties offering
retail foreign currency contracts as either futures commission
merchants (FCMs) or retail foreign exchange dealers (RFEDs), a
new category of registrant. Persons who solicit orders,
exercise discretionary trading authority, or operate pools with
respect to retail forex also will be required to register,
either as introducing brokers, commodity trading advisors,
commodity pool operators (as appropriate), or as associated
persons of such entities.
The rules include financial requirements designed to ensure
the financial integrity of firms engaging in retail forex
transactions and robust customer protections. For example, FCMs
and RFEDs are required to maintain net capital of $20 million
plus 5 percent of the amount, if any, by which liabilities to
retail forex customers exceed $10 million. Leverage in retail
forex customer accounts will be subject to a security deposit
requirement to be set by the National Futures Association
within limits provided by the Commission. All retail forex
counterparties and intermediaries are required to distribute
forex-specific risk disclosure statements to customers and
comply with comprehensive record keeping and reporting
requirements.
The disclosures identified in the referenced news stories
were due to CFTC rule requirements.
Q.3. Do you have a concern that commodities prices--both oil
and food--are increasingly being affected by forces outside of
normal supply and demand fundamentals? Is true price discovery
being affected by trading instruments and traders, rather than
by market fundamentals?
A.3. At its core, the mission of the CFTC is to ensure the
integrity and transparency of derivatives markets so that
hedgers and investors may use them with confidence. Though the
CFTC is not a price-setting agency, rising prices for basic
commodities--energy in particular--highlight the importance of
having effective market oversight that ensures integrity and
transparency.
A specific critical reform of the Dodd-Frank Act relates to
position limits. Position limits have served since the
Commodity Exchange Act passed in 1936 as a tool to curb or
prevent excessive speculation that may burden interstate
commerce. The Dodd-Frank Act directs the Commission to
establish position limits for both futures and swaps in a very
specific manner. It directs the Commission to establish
speculative position limits for futures contracts for
agricultural commodities and exempt commodities (including
crude oil, gasoline, and other energy commodities), and to
concurrently establish limits on swaps that are economically
equivalent to those futures contracts. It also requires the
Commission to establish aggregate limits across the futures and
swaps markets. The Commission published a proposed rule to
implement these statutory directives and received over 12,000
comments from the public. The Commission is evaluating the
comments received before proceeding to a final rulemaking. It
is essential to complete the task of implementing the aggregate
position limits regime, which were congressionally mandated to
guard against the burdens of excessive speculation and foster
orderly markets.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN
FROM GARY GENSLER
Q.1. In the past you have said that you are working to reach
``agreement'' with international regulators on reform of the
swaps market because reform cannot be accomplished alone. What
form will those agreements take? How will they be enforced? And
what steps will you take if international regulatory bodies set
standards that differ greatly from those in the United States?
A.1. As we work to implement the derivatives reforms in the
Dodd-Frank Act, we are actively coordinating with international
regulators to promote robust and consistent standards and avoid
conflicting requirements in swaps oversight. The Commission
participates in numerous international working groups regarding
swaps, including the International Organization of Securities
Commissions Task Force on OTC Derivatives, which the CFTC
cochairs with the Securities and Exchange Commission (SEC). The
CFTC, SEC, European Commission, and European Securities Market
Authority are coordinating through a technical working group.
The Dodd-Frank Act recognizes that the swaps market is
global and interconnected. It gives the CFTC the flexibility to
recognize foreign regulatory frameworks that are comprehensive
and comparable to U.S. oversight of the swaps markets in
certain areas. In addition, we have a long history of
recognition regarding foreign participants that are comparably
regulated by a home country regulator. The CFTC enters into
arrangements with international counterparts for access to
information and cooperative oversight. The Commission has
signed memoranda of understanding with regulators in Europe,
North America, and Asia.
Q.2. In many sections of the statute such as real time
reporting, position limits, and Swap Execution Facilities
(SEFs) the CFTC is required to assess the impact on liquidity
of its proposals. I have not seen in the relevant notices of
proposed rulemakings, any significant discussion of the impact
on liquidity. Has the CFTC reviewed how its real time
reporting, SEF and position limit proposals will affect market
liquidity? If so, what are the results of that review? If not,
why not?
A.2. In its proposed rulemakings, the CFTC considered how the
rule proposals might affect liquidity in the swap markets
through discussions with market participants, domestic and
international regulators, and other interested parties. The
CFTC addressed those issues in the rulemakings. In addition,
the Commission has sought public comment specifically with
regard to expected effects on liquidity. The Commission will
thoroughly and carefully review submitted public comments
before proceeding to consider final rules.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON
FROM DANIEL K. TARULLO
Q.1. Will the margin rules proposed this morning (April 12,
2011) at the FDIC on behalf of the prudential regulators and at
the CFTC require commercial end users to post margin directly
to swap dealers beyond what would ordinarily be required by
current swap dealer practices of mitigating counterparty
exposure? If so, what role will the prudential regulators and
the CFTC play in both establishing and supervising these credit
thresholds going forward? Additionally, how do the prudential
regulators and the CFTC define noncash collateral that could be
used to satisfy end user margin requirements?
A.1. Response not provided.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM DANIEL K. TARULLO
Q.1. How can the Federal Reserve assure us that clearinghouses
that are designated to be systemically important financial
market utilities and have access to Federal Reserve discount
and borrowing privileges do not undertake unsafe and unsound
business practices because of the interplay between profit
pressures and aggressive regulatory mandates?
A.1. Response not provided.
Q.2. A recent letter from the American Benefits Council and the
Committee on Investment of Employee Benefit Assets raised
questions about the process by which the Federal Reserve Bank
of New York has been working with swap dealers to develop
commitments with respect to trading, confirmation, clearing,
and reporting of swap transactions. Decisions made in these
negotiations will affect dealers' counterparties, such as Main
Street corporations, pension funds, and hedge funds. What is
the Federal Reserve Bank of New York doing to take into account
the perspective of nondealer market participants? How are these
negotiations being coordinated with SEC and CFTC rulemaking?
A.2. Response not provided.
Q.3. On April 12, 2011, the Federal Reserve and other
prudential regulators proposed rules to establish minimum
capital and margin requirements for prudentially regulated swap
market participants. Do you believe that Congress intended to
exempt end users from margin requirements? What are the
differences between the Fed's margin rules and the other
prudential regulators' margin rules? For each difference,
please explain why they differ.
A.3. Response not provided.
Q.4. Why did the Fed specify prescriptive margin calculation
models that isolate swap risk rather than considering a
prudentially regulated swap market participants' entire credit
relationship with end users? Please explain how the Fed
determined the key assumptions on margin calculations,
including the determinations of the number of standard
deviations, the time period over which it is applied, and the
data that is used as inputs.
A.4. Response not provided.
Q.5. Please explain how the proposed margin rules provide
incremental credit exposure-reducing benefits, beyond existing
or other forthcoming prudential regulatory requirements
including the Basel III standards.
A.5. Response not provided.
Q.6. How does your agency define the term ``clearing'' with
respect to swaps (or security-based swaps)? Which activities
are encompassed within that definition?
A.6. Response not provided.
Q.7. Swap data repositories and security-based swap data
repositories may not share information with regulators other
than their primary regulator unless they obtain an
indemnification agreement. Please describe how this provision
would work in practice. Are there any issues that would impede
the implementation of this provision?
A.7. Response not provided.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED
FROM DANIEL K. TARULLO
Q.1. Title VII of the Dodd-Frank Act, largely overseen by the
SEC and CFTC, will require firms to keep additional capital for
over-the-counter trades, so that they will be able to pay up,
if the trade moves against them. At the same time, the Volcker
Rule, which is overseen by banking regulators, as well as the
SEC and CFTC, also imposes capital requirements. These
provisions require regulators to impose additional capital
charges for any proprietary trading by the nonbank financial
companies supervised by the board [((a)(2)) and ((f)(4))], and
explicitly authorizes regulators to impose additional capital
charges on banking entities, for even permitted activities such
as market-making. [((d)(3))] And, of course, the Treasury
Department and banking regulators are working with their
international counterparts to effectively implement new Basel
requirements on capital. What work is the Federal Reserve
doing, whether independently or in coordination with the
Department of the Treasury, the prudential regulators, the SEC,
or CFTC, to help enhance the capital requirements for trading
positions, as directed by not just the derivatives title, but
also the Volcker Rule?
A.1. Response not provided.
Q.2. Recently, the Federal Reserve, after conducting stress
tests, allowed some banks to increase dividends or buy back
shares. JPMorgan, for example, not only announced an increase
in its dividends, but also announced that it would buy back as
much as $15 billion in stock. As part of the Federal Reserve's
most recent stress tests, how did the Federal Reserve take into
account all potential liabilities that may arise in light of
all the issues (alleged violations of State real property laws,
securities laws, Federal tax laws, and others) raised as a
result of faulty foreclosure procedures, the so-called robo-
signing issues? That is, by allowing several firms to pay
higher dividends and/or buy back stock, is the Federal Reserve
certifying that these robo-signing issues do not present a
material risk to the banks?
A.2. Response not provided.
Q.3. The Federal Open Market Committee (FOMC) authorized
temporary dollar liquidity swap arrangements with 14 foreign
central banks between December 12, 2007, and October 29, 2008.
The arrangements expired on February 1, 2010. Federal Reserve
data reflects that during October and November 2008, the
Federal Reserve extended over $550 billion in swap lines to
foreign banks. \1\ What specific factors were considered by the
Federal Reserve in taking this action? What other options were
considered? Was intervention considered effective? Why or why
not?
---------------------------------------------------------------------------
\1\ Using the date on which the U.S. dollars were extended to the
foreign central bank in exchange for the receipt of foreign currency
net of maturities. See, http:///www.federalreserve.gov/newsevents/
reform_swaplines.htm.
---------------------------------------------------------------------------
A.3. Response not provided.
Q.4. The Federal Reserve extended swap arrangements with 14
central banks; however, it published data on its swap lines
with 10 foreign banks. Were the other 4 banks involved in the
Federal Reserves' swap lines?
A.4. Response not provided.
Q.5. In May 2010, the FOMC authorized additional swap lines
with five central banks through August 1, 2011. According to
Federal Reserve data, only the European Central Bank
participated (through the end of the data period provided--
October 2010). What facts and circumstances necessitated this
intervention? Why did other banks (Bank of Canada, the Bank of
England, the Bank of Japan, and the Swiss National Bank) not
participate?
A.5. Response not provided.
Q.6. Do any swap facilities remain operational? If so, please
provide additional data regarding to whom swap lines were
extended and the amounts extended. If they are no longer
operational, please provide the same requested data.
A.6. Response not provided.
Q.7. The Federal Reserve extended $3.221 billion to Banco de
Mexico from April 23, 2009, to January 12, 2010. (The $3.221
billion was provided in three separate arrangements, each of
which matured in 88 days and was immediately renewed.) What
facts and circumstances necessitated this intervention?
A.7. Response not provided.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN
FROM DANIEL K. TARULLO
Q.1. On April 12, the banking regulators released their
proposal on ``Margin and Capital Requirements for Covered Swap
Entities.'' The proposal requires dealer banks and significant
counterparties to post two way initial margin and to hold that
margin at third party custodian banks. This margin would be
limited to immediately available cash funds and high-quality,
highly liquid U.S. Government and agency obligations. Re-
hypothecation of such amounts would be prohibited. What are the
costs associated with tying up margin in segregated accounts at
custodian banks? Have you quantified the impact this
requirement will have on liquidity?
A.1. Response not provided.
Q.2. The margin and capital requirements proposal takes a risk-
based approach by distinguishing between four separate types of
derivatives counterparties. The proposal extends the definition
of financial end user to include any government of any foreign
country or any political subdivision, agency, or
instrumentality thereof in the world. How would margin and
capital requirements apply to the dealings of the foreign
subsidiary of a U.S. financial institution that enters into a
swap? What about a U.S. financial institution that enters into
a swap with a foreign government? Would the foreign subsidiary
of a U.S. institution that enters into a swap with a foreign
government be required to post margin in U.S. Treasuries?
A.2. Response not provided.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM MARY J. MILLER
Q.1. How does your agency define the term ``clearing'' with
respect to swaps (or security-based swaps)? Which activities
are encompassed within that definition?
A.1. The Department of the Treasury does not define the term
``clearing'' in any regulations. The Commodity Exchange Act, as
modified by the Dodd-Frank Wall Street Reform and Consumer
Protection Act, defines the term ``derivatives clearing
organization'' as a clearinghouse, clearing association,
clearing corporation, or similar entity, facility, system, or
organization that, (i) substitutes/novates the credit of the
derivatives clearing organization for the credit of the parties
to the transaction; (ii) arranges/provides for settlement/
netting of obligations on a multilateral basis; or (iii)
provides clearing services/arrangements that mutualize or
transfer credit risk among participants.
The term ``clearing'' with respect to swaps (or security-
based swaps) generally is understood to encompass the set of
activities and processes that occur between the execution of a
contract between counterparties and final settlement in order
to ensure performance on the contract. Typical ``clearing''
activities or services provided by a clearinghouse or central
counterparty include reduction of counterparty credit
exposures, netting of offsetting bilateral positions, daily
mark-to-market and collateralization (margin), and
mutualization of the risk of loss.
Q.2. Swap data repositories and security-based swap data
repositories may not share information with regulators other
than their primary regulator unless they obtain an
indemnification agreement. Please describe how this provision
would work in practice. Are there any issues that would impede
the implementation of this provision?
A.2. The Dodd-Frank Wall Street Reform and Consumer Protection
Act requires Swap Data Repositories (SDRs) and Security-Based
Swap Data Repositories (SB-SDRs), upon request, and after
notifying its primary regulator, to make data available to
certain other domestic and foreign regulators. The Act further
requires regulators requesting data to execute a written
confidentiality and indemnification agreement with the SDR or
SB-SDR prior to receiving any data. The CFTC and the SEC have
proposed rules for SDRs and SB-SDRs, respectively, that require
such confidentiality and indemnification agreements (see 75 FR
80808 [December 23, 2010] and 75 FR 77306 [December 10, 2010],
respectively). Both agencies acknowledge in their proposed
rules that certain domestic and foreign regulators may have
difficulty--or even be legally prohibited--from agreeing to
indemnify third parties and that the indemnification provision
could ``chill'' requests for information or otherwise inhibit
certain regulators from fulfilling their mandates. Both
agencies have requested comment on the required confidentiality
and indemnification agreements and are evaluating feedback.
Q.3. Secretary Geithner made the case before the Senate
Committee on Agriculture in December of 2009 that foreign
exchange swaps should not be treated the same as all other
swaps. He explained that foreign exchange markets are different
than other derivatives markets and already are subject to an
elaborate regulatory framework. He cautioned, ``These markets
have actually worked quite well . . . we have got a basic
obligation to do no harm, to make sure as we reform we do not
make things worse, and our judgment is that because of the
protections that already exist in these foreign exchange
markets and because they are different from derivatives, have
different risks, require different solutions, we will have to
have a slightly different approach.'' Please elaborate on
Secretary Geithner's statement and the importance of regulating
foreign exchange swaps in a manner that takes into account
their unique characteristics and their existing regulatory
framework.
A.3. Treasury issued a Notice of Proposed Determination (copy
enclosed) that was published in the Federal Register on May 5,
2011, to exempt foreign exchange swaps and forwards from the
Commodity Exchange Act's (CEA) definition of swap. The reasons
for the proposed determination are explained in the Notice.
Q.4. One of the concerns that the Investment Company Institute
raised about the CFTC's proposed amendments to Rule 4.5 is that
not knowing whether foreign exchange swaps and forwards will be
included in the definition of ``swap'' affects their ability to
analyze the effects that the changes to Rule 4.5 will have.
Have you discussed this issue with the CFTC? More generally,
are you concerned that Treasury's failure to act with respect
to foreign exchange swaps and forwards impedes the ability of
market participants to determine whether and how to comment on
rules and to plan for compliance with Dodd-Frank?
A.4. As noted, Treasury issued a Notice of Proposed
Determination on May 5, 2011 to exempt foreign exchange swaps
and forwards from the definition of a swap under the CEA.
Q.5. At the hearing, I asked you whether Treasury would be
conducting any studies with respect to the effects of
derivatives regulation on job creation. Your answer was
unclear. Please clarify your answer.
A.5. Treasury has not conducted any such studies and is not in
the process of conducting any study on the effects of
derivatives regulation on job creation.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED
FROM MARY J. MILLER
Q.1. Which financial institutions are most active with respect
to foreign exchange swaps and foreign exchange forwards? Which
of these financial institutions have received emergency
Government infusions (TARP funds, capital, etc.)? What portion
of the Government-provided funds were related to activities
unrelated to foreign exchange swaps and foreign exchange
forwards? How do you know?
A.1. As noted in Treasury's May 5, 2011, Notice of Proposed
Determination, banks are the key players in the foreign
exchange swaps and forwards market. Although a number of banks
received emergency assistance during the financial crisis, we
are not aware of any institutions that received such assistance
due to their foreign exchange swaps or forwards activities.
Q.2. According to an analysis by Better Markets, the Federal
Reserve provided $2.9 trillion to stabilize foreign exchange
markets in October 2008. Please describe your understanding of
the facts and circumstances that led to this infusion and
whether it is reasonably possible that such a condition may
reoccur.
A.2. The Federal Reserve made large amounts of dollars
available to other central banks in the fall of 2008 because of
the global demand for dollars related to short-term funding
needs during the financial crisis. Some confusion has arisen
among nonmarket participants because these forms of Federal
Reserve assistance to central banks were called foreign
exchange swap lines. Despite the similar sounding name, the
Federal Reserve swap lines were in fact quite distinct from the
foreign exchange swaps and forwards market. The steps that are
being taken to implement the Dodd-Frank Wall Street Reform and
Consumer Protection Act are designed to improve the safety and
soundness of the financial system and to prevent the recurrence
of the need for such assistance.
Q.3. Please describe in which ways the market for foreign
exchange swaps and foreign exchange forwards is different from
other derivatives markets.
A.3. The enclosed May 5, 2011, Notice of Proposed Determination
sets forth the reasons Treasury believes the market for foreign
exchange swaps and forwards is different from other derivatives
markets.
Q.4. There has been an increase in litigation against banks
related to foreign currency trading activities. Pension funds
and State attorneys general allege that certain banks executed
trades at one price, but charged a higher price to the funds.
Whistleblowers have also come forward alleging improper
practices related to foreign currency trading by banks. An
October 2009 report by Russell Investments noted that there is
``no regulator charged with defending the rights and interests
of clients when converting currency.'' What work has Treasury
done to monitor and investigate allegations of improper
practices regarding currency trading? What is the current state
of the regulatory framework that addresses this area? What
options, if any, has the Department explored for enhancing
transparency? What, if any, legislation might be required in
this area to better protect clients from improper practices in
this area?
A.4. The Treasury Department does not comment on pending
litigation and investigations.
The Dodd-Frank Wall Street Reform and Consumer Protection
Act (DFA) further strengthens the oversight and transparency of
all foreign currency derivatives markets, including foreign
exchange swaps and forwards. It subjects participants in the
derivatives markets to heightened business conduct standards
and provides the CFTC and banking regulators with additional
oversight of market participants and with strong anti-evasion
powers to ensure that they do not structure products or take
other steps to evade the Commodity Exchange Act's requirements.
The DFA's trade reporting requirements will significantly
enhance the transparency and oversight of derivatives markets,
including for foreign currency derivatives.
Q.5. Title VII of the Dodd-Frank Act, largely overseen by the
SEC and CFTC, will require firms to keep additional capital for
over-the-counter trades, so that they will be able to pay up,
if the trade moves against them. At the same time, the Volcker
Rule, which is overseen by banking regulators, as well as the
SEC and CFTC, also imposes capital requirements. These
provisions require regulators to impose additional capital
charges for any proprietary trading by the nonbank financial
companies supervised by the board [((a)(2)) and ((f)(4))], and
explicitly authorizes regulators to impose additional capital
charges on banking entities, for even permitted activities such
as market-making. [((d)(3))] And, of course, the Treasury
Department and the banking regulators are working with their
international counterparts to effectively implement new Basel
requirements on capital. What work is the Treasury Department
doing, whether independently or in coordination with the
prudential regulators, the SEC, or CFTC, to help enhance the
capital requirements for trading positions, as directed by not
just the derivatives title, but also by the Volcker Rule?
A.5. Although the Treasury Department is not directly
responsible for writing the regulations to implement either the
derivatives provisions of the Dodd-Frank Wall Street Reform and
Consumer Protection Act or the Volcker Rule, we are working
closely with the agencies responsible for issuing the
regulations to implement the Volcker Rule to coordinate the
rulemakings so that they are as consistent and comparable as
possible across supervisory jurisdictions.
Q.6. Historically OTC derivatives have been taxed under the
conventional realization method of accounting for stock, bonds,
and other securities, while exchange traded funds have been
subject to Section 1256 of the Internal Revenue Code, which
generally requires that contracts within its scope be marked-
to-market on an annual basis, and provides that gains or losses
are considered capital gains/losses with 60 percent long-term
and 40 percent short term. Section 1601 of the Dodd-Frank Wall
Street Reform and Consumer Protection Act amended Section 1256
of the IRC. On December 7, 2010, the Treasury/IRS business plan
provided for the development of ``guidance on the application
of [Section] 1256 to certain derivatives contracts.'' What tax
issues is the Department considering with respect to
derivatives contracts? When does the Department expect that it
will issue guidance in this area? If the Secretary of the
Treasury exempted foreign exchange swaps and forwards from the
definition of ``swap'' under the Commodity Exchange Act, would
the definition under Section 1256 of the IRC, as amended by
Dodd-Frank, remain applicable?
A.6. Section 1256 of the Internal Revenue Code generally
requires that ``section 1256 contracts'' be marked-to-market
annually. A section 1256 contract is a regulated futures
contract, a foreign currency contract, a dealer securities
futures contract, or certain options listed on a qualified
board or exchange (QBE). Gain or loss from a foreign currency
contract is generally treated as ordinary income and subject to
tax at regular income tax rates; a regulated futures contract,
dealer securities futures contract, and a listed option
generates 60 percent long-term and 40 percent short-term
capital gain or loss, assuming the contract is a capital asset
in the hands of the taxpayer.
In recent years, an increasing number of contracts have
been moving to QBEs and/or centralized clearinghouses, raising
the question as to whether such contracts are section 1256
contracts. The Dodd-Frank Wall Street Reform and Consumer
Protection Act added section 1256(b)(2) to the Internal Revenue
Code, which generally limits the scope of section 1256 to those
contracts that have historically been section 1256 contracts.
Thus, section 1256(b)(2) specifies that over-the-counter swaps
and similar financial instruments are not section 1256
contracts. The exemption of foreign exchange swaps and forwards
from the Commodity Exchange Act does not affect the section
1256 tax analysis.
Guidance under section 1256 is on the 2010-2011 Priority
Guidance Plan published by the Treasury Department and the IRS.
That guidance will address issues related to the Dodd-Frank
Wall Street Reform and Consumer Protection Act amendment to
section 1256, including the scope of section 1256(b)(2). The
section 1256 guidance project is expected to be published this
summer.
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN
FROM MARY J. MILLER
Q.1. On April 12, the banking regulators released their
proposal on ``Margin and Capital Requirements for Covered Swap
Entities.'' The proposal requires dealer banks and significant
counterparties to post two way initial margin and to hold that
margin at third party custodian banks. This margin would be
limited to immediately available cash funds and high-quality,
highly liquid U.S. Government and agency obligations. Re-
hypothecation of such amounts would be prohibited. What are the
costs associated with tying up margin in segregated accounts at
custodian banks? Have you quantified the impact this
requirement will have on liquidity?
A.1. As you note, the banking regulators released a notice of
proposed rulemaking on ``Margin and Capital Requirements for
Covered Swap Entities'' on April 12. Those proposed rules are
currently open for public comment. Among the questions on which
the banking regulators have solicited comments is what costs
the proposed rules would impose and what impact they would have
on liquidity. Comments are due by June 24, 2011. These are
clearly important questions, and we look forward to reviewing
the comments the banking regulators receive in response to
these and the many other questions they have asked.
Q.2. The margin and capital requirements proposal takes a risk-
based approach by distinguishing between four separate types of
derivatives counterparties. The proposal extends the definition
of financial end user to include any government of any foreign
country or any political subdivision, agency, or
instrumentality thereof in the world. How would margin and
capital requirements apply to the dealings of the foreign
subsidiary of a U.S. financial institution that enters into a
swap? What about a U.S. financial institution that enters into
a swap with a foreign government? Would the foreign subsidiary
of a U.S. institution that enters into a swap with a foreign
government be required to post margin in U.S. Treasuries?
A.2. As noted in response to the prior question, the banking
regulators released a notice of proposed rulemaking on ``Margin
and Capital Requirements for Covered Swap Entities'' on April
12 and have requested comments from the public by June 24,
2011. The proposed rules also have specifically solicited
comment on whether the proposed rules appropriately limit the
margin rules consistent with the territorial scope of the Dodd-
Frank Wall Street Reform and Consumer Protection Act, and how
the rules could affect the structure, management, and
competitiveness of U.S. entities.