[House Hearing, 114 Congress]
[From the U.S. Government Publishing Office]
REAUTHORIZING THE COMMODITY FUTURES
TRADING COMMISSION
=======================================================================
HEARINGS
BEFORE THE
SUBCOMMITTEE ON COMMODITY EXCHANGES, ENERGY, AND CREDIT
OF THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED FOURTEENTH CONGRESS
FIRST SESSION
__________
MARCH 24, 25; AND APRIL 14, 2015
__________
Serial No. 114-7
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]
Printed for the use of the Committee on Agriculture
agriculture.house.gov
_____________
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COMMITTEE ON AGRICULTURE
K. MICHAEL CONAWAY, Texas, Chairman
RANDY NEUGEBAUER, Texas, COLLIN C. PETERSON, Minnesota,
Vice Chairman Ranking Minority Member
BOB GOODLATTE, Virginia DAVID SCOTT, Georgia
FRANK D. LUCAS, Oklahoma JIM COSTA, California
STEVE KING, Iowa TIMOTHY J. WALZ, Minnesota
MIKE ROGERS, Alabama MARCIA L. FUDGE, Ohio
GLENN THOMPSON, Pennsylvania JAMES P. McGOVERN, Massachusetts
BOB GIBBS, Ohio SUZAN K. DelBENE, Washington
AUSTIN SCOTT, Georgia FILEMON VELA, Texas
ERIC A. ``RICK'' CRAWFORD, Arkansas MICHELLE LUJAN GRISHAM, New Mexico
SCOTT DesJARLAIS, Tennessee ANN M. KUSTER, New Hampshire
CHRISTOPHER P. GIBSON, New York RICHARD M. NOLAN, Minnesota
VICKY HARTZLER, Missouri CHERI BUSTOS, Illinois
DAN BENISHEK, Michigan SEAN PATRICK MALONEY, New York
JEFF DENHAM, California ANN KIRKPATRICK, Arizona
DOUG LaMALFA, California PETE AGUILAR, California
RODNEY DAVIS, Illinois STACEY E. PLASKETT, Virgin Islands
TED S. YOHO, Florida ALMA S. ADAMS, North Carolina
JACKIE WALORSKI, Indiana GWEN GRAHAM, Florida
RICK W. ALLEN, Georgia BRAD ASHFORD, Nebraska
MIKE BOST, Illinois
DAVID ROUZER, North Carolina
RALPH LEE ABRAHAM, Louisiana
TOM EMMER, Minnesota
JOHN R. MOOLENAAR, Michigan
DAN NEWHOUSE, Washington
______
Scott C. Graves, Staff Director
Robert L. Larew, Minority Staff Director
______
Subcommittee on Commodity Exchanges, Energy, and Credit
AUSTIN SCOTT, Georgia, Chairman
BOB GOODLATTE, Virginia DAVID SCOTT, Georgia, Ranking
FRANK D. LUCAS, Oklahoma Minority Member
RANDY NEUGEBAUER, Texas FILEMON VELA, Texas
MIKE ROGERS, Alabama SEAN PATRICK MALONEY, New York
DOUG LaMALFA, California ANN KIRKPATRICK, Arizona
RODNEY DAVIS, Illinois PETE AGUILAR, California
TOM EMMER, Minnesota
(ii)
C O N T E N T S
----------
Page
Tuesday, March 24, 2015
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, opening statement....................................... 4
Prepared statement........................................... 4
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota; submitted letter on behalf of Paul N. Cicio,
President, Industrial Energy Consumers of America.............. 55
Scott, Hon. Austin, a Representative in Congress from Georgia,
opening statement.............................................. 1
Prepared statement........................................... 2
Scott, Hon. David, a Representative in Congress from Georgia,
opening statement.............................................. 3
Witnesses
Christie, Douglas, President, Cargill Cotton, Cordova, TN; on
behalf of Commodity Markets Council............................ 5
Prepared statement........................................... 7
Submitted questions.......................................... 55
Campbell, Lael E., Director of Regulatory and Government Affairs,
Constellation Energy (An Exelon Company), Washington, D.C.; on
behalf of Edison Electric Institute............................ 13
Prepared statement........................................... 15
Submitted questions.......................................... 56
Cavallari, Lisa A., Director of Fixed Income Derivatives, Russell
Investments, Seattle, WA; on behalf of American Benefits
Council........................................................ 20
Prepared statement........................................... 21
Submitted questions.......................................... 58
Maurer, Mark, Chief Executive Officer, INTL FCStone Markets, LLC,
Chicago, IL.................................................... 26
Prepared statement........................................... 28
Submitted questions.......................................... 60
Peterson, Jr., Howard W., Owner and President, Peterson's Oil
Service, Worcester, MA; on behalf of New England Fuel
Institute; Americans for Financial Reform; American Feed
Association; Industrial Energy Consumers of America; Gasoline;
Automotive Service Dealers; Trucking and Airline Association... 37
Prepared statement........................................... 39
Wednesday, March 25, 2015
Scott, Hon. Austin, a Representative in Congress from Georgia,
opening statement.............................................. 75
Prepared statement........................................... 76
Scott, Hon. David, a Representative in Congress from Georgia,
opening statement.............................................. 77
Witnesses
Duffy, Hon. Terrence A., Executive Chairman and President, CME
Group, Chicago, IL............................................. 79
Prepared statement........................................... 80
Submitted questions.......................................... 119
Jackson, Benjamin, President and Chief Operating Officer, ICE
Futures U.S., New York, NY..................................... 85
Prepared statement........................................... 86
Submitted questions.......................................... 121
Roth, Daniel J., President and Chief Executive Officer, National
Futures Association, Chicago, IL............................... 88
Prepared statement........................................... 90
Submitted question........................................... 123
Corcoran, Gerald F., Chairman of the Board and Chief Executive
Officer, R.J. O'Brien & Associates, LLC, Chicago, IL; on behalf
of Futures Industry Association................................ 92
Prepared statement........................................... 94
Submitted questions.......................................... 124
Bernardo, Shawn, Chief Executive Officer, tpSEF, Inc. at Tullett
Prebon, Jersey City, NJ; on behalf of Wholesale Market Brokers
Association, Americas.......................................... 97
Prepared statement........................................... 99
Submitted questions.......................................... 124
Tuesday, April 14, 2015
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, opening statement....................................... 134
Goodlatte, Hon. Bob, a Representative in Congress from Virginia,
prepared statement............................................. 134
Scott, Hon. Austin, a Representative in Congress from Georgia,
opening statement.............................................. 131
Prepared statement........................................... 132
Scott, Hon. David, a Representative in Congress from Georgia,
opening statement.............................................. 133
Witnesses
Bowen, Hon. Sharon Y., Commissioner, Commodity Futures Trading
Commission, Washington, D.C.................................... 135
Prepared statement........................................... 137
Submitted question........................................... 207
Giancarlo, Hon. J. Christopher, Commissioner, Commodity Futures
Trading Commission, Washington, D.C............................ 142
Prepared statement........................................... 144
Submitted question........................................... 207
Wetjen, Hon. Mark P., Commissioner, Commodity Futures Trading
Commission, Washington, D.C.................................... 167
Prepared statement........................................... 168
Submitted question........................................... 210
REAUTHORIZING THE COMMODITY FUTURES TRADING COMMISSION
(END-USER VIEWS)
----------
TUESDAY, MARCH 24, 2015
House of Representatives,
Subcommittee on Commodity Exchanges, Energy, and Credit,
Committee on Agriculture,
Washington, D.C.
The Subcommittee met, pursuant to call, at 1:04 p.m., in
Room 1300 of the Longworth House Office Building, Hon. Austin
Scott of Georgia [Chairman of the Subcommittee] presiding.
Members present: Representatives Austin Scott of Georgia,
Neugebauer, LaMalfa, Davis, Emmer, Conaway (ex officio), David
Scott of Georgia, Vela, and Peterson (ex officio).
Staff present: Caleb Crosswhite, Carly Reedholm, Haley
Graves, Jackie Barber, Paul Balzano, Ted Monoson, Kevin Webb,
John Konya, Matthew MacKenzie, and Nicole Scott
OPENING STATEMENT OF HON. AUSTIN SCOTT, A REPRESENTATIVE IN
CONGRESS FROM GEORGIA
The Chairman. Good afternoon. This hearing of the
Subcommittee on Commodity Exchanges, Energy, and Credit
regarding the reauthorization of the CFTC as it relates to end-
users, will come to order.
And before we get started, I would like to just make a
brief comment that we have votes coming somewhere around 1:30.
If the vote is called, we will break long enough to have that
and come back for questions after that.
Good afternoon. I would like to welcome you to the
inaugural hearing of the Commodity Exchanges, Energy, and
Credit Subcommittee of the House Agriculture Committee. I am
honored that Chairman Conaway has asked me to serve the
Committee this Congress by chairing our newest Subcommittee.
When Mr. Conaway asked me to step into this role, he said that
he wanted to ensure that the Committee never lost sight of the
importance of derivatives markets not only to our traditional
agricultural firms, but also to the wider economy.
Today's hearing will examine the reauthorization of the
CFTC and the challenges end-users are facing as they use these
markets to manage the risks of doing business in a global
marketplace.
We are fortunate to be joined today by a panel of
distinguished witnesses, each of whom has a unique perspective
of the challenges facing the end-users of derivatives. We look
forward to hearing their thoughts on what issues the Committee
should be considering during the reauthorization process.
Last week, Chairman Conaway laid out three principles for
guiding the Committee's work: derivatives markets exist to meet
the needs of hedgers; regulatory requirements should be both
minimized and justified; and regulations should provide clarity
and certainty. These principles, along with the goal to balance
access with integrity, will frame our discussion today as we
hear from our witnesses.
Over the past two Congresses, this Committee has heard from
dozens of witnesses who have shared with us the difficulties
that they have had understanding and complying with the flurry
of rulemakings issued because of the Dodd-Frank Act. As I have
listened to them, two things have become clear. First, no
witness has called for a repeal of Title VII. In fact, most
witnesses have supported the goals of Title VII. But my second
point is, the process of planning, drafting, and enacting the
rules could be at best called troubling. Today's task is to
look back at the process of the past 5 years and to examine the
places where this Committee can take action. We won't be
repealing Dodd-Frank and we won't be working to weaken its
market-wide protections of Title VII, but, we will be looking
to see where our actions can clarify Congressional intent,
minimize regulatory burdens, and most importantly, preserve the
ability for these necessary risk management markets to serve
the American farmers, ranchers, and businesses.
I want to thank the witnesses for appearing before us
today. I know many of you traveled to be here and worked hard
to prepare your remarks over the past week. I appreciate your
time and efforts.
[The prepared statement of Mr. Austin Scott of Georgia
follows:]
Prepared Statement of Hon. Austin Scott, a Representative in Congress
from Georgia
Good afternoon. I'd like to welcome you to the inaugural hearing of
the Commodity Exchanges, Energy, and Credit Subcommittee of the House
Committee on Agriculture.
I am honored that Chairman Conaway asked me to serve the Committee
this Congress by chairing our newest Subcommittee. When Mr. Conaway
asked me to step into this role, he said that he wanted to ensure that
the Committee never lost sight of the importance of derivatives markets
not only to our traditional agricultural firms, but also to the wider
economy.
Today's hearing will examine the reauthorization of the CFTC and
the challenges end-users are facing as they use these markets to manage
the risks of doing business in a global marketplace.
We are fortunate to be joined today by a panel of distinguished
witnesses, each of whom has a unique perspective of the challenges
facing the end-users of derivatives. We look forward to hearing their
thoughts on what issues the Committee should be considering during the
reauthorization process.
Last week, Chairman Conaway laid out three principles for guiding
the Committee's work:
Derivatives markets exist to meet the needs of hedgers;
Regulatory requirements should be both minimized and
justified; and
Regulations should provide clarity and certainty.
These principles, along with the goal to balance access with
integrity, will frame our discussion today as we hear from our
witnesses. Over the past two Congresses, the Committee has heard from
dozens of witnesses who have shared with us the difficulties that
they've had understanding and complying with the flurry of rulemakings
issued because of Dodd-Frank.
As I've listened to them, two things have become clear: first, no
witness has called for a repeal of Title VII. In fact, most witnesses
have supported the goals of Title VII. But, and this is my second
point, the process of planning, drafting, and enacting the rules could
be at best called ``troubling.''
Today's task is to look back at the process of the past 5 years and
to examine the places where this Committee can take action. We won't be
repealing Dodd-Frank and we won't be working to weaken its market-wide
protections of Title VII. But, we will be looking to see where our
action can clarify Congressional intent, minimize regulatory burdens,
and most importantly, preserve the ability for these necessary risk
management markets to serve American farmers, ranchers, and businesses.
I want to thank the witnesses for appearing before us today. I know
many of you traveled to be here and worked hard to prepare your remarks
over the past week. We are appreciative of your time and efforts.
With that, I'll turn to our Ranking Member and fellow Georgia
Representative, Mr. Scott.
The Chairman. And with that, I will turn to our Ranking
Member and my fellow Georgian, Representative David Scott.
OPENING STATEMENT OF HON. DAVID SCOTT, A REPRESENTATIVE IN
CONGRESS FROM GEORGIA
Mr. David Scott of Georgia. Thank you, Chairman Scott. I
really appreciate that. As the Democratic Ranking Member, I am
looking forward to working with you and the Committee as we
continue our critical mission to reauthorize the Commodity
Exchange Act. Mr. Chairman, I am pleased that, as you know in
the last Congress, we put together a very good bipartisan
package, H.R. 4413, the Customer Protection End User Relief
Act, which was good commonsense legislation that was passed in
this Committee by a voice vote. It was passed on the floor of
the United States House of Representatives, but unfortunately,
was not voted on in last year's Senate.
So this year we need new legislation; new legislation which
mirrors H.R. 4413. And a central component of H.R. 4413 was its
ability to provide much-needed clarity and relief to end-users,
which are our agriculture and energy producers who actually use
the derivatives market to hedge against risk, and they did not
cause the financial collapse. Most specifically, we need
legislation that will do the following: allow end-users who are
legitimate commercial market participants to avoid being
inadvertently classified as financial entities because of their
commercial activities. Additionally, we need language that
provides alternative recordkeeping requirements to grain
elevators, farmers, agriculture counterparties, and commercial
market participants, instead of these entities having to meet
the same recordkeeping rules as swap dealers. Furthermore, we
must allow for a delay in real-time swap reporting for non-
financial end-users whose swap activity can be identifiable in
thinly-traded markets in order to prevent them from being
competitively disadvantaged by financial players. And finally,
we must require a vote by the CFTC before the swap dealer de
minimis level automatically changes from the current level of
$8 billion, which was established by the CFTC in regulations.
In conclusion, Mr. Chairman, let me emphasize Congress
never intended for the end-users to be regulated in the same
manner as financial entities, and I hope that we can continue
our bipartisan work in this Committee to yet again produce
commonsense, bipartisan legislation that will do exactly that.
Thank you, and I yield back the balance of my time.
The Chairman. Thank you, Congressman Scott.
Mr. Conaway?
OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE
IN CONGRESS FROM TEXAS
Mr. Conaway. Thank you, Mr. Chairman. I just want to, on
this inaugural hearing for the--you and David's Subcommittee,
just express my confidence in both of you. I have worked with
David as the Ranking Member. He and I shared this
responsibility for 4 years, and I have great confidence as to
him. And, Austin, based on your professional background, I know
you bring a wealth of talent to the table to make this happen.
And you are motivated with the birth of a new daughter, Carmen
Gabriella Scott, that----
The Chairman. Absolutely.
Mr. Conaway.--on the ground, I guess, last week. And mother
and daughter are doing fine?
The Chairman. They are doing very well. Thank you.
Mr. Conaway. Great.
The Chairman. Thank you very much.
Mr. Conaway. So I thank the panel for being here today. We
have some important things to do.
I too, like David, intend to get a bipartisan bill out with
respect to the reauthorization. We did it last time, and have
no intentions to do anything but have the bill to come out that
would be bipartisan. Your hearings this week, Austin, will be
an important part of our reconsideration of the legislation
that was passed, and I am looking forward to the Scott cousins
making this thing work. I look forward to, and have great
confidence in both of you, being from Georgia.
So with that, I yield back. Thank you.
[The prepared statement of Mr. Conaway follows:]
Prepared Statement of Hon. K. Michael Conaway, a Representative in
Congress from Texas
Chairman Austin Scott has been an important voice of common sense
on our Committee for the past 4 years and I am grateful that he has
agreed to chair this Subcommittee. With his previous experience in the
financial services industry I know he will be an asset to this
Committee during reauthorization and during our oversight hearings in
the coming year.
I am equally pleased that David Scott is back to serve as our lead
Democrat on the Subcommittee. He has a deep knowledge of these issues
and I know firsthand that he makes a great partner on these financial
services issues.
One hundred and fifty years ago, the Chicago Mercantile Exchange
introduced the first exchange traded futures contract.
At the time, these new financial instruments revolutionized the
business of farming. Today, derivatives have expanded into every
financial market and have revolutionized modern business, as well. Yet,
since the financial collapse in 2008, some have questioned the value of
these financial instruments which they have derided as overly complex
and being too inherently risky to be used safely. I respectfully
disagree.
This Committee has spent considerable time hearing from end-users,
market infrastructure managers, CFTC Commissioners, and others. Time
and time again, we have heard testimony about the importance of these
financial tools and the tremendous value they have to those who use
them. As we've heard from many witnesses, derivatives allow businesses
to reduce the risks they cannot control, so they can focus on serving
their customers.
Ensuring that our nation's derivatives markets work for those who
have risks to hedge is no small task.
But, I believe that the Chairman and the Ranking Member are well
suited to lead the Committee's work in this area. The Agriculture
Committee is unique in Congress for its bipartisan focus on outcomes
over partisanship and process over politics. As we dig into CFTC
reauthorization, I know that they will continue to uphold those
traditions. I look forward to seeing what they can accomplish together.
The Chairman. Thank you, Mr. Chairman.
The chair would request that other Members submit their
opening statements for the record so the witnesses may begin
their testimony, and ensure that there is ample time for
questions.
The chair would like to remind Members that they will be
recognized for questioning in order of seniority for Members
who were present at the start of the hearing, after that,
Members will be recognized in the order of their arrival. I
appreciate Member's understanding of this. Witnesses are
reminded to limit their oral presentation to 5 minutes. All of
your written statements will be included for the record.
Our witnesses for panel one, I would like to welcome you to
the Agriculture Committee in Washington. Mr. Douglas Christie
is President of Cargill Cotton, Cordova, Tennessee, and he is
here on behalf of the Commodity Markets Council. Mr. Lael E.
Campbell, Director of Regulatory and Government Affairs,
Constellation, an Exelon Company, Washington, D.C., on behalf
of the Edison Electric Institute. Ms. Lisa Cavallari, Director
of Fixed Income Derivatives, Russell Investments, Seattle,
Washington, on behalf of the American Benefits Council. Mr.
Mark Maurer, Chief Executive Officer, INTL FCStone Markets,
LLC, Chicago, Illinois. And Mr. Howard Peterson, President and
Owner of Peterson Oil, Worcester, Massachusetts, on behalf of
the New England Fuel Institute.
Mr. Christie, please begin when you are ready.
STATEMENT OF DOUGLAS CHRISTIE, PRESIDENT, CARGILL COTTON,
CORDOVA, TN; ON BEHALF OF COMMODITY
MARKETS COUNCIL
Mr. Christie. Thank you, Chairman Scott, Ranking Member
Scott, for the opportunity to testify today on behalf of the
Commodity Markets Council.
The CMC appreciates the opportunity to present our views on
the reauthorization of the Commodity Futures Trading
Commission. As you consider reauthorization, we would like to
point out that the CFTC's multiyear effort to implement new
swap regulatory rules has morphed into an effort to rewrite
longstanding futures market regulations that Congress, via
Dodd-Frank, never contemplated. These regulations are being
proposed without consideration of the real impact on commodity
producers or consumers. The additional regulatory impact that
these actions would force upon end-users and commercial
participants will ultimately be passed on as the effects work
their way through the supply chain.
These actions will also impact market liquidity, which will
further raise the cost of risk management, and ultimately
reduce the pricing efficiency across the supply chain of
finished agricultural and energy goods. These actions will
result in a higher cost for risk management, and more imperfect
risk management. Orderly and established risk management
practices that commercial end-users have used in the past could
now be curtailed or require exemptions. This would result in
more volatility, less price discovery, and more uncertainty for
producers and consumers. This outcome was not intended when
swap reform was initially contemplated.
Let me illustrate. The current proposed position limits
rule intends to curtail excessive speculation by placing limits
on the size of positions that any entity can accumulate across
28 different commodities. As has been the case for decades for
commercial entities that manage risk, such as flourmills,
refineries, grain elevators or exporters, or cotton shippers,
the rule allows an exemption to these limits if the commercial
firm has a bona fide reason for doing so. Unfortunately, the
CFTC's proposed rule narrows the definition of bona fide hedges
to such a degree that established risk management practices may
now be excluded from the definition. The CMC and many industry
groups from agricultural to energy companies have provided many
detailed examples to the CFTC in public filings, and at many of
the public forums the CFTC has held to discuss the position
limits rule.
These examples are too numerous to recount in detail in
this oral testimony. They include, but are not limited to,
merchandising, anticipatory and processing hedges, irrevocable
bids and offers, as well as cross hedges, gross and net
hedging. These give market participants the ability to hedge
not only price risk, but risk associated with time, location
and delivery, or product, quality, form, specifications, or
individual components of a commodity. The CFTC should limit
excessive speculation by focusing the rule on the actions of
excessive speculators, not by limiting the ability of
commercial end-users to engage in commercially and
economically-appropriate risk mitigating, bona fide
transactions for which these markets are intended.
Congress can help by urging the CFTC to adopt a final rule
that reflects the needs of end-users, and by further clarifying
the definition of bona fide hedge.
Amendments to regulation 1.35 have created an unpredictable
and onerous burden for firms in the cash business. An effort to
bring swaps under a regulation that covered previously existing
rules on floor traders has resulted in firms that engage in
cash transactions having to keep more information about their
conversations, if the conversation could lead to a derivatives
transaction. Identifying which of often multiple conversation
or texts or e-mails that ultimately lead to a derivatives
transaction is hard to discern. Thus, the rule will force
members to spend significant amounts of time and resources in a
commercially impractical attempt to capture all required
records, limiting the ability of commercial firms to utilize
modern and efficient means of communication.
The CFTC has recognized the difficulty and attempted to
modify the rule. Despite the CFTC's efforts, the uncertainty
continues. CMC members believe the proposed changes do not go
far enough in providing relief. At an extreme, some may
consider withdrawing from membership in DCMs and SEFs, which
would reduce transparency in the marketplace, and lead to legal
and regulatory uncertainty for end-users and customers.
The CMC has additional priorities that are included in my
written testimony. These include the importance of updating
deliverable supply estimates, ensuring trade options are not
subject to position limits, position aggregation, and swap
dealer de minimis levels.
I appreciate your consideration of all the views in the CMC
oral and written testimony, and I look forward to your
questions.
[The prepared statement of Mr. Christie follows:]
Prepared Statement of Douglas Christie, President, Cargill Cotton,
Cordova, TN; on Behalf of Commodity Markets Council
Chairman Scott, Ranking Member Scott, and Members of the
Subcommittee: thank you for holding this hearing to review the
reauthorization of the Commodity Futures Trading Commission (``CFTC''
or ``Commission''). My name is Doug Christie, President of Cargill
Cotton in Memphis, Tennessee. I am testifying today on behalf of the
Commodity Markets Council (``CMC'').
CMC is a trade association that brings together exchanges and their
industry counterparts. Our members include commercial end-users that
utilize the futures and swaps markets for agriculture, energy, metal
and soft commodities. Our industry member firms include regular users
and members of such designated contract markets (each, a ``DCM'') as
the Chicago Board of Trade, Chicago Mercantile Exchange, ICE Futures
U.S., Minneapolis Grain Exchange and the New York Mercantile Exchange.
They also include users of swap execution facilities (each, a ``SEF'').
The businesses of all CMC members depend upon the efficient and
competitive functioning of the risk management products traded on DCMs,
SEFs or over-the-counter (``OTC'') markets. As a result, CMC is well
positioned to provide consensus views of commercial end-users of
derivatives with respect to CFTC reauthorization.
Cargill provides food, agriculture, financial and industrial
products and services to the world. We help people thrive by applying
our insights and 150 years of experience. We have 143,000 employees in
67 countries who are committed to feeding the world in a responsible
way, reducing environmental impact and improving the communities where
we live and work.
As Congress seeks to once again reauthorize the CFTC, we would like
to emphasize several points starting with this: the CFTC's multi-year
effort to implement new swap regulatory rules has now morphed into an
effort to rewrite many long-standing futures market regulations that
Congress, via Dodd-Frank, never contemplated. These regulations are
being proposed without consideration of the real costs on commodity
producers or consumers. The additional regulatory costs that the CFTC
would force upon end-users and commercial participants will ultimately
be passed on to producers and consumers as the costs work their way
through the supply chain. There will also be an impact on market
liquidity, which will further raise the costs of risk management and
ultimately the cost of finished agricultural and energy goods.
CMC would like to commend the House Agriculture Committee for the
CFTC reauthorization bill that was passed by this Committee and by the
House of Representatives in a bipartisan fashion during the last
session of Congress. CMC believes that this Committee's straight-
forward approach remains the best way to address several issues end-
users still face.
Since the passage of Dodd-Frank, CMC has provided a great deal of
information to the CFTC in an effort to help regulators understand how
our members use derivatives markets to reduce our operational risks. We
have been very appreciative of Chairman Massad's consistent and
appropriate emphasis on end-user issues and we have been quite pleased
with the Commission's efforts to reconstitute several advisory
committees which had not met in several years. The uptick in the number
of public Roundtable discussions on a variety of important topics has
been greatly appreciated by CMC members. With three still relatively
new Commissioners, we have appreciated the Commission's willingness to
listen. We appreciate the Chairman's interest in considering end-user
concerns and the steps he and the Commission have taken to positively
address rules such as the residual interest rule-making. CMC believes
there are additional issues that warrant Congress' attention in the
context of CFTC reauthorization.
End-User Concerns
CMC recognized the need for and supported reform in the over-the-
counter (OTC) swaps market and believes that Dodd-Frank provided a
foundation for an effective overhaul of this important risk-management
market. However, there are various issues that have arisen as part of
the implementation process which we believe the Committee should
revisit going forward.
1. Rule 1.35
CMC recognizes the Commission's actions to amend CFTC Regulation
1.35 (``rule 1.35'') and applauds its efforts. However, CMC members
still believe that the costs and burdens associated with rule 1.35 as
currently written vastly outweigh any benefits. CMC members remain
concerned about the scope of rule 1.35's requirement to retain written
communications made via ``digital or electronic media'' that ``lead to
the execution of transactions in a commodity interest and related cash
or forward transactions'' (``pre-trade communications''). Although
unregistered members of a DCM or SEF are now exempted from the
requirement to retain text messages, unregistered and registered CMC
members are still troubled by the requirement to retain written and
electronic records of pre-trade communications.
CMC members believe the proposed changes do not go far enough in
providing relief and that the rule will force members to either
withdraw from or forego membership in DCMs and SEFs, or, out of an
abundance of caution, spend significant amounts of time and resources
in a commercially impracticable attempt to capture all required
records. Further, CMC members would like additional clarification
regarding what constitutes a ``text message'' under the proposed
amendments. CMC believes that the Commission should encourage
membership in DCMs and SEFs in order to further promote transparency in
the marketplace and to reduce costs for consumers of commodities. If
further relief and clarification is not provided, rule 1.35 will
discourage membership in DCMs and SEFs, which will in effect reduce
transparency in the marketplace, limit the ability of commercial firms
to utilize modern and efficient means of communication, and lead to
legal and regulatory uncertainty for end-users and customers.
2. Deliverable Supply Estimates
CMC requests that the Commission make a determination about the
deliverable supply estimates for each of the twenty-eight physical
commodities covered by the CFTC's proposed rule that will serve as the
baseline for spot month position limits. Until a proper deliverable
supply baseline is established, it will be impossible to assess the
appropriate long or short spot month limits that may be set for
individual contract markets.
The Commission has received updated deliverable supply data from
affected contract markets which CMC believes are conservative
estimates. CMC urges the Commission to make an objective economic study
of the relevant physical commodities that could be delivered upon
expiry.
Additionally, CMC encourages the Commission to analyze physical
markets in an objective fashion that is appropriate for each commodity
asset class. The Commission should consider domestic storage capacity,
real time production levels and historic import activity for asset
classes such as oil and gas. In addition, the Commission should
consider refinery capacity when considering deliverable supply for
gasoline or other refined products. For grains and soft commodities,
storage capacities and flows of the relevant commodity in areas that
are in and tributary to the specified delivery points should provide a
realistic estimate of deliverable supply.
With an objective economic study made (and an opportunity for
public comments), the Commission will be in a better position to
deliberate and decide, if necessary, on the appropriate Federal spot
month position limit levels for each of the relevant commodity asset
classes. Upon establishment of Federal limits based on updated
deliverable supply estimates, the applicable designated contract
markets also will be able to continue to use their discretion in
setting exchange specific limits below the Federal limits as necessary
and appropriate to reduce the potential threat of market manipulation
or congestion.
3. Bona Fide Hedging
Commercial and end-user firms accept and manage several different
types of risks in the supply chain that impact producer and consumer
prices. Examples of risks are below:
Absolute contract price risk with the counterparty (or flat
price).
Relative price risk (basis and calendar spread risk)--
unfixed.
Time, location and quality risk.
Execution/logistics risk.
Credit/counterparty default risk.
Weather risk.
Sovereign/government policy risk.
All of the above risks directly impact the commercial operations of
a merchant and ultimately affect the value of the merchant's commercial
enterprise (including the price the merchant pays and receives for a
product). In each and every transaction, the above identified risks,
including potentially others, are not the same and the relationship
between them is constantly in flux. As a result the merchant must make
a decision how to not only price the risk in the commercial
transaction, but more importantly, how to actively hedge and manage the
risks. For instance, in negotiating a forward contract with a potential
counterparty, the merchant must take into consideration all of these
and will make the most appropriate decision on if/when/how to utilize
exchange traded futures contracts to hedge the multiple risks that are
present. All of these risks affect price. In other words, the hedging
of all of these risks is directly hedging price risk.
The fundamental principle is this: price risk is far more complex
than just fixed-price risk, but may include volatility and similar non-
linear risks associated with prices, and a transaction to hedge any of
these risks in connection with a commercial business should receive
bona fide hedging treatment. Regulators should not condition bona fide
hedging treatment as available only when risk crystalizes by virtue of
a firm holding a physical position or by entering into a contract.
Commercial market practices would be severely impacted if hedging
transactions were not deemed bona fide hedges. We ask this oversight
Committee to help ensure that CFTC regulation empowers commercial and
end-user firms to manage risk to the fullest extent possible.
Unfortunately, the CFTC is taking a different course by seeking to
adopt a narrow view of risk. Within the CFTC's proposed position limits
rule, the Commission has chosen to focus solely on the absolute price
risk of a transaction with a counterparty, and is not considering the
multitude of risks in the commercial operations of enterprises.
By narrowly defining bona fide hedging, the traditional hedger will
be compromised and thus will not be able to effectively manage its
risks. If this happens, risk premiums are going to rise throughout the
business, which will be passed along the supply chain. Bid/offer
spreads will widen and liquidity will be substantially reduced. This
narrow view of hedging, if adopted, will mean that producer prices will
decline and the cost to the consumer will increase.
Commercial producers, merchants and end-users have provided
numerous examples to the Commission in the last three comment letter
periods and have explained how detrimental it would be to constrain the
market participants that are bona fide hedgers. A summary of several
areas of concern related to hedging in the CFTC's proposed position
limits rule follow below.
Anticipatory Hedging, Merchandising, & Processing
Within Title VII of Dodd-Frank and in the Commodity Exchange Act
(``CEA''), Congress explicitly referred to anticipatory and
merchandising hedging as bona fide hedging methods because they are
crucial to the risk management functions of commercial and end-user
firms. Anticipatory hedging allows commercial firms to mitigate
commercial risk that can reasonably be ascertained to occur in the
future as part of normal risk management practices. Merchandising
activity enables producers to place commodities into the value or
supply chains and ultimately brings those commodities to consumers with
minimal price volatility.
In addition, merchandising activity promotes market convergence--a
crucial aspect of the price discovery function commodity markets serve.
A reduction in the efficiency of convergence increases risk, reduces
liquidity, and ultimately may lead to both higher consumer prices and
lower producer prices. Allowing the full scope of hedging activity
promotes more efficient, effective and transparent markets--exactly the
public policy goals of the Commission.
Also of concern is the issue of the anticipatory processing hedge.
While the Commission's proposed rule states that such hedges are bona
fide, the proposed rule simultaneously extinguishes the utility of the
exemption by stating that anticipatory processing positions will only
be recognized as bona fide if all legs of the processing hedge are
entered into equally and contemporaneously. Hedging is based on human
assessment of risk at any given time. Sometimes it is best to hedge
just one leg of processing exposure. The proposed parameters around the
processing hedge exemption not only fail to recognize market dynamics;
worse, they put the Commission in the position of defining risk and
mandating how that risk must be hedged in the market.
Economically Appropriate Risk Management Activities
CMC would also like to express concern to this Committee with
language in the CFTC's proposed position limits rule which suggests
that a bona fide hedge only exists when the net price risk in some
defined set is reduced. This is inconsistent with the manner in which a
commercial firm evaluates risk--which is not limited to price risk, as
mentioned above. The most appropriate way to deem a derivatives
transaction as ``economically appropriate'' is whether a commercial
firm has a risk abated by the transaction, and such risk arose in its
commercial business.
Linking the ability to engage in bona fide hedging to a net
reduction in risks across an entire enterprise, corporate family, or
separately-managed lines of business is not consistent with how
commercial firms commonly address risk. Moreover, individual firms
identify which risks they want to accept. A transaction that may be
risk reducing on one side of a business, but leave an opposite risk
unhedged in another part of the business might serve legitimate
business purposes. Thus, to impose a ``net price risk'' formula across
a corporate group for purposes of bona fide hedging effectively
replaces a commercial firm's business judgment with regulatory
prescription.
Non-Enumerated Hedges
Non-enumerated bona fide hedges are important to commercial market
participants, as they allow additional flexibility for firms to hedge
risk in ways that are unforeseen. However, the ability to utilize these
non-enumerated hedges is often dependent upon utilizing the hedging
strategy in real time in response to fluid market conditions.
Specifically, merchandisers and other intermediaries (physical,
financial and risk, among others) play a vital role in helping end-
users understand and ultimately reduce their risks. To the extent that
these merchandisers and other intermediaries are unable to get
exemptions for the hedges they require to provide these services, risk
mitigation will be reduced and overall systemic risk will increase.
CMC supports allowing market participants to engage in non-
enumerated hedging activity subject to a reasonable review period
similar to that contained within current CFTC Regulation 1.47. In
addition, we would like to emphasize that the expertise of the
exchanges should continue to be drawn upon by the Commission to allow a
timely review of these petitions in the most efficient manner for the
Commission.
Cross-Hedging
Cross-hedging is another important hedging tool for commercial
participants, and is particularly important for commodities which may
be processed or transformed into products which may not be traded
commodities. CMC believes that commercial firms should be granted the
discretion to determine what relationships between two positions are
correlated sufficiently to be considered ``substantially related.'' The
CFTC has advanced a notion of a bright-line test with respect to the
regulation of cross hedges. The decision to use a cross-hedge is multi-
factored, and commercial businesses have a natural profit incentive to
achieve as great a correlation as possible. However, a fixed
correlation is not always achievable, and sometimes risk managers are
limited in their selection to what products are available. CMC members
believe that a position limits regime where risk managers can freely
select their cross-hedges, report them as such, and stand ready to
explain them to the Commission if necessary is the proper regulatory
design.
CMC has urged that the Commission not impose an arbitrary deadline
upon which market participants engaged in cross hedging must exit their
hedges in the spot month, near month, or in the last 5 trading days.
DCMs should be permitted to set restrictions on a contract-by-contract
basis, recognizing the unique characteristics of each individual
commodity and contract, and the need (or lack thereof) for commercial
end-users to continue to utilize cross-commodity hedges in a specific
market during the spot month, near month, or in the last 5 trading
days.
Gross and Net Hedging
CMC continues to request that the Commission allow end-users to
utilize both ``gross hedging'' and ``net hedging'' concepts when
managing risk. The Commission uses concepts of both ``gross hedging''
and ``net hedging'' in its discussion of the economically appropriate
requirement, but these terms are not separately defined and the context
in which they appear does not fully inform their meaning. CMC
understands gross hedging to be the practice of separately hedging each
of two or more related positions. Net hedging happens when that firm
nets its cash purchase and sale contracts to a net long or short
position and then offsets that risk by entering into short or long
derivatives transactions, respectively. It is crucial that the
Commission affirm that each of these methods entail derivatives that
would be eligible for bona fide hedging treatment. Additionally, when
utilizing gross hedging, firms should have the flexibility to hedge
either the gross long or the gross short when this is the most
economically appropriate risk management position.
Wheat Equivalence Determinations
It is critical to maintain equality among the three U.S. Wheat
markets: Chicago, Kansas City and Minneapolis. Currently, each market
has the same spot month limit and the same single-month and all-months-
combined limit. Regardless of the level at which these limits are set,
parity should be maintained among these three markets. Different limits
for the same type (but not necessarily variety) of commodity could
dramatically impact the growth or potential for risk mitigating
strategies between the contract markets. In the case of wheat, this is
particularly critical given the nature of the three differing
varieties. Having three varieties provides not only additional
opportunities for market participants to reduce risk through spread
trades, but also provides opportunity for hedging and risk management
by commercial participants between markets in response to domestic or
global economic factors.
4. Trade Options
CMC is urging the Commission not to categorize trade options as
referenced contracts subject to position limits. These physical
options, including physical forward transactions with embedded
volumetric optionality, are an important tool in physical commodity
markets. Trade options may be used to manage, among other things,
supply chain risk, price risk or both. Subjecting these products to
Federal position limits could severely harm the efficient operation of
physical commodity markets and increase costs for end-users.
Trade options do not trade like physical futures and cannot simply
be traded out of or unwound prior to the spot month. In the spot month,
a trade option that does not qualify as a ``bona fide hedging
position'' could only be offset with another physical position to bring
the net position within the applicable position limit. Taking on a
physical position in order to offset a trade option for position limit
purposes could introduce new risks to the market participant and would
undermine the entire purpose the market participant entered into a
trade option in the first place. Such a result would be extremely
disruptive to the physical markets.
The burden on market participants associated with speculative
position limits on trade options would be substantial. Market
participants would be required, for the first time, to track trade
options separately from spot and forward contracts, develop systems to
calculate the futures contract equivalents for these physical-delivery
agreements, and, ultimately, monitor trade option positions for
compliance with applicable limits.
5. Aggregation
CMC is recommending that the CFTC not pursue aggregation of
positions only based upon affiliation or ownership. Instead, the
Commission should require aggregation of positions where an entity
controls the day-to-day trading of a portfolio of speculative
positions. In the past, Commission staff highlighted the possibility of
using the independent account controller safe harbor as a model for not
requiring aggregation among related companies where there is ownership
but not control. CMC applauds this approach and believes it may provide
a useful framework for capturing the purposes of position limits while
not unduly burdening otherwise separate trading activities.
Towards that end, CMC recommends the Commission adopt an exemption
from the requirement that persons under common control (``excluded
affiliates'') aggregate their positions under certain circumstances
described below.
Accounts of entities under common ownership need not be aggregated
where the entities are excluded affiliates. An excluded affiliate
should be defined as a separately organized legal entity:
(1) That is specifically authorized by a parent entity to control
trading decisions on its own behalf, without the day-to-day
direction of the parent entity or any other affiliate;
(2) Over whose trading the parent entity maintains only such minimum
control as is consistent with its fiduciary
responsibilities to fulfill its duty to supervise
diligently the trading of the excluded affiliate or as is
consistent with such other legal rights or obligations
which may be incumbent upon the parent entity to fulfill
(including policies and procedures to manage enterprise
wide risk);
(3) That trades independently of the parent entity and of any other
affiliate; and
(4) That has no knowledge of trading decisions of the parent or any
other affiliate.
CMC appreciates the Committee's consideration of our views
regarding the regulation of bona fide hedging.
6. The Swap Dealer De Minimis Level
As the Committee is aware, the swap dealer de minimis level,
currently set at $8 billion, is slated to drop to $3 billion by the end
of 2017. CMC members are concerned that a lower swap dealer de minimis
level will cause companies to exit the swap business because the extra
costs of swap dealer registration are not sustainable for most non-
financial companies. This in turn would lead to fewer counterparties
available to offer end-users risk management solutions.
A lower swap dealer de minimis level would lead to further
consolidation of the swap business toward only a hand-full of
registered swap dealers, mostly Wall Street banks. This threat is not
purely hypothetical: when the CFTC initially proposed a lower dealing
threshold for counterparties of municipal utilities, those utilities
found that liquidity rapidly disappeared and the number of available
counterparties diminished. Eventually the CFTC was forced to retreat
and increase the de minimis level for energy swaps with municipal
utilities to $8 billion.
It is likely that a lower de minimis level would have the same
effect, not only for utilities but all companies that use swaps to
manage risk. We respectfully urge the Committee to adopt a provision
similar to that contained in last year's reauthorization bill which
would prevent the de minimis level from dropping without a new
rulemaking by the CFTC.
CMC believes the self-executing provision in this rule as well as
the provision that was recently reversed by the CFTC involving its
residual interest rule are fundamentally flawed. We applaud the
Commission for their reversal on residual interest and urge this
Committee to encourage the Commission to do the same regarding the swap
dealer de minimis level.
In addition to these specific regulatory topics, CMC encourages
Congress and the CFTC to continue to seek resolution to international
regulatory issues. Two in particular are U.S.-EU equivalence and the
Basel III Leverage Ration. With regard to the U.S.-EU equivalence
issue, the lack of an equivalence determination has significant impacts
to end-users that operate globally and depend on access to U.S.
exchanges and clearinghouse for risk management. For example, right now
U.S. futures contracts count as ``OTC derivatives'' under the European
Market Infrastructure Regulation (EMIR) because U.S. futures exchanges
have not yet been ``recognized'' by European regulators. This creates a
disincentive for commercial end-users (Non-financial counterparties, or
NFCs under the EMIR construct) that prefer not to be subject to the
EMIR OTC thresholds and registration requirements as an NFC+. We are
encouraged by recent progress on the broader equivalence debate and
hope to see this resolved soon.
With respect to the Basel III Leverage Ratio issue, CMC members are
deeply concerned that the leverage ratio will significantly increase
the cost of hedging for end-users. CMC was very encouraged by Chairman
Conaway and Ranking Member Peterson's letter to the Federal Reserve and
also by Chairman Massad's public comments on this issue. We appreciate
your engagement on this issue and hope to move the international
regulatory community in the right direction.
Conclusion
Commodity derivatives markets continue to grow and prosper. They
have become deeper and more liquid, thereby narrowing bid/ask spreads,
and improving hedging effectiveness and price discovery. All of these
developments benefit much more than just those who trade commodities.
Efficient derivatives markets offer providers of food and energy the
ability to reduce the multitude of risks they must manage. Consumers
are the ultimate beneficiary of these efficiencies.
The swaps market reforms in Dodd-Frank were not required because of
problems in physical commodity markets. Commercial end-users of
agricultural and energy futures had no role in creating the financial
crisis. In fact, the regulated futures market fared well throughout the
financial crisis. CMC members recognize the need for the Dodd-Frank Act
and support its goals, yet these regulations should be efficient and
reasonable rather than overly prescriptive and complex.
We believe that as Congress considers how the CFTC is to regulate
in the future, it should use the core principles on which the CFTC was
founded as its guide. A balance must be maintained between regulatory
zeal and consideration as to how regulatory changes could result in
negative consequences to not just CMC members in the middle of the food
and energy chain, but also to the producers and consumers on each side
of the chain. Undue regulatory interference with the hedging mechanism
introduces risk that must be priced into the chain, negatively
affecting both ends and everything in between. Given this, we strongly
believe that the CFTC's post Dodd-Frank trend toward very prescriptive
changes to futures market regulation will hinder rather than improve
our economy's ability to manage commodity market risks.
While the independent regulatory agency that this Committee has
oversight responsibilities over must continue to evolve in order to
adequately regulate increasingly complex derivatives markets, many of
these pending changes also introduce the potential for regulators to
create risk and increase costs by going beyond their purview. Doing so,
without consideration of the consequences, is dangerous and goes
against both the ``do no harm'' principle of regulation as well as the
CFTC's core principle regulatory heritage.
Compliance costs for end-users have skyrocketed in the past year.
Today, agriculture and energy end-users are faced with thousands of
pages of new CFTC rules that no one person can comprehend followed by a
multitude of letters issued by the Commission to clarify rule language,
extend compliance dates, or provide temporary no-action relief.
But the problem isn't only that this complexity and regulatory
uncertainty adds unnecessary costs. It is also that, uncertainty, via
additional regulation of the risk management tools that commodity
market participants utilize, actually creates risk where it didn't
previously exist.
CMC members mitigate risks by hedging. The fact that future
regulation may determine that the risk management methods we have
described here today may no longer be considered hedging is of enormous
concern and is an example of where risk could be created.
When regulatory initiatives lack clarity or evolve to be at cross-
purposes with the core principles on which the Commission was founded,
CMC members are compelled to reach out to this Committee for help. We
believe last year's CFTC reauthorization bill provided significant
clarity to the marketplace and we hope to be a resource to the
Committee once again as it pursues CFTC reauthorization this year.
Thank you for this opportunity to testify. We look forward to
continuing to work with this Committee to strike the right balance.
I look forward to your questions.
The Chairman. Mr. Campbell.
STATEMENT OF LAEL E. CAMPBELL, DIRECTOR OF
REGULATORY AND GOVERNMENT AFFAIRS,
CONSTELLATION ENERGY (AN EXELON COMPANY),
WASHINGTON, D.C.; ON BEHALF OF EDISON ELECTRIC
INSTITUTE
Mr. Campbell. Thank you, Chairman Scott, Ranking Member
Scott, and Members of the Subcommittee. Thank you for the
opportunity to discuss the views of end-users in reauthorizing
the Commodity Futures Trading Commission.
I am Lael Campbell, Director of Regulatory Affairs, with
Exelon Corporation, testifying on behalf of the Edison Electric
Institute, EEI.
EEI is the association of U.S. investor-owned electric
utilities whose members serve nearly 70 percent of America's
industries, businesses and consumers with their electricity.
EEI members are the quintessential commercial end-users.
The goal of EEI member companies is to provide their
consumers with reliable electric service at affordable and
stable rates, and the derivatives markets are a critical tool
for insulating our customers from energy price risk. As end-
users, we support the Dodd-Frank Act's primary goals of
mitigating risk to the financial system, and increasing
transparency in the derivatives markets, however, there are
areas where Congress should consider minor adjustments to
ensure that Dodd-Frank achieves its purpose, while not impeding
our ability to hedge and manage risks associated with our core
business of producing and delivering physical energy to our
customers.
I would like to highlight three of these concerns: the
treatment of physical contracts of volumetric optionality, the
de minimis threshold, and the definition of bona fide hedging.
One of the key concerns for end-users is an interpretation of
the definition of a swap that includes options for physical
delivery, as well as physically settled forward transactions
with imbedded optionality. These are physically settled
contracts that are entered into solely between physical market
participants, and serve the purpose of providing flexibility to
respond to changing supply and demand circumstances such as
ensuring delivery of fuel to a generation plant when that fuel
is needed. Treating these everyday physically delivered
transactions that are used to manage operational and physical
supply risk as swaps has significantly and unnecessarily
increased end-user compliance costs with no recognizable
offsetting public benefit. If a transaction at inception is
intended for physical settlement, the transaction should be
excluded from the term swap.
Another important issue for end-users is the automatic drop
of the de minimis threshold for registration with the CFTC as a
swap dealer. The CFTC set this de minimis threshold at $8
billion, however, the de minimis threshold is scheduled to be
reduced automatically to $3 billion at the end of 2017, without
any stakeholder process. End-users are concerned that a lower
swap dealer de minimis threshold will cause companies to cease
transacting in swaps with other end-users, leading to fewer
hedging counterparties available in the market, making hedging
and risk management all the more difficult and costly. Notably,
we have already experienced a negative impact of an
unreasonably low de minimis threshold. When the CFTC initially
proposed a lower swap dealing threshold for counterparties of
municipal utilities, those utilities found that the number of
available counterparties diminished significantly, essentially
leaving only the large banks to transact with. This experience
highlights the important role the end-user-to-end-user swap
market plays in managing risk in the energy space, and shows
that a lower de minimis level will likely result in decreased
market liquidity, and in turn, increased risk, increased cost
to hedgers, and ultimately increased cost to consumers.
The final issue I would like to discuss is the proposed
narrowing of what constitutes a bona fide hedge. The dynamic
and complex nature of energy markets, in particular,
electricity markets, demands flexibility to those charged with
managing risk in these markets. EEI is concerned that the
CFTC's position limit rule unduly precludes long-established
and well-accepted hedging practices. Although EEI has a number
of concerns in the area of position limits, I would like to
highlight the proposed limitation on the ability to engage in
cross commodity hedging, for example, using a natural gas
derivative to hedge electricity price risk. Under the proposed
rule, the CFTC would only presume bona fide hedging status for
a cross commodity hedge if it meets a rigid mathematical
correlation. This quantitative requirement ignores the
undeniable relationship between the price of electricity and
the price of the fuels used to generate electricity, as well as
the longstanding and accepted risk management practice of power
generators and power suppliers to use fuel-based derivatives to
hedge electricity price risk. Deference must be given to long-
established and widely recognized risk management practices of
end-users, such as cross commodity hedging. A narrowing of the
bona fide hedging definition that ignores these industry-
accepted practices will stifle market liquidity, negatively
impact price transparency, and increase hedging costs. These
costs ultimately will be reflected in the prices consumers pay
for energy.
In conclusion, I would like to thank the Committee for
helping to ensure that EEI members continue to use derivatives
to protect our companies and their consumers from energy price
risk.
Thank you for the opportunity to testify, and I would be
happy to answer any questions.
[The prepared statement of Mr. Campbell follows:]
Prepared Statement of Lael E. Campbell, Director of Regulatory and
Government Affairs, Constellation Energy (An Exelon Company),
Washington, D.C.; on Behalf of Edison Electric Institute
Introduction
Chairman Scott, Ranking Member Scott, and Members of the
Subcommittee, thank you for the opportunity to discuss the views of
end-users in reauthorizing the Commodity Futures Trading Commission
(CFTC) through the Commodity Exchange Act Reauthorization.
I am Lael Campbell, Director of Regulatory and Government Affairs
with Exelon Corporation, testifying on behalf of the Edison Electric
Institute (EEI). EEI is the association of U.S. investor-owned electric
utilities, international affiliates and industry associates worldwide.
Our industry directly employs more than 500,000 workers, and EEI's
investor-owned electric utility members serve nearly 70 percent of
America's industries, businesses and consumers.
Headquartered in Chicago, Exelon conducts business in 48 states,
the District of Columbia, and Canada. The company is one of the largest
competitive U.S. power generators, with power plants in 19 states.
Exelon owns or controls approximately 35,000 megawatts of generation
capacity, is the nation's largest nuclear operator, and one of the
nation's largest wind energy generators, comprising one of the nation's
cleanest and lowest-cost power generation fleets. Exelon also owns
three utilities, which reliably deliver electricity and natural gas to
more than 7.8 million utility customers in central Maryland (Baltimore
Gas & Electric Company), northern Illinois (Commonwealth Edison), and
southeastern Pennsylvania (Philadelphia Electric Company or PECO).
Finally, our Constellation-branded family of competitive retail
businesses serves more than 2.5 million residential, public sector, and
business customers with electricity, gas, energy management services
and distributed generation, including more than \2/3\ of the Fortune
100.
The electric power sector is a $910 billion industry and is the
most capital-intensive industry in the United States. It is projected
to spend approximately $90 billion a year, on average, for major
transmission, distribution and smart grid upgrades; cybersecurity
measures; new, cleaner generating capacity; and environmental and
energy-efficiency improvements. The electric power industry represents
approximately two percent of our nation's real gross domestic product.
EEI members are non-financial entities that primarily participate
in the physical commodity market and rely on swaps and futures
contracts to hedge and mitigate their commercial risk. The goal of our
member companies is to provide their consumers with reliable electric
service at affordable and stable rates, which has a direct and
significant impact on literally every area of the U.S. economy. Since
wholesale electricity and natural gas historically have been two of the
most volatile commodity groups, our member companies place a strong
emphasis on managing the price volatility inherent in these wholesale
commodity markets to the benefit of their consumers. The derivatives
market has proven to be an extremely effective tool in insulating our
consumers from this risk and price volatility. In sum, our members are
the quintessential commercial end-users of swaps.
Title VII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (the ``Dodd-Frank Act'') provides certain
exemptions for non-financial end-users, recognizing that they are not
the entities posing systemic risk to the financial system. Since
passage of the Dodd-Frank Act, we have been actively working with
Federal agencies, including the CFTC, as they work their way through
the implementation process to ensure that the Congressional intent of
protecting non-financial end-users from unnecessarily burdensome
impacts of financial market reform remains intact. Even though a
majority of the rules have been promulgated by these agencies, concerns
still surround some of the remaining issues important to electric
companies.
We support the Dodd-Frank Act's primary goals of protecting the
financial system against systemic risk and increasing transparency in
derivatives markets. However, there are areas where Congress should
consider minor adjustments to ensure the Dodd-Frank Act achieves its
purpose while not inadvertently impeding end-users' ability to hedge.
Last year, through the bipartisan leadership of Congressmen Lucas,
Peterson, Conaway, and Scott, and all the Members of this Committee,
H.R. 4413--the Customer Protection and End User Relief Act--was passed
out of the House by a bipartisan vote of 265-144. This legislation
contained a number of those minor adjustments we believed could have
helped to ensure that the end-user community was not inadvertently
swept into regulations that were not intended to cover us.
As this Subcommittee and Congress again examine possible
modifications to the Commodity Exchange Act, we hope we can build upon
the successes of last year's legislation and ask that you again
consider the following issues:
Volumetric Optionality
One of the key concerns for end-users is an interpretation of the
definition of a ``swap'' that includes within that definition certain
physically-delivered contracts entered into only by physical market
participants. EEI members believe that regardless of whether the non-
financial commodity transaction at issue is a forward contract with
``embedded optionality'' or a ``stand-alone'' commodity trade option,
if the transaction at inception is intended for physical-settlement,
the transaction is excluded from the term ``swap'' for all regulatory
purposes by the Commodity Exchange Act (CEA 1a(47)(B)(ii)). The
predominant feature of these contracts, as contemplated by the parties
at the time the contract was entered into, is actual delivery; the
embedded optionality does not undermine the overall nature of these
contracts as forward contracts. As such, we respectfully urge the
Committee to adopt a provision similar to that contained in last year's
reauthorization bill that clarified that all sales of a non-financial
commodity for deferred shipment or delivery, so long as the transaction
is intended to be physically settled at the time it is entered into, is
not a swap regardless of whether it contains an embedded option.
Trade options and physically delivered forward transactions with
embedded optionality serve the purpose of providing the option holder
flexibility to respond to changing supply and demand circumstances,
such as ensuring delivery of fuel to a generation plant when fuel is
needed. EEI members create a physical supply portfolio designed so that
they can provide electric service to their retail consumers at low
rates. Contracts for physical delivery of commodities such as
electricity or natural gas are vital to the business of EEI members.
Treating every-day transactions that are used to manage operational and
physical supply risks as ``swaps'' has significantly, and
unnecessarily, increased end-user regulatory and compliance costs
associated with these transactions, with no recognizable offsetting
public benefit.
De Minimis Level
The CFTC issued a proposed rule on the swap dealer de minimis
threshold for comment in early 2011. After review of hundreds of
comments, a series of Congressional hearings and after dozens of
meetings with market participants, the CFTC set this de minimis
threshold at $8 billion. However, absent an affirmative CFTC action,
the de minimis threshold is scheduled to be reduced automatically to $3
billion at the end of 2017.
End-users are concerned that a lower swap dealer de minimis
threshold will cause companies to cease transacting in swaps with other
end-users because the extra costs and burdens associated with
registration as a swap dealer are not sustainable for most commercial
energy companies. This in turn will lead to fewer hedging
counterparties available in the market, making hedging and risk
management all the more difficult and costly for end-users. This
concern is imminent, despite the 2017 date for the drop in the
threshold. Because the de minimis measurement is over a 1 year period,
end-users will have to make these critical business decisions and
adjust their activities beginning in 2016.
A lower swap dealer de minimis level would lead to further
consolidation of the swap business to a handful of registered swap
dealers, mostly large Wall Street banks whose primary business is
dealing in swaps. This threat is not purely hypothetical: when the CFTC
initially proposed a lower dealing threshold for counterparties of
government and municipal utilities (``utility special entities''),
those utility special entities found that liquidity rapidly disappeared
and the number of available counterparties diminished significantly.
Eventually the CFTC acknowledged the negative impact this low threshold
had on the ability of utility special entities to hedge their risk with
other commercial counterparties, and the CFTC increased the de minimis
level for energy swaps with these special entities to the same $8
billion threshold that applies to all swaps. This example highlights
the important role the end-user to end-user swap market plays in
managing risk in the energy space. It is likely that a lower de minimis
level would result in an impact similar to what was seen for utility
special entities, but this time the impact will be felt by all
commercial end-users that use swaps to manage risk, not just
municipalities.
As such, EEI opposes this dramatic reduction in the de minimis
threshold that is set to take place without any deliberate CFTC action.
The CFTC should not have the authority to change the de minimis level
without a formal rulemaking process that allows stakeholders to provide
input on what the appropriate threshold should be. We respectfully urge
the Committee to adopt a provision similar to that contained in last
year's reauthorization bill that would prevent the de minimis level
from dropping without a new rulemaking by the CFTC.
Requiring that a rulemaking process be in place rather than an
automatic reduction does not take any discretion away from the CFTC but
will help ensure that stakeholders have input into the appropriate
level for the threshold. Absent these procedural changes, we are
concerned a deep automatic reduction in the de minimis level could
hinder the ability of end-users to hedge market risk while imposing
unnecessary costs that eventually will be borne by consumers.
Bona Fide Hedging
The dynamic and complex nature of energy markets, in particular
electricity markets, demands flexibility to those charged with managing
risk in these markets. EEI is concerned that the CFTC's Proposed
Position Limits Rule unduly limits the hedging activities of commercial
end-users by precluding long-established and well-accepted hedging
practices. The question for the Commission is what constitutes
excessive speculation, as some amount of speculation is needed to
maintain liquidity in the markets. What constitutes excessive
speculation may also depend on the market as commodity prices are
inherently volatile and are dependent on a number of factors such as
demand for the commodity, customer demand, weather, and mechanical
outages, among others. If applied inappropriately, position limits
could have the effect of limiting or constraining risk. Unreasonable
and unsupported position limits stifle market liquidity, negatively
impact price transparency, and increase the cost of hedging. Any
increase in hedging costs ultimately results in an increase of the
price our consumers pay for the energy we provide. The CFTC has not
made fact-based findings on the need for position limits.
EEI is concerned that the Proposed Rule discounts the importance of
long-established hedging practices that have been used by EEI members
and other commercial end-users by limiting traditional practices such
as hedging on a portfolio basis, anticipatory hedging, cross-commodity
hedging and hedging of unfixed price risk.
Gross Hedging
The proposed position limits rule implies that an entity has to net
all of its physical exposures enterprise wide in order to qualify for
bona fide hedge status, and that the entity cannot take into account
exposures on a legal entity or portfolio basis. Portfolio-based risk
management is a common and long-standing commercial practice of
producers, processors, merchants and commercial users of commodities
and commodity byproducts. This is especially important to EEI members
as energy markets are regional in nature. As a result, many utilities
and independent power producers manage portfolios of risk by region. In
one region, a power producer may be long physical generation, and in
another region it may be short physical power (i.e., it has more load
or demand for power than it has generation). A power producer's long
physical position in one region should not limit its ability to hedge
its short physical position in another region. The regional nature of
the electric power industry also means that hedging on a net basis
would be unworkable, requiring costly new technology systems to be
built around more rigid, commercially impractical hedging protocols
that prevent dynamic risk management in response to rapidly changing
market conditions. Moreover, forcing end-users to net positions between
regions, or business units, that may have limited commercial
relationship with each other, will increase risk, not decrease risk.
Cross-Commodity Hedging
Under the Proposed Rule, the CFTC would only presume bona fide
hedging status for a cross-commodity hedge (e.g., hedging electricity
price risk with a natural gas derivative) where there is an appropriate
quantitative relationship ``when the correlation, between first
differences or returns in daily spot price series for the target
commodity and the price series for the commodity underlying the
derivative contract is at least 0.80 for a time period of at least 36
months.'' This quantitative requirement ignores the relationship
between the price of the fuel used to generate electricity and the
price of electricity, and the long-standing and accepted risk
management practice of utilities and other power generators to use
natural gas Referenced Contracts and other fuel-based derivatives to
hedge the price risk associated with their electricity production.
Many market participants hedge long-term electricity price exposure
with natural gas derivatives contracts because there is insufficient
liquidity in deferred month electricity derivatives contracts.
Therefore, requiring the proposed quantitative correlation in outer
months would eliminate all available tools for hedging at illiquid
locations which, in turn, would result in higher risks for market
participants and higher costs for consumers. Due to long-established
risk manage[ment] practices using cross-commodity hedges, EEI would
urge the Commission to give discretion to this widely recognized risk
management practices used in the industry.
Anticipatory Hedging
There are legitimate commercial reasons for commercial end-users to
engage in anticipatory hedging, and a final position limits rule should
not restrict this activity. For example, an EEI member should be
permitted to hedge a binding and irrevocable bid in a state-
administered auction for suppliers to provide electricity to utility
consumers. Taking away suppliers' ability to hedge their irrevocable
bids in the period between making the bid and the auction results being
approved by the state utility commission will result in the risk of a
market move during this interim period being factored into the bid
price, which will raise prices for consumers.
Unfixed Price Risk
EEI members are concerned that the proposed position limits rule
only provides bona fide hedge treatment for ``unfilled'' anticipated
fuel requirements for a generator. However, it is common in the
electricity industry for a generator to ``fill'' its fuel requirements
with an unfixed price fuel supply contract. This contract ensures the
generator will have the physical fuel supply, but still leaves the
generator exposed to unfixed or variable price risk. Bona fide hedging
treatment should be provided to generators (or other commercial market
participants) for transactions that hedge or ``fix'' their market
exposure to unfixed price risk, even if their anticipated fuel
requirements are ``filled''. The fact that such a common transaction
does not receive bona fide hedge treatment under the Proposed Position
Limits rule further supports the need for the Committee to require the
CFTC to recognize commonly accepted risk management practices of end-
users.
EEI members follow documented risk management procedures to ensure
that hedging transactions are designed to manage the risks incurred in
their commercial operations. In addition, since the hedges are based on
physical commodities, the value of the hedge changes as the market
moves. Many EEI members have front office commercial operations
personnel, supported by middle office risk management policies and back
office derivative accounting processes, who have the responsibility of
managing complex and dynamic commercial operations that incur risks
from volatile commodity prices. If a hedge is not effective, these
controls will identify it and require a change. As such, the CFTC
should be required to continue to recognize the industry's risk
mitigation practices, and the Committee should not permit the CFTC to
further restrict what constitutes a bona fide hedge.
Inter-Affiliate Transactions
Currently, the CFTC's rules and proposed rules generally treat
inter-affiliate swaps like any other swap. Hence, companies must, under
certain circumstances, report swaps between majority-owned affiliates
and must submit such swaps to central clearing unless the end-user
hedging exception applies or complex criteria for the inter-affiliate
clearing exemption are met. In the absence of a more expansive clearing
exemption for inter-affiliate trades, the costs of clearing likely
would deter most market participants from entering into inter-affiliate
transactions. For example, without an exemption, additional affiliates
in a corporate family would need to become clearing members or open
accounts with a Futures Commission Merchant, and all affiliates would
need to develop and implement redundant risk management procedures and
trade processing services.
In contrast to market-facing swap transactions, swaps between
majority-owned affiliates are typically entered into for operational
and administrative efficiency in managing a commercial enterprise. The
CFTC has provided some relief in the form of no-action letters, but
these no-action letters do not provide end-users with adequate
certainty. We ask that the Committee provide this certainty by
permanently exempting swap transactions between majority-owned
affiliates from these unnecessarily burdensome reporting and clearing
obligations.
1.35
CFTC Regulation 1.35(a) imposes broad recordkeeping requirements on
certain market participants, including ``members'' exchanges (DCMs and
SEFs). EEI appreciates the Commission's proposal to reduce some of the
recordkeeping burden imposed by Commission Regulation 1.35(a) on
commercial end-users. However, while the Commission's intentions are
well-placed, the approach in the Commission's Proposed Rule still
leaves uncertainty and costs that are not necessary to impose on
persons that are not registered with the Commission and who are only
executing trades for their own account. For example, although
unregistered members of a DCM or SEF are now exempted from the
requirement to retain text messages, unregistered members must still
retain written and electronic records of pre-trade communications. As a
result of these unnecessary burdens, end-users may opt not to become
members of a DCM or SEF, despite the policy goal of the Dodd-Frank Act
to encourage more on-exchange activity. For this same reason end-users
may also forgo a direct clearing membership arrangement, despite
growing global concerns with rising costs of clearing that a direct
clearing membership would help mitigate.
EEI respectfully requests that the Committee clearly exclude from
the application of Regulation 1.35 commercial end-users that are not
registered with the Commission and who are not transacting on behalf of
consumers.
Financial Entities
The Dodd-Frank Act defines the term ``financial entity'', in part,
as an entity that is ``predominantly engaged in activities that are in
the business of banking, or in activities that are financial in nature,
as defined in section 4(k) of the Bank Holding Company Act of 1956.''
Incorporating banking concepts into a definition that also applies to
commercial commodity market participants has had unintended
consequences.
Unlike our members, banks and bank holding companies generally
cannot take or make delivery of physical commodities. However, banks
and bank holding companies can invest and trade in certain commodity
derivatives. As a result, the definition of ``financial in nature''
includes investing and trading in futures and swaps as well as other
physical transactions that are settled by instantaneous transfer of
title of the physical commodity. An entity that falls under the
definition of a ``financial entity'' is generally not entitled to the
end-user exemption--an exemption that Congress included to benefit
commercial commodity market participants--and can therefore be subject
to many of the requirements placed upon swap dealers and major swap
participants. In addition, the CFTC has used financial entity as a
material term in numerous rules, no-action relief, and guidance,
including, most recently, its cross-border guidance. The Dodd-Frank Act
allows affiliates or subsidiaries of an end-user to rely on the end-
user exception when entering into the swap on behalf of the end-user.
However, swaps entered into by end-user hedging affiliates who fall
under the definition of ``financial entity'' cannot take advantage of
the end-user exemption, despite the fact that the transactions are
entered into on behalf of the end-user.
Many energy companies structure their businesses so that a single
legal entity within the corporate family acts as a central hedging,
trading and marketing entity--allowing companies to centralize
functions such as credit and risk management. However, when the banking
law definitions are applied in this context, these types of central
entities may be viewed as engaging in activity that is ``financial in
nature,'' even with respect to physical transactions. Hence, some
energy companies may be precluded from electing the end-user clearing
exception for swaps used to hedge their commercial risks and be subject
to additional regulations applicable to financial entities.
Importantly, two similar energy companies may be treated differently
if, for example, one entity uses a central affiliate to conduct these
activities and another conducts the same activity in an entity that
also owns physical assets or that has subsidiaries that own physical
assets. Accordingly, Congress should amend the definition of
``financial entity'' to ensure that commercial end-users are not
inadvertently regulated as ``financial entities.''
Conclusion
Thank you for your leadership and ongoing interest in the issues
surrounding implementation of the Dodd-Frank Act and their impact on
commercial end-users. We appreciate your role in helping to ensure that
electric utilities can continue to use over-the-counter derivatives in
a cost-effective manner to help protect our electricity consumers from
volatile wholesale energy commodity prices.
Again, I appreciate the opportunity to testify and would be happy
to answer any questions.
The Chairman. Ms. Cavallari.
STATEMENT OF LISA A. CAVALLARI, DIRECTOR OF FIXED
INCOME DERIVATIVES, RUSSELL INVESTMENTS, SEATTLE, WA; ON BEHALF
OF AMERICAN BENEFITS COUNCIL
Ms. Cavallari. Good afternoon, Chairmen Conaway and Scott,
and Ranking Members Peterson and Scott. I am Lisa Cavallari,
Director of Fixed Income Derivatives at Russell Investments.
Russell Investments is a global financial services firm,
and provides consulting, asset management, trading
implementation, and index services. We provide these services
as a fiduciary for our clients, and an agent of our clients,
which means that we act exclusively on their behalf. The
overwhelming majority of our clients are pension plans. Russell
is also a Member of the Board of Directors of, and works
closely with, the American Benefits Council, whose mission,
like ours, is dedicated to the advocacy of employer-sponsored
benefit plans. The Council is a public policy organization
representing principally Fortune 500 companies, and other
organizations that assist employers of all sizes.
I am grateful for the opportunity to speak to this
Subcommittee, and share my ideas and ways about which we can
collectively continue the good work that Congress and the CFTC
has chosen to achieve its ambitious goals set about by the G20.
First, I would like to discuss how pension plans and end-
users of the swaps use particularly bilateral, cleared and
futures markets, then I would like to discuss some very real-
life costs that our pension plan users are facing, and some of
the challenges that we have had to face these last couple of
years.
Pension plans use swaps for a range of risk-reducing
activities, in part because they are a cost-effective way of
obtaining and eliminating specific exposures quickly. An
example of risk reduction is the use of interest rate hedging
by pension plans. Interest rate swaps, both cleared and
uncleared, are an effective hedge against any potential
volatile interest rate movements. If a plan has $5 billion in
assets and $5 billion in liabilities today, everything is
balanced. However, if interest rate swaps decline, this impacts
the liability side of the equation, and it could create a
funding shortfall. Depending upon the severity of this
shortfall, under the worst circumstances, it could serve to
strain the employer's balance sheet and give rise to solvency
risk. Under the more likely scenario, however, is that it will
require the employer to divert resources away from efforts that
lead to economic expansion. This shortfall can be cost-
effectively eliminated by employing interest rate swaps. Even
in this low interest rate environment that we are experiencing
today, interest rate swap instruments can meaningfully reduce
the volatility of the funded status of a plan. This is a
powerful risk mitigant that we need to ensure can continue to
be assessable by plans.
I would like to discuss briefly some of the costs that our
end-users are now facing in a very real-life and dramatic
example. A pension plan client of Russell's, one that is active
in the futures, cleared swaps, and bilateral swaps worlds, is
facing significantly-rising costs. Russell is an agent and
fiduciary and investment advisor for this pension plan that
trades billions of dollars. On an annualized basis, their costs
were, at the end of 2014, about $25,000, again annualized, for
billions of dollars and positions. The FCM, a clearing member
who acts as an agent on our client's behalf, has recently
raised their fee schedule to over $560,000 annually. They have
cited a combination of Title VII regulations that, conspired
with the Basel III capital ratios that these swap dealers need
to maintain, together, these forces have conspired to increase
the cost of these pension plans, and we have no doubt that that
will continue.
Some of the factors that contribute to these increases in
costs are ideas of netting, when it regards--in regards
particularly to pension plans, and also the posting of initial
margin. Though complicated in nature and multifaceted, we look
forward to working with different regulators, prudential and--
as well as the CFTC, to overcome these obstacles. A
conservative pension plan client base is important as well as
other members of this panel in terms of the constituencies for
the liquidity that they provide the swaps market. This is a
very important detail.
As a side note, the initial margin, which traditionally
pension plans have not posted in the bilateral markets, could
be imposed if proposed rules are set in place. This is, again,
something that we would challenge, as the end-user of a
derivative, is a very conservative pension plan.
Some of these forces have conspired to increase costs, as I
used in my example. We welcome the opportunity and we have
seen, certainly with Commissioner Giancarlo's white paper on
SEFs, we welcome the opportunity and have worked closely with
the CFTC and staff to make tweaks around the margin for the
different rules that have been put in place as a result of
Title VII.
Again, I am grateful for the opportunity to just outline a
few of the issues which are very pertinent to the pension plan
community and the end-users that I represent.
Thank you again for your time.
[The prepared statement of Ms. Cavallari follows:]
Prepared Statement of Lisa A. Cavallari, Director of Fixed Income
Derivatives, Russell Investments, Seattle, WA; on Behalf of American
Benefits Council
Good afternoon Chairmen Conaway and Scott and Ranking Members
Peterson and Scott. I am Lisa Cavallari, Director, Fixed Income
Derivatives at Russell Investments. Russell Investments is a global
financial services firm that provides consulting, asset management,
trading implementation and index services. We provide these services as
a fiduciary and an agent of our clients which means that we act
exclusively on their behalf. The overwhelming majority of our clients
are pension plans or other retirement arrangements that themselves are
focused on finding ways to improve their financial security and the
long-term financial security of their participants. These clients
include many of the major and mid-size U.S. corporations, endowments
and foundations, and public retirement systems that drive our economy.
Our entire business is built around serving the needs of these clients.
Russell is also a Member of the Board of Directors of and works
closely with the American Benefits Council (the ``Council'') whose
mission, like ours, is dedicated to the advocacy of employer sponsored
benefit plans. The Council is a public policy organization representing
principally Fortune 500 companies and other organizations that assist
employers of all sizes in providing benefits to employees.
Collectively, the Council's members either sponsor directly or provide
services to retirement and health plans that cover more than 100
million Americans. We appreciate the Council's years of service and
hard work to be an advocate for employer plans and the many thousands
of employees who rely on those plans and their employers to help them
reach a more secure financial future.
In order to efficiently and effectively help these clients reach
their financial goals, Russell trades a variety of instruments through
a number of global trading partners and venues. Those instruments
include billions of dollars of exchange traded futures and cleared
swaps as well as bilateral, uncleared swaps. As a practitioner who
trades these instruments for our clients, I am grateful for the
opportunity to speak to this Subcommittee and share my views about ways
that we can collectively continue the good work of Congress and the
CFTC to achieve the ambitious goals set forth by the leaders of the G20
starting in 2009. Derivatives, including both futures and swaps, are an
important part of any investment advisor's toolkit and are crucial to
achieving many investment goals. Fiduciaries like Russell evaluate them
for their appropriateness and often recommend them to achieve client
investment objectives.
My trading team is dedicated to facilitating and executing
derivatives trading for our clients. It is truly a team effort. We work
closely with our colleagues in the documentation, legal, compliance,
risk and technology areas to achieve this. Whether it was Mies Van de
Rohe or Flaubert who are each alleged to have said ``God is in the
details,'' the fact remains that those details have very real
consequences. The trading desk often stands at the intersection of many
of those details as it pertains to derivatives regulation.
We appreciate the role of the Dodd-Frank Act in adding greater
transparency to the marketplace so that investors can make use of
available products in a way that allows them to effectively meet their
specific investment and risk mitigation goals. We believe the
agencies--including the Commodity Futures Trading Commission
(``CFTC''), which has jurisdiction over the types of swaps most
important to plans, and the prudential regulators--have worked hard to
provide helpful guidance and have been very open to input on the
derivatives issues from the pension plan community. We recognize the
diligence and enormous effort required of U.S. and other global
prudential regulators to bring transparency to an over-the-counter
marketplace for bilateral swaps that in terms of dollars notional
outstanding is nearly 24x that of the exchange traded futures
markets.\1\
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\1\ Bank for International Settlements BIS Quarterly Review Dec
2014 and March 2015. http://www.bis.org/publ/qtrpdf/r_qs1503.pdf.
Statistical Annex: Detailed Tables 19 and 23A.
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As Russell and other industry participants work to ensure a
transition from the rulemaking phase to implementation, we welcome
continued open dialogue surrounding these historically unprecedented
changes. In this regard, there are implementation issues affecting the
pension plan community that could have very adverse effects on plans
and on their ability to mitigate risk.
To further the dialogue, I would like share my views on the
following topic areas:
Background on the primary types of derivatives we trade.
How, why, and the extent to which pension plans use these
derivatives.
Factors driving increasing costs and barriers to access for
pension plans to use derivatives.
Summary of specific examples of concerns and thoughts on how
to address emerging challenges.
Background on the Primary Types of Derivatives We Trade
Today the primary three categories of derivatives are (i) Bilateral
Swaps, (ii) Futures, and (iii) Cleared Swaps. While these products may
appear complicated and it is in part due to that they are questioned,
each has a valuable role in the world of investments, particularly for
pension plans.
At the time of the Global Financial Crisis, there were only futures
and bilateral uncleared swaps. Pension plans frequently used a
combination of both. Exchange traded futures are trade standardized
contracts executed and cleared with a clearing member under a Futures
Commission Merchant (FCM) Agreement. Pensions frequently use futures
exposure to gain access to a variety of global equity indices. Futures
contracts have counterparty credit risk with the clearinghouse and the
FCM. Collateral in the form of both initial margin (different for the
risk profile of each product contract) and variation margin (for daily
marked-to-market changes) is applicable.
Bilateral swaps, like their name suggests, are traded under
specific negotiated documentation with a trading counterparty. Only the
two parties involved in the agreement may trade under it. An
International Swaps and Derivatives Association (ISDA) Master Agreement
is frequently used as the contract that outlines the rights of each
party involved with a trade. Bilateral swap exposures, unlike futures,
can be tailored to suit a specific need. One example of a trade type is
a Russell 2000 total return swap, where a pension plan may want to pay
a fee in order to receive the return of the Russell 2000 stock index.
Whereas the future trades with quarterly expirations, in set contract
amounts and sizes, the bilateral swap can be tailored to have a
maturity to match exactly the need of the pension. This flexibility and
customization is extremely important for pension plans who have precise
asset and liability needs. In contrast to futures, the movement of
collateral associated with bilateral swaps is negotiated and is highly
dependent upon the credit worthiness of the counterparty because there
is no clearinghouse.
After Title VII, there emerged the growing, nascent sphere of
cleared swaps. Cleared swaps are like a hybrid between bilateral swaps
and futures. The cleared swap is traded under an Addendum to the FCM
Agreement. Depending upon the product, the swap may be required to
trade on a Swap Execution Facility (SEF). An example of a cleared swap
would be a credit derivative index product, called CDX, on U.S.
corporate bond names. The product is standardized so it is traded as a
swap but cleared on an exchange. Cleared swaps also exist with a
distinct and separate collateral regime that is different from futures.
Each of these products, futures, bilateral swaps and cleared swaps
have their own unique workflow in terms of documentation and
onboarding, trading and execution, confirmations and reconciliation and
collateral and resets.
How, Why, and the Extent to Which Pension Plans Use These Derivatives
Pension plans use exchange traded futures, cleared swaps and
bilateral over-the-counter swaps in a variety of ways. I will limit my
comments today to the cleared and bilateral swaps. Pension plans use
these derivatives for a range of risk-reducing activities, in part
because they are a cost-effective way of obtaining or eliminating
specific exposure quickly. An example of risk reduction is the use of
interest rate hedging by pension plans. Pension plans have both assets
and liabilities (pension obligations to employees) to manage. Interest
rate swaps, both cleared and uncleared, are an effective hedge against
any potential volatile interest rate movements. If a plan has $5
billion in assets and $5 billion in liabilities, today, everything is
balanced. However, if interest rates decline, this impacts the
liability side and there will be a funding shortfall. Depending on the
severity of that shortfall, under the worst of circumstances, it could
strain the employer's balance sheet and give rise to solvency risk. The
more likely scenario though is that it will require the employer to
divert resources away from efforts that lead to economic expansion and
job creation and into funding the pension shortfall.
This shortfall can be cost-effectively eliminated by employing
interest rate swaps. Even in this low interest rate environment we are
experiencing today, interest rate swap instruments can meaningfully
reduce the volatility of the funded status of a plan. This is a
powerful risk mitigant that we need to ensure can continue to be
accessible by pension plans. Take for example a pension plan that has
hired an investment manager to trade small capitalization stocks. They
recently made a strategic decision to decrease the weight allocated to
small cap stocks and move into intermediate corporate bonds. It will
take a while for them to identify a new manager and transition the
physical portfolio. The pension plan could buy derivatives, for example
a total return swap that mimics the intermediate corporate bond
benchmark index or a combination of interest rate swaps and index
credit derivatives. In this way they obtain the desired exposure more
quickly, cheaply and efficiently. To be clear, the cost-efficiency of
this is a direct benefit to the pension plan participants.
Pension plans are a high quality credit counterparty. In the
bilateral world, under ISDA documentation that is negotiated and
managed between a pension plan and/or their investment advisor and a
swap dealer, the pension is undeniably the stronger counterparty. With
exchange traded swaps and futures, initial margin is posted by the
client in an amount that is deemed by regulation or by the FCM to be of
sufficient amount for a guarantee of contract fulfillment at the time a
market position is established.\2\ For bilateral swaps, the concept of
initial margin is referred to as an independent amount. Indeed, the
concept of posting collateral in the form of an independent amount for
a bilateral swap is almost unheard of for a pension plan. Depending
upon how the agreement was negotiated, there may even be unilateral
payments. This means that because the pension plan is so creditworthy,
that when they owe a swap dealer on a payment, they do not pay the swap
dealer, but if the swap dealer owes the pension plan, then the swap
dealer makes the payment.
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\2\ http://www.cftc.gov/consumerprotection/educationcenter/
cftcglossary/glossary_ijk.
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These examples highlight how swaps are used by pension plans often
in risk reducing ways. The fact that pension plans are a high quality
trading counterparty is also instructive. Keeping these concepts in
mind, I move on to the changing (increasing) costs associated with
derivatives use and developments that are affecting (negatively)
pension plans' access to derivatives. I strongly believe that every
pension plan should have a choice between how best to obtain synthetic
exposure in a risk disciplined way, whether that be a future, cleared
swap or bilateral swap. Pension plans, together with their strategic
advisors have a fiduciary duty to thoroughly investigate, research and
determine the most appropriate way to obtain their outlined investment
objectives. Agents and fiduciaries like Russell can and do help pension
plans and others navigate this.
Factors Driving Increasing Costs and Barriers To Access for Pension
Plans To Use Derivatives
Costs surrounding cleared and bilateral swaps are both explicit and
implicit. Tackling the explicit costs of the new era of cleared swaps,
there have been and will continue to be additional costs borne as the
result of introduction of this new product to the swaps solar system
that previously only consisted of futures and bilateral swaps. As
mentioned previously, cleared swaps require their own workflow. Cleared
swaps do not replace anything per se, they add something entirely new.
These situations surrounding workflows, from trading to collateral
movements, directly impact pension plans and/or their investment
advisors as well as the swap dealers--in the case of cleared swaps, the
Futures Commissions Merchants (FCMs). As of January 31, 2015, the CFTC
Financial Data for FCMs report reflects 74 FCMs with just 23 of them
supporting cleared swaps.\3\ There have also been some high profile FCM
exits from the cleared swaps business.\4\-\5\
---------------------------------------------------------------------------
\3\ http://www.cftc.gov/ucm/groups/public/@financialdataforfcms/
documents/file/fcmdata0115.pdf.
\4\ http://www.thetradenews.com/news/Trading__Execution/
Industry_issues/EMIR_delay_
prompts_BNY_Mellon_clearing_exit.aspx
\5\ http://finance.yahoo.com/news/rbs-wind-down-swaps-clearing-
091729703.html.
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At this point I would like to provide a recent, dramatic example of
the dynamic of increased costs. A pension plan client of Russell's, one
that is active in the futures, cleared swaps and bilateral swaps arenas
is facing significant rising costs. Russell is an agent, fiduciary, and
investment advisor for the pension plan and trades cleared swaps and
futures with one FCM. Their book in gross notional size is a few
billion dollars in futures and cleared swaps. On the cleared swaps
side, their fees with the FCM had been a per ticket (i.e., one order
for $300 million would be one trade ticket) charge of between $250 and
$500. If the pension plan traded, assume twice a month a variety of
different cleared products, those charges on an annualized basis were
equivalent to about $25,000. The FCM citing a number of different
regulatory pressures recently presented Russell with a revised fee
schedule that represented fees, on an annualized basis, based upon
their current portfolio, of $550,000. We've now moved into the fee
stratosphere. This is an unwelcome byproduct of this new solar system
and one that not only significantly reduces the cost-efficiency of
these highly useful and important instruments, but it also may be so
cost prohibitive to most clients (particularly midsize or smaller
clients) that those clients are priced out of the market. That is a
tradeoff between certain costs and uncertain (but potentially
significant) funding risk that will face all pension clients.
Implicit costs abound everywhere. With new legal definitions,
trading venues and addenda to append FCM agreements all attached to
derivatives regulation, significant time energy and resources have been
spent. Investment Management Agreements (IMAs) have also had to be
revised. In 2012, I spent numerous hours explaining to pension plans
why they need to register and maintain a LEI (Legal Entity Identifier)
and its predecessor the CICI (CFTC Interim Compliant Identifier).
Countless hours have also been spent trying to navigate the new world
of Special Entities that pension plans invariably became a part of with
new regulation. Never has a seemingly innocuous question like ``are you
a U.S. Person?'' been so loaded with meaning, complexity, and work.
There are other more subtle implicit costs for pension plans. With
pension plans, advisors and swap dealers all working together to ink
new agreements and documents, whereas in the past certain terms or
rights were negotiated carefully, that approach was difficult to
replicate this time around. The timelines for cleared swaps
implementation required that documents be fully executed and
``operationalized'' well ahead of the start date for each category of
derivative end-users. Similarly, in very short order, end-users were
left to discern whether to be a Swap Execution Facility (SEF) member
directly or not. All of these examples had the potential to collide in
the swaps solar system, and it took an enormous amount of effort to
remain in orbit. The degree to which each of these affected a pension
plan was largely determined by the instruments that they were using.
Based on my own experience and observations, if a pension plan was
using futures and bilateral OTC swaps, it was certainly going to use
cleared swaps. However, if a pension plan was only using futures and
now had the ability (after signing more documentation) to use cleared
swaps, they would choose to stick to using just futures. In other words
I would have thought there would be more pension plans emerging as new
end-users of cleared swaps by now, but that has, so far, not been my
experience.
There are always growing pains associated with big dramatic change
and Russell is cognizant that costs are associated with change. We are
also aware of the long-term benefits and value of swaps and respectful
of the policy goals of transparent markets. The few points I have
mentioned about costs both explicit and implicit are extremely
important in the context of having a liquid and well-functioning
marketplace. Pension plans and other end-users of derivatives benefit
from cost efficient ways to obtain their exposures.
Some cost pressures associated with derivative use by pension plans
are a direct result of some unintended consequences that are created
when considering the implications of different global regulations. This
is the last area I would like to mention.
Summary of a Few Areas of Concern and Thoughts on How To Address
Emerging Challenges
There are a lot of things in orbit in the new swaps solar system
that I have outlined. Pension plans are a high quality credit worthy
counterparty in the bilateral OTC swaps construct and play a key role
in diversifying customer types for an FCM. FCMs are adapting and
changing their own business models. The broad implications of
international banking regulations such as Basel III have caused FCMs to
re-evaluate the profitability of not just cleared swaps, but futures as
well. FCMs are being increasingly more discerning about what products
they want to facilitate, under what conditions they will trade and
importantly with what type of client they will accept. Though a certain
amount of this is healthy and expected, and is the price to pay for
transparency, there have been some unintended consequences. Those
include (1) increasing fragmentation; (2) reduction in competition as
some FCMs exit; (3) increased concentration; (4) increased costs that
erode pension or corporate resources; and (5) reduced access as certain
client types and sizes are potentially unprofitable for FCMs to face.
The combination of these variables creates a situation where pension
plans are unable to use risk reducing instruments. Ironically, due to a
combination of factors surrounding capital ratios that impact FCMs,
pension plans and the type of stable real money accounts they represent
are becoming less desirable clients to both swap dealers and FCMs.
Though highly technical in nature, the U.S. implementation of Basel
III's Supplemental Leverage Ratio, the Net Stable Funding Ratio, the
Liquidity Coverage Ratio, and the risk weights of certain assets are
just a few of the calculations that can severely impact the cleared and
bilateral swaps pension plans utilize. Where a pension plan is located
and what jurisdiction it operates under can also be a key component for
determining if a robust legal netting opinion can be obtained from
counsel in order to be considered a Qualified Master Netting Agreement
under Basel III. The problem some pension plans are at risk of facing,
is that if an unqualified legal opinion cannot be obtained, then the
swap dealer must account for the pension plan's derivative exposures on
a gross basis. This creates a situation where trades by the affected
pension plans become either prohibitively expensive to enter, or
alternatively, those pension plans are not offered certain products at
all. In other words, affected pension plans cannot engage in offsetting
risk or reducing risk exposures. This at best significantly increases
costs and at worst paradoxically creates a situation where pension
plans are less desirable as clients for an FCM or swap dealer. The
issue is multi-faceted, but the industry is willing to work with
prudential regulators to help remove artificial barriers that only
serve to hinder pension plans' use of derivatives.
Another area of concern surrounds the aggregation across affiliates
of exposures for the margin of uncleared swaps. It may be worth
reiterating the high quality nature of the creditworthiness of pension
plans. As it is rare that a pension plan posts an independent amount
associated with an uncleared swap today, I believe pension plans should
be exempt from posting in the future. However, under the current
proposed rules surrounding the calculations used to determine who
should be posting initial margin, it is necessary to aggregate
exposures. Interestingly, these proposed rules differ significantly
from the Major Swap Participant (MSP) rules already in place. Aligning
these rules with the MSP rules already in place could be one possible
solution to explore. At Russell, we have a number of different pension
plan clients. Those pension plans hire Russell to do very specific
things. That same pension plan hires many other investment managers
that all have their own unique mandates. The pension plan is the
beneficial owner and technically the end-user of the derivative. The
challenge is trying to assess and roll up all of that derivative
exposure. Russell does not have any knowledge of what other managers
are doing or what other derivative exposures are present.
Certainly there are other areas of concern. However, various Basel
III elements that conspire to make the business less profitable for
swap dealers and FCMs also create the unintended consequence of making
pension plans appear less desirable as customers. The aggregation issue
serves to highlight how some rules are not consistent in their approach
and how difficult it is in practice to collect information considering
the separate and limited recourse inherent in pension plan structures.
To summarize and conclude, I have so far attempted to describe broadly,
the use of derivatives by pension plans, some concerns surrounding the
increased costs for pension plans that use derivatives and highlight
just a few areas of concern. As the new swaps solar system evolves and
continues to revolve, Russell is hopeful that certain elements can be
fixed along the way to make sure pension plans and other market
participants can keep humming along in orbit. We are hopeful that with
careful consideration and help the derivatives marketplace will
continue to evolve in a way that ensures access and transparency for
use by pension plans.
The Chairman. Thank you.
Mr. Maurer.
STATEMENT OF MARK MAURER, CHIEF EXECUTIVE OFFICER, INTL FCStone
MARKETS, LLC, CHICAGO, IL
Mr. Maurer. Chairman Scott, Ranking Member Scott, thank you
for having me here today. I appreciate the time, and it is an
honor being here.
My name is Mark Maurer. I am from the State of Kansas and
moved to Chicago about 13 years ago. My background is primarily
in the risk management side, but I also have experience in
operations and trading. I work for INTL FCStone Markets, which
is a subsidiary of INTL FCStone, Inc., a publicly traded
company listed on the NASDAQ. I will refer to INTL FCStone
Markets as IFM for the rest of this testimony.
We were the first non-bank swap dealer to register with the
CFTC, and our business is built on servicing the commercial
end-user; our customers, offering them the ability to hedge
their commodity exposures.
Who are these customers? We are talking about the soybean
co-ops in Illinois, we are talking about the corn co-ops in
Iowa, we are talking about the cattle ranchers in Texas. The
majority of our business is helping the farmers of America
hedge their commodity exposures.
The markets we are discussing today were built for the end-
users; that is why they are in existence. Today, we are here to
discuss a few different proposals from the CFTC that were
intended to prevent systemic risk in our industry. We believe
we are in a stable and growing industry when it comes to the
farmers of America and their ability to hedge their commodity-
based risk, but if these rules are finalized as proposed, our
customers will either lose their ability to hedge as they have
in the past, or their hedging costs will be much greater.
First, I will talk about the CFTC's proposed margin rules.
One of the reasons we are currently able to give our customers
great pricing is because we are able to use the margin
delivered by customers to finance the offsetting hedge to
support the customers' trade. Without these offsetting hedges,
we would be adding systemic risk to the industry. We believe
our customers should have the ability to choose whether their
margin should be used in this manner. Last year, we offered our
customers the choice as to whether to instead hold their margin
in a segregated account. Not one of our customers made this
election, as the cost of using segregated accounts were, in
their view, unnecessary, but the CFTC's proposed rule would
have required holding these funds in separate accounts. Under
the proposed rule, not only the cost of setting up the margin
accounts, but also the cost of the offsetting hedge will have
to be passed onto the customers, which will make it less
appealing for them to hedge and, therefore, add systemic risk
to the industry.
Now, let us talk about the CFTC's proposed swap dealer
capital rule. We are 100 percent in favor of having a fair
capital requirement that applies to all swap dealers, both
banks and non-banks. In Chairman Conaway's remarks at the
recent Futures Industry Association conference, he said that
regulatory burdens should be both minimalized and justified.
What does this proposed capital rule mean for our
customers? Our customers continually think about price risk,
basis risk, volatility risk, and credit risk, but they also are
affected by regulatory risk.
We appreciate the acknowledgement, as was included in the
Committee's bipartisan CFTC reauthorization bill of the last
Congress, that the CFTC's proposed rule for non-banks versus
banks were not fair and needed to be addressed. For example, a
position that a bank swap dealer has on that requires a capital
usage of $10 million would require a non-bank swap dealer to
have upwards of $1 billion of regulatory capital set aside.
This large difference will significantly impact the regulatory
risk incurred by our customers. Why is there such a large
difference? Under the CFTC's proposed rule, bank affiliate swap
dealers are allowed to use their own internal models to
calculate their capital requirements, but non-bank swap dealers
are not permitted to use internal models in the same way. Non-
bank swap dealers must calculate their capital based on a
formula created by the CFTC. This formula does not permit
netting, except for identical offsetting positions. For
example, if IFM has a short $10,000 March swap corn position,
and a $10,000 long swap position in May contrast, this would
constitute a $20,000 gross exposure and there would be no
netting. But as all of us know, a March-May spread is actually
less risky than an outright March or an outright May contract.
Coming up with a solution that is fair for non-bank and
bank swap dealers is in the best interest of our industry and
our customers. And remember, our midmarket customer base may
not have a wide range of solutions that larger players in these
markets have, but these customers are our core client base. If
a solution is not found to make these capital rules equitable,
our customer base and the farmers of America may lose many of
their competitive choices to hedge.
In closing, thank you for your time. I would like to
reiterate that we are currently in a stable, growing industry
that allows us to manage risk for our farmers in America. We as
a group need to come up with a solution to keep it that way.
Thank you.
[The prepared statement of Mr. Maurer follows:]
Prepared Statement of Mark Maurer, Chief Executive Officer, INTL
FCStone Markets, LLC, Chicago, IL
Chairman Austin Scott, Ranking Member David Scott, Chairman
Conoway, Ranking Member Peterson, and other Members of the Committee
and Subcommittee, thank you for inviting me to testify at this
important hearing. I am the Chief Executive Officer (``CEO'') of INTL
FCStone Markets, LLC.
Prior to my current role, I was the Head of Risk for one of the
leading Agricultural trading firms in Chicago. It is there that I began
to understand how important it is for the farmers of America, our
customers, to have the ability to hedge their exposures. I have served
in various capacities, which include derivatives, operations, trading
and sales and I enjoy looking at the business from every view point.
What I am going to share with you today builds upon the testimony
provided on May 21, 2013 by my colleague William Dunaway, Chief
Financial Officer of INTL FCStone Inc., before the U.S. House Committee
on Agriculture's session on ``The Future of the CFTC: Market
Perspectives.''
Above all, INTL FCStone is here to advocate for our customers, for
regulations to be finalized in a way that will continue to allow even
the smallest end-users to have access to firms like ours, to hedge
against market risk, in a cost efficient way.
I. INTL FCStone's Evolution Servicing Agricultural Customers
INTL FCStone Inc. (collectively with its affiliates, ``we'' or
``INTL FCStone'') is a publicly held, NASDAQ listed company that dates
back to 1924 when a door-to-door egg wholesaler formed Saul Stone and
Company. This company went on to become one of the first clearing
members of the Chicago Mercantile Exchange. In June of 2000, Saul Stone
was acquired by Farmers Commodities Corporation, which at the time was
a cooperative owned by approximately 550 member cooperatives, and was
renamed FCStone LLC. In 2009 we merged International Asset Holding
Corp. and FCStone Group, becoming a global financial services
organization. We currently maintain more than 20,000 accounts
representing approximately 11,000 customers located in more than 135
countries through a network of 37 offices around the world and employ
approximately 1,100 professionals.
INTL FCStone offers its customers a comprehensive array of products
and services, including our proprietary Integrated Risk Management
Program, exchange-traded futures, OTC derivatives execution and access
to different commodity markets and asset classes. Our products are
designed to help customers limit risk, reduce costs, and enhance
bottom-line results. We also offer our customers physical trading in
select soft commodities including agricultural oils, animal fats and
feed ingredients, as well as precious metals. In addition, we provide
global payment services in over 130 foreign currencies as well as
clearing and execution services in foreign exchange, unlisted American
Depository Receipts and foreign common shares. We also provide
securities broker-dealer and investment banking advisory services.
From its early beginnings up to the present, INTL FCStone has
predominately serviced midsized commercial customers, including
producers, merchandisers, processors and end-users of virtually every
major traded commodity whose margins are sensitive to commodity price
movements. Our largest customer base is serviced from offices in the
agricultural heartland, such as West Des Moines, Iowa, Omaha, Nebraska,
Minneapolis, Minnesota and Kansas City, Missouri. We are successful
because we are a customer-centric organization, focused on acquiring
and building long-term relationships with our customers by providing
consistent, quality execution and value-added financial solutions.
The primary markets we serve include: commercial grains; soft
commodities (coffee, sugar, cocoa); food service and dairy (including
feedyards); energy; base and precious metals; renewable fuels; cotton
and textiles; forest products and foreign exchange. Our offices are
located near the customers we serve and our customers are the
constituents of the Members of this Committee--the farmers, feedyards,
grain elevator operators, renewable fuel facilities, energy producers,
refiners and wholesalers as well as transporters who are in involved in
the production, processing, transportation and utilization of the
commodities that are the backbone of our economy. As an example, we
believe our customers handle more than 40% of domestic corn, soybean
and wheat production, including 20% of the grain production in Texas,
40% of grain production in Kansas, and 50% of grain production in Iowa
and Oklahoma.
We offer our customers sophisticated financial products, but are
not a Wall Street firm. Our mid-sized Futures Commission Merchant
(``FCM''), FCStone LLC, according to recent industry publications, is
the 20th largest FCM based upon customer segregated assets on deposit.
However, it is the fifth largest independent FCM not affiliated with a
banking institution or physical commodity business.
INTL FCStone Markets, LLC (``IFM''), a subsidiary of INTL FCStone
Inc., is a member of the National Futures Association (``NFA'') and
registered with the U.S. Commodity Futures Trading Commission
(``CFTC'') as a Swap Dealer. IFM was one of the first to register as a
Swap Dealer and at the time, we were the only organization not
affiliated with a bank to register.
Although the INTL FCStone Inc. group of companies conducts a global
full-service, integrated commodities, futures, investment banking,
derivatives trading and risk-management business, we remain unique, in
that we are still not affiliated or owned by a bank and we primarily
serve the worldwide commercial mid-market agricultural community.
It is in this capacity that we come before the Committee and
request that this Committee ensure that the laws passed by Congress,
and the regulations of the CFTC, are beneficial to the end-users that
are our customers.
II. INTL FCStone Supports the Goals of the Dodd-Frank Act & the CFTC's
Mission to Protect End-Users
INTL FCStone continues to support the goals of the Dodd-Frank Act
aimed at promoting customer protection, and reiterates its support for
the CFTC's continued mission to protect derivatives customers and
provide end-users with market certainty. This can be accomplished by
promulgating laws and regulations that help farmers, merchandisers, and
end-users to effectively manage risks in a cost-efficient manner. In
particular, we supported Section 356 of the previous Congress' H.R.
4413, the Consumer Protection and End User Relief Act, a bipartisan
bill passed by the House of Representatives last Congress. We supported
the Bill because it will create a level playing field for non-bank Swap
Dealers like FCStone, rather than discriminate against commodity Swap
Dealers who are not affiliated or owned by a bank.
The heart of our business is making available to our customers
access to futures and OTC derivatives through our affiliated FCM and
our Swap Dealer. We make a market for customers who transfer their risk
to us, and we in turn need to create an opposite trade in the market so
that our position and the risk associated with that position remains
neutral. A provision such as Section 356 of H.R. 4413 will allow us to
do this without prohibitively increasing our capital costs. Otherwise,
these costs would need to be passed on to our customers, impeding
market efficiency by making it too expensive for farmers and other end-
users to hedge their exposures.
III. Capital and Margin Rule Proposals Treat of Swap Dealers Not
Affiliated or Owned by Banks Unfairly Compared with Bank-Owned
Swap Dealers
A. Proposed Capital Rule
Ensuring that swap-dealers have an adequate capital base and that
customer collateral arrangements do not add to systemic risk are
positive and commendable objectives of Dodd-Frank. However, the capital
and margin regulations, as proposed by the CFTC, would significantly
disadvantage Swap Dealers that, like INTL FCStone, are not affiliated
with a bank, in favor of bank-affiliated Swap Dealers that perform the
same market functions.
As we have previously highlighted in our testimony of May 21, 2013,
the competitive advantage given to bank-affiliated Swap Dealers under
proposed rules is extraordinary. IFM will be required to hold
regulatory capital potentially hundreds of times more than that
required for a bank-affiliated Swap Dealer for the same portfolio of
positions. This disparate treatment to non-bank Swap Dealers like IFM
is in part because the proposed rules allow bank-affiliated Swap
Dealers to use internal models to calculate risk associated with
customer positions, while IFM and other non-banks cannot use their
internal models. These models are in some cases the very same models
used by the banks.
The use of internal models is important because internal models
generally provide for more sophisticated netting of commodity positions
to determine applicable market risk capital charges. As a result of
limited netting under the CFTC's ``standardized approach,'' a non-bank
Swap Dealer will have to hold market risk capital against economically
offsetting commodity swap positions, resulting in a higher capital
requirement overall \1\ relative to the capital requirement for a
bank-affiliated Swap Dealer using an internal model.\2\ This increased
capital requirement would have the perverse effect of actually
incentivizing a non-bank affiliated Swap Dealer to not fully offset the
risk of a customer OTC transaction and thus incurring potentially
unlimited market risk.
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\1\ Dealers should depend primarily on spreads between transactions
for earnings, not on directional price change speculation. This is an
underlying intent of many provisions of Dodd-Frank (e.g., the Volcker
Rule). In the ordinary course of their operations, Swap Dealers relying
on spreads are incentivized to run flat books, which in turn reduces
risk in the market. Based upon our conversations with staff, we
understand that the CFTC does not intend to allow Swap Dealers to
recognize commodity position offsets as to maturity and delivery
location. If this is true, it seems counterproductive from a capital
and a risk standpoint. A capital rule that adequately risk-adjusts
offsetting positions would properly incentivize Swap Dealers to run
flatter portfolios (thereby decreasing systemic risk) because the Swap
Dealer would be able to lower its capital requirement by entering into
offsetting positions.
\2\ We consider it significant that the SEC's proposed rules on
capital, margin and collateral segregation for non-bank Security-Based
Swap Dealers and non-bank Major Security-Based Swap Participants permit
the use internal value-at-risk models. We believe the CFTC will foster
productive end-user markets if they take a similar approach with their
capital and margin rules. Consistent CFTC and SEC rules will also allow
Swap Dealers who have SEC-regulated affiliates to operate more
smoothly, with a risk program that applies across all affiliated
entities.
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Under the ``standardized approach'' proposed by the CFTC to
calculate Swap Dealer capital requirements, which is based on European
banking standards (i.e., Basel II), many of the commodity derivatives
that we make available to our agricultural customers are subject to
higher capital requirements than any other derivatives asset class.
Agricultural products are at the heart and soul of the U.S. and global
infrastructure, and requiring more capital for derivatives in
agricultural products is counterproductive to the hedging needs of
America's agricultural businesses. We will have to hold more capital
for agricultural products than interest rate swaps, because the rules
treat ``commodities'' disparately from other asset classes, and in
addition, as a non-bank Swap Dealer, we will not be allowed to use our
internal models, simply because we are not affiliated with a bank.
Taken in conjunction, the same derivatives portfolio that would
require a bank-affiliated Swap Dealer to hold $10 Million in regulatory
capital using standard internal models would require us to set aside up
to $1 Billion in capital in a worst case scenario. Regulatory capital
requirements of this magnitude are wholly unsustainable for a company
of INTL FCStone's size. The numbers are not economically feasible for a
company of any size. Calculations supporting these estimates are
attached to this testimony as Addendum A. INTL FCStone submitted these
same calculations to the CFTC with our comment letter on this issue.
As previously mentioned, INTL FCStone was the first non-bank to
register as a Swap Dealer. As other non-banks register, particularly
those in the agricultural and energy space, additional market
participants will be caught in this position and either squeezed out of
the market, or at least seriously disadvantaged relative to the bank-
affiliated dealers.
Obviously, this regulatory capital disparity is not a small hurdle
for the already disadvantaged independent dealers to overcome. If left
unchanged, these capital rules will eventually cause nonbank Swap
Dealers to exit the business. The direct result will be higher costs
for end-users, and then for consumers. Increasing concentration in the
industry until only the big banks are left will leave many customers
with no place to go. Serving farmers, ranchers and grain elevators has
not been a focus or a profitable business model for the large dealers.
Even larger customers who might be able to access to OTC hedging
tools through bank-affiliated dealers will still face higher costs as
the big bank dealers will be able to take advantage of decreased market
competition. A larger percentage of customers carried through a handful
of large, bank affiliated Swap Dealers will increase systemic risk.
FCStone still believes every Member of this Committee would agree
that the CFTC rules were not intended to preclude small commodity
producers from hedging. Nor were the rules intended to concentrate swap
activity at the banks, which would increase the potential for systemic
risk. That said, that is the result that will follow if the capital and
margin rules are adopted as proposed.
How do we solve this problem? By complying with the mandate under
the Commodity Exchange Act which requires the CFTC, the prudential
regulators, and the SEC to establish and maintain ``comparable''
minimum capital requirements for all Swap Dealers. We have asked the
regulators to address the fact that the proposed Capital & Margin Rules
are not ``comparable.'' We urge Congress to ensure the CFTC's proposed
rules ensure capital and margin requirements that apply to non-bank
Swap Dealers are in fact, comparable to those applicable to bank-
affiliated Swap Dealers, and to refrain from creating a commercial
disparity based on the commodity asset class, and commodity end-users.
This can be accomplished by altering the rules to permit the following:
Internal Models. We believe the CFTC could permit all Swap
Dealers, including Commodity Swap Dealers, to request approval
of, and rely upon, internal models to measure market risk. The
language in the previous Congress' H.R. 4413 would have
accomplished this task. To the extent that the CFTC currently
lacks the resources to review and approve such internal models,
it should permit Swap Dealers to certify to the CFTC or the NFA
that their models produce reasonable measures of risk, subject
to verification by the CFTC when its resources enable it to do
so;
Full Netting. We believe that to the extent a Swap Dealer is
unable to rely on an internal model, the CFTC should revise the
``standardized approach'' in the CFTC's proposed capital rules
to clarify that it allows full netting of offsetting commodity
swap positions, which will create a capital requirements
framework that is more similar to the prudential regulators;
Matched Position Offsetting. Alternatively, the CFTC could
allow position offsetting for ``matched positions,'' either on
a per commodity/per expiry basis, or by using a ``maturity
ladder'' approach to netting, as described in the Basel
Committee's Amendment to the Capital Accord to Incorporate
Market Risks (the ``Market Risk Amendment''), in order to
facilitate the netting of commodity swap positions; or
Flat Book Incentives. Default risk is reduced when an entity
maintains a relatively flat book. We believe the CFTC should
incentivize dealers to reduce default risk by decreasing
capital requirements for operating a flat book. This incentive
can be achieved by revising the Capital Rules to recognize
netting for economically offsetting commodity swap positions
(whether through the maturity ladder approach, or otherwise).
Under the current proposal, dealers get no credit, from a
capital perspective, for running a flat book and in fact are
penalized.
B. Proposed Margin Rule
Similar to the unintended effects of the Swap Dealer capital rule,
the CFTC's proposed swap margin rules will have a negative impact on
end-users because of the difficulty that Swap Dealers will have in
complying with it. The cost to the Swap Dealer will inevitably passed
on to the Swap Dealer's customers.
Customer protection tools, such as segregation of customer funds
and prompt transfer of those funds to customers in the event of a
bankruptcy, are core protections in the Commodity Exchange Act. At the
same time, customers are capable of exercising discretion to choose
whether to opt-in or opt-out of certain protections. For example, the
CFTC permits customers to elect whether to require or not require
segregation of margin for uncleared swaps. In order to set up a
segregated margin account for an individual customer, a bank will
typically charge directly to the customer an amount that ranges from
$10,000-$20,000 per account, per year, plus one-time set up fees up to
$6,500. These fees are not in the discretion of the Swap Dealer and
must be borne by the customer. All of INTL FCStone's swap customers
elected not to segregate margin with a third party custodian
unaffiliated custodian. Our customers indicated that they were
comfortable with FCStone's credit as swap counterparty, and they did
not agree that the cost to them of having an independent custodian bank
`lock-up' their margin was worth the remote eventuality that FCStone
would become bankrupt and be unable to return their assets.
In the CFTC's most recent proposal regarding margin, however, INTL
FCStone and certain of its customers would have been required to incur
these excess costs, due to the CFTC's segregation requirement for
trades with customers that met specified exposure thresholds.
Also, similarly to the CFTC's proposed Swap Dealer capital rules,
the proposed margin rules do not permit Swap Dealers (whether or not
affiliated with a bank) to calculate their margin requirements using
internal models. This increases costs to the Swap Dealer, which must be
passed on to the customer, and also increases the customer's direct
costs, since under the CFTC rules Swap Dealers are required to collect
margin from their customers. As we stated in our letter to the CFTC
dated December 2, 2014, continued increases in the cost of hedging
could have the counterproductive result of driving customers out of the
markets altogether, leaving them with unexposed risk. We requested the
following modifications to the margin rule:
Calculation of Initial Margin. We believe the CFTC should
limit the posting and segregation of excess margin by allowing
Swap Dealers and major swap participants (collectively,
``Covered Swap Entities'' or ``CSEs'') to submit margin
methodology filings as self-executing filings if the
methodologies have previously been approved on behalf of their
affiliates by other regulators, including foreign regulators
that have implemented margin regimes consistent with the BCBS-
IOSCO Margin Requirements for Non-Centrally Cleared Derivatives
(the ``BCBS-IOSCO Framework'').\3\ We also believe that the
CFTC should encourage the use of standardized models developed
by industry groups by allowing CSEs to submit such models as
self-executing filings if they have been approved for use by
another market participant.
---------------------------------------------------------------------------
\3\ Basel Committee on Banking Supervision and Board of the
International Organization of Securities Commissions, Margin
Requirements for Non-Centrally Cleared Derivatives, September 2013,
available at http://www.bis.org/publ/bcbs261.pdf.
Re-Use of Posted Margin. The Proposed Rules do not permit
initial margin (``IM''), which must be held by a third-party
custodian, to be rehypothecated, re-pledged, or reused.
Customers, given the choice, do not chose this option, as we
observed when we gave this option to our customers. The margin
rules should instead permit reuse of posted margin if the
relevant model meets the standards proposed in the BCBS/IOSCO
Framework. In addition, the Department of the Treasury, the
Federal Reserve and other prudential regulators (the
``Prudential Regulators'') and the Securities and Exchange
Commission may permit reuse of posted margin,\4\ and if so, a
prohibition by the CFTC will create a competitive disadvantage
for market participants regulated by the CFTC.
---------------------------------------------------------------------------
\4\ See Margin and Capital Requirements for Covered Swap Entities;
Proposed Rule, 79 Fed. Reg. 573458 at 57374 (September 24, 2014).
According to the BCBS-IOSCO Framework, IM collateral
posted to a CSE may be re-used by the CSE to finance a
hedge position associated with a counterparty's
transaction, so long as applicable insolvency law gives the
posting counterparty protection from risk of loss of IM in
the event the CSE becomes insolvent. If such protections
exist, and a financial end-user consents to having its IM
reused, then a CSE may re-use IM provided by a financial
end-user or another CSE one time to hedge the CSE's
---------------------------------------------------------------------------
exposure to the initial swap transaction.
The reuse of IM collateral can efficiently reduce the
cost of non-cleared swaps for U.S. financial end-users,
because it allows CSEs to hedge their exposures. For
example, a CSE selling non-cleared credit swap protection
to a financial end-user counterparty could re-use the IM
that it receives from that transaction to buy noncleared
credit swap protection from another counterparty. As a
result, allowing for the reposting of IM can reduce the
liquidity burden on CSEs when they enter into offsetting
positions, thereby reducing transaction costs for
derivatives users. Moreover, because U.S. bankruptcy laws
protect U.S. financial entities in the case of an
insolvency of the covered swaps entity, and the collateral
may only be reused once for hedging purposes, aligning the
Proposed Rules with the BCBS-IOSCO Framework in this
respect would not expose U.S. financial entities to any
undue risk.
As you can see, the ability to reuse margin in this
manner is particularly important for mid-market non-bank
Swap Dealers like IFM. Such mid-market Swap Dealers would
not reuse margin to engage in proprietary trading or
securities lending, but need the ability to use margin to
finance hedges directly related to their customer-facing
trades. Such hedges are beneficial to customers, as they
are entered into in order to enable the Swap Dealer to
fulfill its obligations under customer-facing transactions.
Thus, we believe that a restriction on re-use of posted
margin will actually add to market risk. On the other hand,
if mid-market Swap Dealers are permitted to use IM to
finance hedge activity, on the condition that the hedge is
directly related to the underlying customer and the
specific trade at hand, then this activity will mitigate
transaction risk and market risk.
If mid-market non-bank Swap Dealers are required to
independently post IM to an exchange or counterparty,
rather than utilize customers' IM, then such Swap Dealers
would have to borrow from external sources, at a cost, in
order to fund the posting of the IM. The cost to the Swap
Dealers, would in turn, be passed on to their
counterparties. Although the margin rule is intended to
manage systemic risk, an unintended consequence of the rule
for mid-market Swap Dealers and their end-user customers
would be that transaction costs will increase. As a result,
the Proposed Rules may cause certain market participants to
be squeezed out or otherwise unwilling to tie up capital,
leaving those market participants with unhedged risk.
For the forgoing reasons, we suggest the CFTC revise
the Proposed Rules to be consistent with the BCBS-IOSCO
Framework and permit the reuse of IM where (i) applicable
insolvency law affords protection from risk of loss of IM
if the Swap Dealer becomes insolvent, (ii) where the hedge
is directly related to the underlying customer and the
specific trade at hand, (iii) where the reuse is not in
connection with proprietary trading or another customer's
trade, and (iv) where the customer consents.
IV. Customer Issues
A. Three Key Principles
Chairman Michael Conaway highlighted three key principles in his
remarks at the Annual FIA Conference recently: (i) the derivatives
markets grew up in response to the needs of hedgers; (ii) regulatory
burdens should be both minimized and justified; and (iii) regulations
should provide clarity and certainty.
i. Derivatives Markets Grew Up in Response to the Needs of Hedgers Who
Are Farmers, Merchandisers and Producers
We are called upon by end-users faced with the risk that the
commodity they grow, for example, may not grow in the amount
anticipated or required, or be capable of being delivered as planned or
be priced as anticipated or bought or sold as planned. These risks
faced by commercial end-users are unique to them. To help these markets
grow at a natural pace, allow the market activity to drive what rules
are relevant to this market, not the other way around. And certainly do
not impose rules designed for banks, speculators or institutional
customers onto farmers, merchandisers, producers and other end-users.
ii. Minimize and Justify Regulatory Burdens and Costs
We believe the CFTC should develop rules in consultation with end-
users before proposing or implementing them. Closer coordination with
end-users will help create better rules, and can provide the CFTC with
important, relevant information about market practice, as well as the
costs associated with a proposed rule. Rule changes require legal and
compliance expertise to assess and understand the rule itself, and
depending upon the complexity of the rule, greater and ongoing legal
and compliance expertise is needed. Rules need to be operationalized
and can impact multiple business units, and require costly changes to
existing business models. Staffing requirements can also change due to
changes in rules, both with regards to staff expertise and number.
While the recent Basel committee decision to postpone the
implementation dates for the margin rule will be helpful, the problems
with the substance of the margin rule remain. Therefore, we believe the
CFTC should modify the margin and capital rules as we have outlined.
Otherwise, as proposed, the rules will cost end uses an exorbitant
amount of money to hedge a commercial risk.
Rules should be responsive to a problem that actually exists or
that is demonstrated to be imminent, rather than a theoretical problem
or a problem whose eventuality is remote. Complex rules have been
accompanied by complex exceptions, placing new burdens on end-users to
try to understand both the complex rule and whether they satisfy the
exception, which is fraught with complex conditions and tests.
Implementing rules without consultation with end-users has required the
CFTC to react after the implementation of final rules, by issuing no-
action letters and interpretive guidance, which creates additional
burdens on CFTC resources as well as market participants. This
complexity is unnecessary given the relative simplicity of the
agricultural end-users conduct in the market and the manner in which
they utilize derivatives.
iii. Regulations Should Be Clear and Provide Certainty
Not only farmers, manufacturers, and other end-users, but the
industry as a whole have struggled to comply with many rules because
they are too complex to understand. The extraordinary number of no-
action letters (170), plus interpretations or ``guidance'' that the
CFTC issued to try to clarify its rules (60 new rules finalized by the
CFTC since Dodd-Frank was enacted) evidences that the rules were overly
complex, not always relevant to the product or business they were aimed
to regulate, were overly restrictive, or not inclusive enough or time-
limited in nature.
B. The CFTC's Cross-Border Guidance
The CFTC's cross-border guidance proved to be overly complex,
resulting in industry challenges and culminating in litigation. We
support recognition of non-U.S. regulators' interest in regulating
their own markets, with deference to regulators that have comparable
regulatory regimes. Better foreign relations are needed going forward
to have a cohesive, global swap market.
V. Conclusion
As we expressed in 2013, INTL FCStone is not interested in
dismantling Dodd-Frank. We are simply trying to help ensure that final
rules reflect that commercial end-users, and the firms like INTL
FCStone who serve them, are not subject to rules that prevent them from
successfully hedging risk.
Unless the proposed margin and capital rules are changed to be
comparable to the rules for bank-affiliated Swap Dealers, we, and as a
result, our customers, will have to assume extraordinary financial
burdens that place us at a competitive disadvantage. Without the
changes we propose, the consequences of the rules will be forced on our
customers, who will have no alternatives to hedge elsewhere.
We will continue to work with the regulators to ensure that we and
firms like INTL FCStone will be here well into the foreseeable future
to help our customers manage their risk. We are here to advocate for
our customers regulations drafted in such a way that will continue to
allow even the smallest end-users to have access to hedge against
market risk.
Thank you for inviting me to testify today. INTL FCStone greatly
appreciates the ongoing work and support that the Committee has
provided and continues to provide during these challenging times for
our nation, and I look forward to answering any questions that you may
have.
Appendix A
The purpose of this Appendix is to provide a detailed illustration
of the netting of offsetting exposures described in the comment letter.
For the sole purpose of this illustration, we have put together the
below hypothetical portfolio which contains both OTC and centrally-
cleared corn swaps, swaptions, futures and futures options. This is not
the same portfolio used for the calculations noted in the comment
letter, but rather a much smaller and single commodity portfolio.
For simplicity, this illustration only covers the market risk
charges applicable to 15% directional risk on the net position and the
3% of ``gross'' to cover forward gap, interest rate and basis risk. The
Maturity Ladder Approach (iv) and Internal Models (VaR) (v) are
excluded from this illustration. The initial offsetting allowed under
the Maturity Ladder Approach is the same as reflected in (iii) below
although the resulting charges would be slightly less due to lower
charges (1.5%) for offsetting exposures within a broader ``Time Band''.
Corn
------------------------------------------------------------------------
Position OTC Delta
------------------------------------------------------------------------
A Long 50 December 2013 swaps 250,000
B Long 100 December 2013 5.50 puts (164,379)
C Long 250 December 2013 6.50 calls 518,800
------------------------------------------------------------------------
Position Central Clearing Counterparty Delta
------------------------------------------------------------------------
D Short 150 December 2013 futures (750,000)
E Short 100 December 2013 5.50 puts (164,384)
F Short 25 March 2013 6.91 puts 59,762
G Short 25 March 2013 6.91 calls (65,199)
H Short 25 July 2013 6.92 puts 57,717
I Short 25 July 2013 6.92 calls (65,199)
------------------------------------------------------------------------
Definitions of fields used in the below illustrations:
Underlying Group--the underlying commodity upon which the position is based.
Positions Included--the positions from the above portfolio that are included in each line. This really helps to illustrate how the netting described
is working.
Contract Month--the delivery month of the underlying on which the position is based.
Option Type--Call, Put or, in the case of swaps and futures, N/A for the position shown.
Strike--The strike price for the position shown.
Delta--the underlying equivalent size of the position expressed here, not as futures equivalents, but notional quantity (i.e., Notional Delta). In
this illustration using corn, the delta is expressed in bushels. To derive the futures contract equivalent size, simply divide the number shown by
5,000.
Spot Price--in this case, the spot price of corn used in the calculations as prescribed by the proposed rules.
Delta Notional--derived by multiplying Delta * Spot Price. This is the notional value of the based upon the delta as prescribed to do in the
Amendment to the Capital Accord to incorporate market risks page 31 under Delta-plus method.
15% Net Charge--this calculation only applies to the net remaining position and is the capital charge for directional risk. It is derived by
multiplying to total net Delta Notional by 15%.
3% Gross Charge--this value is derived by multiplying the absolute value of Delta Notional by 3% per line item. This is the only charge which will
vary between the examples below and is dependent upon what is allowed to offset/net.
(i) Standardized Approach with no offsetting--Same methodology used in Row 1 of the comment letter
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Positions Contract Month 3% Gross
Underlying Group included (MMM-YY) Option Type Strike Delta Spot Price Delta Notional 15% Net Charge Charge
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Corn
A Dec-13 N/A 0 250,000.00 5.9975 $1,499,375.00 $44,831.35
C Dec-13 Call 6.5 518,800.17 5.9975 $3,111,504.00 $93,345.12
B Dec-13 Put 5.5 ^164,379.00 5.9975 $(985,863.08) $29,575.89
D Dec-13 N/A 0 ^750,000.00 5.9975 $(4,498, 125.00) $134,943.75
E Dec-13 Put 5.5 164,383.79 5.9975 $985,891.79 $29,576.75
F Mar-13 Put 6.91 59,761.61 5.9975 $358,420.27 $10,752.61
G Mar-13 Call 6.91 ^65,198.86 5.9975 $(391,030.18) $11,730.91
I Jul-13 Call 6.92 ^67,119.50 5.9975 $(402,549.20) $12,076.48
H Jul-13 Put 6.92 57,716.57 5.9975 $346,155.12 $10,384.65
--------------------------------------------------------------------------------------------------
Corn Total Net Total 3,131.62 5.9975 $18,781.89 $2,817.28 $377,217.50
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
(ii) Standardized Approach offsetting exact same Commodity, Month, Strike, Put/Call--Same methodology used in Row 2 of the comment letter
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Positions Contract Month 3% Gross
Underlying Group included (MMM-YY) Option Type Strike Delta Spot Price Delta Notional 15% Net Charge Charge
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Corn
F Mar-13 Put 6.91 59,761.61 5.9975 $358,420.27 $10,752.61
G Call 6.91 ^65,198.86 5.9975 $(391,030.18) $11,730.91
H Jul-13 Put 6.92 57,716.57 5.9975 $346,155.12 $10,384.65
I Call 6.92 ^67,119.50 5.9975 $(402,549.20) $12,076.48
A, D Dec-13 N/A 0 ^500,833.15 5.9975 $(3,003,746.82) $90,112.40
B Put 5.5 4.79 5.9975 $28.71 $0.86
C Call 6.5 518,800.17 5.9975 $3,111,504.00 $93,345.12
--------------------------------------------------------------------------------------------------
Corn Total Net Total 3,131.62 5.9975 $18,781.89 $2,817.28 $228,403.03
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
(iii) Standardized Approach offsetting within same commodity and expiry--Same methodology used in Row 3 of the comment letter
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Positions Contract Month 3% Gross
Underlying Group included (MMM-YY) Delta Spot Price Delta Notional 15% Net Charge Charge
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Corn
F, G Mar-13 ^5,437.25 5.9975 $(32,609.91) $978.30
H, I Jul-13 ^9,402.93 5.9975 $(56,394.09) $1,691.82
A, B, C, D, E Dec-13 17,971.80 5.9975 $107,785.89 $3,233.58
--------------------------------------------------------------------------------------------------
Corn Total Net Total 3,131.62 5.9975 $18,781.89 $2,817.28 $5,903.70
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
The Chairman. Thank you.
Mr. Peterson.
STATEMENT OF HOWARD W. PETERSON, Jr., PRESIDENT AND OWNER,
PETERSON OIL SERVICE, WORCESTER, MA; ON
BEHALF OF NEW ENGLAND FUEL INSTITUTE; AMERICANS FOR FINANCIAL
REFORM; AMERICAN FEED ASSOCIATION; INDUSTRIAL ENERGY CONSUMERS
OF AMERICA; GASOLINE; AUTOMOTIVE SERVICE DEALERS; TRUCKING AND
AIRLINE ASSOCIATION *
---------------------------------------------------------------------------
* This organization endorses only the testimony on position limits.
---------------------------------------------------------------------------
Mr. Peterson. Chairman Scott, Ranking Member Scott, and
Members of the Committee, as the Owner and President of a small
Main Street business, I thank you for the opportunity to
provide my perspective on the CFTC reauthorization.
My company, Peterson Oil Service, is a fourth generation,
family-owned and operated business that has served the home
heating needs of central Massachusetts since 1946. Our company
sells BioHeat' Fuel, a blend of biodiesel and low
sulfur heating oil produced by local biodiesel manufacturing
plants and waste vegetable oil. This blend burns cleaner and
more efficiently, and has a lower carbon footprint than natural
gas.
I am testifying as past Chairman of New England Fuel
Institute, and as the Director of the Petroleum Marketers
Association of America. Together, these associations represent
marketers who serve more than eight million BioHeat'
fueled households in home, industry--to over 100,000
convenience stores and gasoline stations. These businesses,
including my own, rely on functional commodity futures, options
and swap markets as a hedging and price discovery tool in order
to minimize the exposure to price volatility, and to provide
our customers with the most affordable products possible.
We urge the Congress to fully fund the CFTC at the amount
requested for Fiscal Year 2016. The importance of funding the
CFTC cannot be overstated, especially given its mission to
protect businesses like mine from fraud, manipulation, and wild
price swings that can result from excessive speculation and
disruptive trading practices.
The CFTC is the cop on the beat, and needs adequate
resources to oversee constantly these evolving markets. In the
4 years leading up to the passage of Dodd-Frank, this Committee
and others in Congress held countless hearings on the causes of
the 2008 crisis that created unprecedented volatility in energy
and other commodities. During these hearings, businesses like
mine joined in bipartisan support with other industries, and
called upon Congress to bring greater transparency,
accountability and oversight to the commodity markets. Since
then, these markets have become even larger, and the need for
oversight is even greater.
Congress did three important things. First, through Dodd-
Frank, it improved the transparency and market oversight to
further protect end-users against fraud and manipulation.
Second, Congress strengthened the CFTC's ability to police and
prosecute market manipulation. Penalties imposed by the CFTC
have increased from $100 million in 2009, to $1.8 billion in
2014. Last, Congress required the CFTC to impose speculative
position limits on all commodities in futures and swaps
markets. It did so to reinforce the ability of hedgers like me
to effectively manage commodity price risks.
Despite having missed the deadline set by Congress, the
Commission has continued to work on a final position limits
rule, however, there has been talk of ceding the CFTC's
authority to set position limits and define hedge exemptions to
the exchanges. NEFI and PMAA oppose this proposal. The
exchanges are publicly traded entities that have a profit
motive favoring higher trader volumes and a larger number of
market participants. As such, they would have a bias towards
higher limits and broader exemptions.
We hope the Committee will once again include language to
enhance protections of regulatory relief for end-users. During
the MF Global crisis, for example, several of my peers became
victims when their accounts were frozen. It is important that
Congress expand and protect companies like these. We also
applaud you for reinforcing the need to keep small hedgers from
being caught in the net by regulations meant for larger market
participants. The Committee should also take a zero tolerance
approach to fraud and manipulation. Current civil penalties are
inadequate to deter such actions, especially when compared to
the overall profits of large market participants who view them
simply as the cost of doing business. Congress should increase
these penalties.
As we move forward in the process, we caution you against
inadvertently creating new loopholes that might benefit
financial institutions and other large market participants.
These include overly broad exemptions meant only for bona fide
hedges. We oppose Congressional intervention in the CFTC's
negotiations with its overseas counterparts regarding the
harmonization of cross-border regulation of derivatives. Large
traders should not be allowed to evade U.S. oversight by
trading through offshore affiliates. We also caution against
dramatically expanding the CFTC's cost-benefit requirements.
This will result in more litigation, not less, and delay
important new rules meant to protect small hedgers.
Thank you again for the opportunity to testify, and I would
be happy to answer any questions you may have.
I know my time is up, but I might ask for the following
groups to be added to the record as endorsing my testimony. The
Americans for Financial Reform, the American Feed Association,
the Industrial Energy Consumers of America, the Gasoline and
Automotive Service Dealers, and on position limits, the
Trucking and Airline Association.
Thank you for your time.
[The prepared statement of Mr. Peterson follows:]
Prepared Statement of Howard W. Peterson, Jr., Owner and
President, Peterson's Oil Service, Worcester, MA; on Behalf of New
England Fuel Institute; Americans for Financial Reform; American Feed
Association; Industrial Energy Consumers of America; Gasoline;
Automotive Service Dealers; Trucking and Airline Association *
---------------------------------------------------------------------------
* This organization endorses only the testimony on position limits.
---------------------------------------------------------------------------
Chairman Austin Scott, Ranking Member David Scott, and Members of
the Committee, thank you for the opportunity to testify before you
today. My name is Howard Peterson and I am Owner and President of
Peterson's Oil Service of Worcester, Massachusetts. I am an ``end-
user'' or more appropriately, a bona fide hedger, of energy
commodities. I look forward to providing the Committee with my
perspective on the Commodity Future Trading Commission (CFTC) and its
forthcoming reauthorization.
Introduction
Peterson's Oil Service is a fourth generation family-owned and
operated company that has served the home heating needs of central
Massachusetts since 1946. Our company sells BioHeat' Fuel, a
blend of biodiesel and low sulfur heating oil. BioHeat has been shown
to be the cleanest burning and most efficient home heating fuel on the
market.\1\ We purchase biodiesel that has been produced from waste
vegetable oil by locally-owned and operated biodiesel manufacturing
plants. We also provide a variety of other home energy services such as
Heating, Ventilation and Air Conditioning (HVAC) system maintenance and
repair, and market gasoline and other motor fuels. Peterson's Oil
Service is a small business with little more than 80 employees. We are
invested in and active members of the communities we serve and are
personally acquainted with many of the customers. We hope the Committee
will benefit from the perspective of our company as it is a true ``Main
Street'' end-user of commodity derivatives.
---------------------------------------------------------------------------
\1\ Natural Gas Expansion Study: A Stakeholder Response, Prepared
by Exergy Partners Corp. for the Massachusetts Energy Marketers
Association, Submitted to the Massachusetts Department of Energy
Resources (DOER), December 18, 2013.
---------------------------------------------------------------------------
I am also testifying on behalf of the New England Fuel Institute
(NEFI). Peterson's Oil Service is a long-time member of NEFI and I
served as its Chairman for 4 years (2010-2014). NEFI has been a leading
voice and advocate for the home heating industry for more than 70
years, representing the industry on a variety of state, regional, and
national public policy issues. Nationwide, approximately 8,000 home
heating oil and BioHeat' retailers serve more than eight
million households and employ over 50,000 people. Many of these
retailers also market other heating fuels such as kerosene, propane and
coal, and most offer a variety of home energy solutions designed to cut
heating and cooling costs, including energy audits, efficiency upgrades
and weatherization services.
In 2007, NEFI formed the Commodity Markets Oversight Coalition
(CMOC), a diverse and nonpartisan alliance of consumer, business and
industry groups in the energy, transportation and agricultural sectors
concerned with opacity in the commodity derivatives markets. This
includes airlines, trucking companies, utilities, industrial
manufacturers, food processors, farmers, and ranchers. CMOC members
successfully advocated for many of the reforms included in the last
reauthorization of the CFTC and, more recently, in Title VII of the
Dodd-Frank Wall Street Reform and Consumer Protection Act.
Like many in our coalition, my business relies on functional
commodity futures, options and swaps markets as a hedging and price
discovery tool. Peterson's Oil Service has long deployed a hedging
program to insulate our business from volatility associated with the
price of crude oil and refined petroleum products and to provide our
customers with the most affordable product possible. Many home heating
fuel dealers either hedge directly, or enlist the assistance of a
broker, futures merchant or swaps dealer, in order to minimize their
exposure to price volatility. Hedging programs are especially important
for retailers that offer fixed price or prepay agreements to their
customers, wherein a customer can lock-in a price for their fuel prior
to the start of the heating season. Hedging affords our customers
downside protection in the event that prices moves unexpectedly when
the physical delivery is made in the winter time.
In order for our industry to hedge with confidence, security and
protection from manipulation, a fully authorized and funded CFTC is
essential. As such, let me begin by commending this Committee on its
efforts to reauthorize the CFTC and urge the Congress to fully fund the
agency at the $322 million level as requested for Fiscal Year 2016. The
importance of fully funding the CFTC cannot be overstated, especially
given the mission it has been tasked with by Congress: that is, to
protect businesses like mine from fraud, manipulation and wild price
swings that can result from excessive speculation and disruptive
trading practices. The CFTC must do all of this despite its limited
resources, an unprecedented expansion of its responsibilities under the
Dodd-Frank Act, constantly evolving markets, and ever-changing trading
practices and technologies. CFTC Chairman Massad and Commissioners
Wetjen, Bowen and Giancarlo should be commended for their commitment to
transparent, accountable and functional markets that serve the needs of
small hedgers like me. They are the cops on the beat and need proper
resources to be successful. It is important that Congress continue to
provide the Commission with the resources it needs and the authorities
necessary to get the job done.
Perspectives on Dodd-Frank
Through Title VII reforms in the Dodd-Frank Act, Congress sought to
address the root causes of the 2008 financial crisis--but this was not
the only crisis that Congress sought to address. Many of the Title VII
reforms also sought to address a crisis of opacity, instability and
diminished confidence in the derivatives markets following an historic
bubble in commodity prices. In the 4 years leading up to the passage of
Dodd-Frank, this Committee and others in Congress held countless
hearings on the causes of this bubble and unprecedented volatility in
energy and other commodities. During these hearings, business groups
like ours joined with other like-minded industries and called upon
Congress to bring greater transparency, accountability and oversight to
the commodity derivatives markets. Since the crisis in 2008, these
derivative markets have become even larger and need for oversight even
greater.
In response to these requests from end-users of derivatives and
other commodity-dependent businesses, Congress did three important
things. First, in an attempt to improve price transparency and market
surveillance and to further protect end-users against fraud and
manipulation, it expanded CFTC jurisdiction to the $700 trillion
(notional value) over-the-counter swaps markets.\2\ Swap dealer
registration, data collection, price transparency, and central clearing
helps to promote greater competition in these markets and is necessary
in order to hold parties responsible for violations of the Act. Prior
to the enactment of Dodd-Frank, these markets were almost entirely
opaque and on several occasions had given cause to alleged or proven
cases of market manipulation.\3\
---------------------------------------------------------------------------
\2\ Source: Testimony of CFTC Commissioner Timothy Massad before
the U.S. House of Representatives, Committee on Appropriations,
February 11, 2015.
\3\ Examples of energy market manipulation or alleged manipulation
include the copper markets (Bankers Trust, 1996), natural gas
(Amaranth, 2006), Propane (BP North America, 2007), crude oil (Parnon
Energy, et al., 2008), gasoline and heating oil (Optiver Holding BV,
2007) and electricity (JP Morgan, 2010-2012).
---------------------------------------------------------------------------
Second, Congress also strengthened the CFTC's ability to prosecute
instances of manipulation and attempted manipulation, including
expanded authority to prevent disruptive trading practices and the
inclusion of Senator Cantwell's ``Anti-manipulation Amendment.'' The
Cantwell Amendment provided the CFTC with new authority to more
effectively prosecute and deter manipulation by changing the burden of
proof from ``specific intent'' to the same fraud-based ``reckless
conduct'' standard employed by the Securities & Exchange Commission
(SEC) and other financial regulators. The effects of these measures to
bolster the policing and prosecution of fraud and manipulation are
clear. Since 2009, penalties imposed by the CFTC have increased from
$100 million in Fiscal Year 2009 to $1.8 billion in Fiscal Year
2014.\4\
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\4\ Source: Written Testimony of CFTC Commissioner Timothy Massad
before the U.S. House of Representatives, Committee on Appropriations,
February 11, 2015.
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Last, Congress included in Dodd-Frank a requirement that the CFTC
impose speculative position limits across all commodities in the
futures and swaps markets. This includes energy futures and OTC energy
and agricultural swaps which had been exempt from such limits since the
enactment of the Commodity Futures Modernization Act of 2000. The
``position limits mandate'' was included in response to concerns raised
by NEFI, its coalition allies and other bona fide hedgers that
excessive speculation was harming price discovery and their ability to
effectively manage commodity price risks. Congress included the mandate
as a prophylactic measure to help prevent a repeat of the 2007-2008
commodity market bubble, to minimize wild price swings and extreme
market volatility, and to prevent market manipulation.
It is also important to note that this rule was included with broad
bipartisan support. In fact, as far back as the 110th Congress, a
stand-alone bill that would have mandated the imposition of speculation
limits was passed with broad bipartisan support. The bill, known as the
Commodity Markets Transparency and Accountability Act of 2008, passed
with the support of 69 Republicans. Several of those Republicans remain
in Congress and are Members of this Committee, including past Chairman
Frank Lucas of Oklahoma and current Vice Chairman Bob Goodlatte of
Virginia.
Congress had required that the CFTC promulgate a position limits
rule by mid-January 2011. Four years have now passed and the CFTC has
still not finalized a rule. A revised rule was proposed in December of
2013 that addresses the concerns of the court and that seeks additional
input from bona fide hedgers on the proper structure of the hedge
exemption. This is the third position limits rule to be considered by
the CFTC since January, 2009. Over the last fifteen months the current
proposal has been opened up to public comments at least four times.
Most recently the CFTC has opened up the rule to comments following a
meeting of the Energy & Environmental Markets Advisory Committee
(EEMAC) on February 26th with comments due on Saturday, March 28th.
NEFI is concerned with a suggestion made at the recent EEMAC
meeting that the Commission cede to the exchanges its authority to set
speculative position limits and issue bona fide hedge exemptions.
Commodity exchanges are not regulatory agencies tasked with protecting
the public interest. They are publically-traded, for-profit entities.
As such, they benefit from higher trading volumes and a large number of
market participants. Therefore the exchanges have a profit motive to
make positon limits voluntary or unreasonably high, and to institute
broad hedge exemptions that may include non-commercial market
participants (such as financial speculators). NEFI strongly opposes
these suggestions. They clearly run contrary to the intent of Congress,
which is that the CFTC--not the exchanges or self-regulatory
organizations--should be tasked with the responsibility to set position
limit levels and define who should be eligible for bona fide hedge
exemptions. Congress should watch developments closely and take action
as necessary to ensure that this intent is preserved.
Recommendations for Reauthorization
Again, we commend Chairmen Scott and Conway and Ranking Members
Scott and Peterson their commitment to moving forward with CFTC
reauthorization. We further commend the Committee for its interest in
giving the CFTC the necessary authority to preserve market integrity
and to protect small hedgers like myself from fraud and manipulation or
from inadvertently being ``caught in the net'' by CFTC rules and
regulations meant for financial firms and large commercial entities.
The reauthorization process also provides an opportunity to correct
imperfections either in Dodd-Frank reforms themselves or in their
implementation. In order to better serve bona fide hedgers and
businesses like mine, we urge Congress to:
Provide Greater Protections for Customer Funds. The
Committee should most certainly include the same robust
customer protections found in Title I of H.R.4413 last year.
While my company was not directly affected, several of my peers
in the heating oil industry were victims of the collapse of MF
Global. Their accounts were frozen and in some cases their
market positions were jeopardized. If the effect of the crisis
were more widespread it could have had a dramatic impact on my
industry and the ability of some companies to serve their
customers. Congress, CFTC and the exchanges should be commended
for their efforts to strengthen consumer protections and
prevent a repeat of ``MF Global.''
Reinforce Congressional Intent Regarding End-users. In
enacting the Dodd-Frank Act, Congress did not intend for many
of its rules and regulations to adversely impact bona fide end-
users of commodity derivatives, including businesses like mine.
Therefore, we commend this Committee for reinforcing end-user
protections in Title III of H.R. 4413 last year. However, NEFI
and its coalition allies would like to caution this Committee
against inadvertently creating new loopholes or regulatory
exclusions that might benefit financial institutions and other
large market participants by weakening exemptions meant only
for bona fide commercial hedgers.
Prevent Cross-Border Regulatory Arbitrage. We also caution
the Committee against intervening in CFTC negotiations with its
overseas counterparts regarding the harmonization of cross-
border regulation of derivatives transactions. Systemically
significant market participants, especially large financial
institutions, should not be allowed to evade U.S. oversight and
regulation by trading through off-shore branches, subsidiaries
and affiliates. As we learned from the 2008 financial crisis
and the LIBOR scandal, the Amaranth case and other instances of
market manipulation, cross-border derivatives transactions can
have significant consequences for American businesses and
consumers and the broader U.S. economy.
Expand the Study into High-Frequency Trading. The Committee
was wise to include a study into High-frequency Trading in H.R.
4413 last year, however this study should be expanded. Congress
should require a broad inquiry into the role of new trading
technologies and practices that utilize complex algorithms and
conduct automated trading, and the development new transmission
technologies.\5\ It should also examine the cyber-security and
national security implications of such technologies and
activities, their impact on market volatility, and whether or
not they could (intentionally or unintentionally) disrupt or
manipulate futures and swaps markets.
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\5\ Examples include fiber optic, wireless and microwave- and
satellite-based transmissions.
Increase Penalties for Fraud and Manipulation. The previous
reauthorization in 2008 strengthened antifraud provisions and
increased civil monetary penalties for manipulation from
$500,000 to $1 million per violation. As a matter of course,
these penalties have become insignificant when compared to the
overall profits of large market participants and have become
part of the ``cost of doing business.'' The Committee should
take a ``zero tolerance'' approach to such behavior. We urge
you to include in reauthorization an increase in fines and
penalties for fraud, manipulation and other severe violations
of the law, and include jail time as appropriate in order to
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further deter such acts.
Remove Expanded Cost-benefit Requirements. As a heavily
regulated business I understand and appreciate the importance
of thoroughly weighing potential costs and benefits of any
Federal rule or regulation. However, unlike many Federal
agencies, the CFTC is already subject to robust cost-benefit
requirements. In many of its final rulemakings, the Commission
``quantified a variety of costs, considered alternative
approaches, sought to mitigate costs and responded to
significant comments'' and in one instance the quantification
of costs ran on for 24 pages in the Federal Register.\6\
Furthermore, costs and benefits with respect to certain
financial regulations can be difficult to quantify, especially
in the case of prophylactic regulations such as the position
limits rule. The dramatic expansion of cost-benefit
requirements proposed under Section 203 of H.R. 4413 last year
would establish unreasonable hurdles for the CFTC to overcome,
including a requirement that the CFTC analyze abstract and
theoretical cost impacts and that it list all of the
ambiguously defined ``alternatives.'' This could lead to more
litigation, not less, and result in the significant and
unwarranted delay of many new rules, including those meant to
protect small hedgers.
---------------------------------------------------------------------------
\6\ Berkovtiz, Dan M., ``Swaps Provisions of Dodd-Frank Act: Cost-
Benefit Analysis and Judicial Review,'' Banking & Financial Services,
September 2014, Page 8.
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Conclusion
We commend the Committee for holding hearings to solicit the input
of bona fide hedgers and other market stakeholders before it moves
forward with CFTC reauthorization. Congress should not miss this
opportunity to expand protections for small hedgers and strengthen
prohibitions against fraud and manipulation. Markets function best when
they are fair, transparent, competitive and accountable; and the
commodity derivatives markets are no exception. Thank you again for the
opportunity to appear before you today. I would be happy to answer any
questions you might have and our industry would be happy to provide
further input to the Committee as things progress.
The Chairman. Thank you, Mr. Peterson, and without
objection, we will be happy to add that to your written
testimony for you as you requested.
They haven't called votes yet so we are going to go ahead
with the questions. And I will yield myself 5 minutes.
And as many of you outlined in your testimony the real
costs that are being incurred by end-users in complying with
the Dodd-Frank Act rules. Can you be more specific with the
sort of measures that you and your organizations have had to
undertake to address the new rules, and whether or not you
think that the cost and benefit is reasonable?
Mr. Christie. I will take a stab at that. I think when you
talk about costs or regulations, there are really two elements
of costs. One is the direct cost of compliance, and in our case
as a cash user, one of those is technology and resources to
capture and retain records to meet reporting requirements. That
is a fixed and known cost. The cost that is less quantifiable
is the secondary cost of the cost of risk throughout the
system, and if we don't have access to the current commercial
risk management practices that we have utilized, costs go up
and those get passed throughout the system. And in some cases,
it could result even in loss of liquidity in markets, and less
price signal. So there is both a direct and an indirect cost to
an environmental regulation around position limits
particularly.
Ms. Cavallari. I would just build on that, if I could.
The Chairman. Yes, ma'am.
Ms. Cavallari. Thank you, Mr. Chairman. The implicit and
explicit costs are also very visible to pension plans as well
as an end-user, similarly. In my testimony, I talked about
costs being raised explicitly by over 20 times by an FCM that
our pension plan faces. So we are starting to see the direct
cost. The implicit cost is going back and revising investment
management agreements, getting internal and legal external
counsel to sign off on revised documentation, and new
documentation for new specific terms that have never been in
the marketplace before, as well as concepts in terms of
representations that are needed from clients, and new ways of
trading swap execution facilities were not in existence before.
So those are just a few of some of the direct and indirect
costs. Thank you.
The Chairman. All right, thank you.
Mr. Christie, if the CFTC significantly narrows the scope
of bona fide hedging exemptions for position limits, will that
impact your ability to serve cotton producers, and how would it
impact commodity users generally?
Mr. Christie. Sure. I can give you a cotton example, and
then other examples as well. But in the cotton industry, it is
very common for a commercial firm to make a commitment to buy
all of the production that would come off of fixed acreage.
That is particularly common in Texas. That production is highly
variable based on weather. So a single weather event, a timely
rain or an untimely hailstorm could have a positive or negative
impact on production.
A commercial user like us needs to be able to reflect our
real-time perceptions of that production and the obligation to
buy that production by having active hedges. And a narrow
definition of bona fide hedges, we would only be able to count
as bona fide a hedge once a final volume was known, and that is
really too late to pass the right price signals to producers.
That is an example of a fixed commitment in the cotton
business, but it could be in irrevocable bid or offer in a
grain market. I am sure there are examples in the energy
markets as well where we have a clear risk obligation that we
need to hedge with traditional mechanisms that we have used in
the past.
The Chairman. Okay. Thank you.
Mr. Campbell, what would the consequences for energy
markets be if the CFTC significantly lowered the swap dealer de
minimis threshold from the current $8 billion to $3 billion?
Mr. Campbell. Thank you, Mr. Chairman. I brought it up in
my testimony, and we have a case study that we saw with regard
to special entities in the lower limit--of the lower threshold
that applied to them. And people made the conscious choice not
to transact and swap with these entities because they did not
want to trigger the swap dealer threshold. These entities were
dramatically impacted by that. They did not have a market, a
market that they usually relied on with entities like ours that
were counterparties with them in the physical space, were no
longer willing to transact with them in the financial space to
help them hedge. And they were left with basically,
essentially, the large banks, the very large registered dealers
to transact with, and ultimately, they sought relief from the
CFTC.
The Chairman. Thank you.
I am going to yield the remainder of my time back. And I
would like to recognize now my colleague, Congressman Scott
from Georgia. And after his questions, we will break for votes,
and then we will come back as soon as the votes are over with.
Mr. David Scott of Georgia. Yes. Let me ask you. As I
mentioned in my opening statement, I am very concerned about
keeping the continuity of H.R. 4413. I think that that is a
path we need to keep on. And in our bill last year, we did
something very important for you. We eased some reporting
requirements for our end-users, and I believe that it was
critical that we do so in order to relieve some practices that
were very burdensome on you all.
So for each of you, could you tell me what were your
recordkeeping practices before Dodd-Frank, and how have they
changed since?
Mr. Christie. I can give a couple of examples. We always
place a high premium on compliance, and we will keep the
records that are required to meet those obligations. An example
in our business as times have evolved, more and more of our
business gets transacted or communicated via e-mail, via text
message, and not just on hardline phones that come into our
office. So a requirement to keep records on cash transactions
that may ultimately lead to a derivative transaction, capturing
all of the methods and the modes in which that might come in
has been a challenge. And our response to that has been to, in
some ways, narrow the access or limit the kinds of transactions
that we will accept in order to be compliant with recordkeeping
requirements.
Mr. David Scott of Georgia. Yes.
Mr. Christie. And we think that is detrimental to the
interests of the users that we are serving.
Mr. David Scott of Georgia. Yes. One of the concerns I had
was the unfortunate financial burden that some of this had on
you. So give me an example, what are your monthly expenses
associated with these recordkeeping requirements?
Mr. Christie. I think that is a good question. I don't have
access today to tell you what our monthly costs would be, but
that is certainly information that we could provide to you.
Mr. David Scott of Georgia. Does any of you--would any of
you have access to that? That would be very helpful in us
keeping some of these regulatory burdens off of you if we did
have some actual factual implications of the degree of
financial burden, and how beneficial what we were doing were to
you. Is there anyone----
Mr. Maurer. I could----
Mr. David Scott of Georgia. Yes, Mr. Maurer. Yes.
Mr. Maurer. I could speak for the, we are not an end-user,
but most of our--all of our customers are end-users, but in
terms of the monthly cost, we have to report all of our over-
the-counter trades to the DTCC on a monthly basis. And
annualized it is, I want to say, right around $600,000, not
including the programming, not including the staff, just the
fees that we have to pay.
Mr. David Scott of Georgia. You said $600,000?
Mr. Maurer. Yes, that is not including the people, the
programming, just the fees associated with reporting those
trades.
Mr. David Scott of Georgia. Okay. Yes, Mr. Campbell?
Mr. Campbell. Sure. The great example on the EEI side is
physical options. I mean these are physical products that were
never considered swaps in the first place. So after Dodd-Frank,
we were required to--industry was required to treat these
things and track these things and record these things as if
they were swaps. Although the CFTC did provide some relief, we
still had to set up new systems to identify these things as
swaps to track all exercises of these options. So even though
there is relief from reporting to some degree, there are still
additional systems and build-out that needs to be done to meet
the obligations, even under the relief.
EEI did a poll, in general, most companies had to hire
additional employees and staff to meet these obligations, and
develop systems. I know my company spent a significant amount
of money developing systems to do all the new tracking that it
had to do. And I believe EEI does have a number and we can get
that to you later on. But that is just one example.
And to my point in my testimony, we still don't see the
offsetting public benefit of regulating physical transactions--
--
Mr. David Scott of Georgia. Yes.
Mr. Campbell.--like they are financial products.
Mr. David Scott of Georgia. So for all of you, what we did
in H.R. 4413 is what we should continue to do in the new
legislation. It was helpful to you in relieving some of that
burden, is that correct?
Mr. Campbell. I would say absolutely, yes.
Mr. David Scott of Georgia. All right, thank you, sir.
The Chairman. All right, vote has been called. We should be
back in approximately 30 minutes. I would just ask that we all
return as quickly as possible. And this hearing will stand in
recess, subject to the call of the chair.
[Recess.]
The Chairman. We'll try to start about 35 after, but as a
courtesy, I'm trying to wait until there is a representative of
the minority party.
All right, we will call the meeting back to order.
And Mr. LaMalfa would be next. Mr. LaMalfa, the floor is
yours for 5 minutes.
Mr. LaMalfa. Okay, thank you, Mr. Chairman.
To Mr. Maurer, thanks for your patience in us doing our
thing over there. Earlier in your testimony, you mentioned that
with CFTC, the cross-border guidance proved to be much more
complex than what we need. We are all concerned that some of
these requirements impose a burden that is much greater than
any possible benefit for U.S. markets, and so the uncertainty
remains over how to apply this directive in terms of the
personnel that are overseas, and the U.S. personnel of foreign
entities in trading swaps. Your support for recognition of non-
U.S. regulators interests in regulating their own markets. Can
you elaborate a little bit more on that please?
Mr. Maurer. Sure thing. Thank you, Congressman.
The issue I see there, I was in London last week, and we
were sitting around a table and talking about how can we grow
the business, and we have a significant amount of our customers
that don't want to go through the rigmarole and the necessary
paperwork, and all of the regulations that come from Dodd-
Frank. And we are trying to, and that is our issue to deal
with, we recognize that, and we have to get those customers
comfortable. But----
Mr. LaMalfa. But some of you on the panel, just with Mr.--
--
Mr. Maurer. Yes.
Mr. LaMalfa.--Mr. Scott, before our break, you were talking
about how that basically have people not willing to write
certain types of swaps or deals, at least at a lower level,
that there has to be a pretty high bar of value to make it
worth the trouble. Does that kind of dovetail with that then?
Mr. Maurer. Well, there has to be a commercial reason why
we do the business, for sure.
Mr. LaMalfa. Yes.
Mr. Maurer. And----
Mr. LaMalfa. But let us raise the bar to make it
commercially viable, right? It has to be a bigger transaction
to make it worth all the paperwork trouble, yes?
Mr. Maurer. Well, our business model is, no matter the size
of the trade, we are wanting to help out the end-user. But I
see your point and it is noted, but we have many customers that
we do trades at a loss for because we are here to help out the
customer. I understand your point there. And we are seeing even
in some of our competition also taking their--they may or may
not be a swap dealer, but taking their business and those jobs
and that staffing outside of the United States, so they do not
have to deal with Dodd-Frank. And, we obviously are not doing
that, we are here.
And if you look back, I would say, a couple of years when
Dodd-Frank was first being implemented, you saw a rather
noticeable decline in the amount of over-the-counter business,
and what you are seeing now is we are seeing our domestic
business starting to pick back up. And I believe that that is
partly cyclical, but also because our customers and our end-
users, once again, the farmers of America are realizing there
is a lot of value added when doing over-the-counter-type
hedging, and they are coming back and they are saying maybe the
paperwork, yes, it is labor-intensive, and yes, it is almost
intimidating, but----
Mr. LaMalfa. Yes.
Mr. Maurer.--it is worth it to get the value-added services
that we offer.
Mr. LaMalfa. Good. Thank you.
I am about out of time. Mr. Campbell, I appreciate your
comments on how it applies to energy. Of course, we carried the
bill my last term here on how municipal utilities were affected
negatively by Dodd-Frank by having to be considered swap
dealers at that low threshold, and of course, this shows that
this--changes can be made in Dodd-Frank, at least on a subtle
level. We were successful on a bill getting out to the House,
for 23 to 0, that the CFTC later adopted those regs. And so I
am glad we could move the ball in that area here. So we as a
Committee certainly need to understand or know of certain areas
we can tweak to continue to have more opportunities for swaps
to be made and not have this regulatory burden to artificially
stop them and chill the market.
So with that, I will yield back my time. Thank you, Mr.
Chairman.
The Chairman. Thank you.
Mr. Scott?
Mr. David Scott of Georgia. Thank you.
One of the areas that I have been especially concerned
about is, in order for everything that we actually have done to
help you, and to put into H.R. 4413, requires the CFTC to do an
effective job. Each of you are stakeholders in this, with the
most direct exposure to how well the CFTC does its work, do you
feel the CFTC is adequately funded? Yes, any of you can answer
that. I think it is good to get a feel from you, if you all
think it is adequately funded or not.
Mr. Christie. Yes, it is obviously difficult to set an
absolute level of what funding should be, but one comment I
would make on that is that historically, when we have looked at
regulatory issues or position limits in particular, it has been
more of a collaborative relationship between the CFTC, market
participants, the exchanges, and even industry associations----
Mr. David Scott of Georgia. Yes.
Mr. Christie.--involved in that process. And that brought
some efficiency and some clarity to that process that a lot
recordkeeping maybe doesn't necessarily do as effective a job
as having a more of a conversational approach. To the extent
that it is driven by recordkeeping and reporting, that may
carry a cost burden that is higher than when it is more
collaborative and more shared across all market participants.
Mr. David Scott of Georgia. Yes, but are there any of you
here that feel it is not adequately funded, and needs to have
effective funding to do the job that we are asking them to do?
Ms. Cavallari. Yes.
Mr. David Scott of Georgia. Yes, Ms. Cavallari.
Ms. Cavallari. Yes, it is critically important that as we
are moving towards implementation, that we have shifted from
regulation and rules being promulgated by the CFTC, and
certainly the CFTC is a global leader in that----
Mr. David Scott of Georgia. Yes.
Ms. Cavallari.--in that construct in terms of tapping these
markets when other regulators are not as far along in their
rulemaking. As we shift towards that implementation, that is
where some of these issues are vitally important in terms of
getting it right. So it really reemphasizes the importance of
that, of the CFTC, in that process.
Mr. David Scott of Georgia. And so how important do you all
think it would be for us to ask the CFTC, in other words, to
allow for a delay in real-time swap reporting for non-financial
end-users whose swap activities can be identifiable in thinly-
traded markets in order to prevent them from being
competitively disadvantaged by the financial players? How
important is that? See, what I am trying to get at here is the
fact that, while we have you here, I just think it is important
because it is the CFTC that has to carry all of this out, and
my concern is that I feel, quite honestly, that all that we are
asking it to do, its workload has tripled, I just want to get a
feel from those of you who are impacted by the work of the CFTC
if we are giving them enough funding, if they have enough
staff. I think we have to look at that with a very serious
jaundiced eye as we move forward, especially for you all. You
are the ones, not me, but you are the ones that sort of have to
say, ``Hey, they may need to pick the wicket up here or do what
they should be doing in a better way.''
Mr. Maurer. I will agree with what Mr. Christie said
earlier. When you involve the end-user and the market
participants and get the voices of who the rules are actually
affecting, it creates a more efficient environment, and
hopefully one where the CFTC can make do with their current
budgeting. But I can't speak to the CFTC's budget, but I do
agree with Mr. Christie.
Mr. David Scott of Georgia. Well, let me ask you this, and
I will be thorough on it. Are there any areas, in your opinion,
of the Commission's work that you feel need more support? Is
there anything they are doing that affects you and which you
think we need to address that they could do better? I mean you
have a chance here to say something about them, but----
Mr. Christie. Yes.
Mr. David Scott of Georgia.--their feelings are not going
to be hurt. It would help us to either continue to fight for
them to get more or not. But if you all are happy, is there any
area in which you feel they need more support or can do better?
Yes, Ms. Cavallari?
Ms. Cavallari. Again, when it comes back to the
implementation of these particular regulations, the CFTC is
critically important in terms of how we go forward, and the
intersection of so many rules, not just that the CFTC makes,
but that has been emphasized in terms of cross-border, these--
we need to keep liquid markets and those market participants
active. And each one of us at the--this table actually
represents a different end-user, and I realize it is more of a
philosophical statement, but I truly believe that we need to
preserve, and the CFTC can help this, the liquidity of these
marketplaces.
Mr. David Scott of Georgia. Okay, well, thank you. But I
guess we could say all of you feel, in conclusion, that the
CFTC is doing a good job and has sufficient funding. Thank you,
sir.
Mr. Maurer. If I----
Mr. David Scott of Georgia. Pretty much?
The Chairman. Mr. Maurer, you can answer, but then we are
going to have to move to the next Member.
Mr. Maurer. Okay. The CFTC could be doing a better job of
getting the end-user and getting the people that are affected
by the rules into the rooms, and to get those people more
involved with the decisions and more involved with the
rulemakings so we can make the whole process more efficient for
everybody in the industry.
Mr. David Scott of Georgia. Well, thank you. That helps us
a lot.
The Chairman. Mr. Davis.
Mr. Davis. Thank you, Mr. Chairman. It was nice somebody
didn't care about hurting the CFTC's feelings today, so I
appreciated your comments, the honesty and openness is really
what we want, Mr. Maurer, and thank you for your comments on my
colleague, Mr. Scott's, question.
I want to thank the Chairman for calling this hearing
today. It is important that we do hear from end-users of
derivatives because as others on this Committee have stated, we
know that end-users didn't cause the financial crisis. End-
users, including many agribusiness leaders in my home State of
Illinois, they use derivatives to manage risks that are not
central to their commercial activities, and yet they continue
to deal with significant obstacles because of the CFTC,
regulations. that follow the passage of Dodd-Frank. So again,
Mr. Chairman, thank you.
And I would like to start my questions with Mr. Christie.
Can you describe for the Committee what type of financial
resources it takes for an ag, co-op, or a warehouse to hedge
its future purchase obligations in the futures market?
Mr. Christie. I can't comment on any specific firm what
resources might be required, but to the extent that you have a
wide breadth of tools to use, including exchange-traded
instruments or swaps, if that is appropriate for the particular
instance, that minimizes the resource requirement and it allows
for customization for a particular situation. Both of those
things are important for minimizing cost. There, obviously, are
capital requirements if you want to compete or participate in
an over-the-counter exchange, and that varies based on the size
of the business. So I couldn't comment on any individual, but
having access to a wide breadth of tools minimizes the costs
overall.
Mr. Davis. All right, well, thank you.
Mr. Maurer, at a hearing before this same Committee in
February, I expressed to Chairman Massad concerns I have with
the position limits rule. Specifically, I expressed my concern
with the so-called conditional limit proposal which would allow
traders to hold positions in cash-settled contracts of up to
five times the spot month limit, but only if they do not hold
any positions in physical delivery contracts.
Can you explain how the conditional limit proposal would
impact your business and the derivatives market in general?
Mr. Maurer. Thank you, Congressman. I would be happy to
give you my opinions on those. Our firm specifically does very
little business on the actual physical side and on the cash
side. We are more financially based, at least the INTL FCStone
Markets subsidiary, the company. I can give you my opinion on
two areas in position limits if that would be okay?
Mr. Davis. That would be great.
Mr. Maurer. Okay. So I believe that the aggregation of
position limits is one area that is affecting the company I
work for, the parent company has multiple different subsidiary
companies. We are talking merchants, I won't go through all the
names but they are all running separate, individual businesses.
And if you have a customer that needs to belong, let us say 100
corn swaps--or 100 corn futures, pardon me, in one of these
five subsidiaries, and then you have one in the other, and all
of a sudden you are tying up the full limit at this point. As a
company, we have to, at that point, pick which customer is more
important, or which business line is more important because
they are seen in aggregate. So what I would propose is that
each business unit have their own limit. We are monitoring in
that way now, it is preventing some of our customers to be able
to do all their hedging.
And then the second hedging that is necessary--and then the
second component would be the ability for the customers to--
what is a hedge. Mr. Christie spoke on that earlier. I think
that the definition of a bona fide hedge needs to be less
complex, and needs to be more broad and give our end-users the
ability to hedge their true needs. So----
Mr. Davis. All right, thank you.
Mr. Maurer, you mentioned the CFTC issues and what you
thought they could do to possibly improve some of their
interaction with end-users. I want to ask you a question about
if there is a disagreement with the CFTC, are there any
recommendations that you would have for this Committee for the
administrative hearings process, for the adjudication process,
or the conflict resolution process over a decision that the
CFTC has? I have had different interactions about some
frustrations that many end-users have with the CFTC in trying
to resolve a problem, so can you give me your opinion on what
they could do better?
Mr. Maurer. Well, you just hit it on the head there. I
think that when we have those interactions with the CFTC, and
when you are seeing a disagreement, the end-user needs to have
a voice. And having panels like this gives them a voice, and
there needs to be other avenues as well where we can reach out
to our Representatives and make sure they are aware of the
issues.
Mr. Davis. Thank you all very much for being here.
Mr. Maurer. Thank you.
The Chairman. Mr. Emmer.
Mr. Emmer. Thank you, Mr. Chairman. And I am going to--
forgive me, Mr. Campbell, I am going to start with you--I am
sorry, Mr. Peterson, because you are operating a business, and
this is kind of a rhetorical question but it applies to
everybody, and hopefully, it will make sense when I lead into
the next ones.
Could you just explain briefly why regulatory certainty is
so important from a business planning perspective?
Mr. Peterson. I am a Main Street merchant, and my customers
depend upon me in my hometown to deliver a commodity that is
essential to their wellbeing. I deliver heating oil. And it is
essential for them to--we just went through, in Massachusetts,
we were in the national news, some very cold weather, some
adverse situations, and our customers have a basic
understanding that these basic commodities of life are going to
end up on their doorstep in a timely manner, and that they are
going to be treated fairly and priced fairly so that we do not
have wild swings in price.
I am an end-user, and when I hedge, I have the expectation
is that I do take final delivery, and I can't--there are very
seldom, except in a few option series, but most cases, my
hedging is entirely with physical delivery. So for me, price
discovery and transparency of the transaction is paramount. And
since Dodd-Frank and Title VII has come through, is that we
have seen there has been more transparency in the aggregate,
and more price discovery that makes me more comfortable with
how I make presentations to my customers, who I see every day
on Main Street.
I can't speak to some of the internal rules and regulations
because most of my trading goes through a swap dealer, so they
deal with the staff in Wall Street, but I look to take physical
delivery.
Mr. Emmer. Fair enough. And, maybe it was inappropriate to
pick on the business guy that is delivering the heating oil
because, where I was going is, certainty is what the issue is
for most businesses. You can adjust, but you need to be able to
plan for the future, and these sudden changes make it very
difficult.
Mr. Christie, I am going to ask you, has the CFTC's
approach to rulemaking and the resulting rules caused you to
restructure, reduce hedging, change your means of hedging, or
trade less efficiently, and if it has, I ask this of Mr.
Campbell and Ms. Cavallari as well, but if it has, can you
explain how?
Mr. Christie. In the case of rule 1.35, we have made
changes in our organization to limit the points and means of
contacts that we have with the market in order to meet
recordkeeping requirements on cash transactions that may lead
to a derivatives transaction.
Our greater concern would be if CFTC were to go ahead with
a narrow definition of bona fide hedges, that would have a very
broad and very widespread impact on our commercial activities,
and that would be of significantly greater scale than the
changes that we have had to make so far around rule 1.35.
Mr. Emmer. Well, that is actually a question for--that I
was going to say, but I can see I am going to run out of time.
Ms. Cavallari, Mr. Campbell, if you want to add to Mr.
Christie's comments that would be great, but if you could all
just address, in the time I have left, on this definition of a
bona fide hedge, do you think Congress needs to be more
explicit in defining what that is?
Mr. Campbell. There is a definition in the Commodity
Exchange Act that is pretty good. I think the issue that we are
most concerned about from the end-user's side is the CFTC
narrowing that definition even further, and really kind of
picking away at practices that we have engaged in, sound risk-
management practices, for years. So it is really more of a
narrowing of the definition that Congress provides, as opposed
to the definition itself.
Mr. Emmer. So it might be helpful if Congress would be more
explicit with the definition so that it isn't narrowed?
Mr. Campbell. Yes.
Mr. Emmer. All right. All right, and then I don't know if
you had anything more to add on whether or not these other
things have affected your ability to hedge, and you have had to
restructure.
Ms. Cavallari. We have had to more closely examine the
costs and what they are for the end-user in terms of the
opportunity, whether we are looking at futures, cleared swaps,
or bilateral swaps. So that component, the indirect cost, if
you will, of regulation has trickled down specifically into
costs for the end-user. So because of that, we are more closely
examining what specific instruments are appropriate for a
pension plan to use.
Mr. Emmer. Thank you.
I see my time has expired. I yield back.
The Chairman. Mr. Neugebauer.
Mr. Neugebauer. Thank you, Mr. Chairman. Thanks for holding
this hearing. And I apologize, some of these questions may have
already been asked but I didn't get to hear the answer. Mr.
Christie, the Commission closed out its comments on the
proposed position limits. And when I was back home last week, I
heard from the cotton industry, specifically from the risk co-
ops on the concern about being able to market and hedge the
cotton farmer, the producers, as those producers put that
cotton in the cooperatives. And the, of course, comes around
the bona fide hedge. Can you kind of describe the problems that
that could potentially create for those cooperatives, and how
that might impact--the person I am most concerned about is that
producer that has put his cotton with the cooperative and
hoping that they are going to be able to use all the tools to
get him the best return on his cotton that he can?
Mr. Christie. Thank you for the question. And, your
district is an important one for us. We buy a lot of cotton out
of that area, so I am happy to answer that question.
Particularly in west Texas, it is a dryland cotton
production, it is very dependent on weather, and that can
include favorable or unfavorable weather events. And in the
case of a co-op, members are typically putting all of their
production into that co-op, so it is important that the
managers of that organization can consistently reflect their
real-time view of how much production is going to be coming at
them and be able to actively hedge that. If we had a very
narrow definition of bona fide hedges where a fixed price
needed to be attached to that cotton, or a fixed volume, that
would limit the ability to make anticipatory hedges on that
obligation. It is a very real concern that market participants
have the ability to anticipate production and make hedges
accordingly.
Mr. Neugebauer. And are you concerned that the Commission's
current position on that, or where you think they are headed,
is going to be problematic for those cooperatives?
Mr. Christie. I think the risk or the concern would be that
conditions change very dynamically, and so to have a single
definition or a single line around what constituted a bona fide
hedge, can be challenging because associated risk with that, it
could be price risk, it could be delivery risk on forward
commitments, there are a lot of things that could enter into
the risk picture, and so letting people make economically-
appropriate hedges that mitigate risk, it is important that
they have that degree of freedom to do that.
Mr. Neugebauer. So here is just a general question, because
one of the concerns I have about when we start down the road of
position limits and so forth is making sure that we have an
appropriate amount of liquidity in the marketplace, and when
you start beginning to say you can play, and you can't play,
then I worry about that. Would--just in a general--Mr.
Campbell, would you like to reflect on that?
Mr. Campbell. Yes, and thank you. Because, loss of
liquidity in the markets not only impacts your ability to
access markets to hedge, but there is a lot of value in the
futures markets for transparency. We use the futures markets
for the price signal we get to price the contracts we enter
into in the physical space. So if you have less liquidity and
wider bid of spreads, it gets really difficult to price
contracts in the physical space. So it can certainly impact all
aspects of business, not just our ability to hedge.
Mr. Neugebauer. Yes, ma'am. Ms. Cavallari.
Ms. Cavallari. Again, I couldn't agree more with Mr.
Campbell. An important part of liquidity is also the diversity
of the market participants, and having that diversity of market
participants, it is just crucial that that be preserved because
that just only contributes to the overall efficiency of these
markets.
Mr. Neugebauer. Anything? I think that one of the questions
I would have, what is remaining, are there safeguards already
in place that would--what people want to make sure with
position limits is somehow somebody is manipulating the price
by the number of positions they have. Do you feel like there
are already within the system protections, and we don't need to
tighten those rules up? It is a question.
Mr. Campbell. I will go out on a limb here and try to
answer it. I think everybody supports the ability to hedge. I
think most people recognize the value of speculators and to
providing liquidities and providing counterparties for those
looking to hedge. I don't think anybody to date has actually
identified what an excessive speculator looks like.
Mr. Neugebauer. Yes.
Mr. Campbell. So I will leave it at that. I think liquidity
is vital to the entire financial system and the entire energy
and commodity markets.
Mr. Neugebauer. Well, we need people on both sides of the
transaction or there is no marketplace.
Mr. Campbell. Absolutely.
Mr. Neugebauer. Mr. Chairman, thank you.
The Chairman. Thank you. I have one last question and then
I will turn it over to Mr. Scott, if he has any closing
comments, and then we will adjourn. But this deals with the
recordkeeping. And Mr. Christie, the expanded recordkeeping
requirements enacted by the CFTC, were they called for in the
Dodd-Frank Act, and is the Commission's proposed relief
adequate for you and for your customers on the recordkeeping?
Mr. Christie. Being several years down the road, it is
probably difficult to form an opinion on what was initially
envisioned. I do think that, to the extent that cash
transactions and cash discussions are subject to the same
recordkeeping records as futures transactions or swap
transactions, that is a broader universe than what maybe was
initially envisioned. So while there is clearly a connection
between cash transactions and eventually derivative
transactions, having comparable recording requirements is a
pretty broad application.
The Chairman. All right.
Mr. Scott, before we adjourn, I just want to recognize you
for any closing statements that you may have.
Mr. David Scott of Georgia. Sure. First of all, this has
been a very, very informative hearing. Before us is an
opportunity to reintroduce some much-needed legislation, and we
are going to basically mirror this legislation after the one we
did last year, H.R. 4413, that will give some clarity. That
would also mainly make sure end-users and the commodities and
agriculture, energy, those that are not financial entities, are
not dealt with the same way, because it is not fair to you.
I am also very concerned, as I mentioned in my statement,
that we make sure, and I hope that as you move forward, it is
very important that the CFTC have the financial resources to do
this job. If it doesn't have those financial resources, I mean
their workload has tripled as a result of the meltdown. Burnout
rate has been tremendous. It is a new Commission. They are the
ones that have to carry this forward to make sure we have
smooth sailing in dealing with the swaps market and the
derivatives. It is a very complicated, complex area. It is now
nearly $700 trillion of the world's economy, and we are the
biggest player in that economy, and we want to maintain that as
we move with things like cross-border, push-out, all of that
that affects end-users, that not be categorized in there where
you have to be pushed out of one bank, where you need to be in
there where you can do your hedging with--especially interest
rate swaps, which is the pivot swap to hedgers. So this is a
very complex, complicated area we are dealing with, and we want
to make sure, and we will, that we get some good legislation
that is bipartisan that reflects your concerns.
And again, we want to make sure--I am very worried about,
as you can imagine from my comments, that we make sure that we
give the CFTC the resources that are needed, because if they
don't, it is going to back-up and be more detrimental to you.
So, Mr. Chairman, it is a pleasure working with you. This
is our first hearing----
The Chairman. Thank you.
Mr. David Scott of Georgia.--together.
The Chairman. Yes, sir.
Mr. David Scott of Georgia. Thank you very much.
The Chairman. And I too am committed to a piece of
legislation that will increase access and integrity in the
market, because that is key for all of us. And I want to thank
you for coming and testifying today. These are complex issues,
and we need to hear from those of you who deal with them on a
daily basis, so thank you all for coming.
And under the rules of the Committee, the record of today's
hearing will remain open for 10 calendar days to receive
additional material, and supplementary written responses from
the witnesses to any questions posed by a Member.
The Subcommittee on Commodity Exchanges, Energy, and Credit
hearing is now adjourned.
[Whereupon, at 3:06 p.m., the Subcommittee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Letter by Hon. Collin C. Peterson, a Representative in
Congress from Minnesota; on Behalf of Paul N. Cicio, President,
Industrial Energy Consumers of America
March 24, 2015
Hon. Austin Scott, Hon. David Scott,
Chairman, Ranking Minority Member,
Subcommittee on Commodity Subcommittee on Commodity
Exchanges, Energy, and Credit, Exchanges, Energy, and Credit,
House Committee on Agriculture, House Committee on Agriculture,
Washington, D.C.; Washington, D.C.
Re: Public Hearing_CFTC Reauthorization
Dear Chairman Scott and Ranking Member Scott:
Thank you for having the hearing entitled ``Reauthorizing the
Commodity Futures Trading Commission: End-user Views.'' The Industrial
Energy Consumers of America (IECA) * fully endorses the testimony of
Howard Peterson, Owner and President of the Peterson's Oil Service in
behalf of the New England Fuel Institute.
---------------------------------------------------------------------------
* The Industrial Energy Consumers of America is a nonpartisan
association of leading manufacturing companies with $1.0 trillion in
annual sales, over 2,900 facilities nationwide, and with more than 1.4
million employees worldwide. It is an organization created to promote
the interests of manufacturing companies through advocacy and
collaboration for which the availability, use and cost of energy, power
or feedstock play a significant role in their ability to compete in
domestic and world markets. IECA membership represents a diverse set of
industries including: chemical, plastics, steel, iron ore, aluminum,
paper, food processing, fertilizer, insulation, glass, industrial
gases, pharmaceutical, building products, brewing, independent oil
refining, and cement.
---------------------------------------------------------------------------
IECA represents energy-intensive trade-exposed manufacturing
companies whose competitiveness is dependent upon the cost of natural
gas and electricity. The industrial sector consumes up to \1/3\ of the
U.S. natural gas and electricity. Therefore, we are an important
stakeholder on these important issues.
We look forward to working with you.
Paul N. Cicio,
President.
______
Submitted Questions
Response from Douglas Christie, President, Cargill Cotton; on Behalf of
Commodity Markets Council
Questions Submitted by Hon. Austin Scott, a Representative in Congress
from Georgia
Question 1. Mr. Christie it is my understanding that CFTC guidance
and staff interpretations do not carry the weight of law and that CFTC
staff ``no-action'' letters typically carry the disclaimer that the
terms of the letter could be changed or revoked at any time. Why is the
Commission rulemaking process with comment periods and votes better for
business planning?
Answer. Notice and comment rulemaking allows for a full, complete
and transparent exposition of CFTC's proposal by all parties involved
in the rulemaking. The publication of the proposal allows the CFTC to
explain the agency's point of view on the matter and allows the public
time to consider those views and develop comments in response to the
agency's point of view. This process is governed by the Administrative
Procedures Act (``APA'') which is generally understood by all parties.
The process is transparent and known. Once a rule is finalized,
participants in the process have confidence in the outcome and they
have certainty because the rule cannot be changed absent a similar
rulemaking, with notice and comment. This process also requires
approval by a majority vote of the Commission.
The agency has made some regulatory decisions by staff ``no-
action'' letters. This process lacks the transparency that is present
in the full rulemaking process discussed above. Since the decisions are
made at the staff level, not the Commissioner level, decisions could be
revoked at any time. Many decisions made by the CFTC, whether through
rulemaking or staff guidance require outlays of time and resources to
ensure compliance by the regulated party. A staff ``no-action'' letter
that could be revoked at any time could end up with sunk costs by
regulated parties should the staff or the Commission revoke a no-action
letter if staff change their view. This could occur without the due
process that is afforded regulated parties under a public notice and
comment rulemaking process set out in the APA. Rulemakings for
compliance purposes should be subject to notice and comment rulemakings
for this reason.
There may be instances in which an individual firm presents unique
circumstances that the agency needs to judge on a case-by-case basis.
In these cases staff ``no-action'' letters are entirely appropriate.
This has been the history of staff ``no-action'' letters. The CFTC
should reserve ``no-action'' letters for this purpose and not use them
as an expedient substitute for notice and comment rulemaking.
Otherwise, regulated entities may be deprived of due process,
transparency and long-term confidence in the outcome.
Question 1a. Can you provide examples of a time when your
businesses had to rely on the relief of a ``no-action'' letter or had
to seek clarification on regulations from CFTC's general counsel? How
did that process work? Legally, how comfortable were you in the result?
Answer. There have been circumstances in the past when Cargill has
requested and received staff ``no-action'' letters. We have also had
occasion to consult with the CFTC Office of General Counsel to receive
clarification of Commission regulations. These steps were generally
taken to better understand specific regulatory requirements or to
clarify statutory obligations in the absence of regulatory guidance.
The agency provided the necessary clarity needed at the time.
Question 2. Mr. Christie, in your testimony you discuss the
deliverable supply data the Commission is using to inform its position
limits rule, which you say is leading to ``conservative estimates.''
Generally, we support erring on the side of caution. Can you explain
why a conservative estimate is not a prudent option here?
Answer. The deliverable supply estimates used by the CFTC should be
as accurate as possible to ensure that the position limits established
by the agency are consistent with the volumes of product that are used
in commerce. If the deliverable supply estimates are too conservative,
then position limits may be set at too low a level to allow for price
discovery and risk management. This could hinder the proper function of
the marketplace for those market participants that use the markets for
risk management.
Response from Lael E. Campbell, Director of Regulatory and Government
Affairs, Constellation Energy (An Exelon Company); on Behalf of
Edison Electric Institute
Questions Submitted by Hon. Austin Scott, a Representative in Congress
from Georgia
Question 1. Mr. Campbell it is my understanding that CFTC guidance
and staff interpretations do not carry the weight of law and that CFTC
staff ``no-action'' letters typically carry the disclaimer that the
terms of the letter could be changed or revoked at any time. Why is the
Commission rulemaking process with comment periods and votes better for
business planning?
Question 1a. Can you provide examples of a time when your
businesses had to rely on the relief of a ``no-action'' letter or had
to seek clarification on regulations from CFTC's general counsel? How
did that process work? Legally, how comfortable were you in the result?
Answer 1-1a. Electric utilities value the regulatory certainty
provided by a formal rulemaking process. As outlined in the
Administrative Procedures Act, there are a number of benefits
associated with a transparent rulemaking process with the notice and
the opportunity for public comment. First, all interested and affected
stakeholders have the opportunity to participate in the process using
formal rules for participation which creates a public record. Second,
all the Commissioners participate in the process and a majority need to
agree in order to have a final rule. Third, the Commission needs to
engage in this process in order to change the final rule. EEI members
are non-financial entities that primarily participate in the physical
commodity market and rely on swaps and futures contracts to hedge and
mitigate their commercial risk. The goal of our member companies is to
provide their consumers with reliable electric service at affordable
and stable rates, which has a direct and significant impact on
literally every area of the U.S. economy. Since wholesale electricity
and natural gas historically have been two of the most volatile
commodity groups, our member companies place a strong emphasis on
managing the price volatility inherent in these wholesale commodity
markets to the benefit of their consumers. The derivatives market has
proven to be an extremely effective tool in insulating our consumers
from this risk and price volatility. As such, the regulatory certainty
provided by a formal rulemaking process is invaluable to EEI members
who rely on this certainty to make long term business decisions and
investments in compliance and operational infrastructure.
In the absence of authoritative action by the Commission, ``no
action letters'', notwithstanding their unofficial status, assume a
considerable degree of importance to market participants in planning
transactions and conducting business.\1\ However, ``No action letters''
are not provided through a transparent process and affected
stakeholders may not have the opportunity to provide comment or may not
even know that a ``no action letter'' that could potentially affect
their business is being contemplated. Since they are not formal
Commission action, the letter does not bind Commissioners and can be
revoked or expire.
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\1\ Section 140.99 of the Commodity Exchange Act defines ``no
actions letters'' as a written statement issued by the staff of a
Division of the Commission or of the Office of the General Counsel that
it will not recommend enforcement action to the Commission for failure
to comply with a specific provision of the Act or of a Commission rule,
regulation or order if a proposed transaction is completed or a
proposed activity is conducted by the Beneficiary. A no-action letter
represents the position only of the Division that issued it, or the
Office of the General Counsel if issued thereby. A no-action letter
binds only the issuing Division or the Office of the General Counsel,
as applicable, and not the Commission or other Commission staff. Only
the Beneficiary may rely upon the ``no-action letter.'' As such, no
action letters are informal and advisory, rather than official and
definitive. Courts may also rely on a ``no action letter'' to resolve
legal disputes.
---------------------------------------------------------------------------
There have been a number of instances where the industry has had to
rely on the ``clarification'' as well as additional regulatory
requirements imposed by ``no action letters.'' These include no-action
relief addressing the reporting of trade options, which imposed new
regulatory requirements, no-action relief regarding the reporting of
inter-affiliate transactions, and interpretive guidance under the
products definition relating to facility usage contracts and forwards
with embedded volumetric optionality. While these actions have provided
welcome relief to EEI members and other end-users, they do not provide
any long term certainty to the market as they lack formal legal
authority.Although the clarifications in these no-action letters were
needed, many EEI members have not been comfortable making long term
investment decisions on these informal letters issued by Commission
staff.
Question 2. Mr. Campbell, in your testimony, you raised concerns
about the CFTC's position limit proposals. Do you think the exchanges
do a sufficient job of setting and policing position limits in the
energy markets? Are there potential consequences to limiting the
ability of participants to trade in derivatives markets?
Answer. Yes, EEI members that conduct hedging transactions on DCMs
are comfortable with the way position limits are administered at the
exchange level. Exchanges have experience with our hedging practices
and there is confidence from energy market participants that they will
appropriately administer their position limits regimes and recognize
industry-accepted hedging practices. The exchange administration of
position limits incorporates both enumerated and non-enumerated hedge
exemptions. This is why it is so critical that Congress preserve a bona
fide hedge definition that does not restrict the broad recognition of
hedging activities that are required to manage risk in the complex
world of physical commodities.
Limitations on the ability of participants to trade in derivatives
markets have a detrimental impact on liquidity, the most vital element
of a well-functioning market. Inadequate liquidity widens bid/ask
spreads, adds volatility to the market, negatively impacts price
transparency, and increases the cost of hedging all around. The risks
and costs of illiquid markets ultimately will be reflected in higher
prices paid by end use consumers.
The derivatives market has proven to be an extremely effective tool
in insulating our consumers from this risk and price volatility.
However, as market liquidity goes away the markets become less
effective in reaching this goal. Legislators and policy makers should
be doing everything in their power to increase liquidity in the market.
Instead regulatory trends have had the opposite impact of decreasing
liquidity, which increases risk, increases hedging costs, and
ultimately results in an increase of the price consumers pay for the
energy we provide.
Question 3. Mr. Campbell, how have energy companies, specifically,
been impacted by the CFTC deciding to regulate forward contracts with
imbedded ``volumetric optionality'' as swaps? What are the future
consequences of this regulatory over-reach if the CFTC does not change
its regulations? Does the CFTC's proposed rule regarding volumetric
optionality address industry concern? If not, what more needs to be
done to provide companies the certainty they need to continue operating
under their current business models?
Answer. The Commission has created significant regulatory
uncertainty and regulatory costs for end-users, such as EEI members, by
determining, contrary to 30 years of precedent and the clear language
of the CEA, that all commodity options, including commodity trade
options that are intended to physically-settle, are included in the
defined term ``swap.'' CEA 1a(47) provides that a commodity option is a
``swap,'' except if the nonfinancial commodity transaction for deferred
shipment or delivery is intended to be physically settled. By
classifying these physically settled transactions as trade options with
recordkeeping and reporting requirements, the Commission has imposed
regulatory costs on end-users on contracts that are traditionally used
to manage the volatility in the electric and natural gas markets as
well as customer needs.
While the Commission has tried to address industry concerns by
issuing further clarification on the seven factor test for volumetric
optionality as well as its proposed trade option rule, the relief does
not go far enough as it still requires end-users to jump through
regulatory tests that still may result in contracts that are intended
to physically settle falling under the CFTC's definition of a ``Swap''.
The best outcome would be for the Commission, consistent with the
language in the CEA, to exclude from the definition of a ``Swap'' all
transactions that are intended to be physically settled at the time the
contract is entered into. This would provide clear guidance to the
industry and allow them to continue to meet the needs of its consumers.
Question 4. Mr. Campbell, the swap dealer de minimis threshold is
based on notional value. That may work for interest rate swaps, but in
the commodities markets rising prices could push entities over the
threshold without them changing their trading. In fact, entities might
be forced to reduce trading when faced with rising prices, reducing
liquidity at exactly the wrong time. How do you suggest the CFTC
address this issue?
Answer. Regulatory certainty and the opportunity for regulatory
input are important to our industry. Rather than have a regulatory
cliff in which there is a dramatic reduction from $8 billion to $3
billion absent Commission action, the Commission should be required to
affirmatively act and solicit comments through a transparent rulemaking
process before making any changes. A deep automatic reduction in the de
minimis level could hinder the ability of end-users to hedge market
risk while imposing unnecessary costs that eventually will be borne by
consumers.
Under current market conditions, where we are at a low price point
in the commodity cycle, $8 billion is an appropriate floor for the swap
dealer de minimis threshold. While the current threshold has resulted
in entities that are materially engaged in the business of swap dealing
to register, it has not stifled the ability for end-users to enter into
swaps with each other, which is very critical in energy markets.
However, as commodity prices increase EEI members may encounter
unnecessary pressure under the current $8 billion threshold. One way to
address this would be to establish $8 billion as a floor, but provide a
mechanism whereby the threshold could increase over time as commodity
prices increase, similar to the annual adjustment of the consumer price
index.
Response from Lisa A. Cavallari, Director of Fixed Income Derivatives,
Russell Investments; on Behalf of American Benefits Council
Questions Submitted by Hon. Austin Scott, a Representative in Congress
from Georgia
Question 1. Ms. Cavallari, it is my understanding that CFTC
guidance and staff interpretations do not carry the weight of law and
that CFTC staff ``no-action'' letters typically carry the disclaimer
that the terms of the letter could be changed or revoked at any time.
Why is the Commission rulemaking process with comment periods and votes
better for business planning?
Answer. The traditional rulemaking lifecycle involves proposed
rules, consultations and comment periods, and sometimes public
hearings, all of which eventually lead to final rules. Industry
engagement and cooperation with regulators plays a critical role in
helping to inform the Commission and its staff and to improve the
effect of final rules. Business planning mirrors the iterative
rulemaking process. As the regulatory process reaches its crescendo,
business planning must become concrete and actionable as businesses
need to invest in and implement new systems, personnel, controls, and
tools to help comply with forthcoming regulations.
No-action letters serve a tremendously important role in the
regulatory process. It is unrealistic to expect that any regulatory
agency will get a new regulation `right' on the first try. What works
for 95% of the market may not make sense for the other 5% of the market
so regulators need the latitude to adapt. No-action letter relief is a
valuable, cost and time efficient tool to regulators and the regulated
alike in that it enables regulators to navigate untested waters and
adjust for unintended consequences that could not have been fully
anticipated in the rulemaking process. But it is just that . . . an
instrument for fine tuning, not a substitute for thoughtful regulation.
Among many reasons for this is that no-action letters are highly fact
specific and often highly company or product specific. This limits
their utility to the broader market. Furthermore, because they are fact
dependent and not principles-based, they can quickly become dated as
technology or best practices evolve. This further limits their utility
and, unlike principles-based regulation, does not promote innovation
and could, at worst, stifle innovation. Last, where no-action relief or
other regulatory guidance is intended to be of market-wide application,
it provides far less certainty than regulation which is less
susceptible to revocation or rapid change.
Question 1a. Can you provide examples of a time when your
businesses had to rely on the relief of a ``no-action'' letter or had
to seek clarification on regulations from CFTC's general counsel?
Answer. Russell has relied on no-action letters with respect to
certain aspects of derivatives trading such as No-Action Letter 14-01
which extended temporary no-action relief from certain Dodd-Frank
cross-border swaps activities. We have not, however, directly sought
clarification from CFTC's general counsel about CFTC regulations.
Question 1b. How did that process work? Legally, how comfortable
were you in the result?
Answer. Using No-Action Letter 14-01 as an example, the process was
not ideal. While the relief was appropriate and welcomed, it provided
only temporary relief to a highly complex challenge facing global
regulators and markets. Ahead of the expiration of the relief (first in
January 2014 and then again in September 2014), businesses like ours
had to anticipate and plan as though that relief may not be extended or
that the rules themselves may not be modified. All too often, relief
comes at the 11th hour. This amplifies the ambiguity and consumes
valuable resources, neither of which helps us achieve our purpose of
improving financial security for our clients.
Question 2. Ms. Cavallari, some, including Commissioner Giancarlo,
have suggested that imposing futures-market style rules on the
unregulated swaps market was a mistake. Do you agree with this
assessment?
Answer. Yes. The OTC swaps market grew independently of futures
markets largely because specific investment needs could not be met
directly using futures. At Russell, we believe that there is a place
for listed futures, cleared swaps and other bilateral OTC swap
products. Futures market style rules will never fully displace cleared
or bilateral OTC swaps.
Question 2a. Have the new rules been harmful to your clients?
Answer. Some of the rules have been detrimental to our clients,
especially those imposing futures-type rules. As Commissioner Giancarlo
iterates in his white paper, Pro-Reform Reconsideration of the CFTC
Saps Trading Rules: Return to Dodd-Frank, such rules are an artificial
construct.
Question 3. Ms. Cavallari, can you explain how the Commission's
proposed position limits and aggregation rules would impact pension
funds?
Answer. Russell interprets this question as directed towards
commodities. Pension plans allocate to a wide variety of asset classes
and commodities can be an appropriate asset class for pension plans.
Access to commodities exposure is obtained from both futures and OTC
swaps. Position limits and aggregation are metrics that both a swap
dealer and a pension plan must acknowledge and track. A swap dealer may
become constrained in terms of what it can offer a pension plan
customer due to position limits. This prevents a Russell pension plan
client from obtaining exposure vital for the plan. Alternatively the
limits could create a situation where the swaps offered by the swap
dealer are prohibitively expensive. For a pension plan, real-time
continuous monitoring of all of its investment managers' commodities
holdings may not be operationally feasible. If this is the case, the
plan may choose to avoid the commodities allocation altogether. This
would be a sub-optimal outcome.
Question 3a. From your perspectives, is it possible to comply with
them as they have been proposed?
Answer. Currently, the rules create a number of operational
challenges for our clients as noted and may eventually curb their
access to these important risk-hedging products.
Question 4. Ms. Cavallari, the Commodity Exchange Act states that
the Act shall not apply to swap activities outside the United States
that do not have a ``direct and significant'' connection with
activities in, or effect on, commerce of the United States. Has the
CFTC adequately clarified what exactly is a ``direct and significant''
connection to U.S. commerce?
Answer. No.
Question 4a. How do you and your customers comply with the CFTC's
guidance?
Answer. Russell spends a great deal of time attempting to
triangulate between (i) the domicile of our clients who use our trading
services, primarily our commingled funds and third-party institutional
clients such as pension funds, (ii) the domicile of the swap dealer who
is facilitating compliance, and (iii) the domicile of other parties who
are part of the trading process such as custodians or other investment
managers to whom we outsource some investment activities for our funds
or clients. The ambiguity of the current regulations is immense and
creates challenges for firms like ourselves, for our vendors, and for
our clients to navigate especially in this globally interconnected
world where staff of all parties is dispersed. This challenge is
amplified due to similar emerging regulating coming into force in other
global markets with inadequate harmonization or coordination. Moreover,
as we learned during the Global Financial Crisis and other events
involving financial volatility, our markets are inextricably tied such
that, in any given situation, someone could claim that an activity has
the potential to have a direct and significant connection with
activities in, or effect on, the United States.
Response from Mark Maurer, Chief Executive Officer, INTL FCStone
Markets, LLC
Question Submitted by Hon. Austin Scott, a Representative in Congress
from Georgia
Question. Mr. Maurer can you explain how the Commission's proposed
position limits and aggregation rules would impact swaps dealers? From
your perspectives, is it possible to comply with them as they have been
proposed?
Answer. Three main points on position limits affect INTL FCStone
Markets, LLC's customers:
1. The market requires a broader definition of a bona fide hedge.
The definition should not operate in practice to restrict
normal hedging practices. If it does, then it will disrupt
the marketplace and our customer's operations.
2. In practice, scaling down position limits should not affect cash
contracts, as this disrupts the ability of the futures
contract to mimic a true hedge. Requiring hedgers to get
out of a contract that is cash settled disrupts the
intended purpose of the hedge exemption.
3. On spreads, there is danger in taking a narrow view of absolute
price risk. We must not fail to consider the multiple risks
of a commercial operation, otherwise, we risk bid-offer
spreads and credit risk spreads will widen and reduce
liquidity. This leads to wider risk premiums throughout the
business channel, which will ultimately be a cost passed on
to end-users and consumers.
The industry expressed concern about the CFTC's view of
unfixed price
commitments, which failed to recognize hedging needs of
unfixed price con-
tracts (i.e., basis contracts) as bona fide hedging. The
business of
merchandising is conducted substantially in the form of
basis contracts.
Merchants must be allowed to utilize hedging strategies,
including calendar
spread hedging to manage this risk.
One of the main reasons for hedging is to turn flat
price risk into relative
risk, and by taking flat price risk and offsetting it
with a futures position,
a commercial firm creates exactly unfixed or basis
positions, the same posi-
tions the CFTC has resisted to recognize as a bona fide
hedge.
Although basis risk is generally less volatile than flat
price risk, it is not
always the case--basis and unfixed positions still
maintain risk and must
be allowed to be hedged, managed and recognized.
Attached, CMC's comment letter which INTL FCStone
Markets, LLC par-
ticipated in drafting, illustrates informative examples.
Last, I wish to take this opportunity to reiterate our concerns
regarding margin for uncleared swaps.
B. Margin for Uncleared Swaps:
Many swap dealers expect to continue to collect margin
from end-users in order to manage risk, even if the rules
say it is not required for end-users.
To the extent swap dealers continue to collect margin,
many in the industry believe that the treatment of margin
should remain intact, i.e., the swap dealers be allowed to
use that margin to purchase futures contracts to mitigate
risk, and manage the customer's hedge.
Of course, if customers seek to segregate margin, they
have the option to do so. However, the requirement to
segregate margin should not be mandatory, if, margin is
used to facilitate the customer's hedge, which will retain
costs to end-users and consumers at current levels, rather
than shift extraordinary costs to end-users and customers.
Attached, INTL FCStone Market's comment letter in this
regard.
Please give me a call with any questions or if INTL FCStone
Markets, LLC can be of further assistance. These are critically
important issues to our agricultural customers, and all of our
customers appreciate an approach aimed to facilitate their important
commercial hedging needs.
Regards,
Catherine E. Napolitano,
Deputy General Counsel.
attachment 1
March 28, 2015
Via Electronic Submission
Chris Kirkpatrick,
Secretary,
Commodity Futures Trading Commission,
Washington, D.C.
Re: Re-Opening of Comment Period Regarding the Commodity Futures
Trading Commission Energy and Environmental Markets
Advisory Committee Discussion of Position Limits for
Derivatives (RIN 3038-AD99) and Aggregation of Positions
(RIN 3038-AD82).
Dear Mr. Kirkpatrick:
The Commodity Markets Council (``CMC'') appreciates the opportunity
to submit the following comments to the Commodity Futures Trading
Commission (the ``CFTC'' or ``Commission'') as part of its reopening of
the comment period for its proposed rules on position limits for
physical commodity derivatives and the aggregation of positions.\1\
---------------------------------------------------------------------------
\1\ See Position Limits for Derivatives and Aggregation of
Positions, 80 Fed. Reg. 10022 (Feb. 25, 2015) (proposed rule, reopening
of comment period).
---------------------------------------------------------------------------
I. Introduction
CMC is a trade association that brings together exchanges and their
industry counterparts. Its members include commercial end-users which
utilize the futures and swaps markets for agriculture, energy, metal
and soft commodities. Its industry member firms also include regular
users of such designated contract markets (each, a ``DCM'') as the
Chicago Board of Trade, Chicago Mercantile Exchange, ICE Futures U.S.,
Minneapolis Grain Exchange and the New York Mercantile Exchange. They
also include users of swap execution facilities (each, a ``SEF''). The
businesses of all CMC members depend upon the efficient and competitive
functioning of the risk management products traded on DCMs, SEFs or
over-the-counter (``OTC'') markets. As a result, CMC is well positioned
to provide a consensus view of commercial end-users on the impact of
the Commission's proposed regulations on derivatives markets. Its
comments, however, represent the collective view of CMC's members,
including end-users, intermediaries and exchanges.
II. The Proposed Position Limits
The CMC has submitted several comment letters to the Commission
regarding its Proposed Position Limits rules.\2\ Rather than repeat
prior comments, the CMC would like to use this opportunity to highlight
some of the issues raised at the February 26, 2015 Energy and
Environmental Markets Advisory Committee (``EEMAC'') meeting and issues
related to the new position limits table 11a.
---------------------------------------------------------------------------
\2\ September 24, 2013--http://www.commoditymkts.org/wp-content/
uploads/2014/05/CMC-Final-Anticipatory-Hedge-9.24.13.pdf; February 10,
2014--http://www.commoditymkts.org/wp-content/uploads/2014/05/CMC-
Position-Limits-Comment-Letter-2-10-2014.pdf; July 25, 2014--http://
www.commoditymkts.org/wp-content/uploads/2014/07/CMC-PL-Roundtable-
Comment-Letter-FINAL.pdf; January 22, 2015--http://
www.commoditymkts.org/wp-content/uploads/2015/02/CMC-Position-Limits-
Comment-Letter-1.22.15-AS-FILED-.pdf.
---------------------------------------------------------------------------
Comments Related to the February 26, 2015 EEMAC Meeting
A. Bona Fide Hedging in General
Pursuant to the Dodd-Frank Act, position limits are to be used, not
to prevent speculation, but only to prevent excessive speculation, to
the extent it exists. Dodd-Frank was never intended to focus on
commercial market participants, such as CMC members, engaging in
hedging activity. This is not surprising given that the list of market
events that led to the passage of Dodd-Frank does not include trading
in the agriculture or energy markets, and it certainly does not include
allegations of speculative trading by commercial market participants
disguised as bona fide hedging. Unfortunately, in an attempt to address
concerns about how one might disguise speculative conduct as hedging,
the proposed rules will curb the legitimate practice of hedging.
Unfortunately, the proposed rules will curb the practice of hedging
by producers, end-users and merchants. Merchants play a critical role
in the marketplace by, among other things, promoting convergence
between the physical and futures markets. Convergence is a crucial
aspect of the price discovery function and markets with effective
convergence ultimately reduce risk and provide liquidity. Merchants
face, accept, and manage several different types of risks in the supply
chain. Commercial merchants face countless risks including, but not
limited to: absolute price risk, relative price risk (which is basis or
unfixed risk), calendar spread risk, time risk, location risk, quality
risk, execution and logistics risk, credit risk, counterparty risk,
default risk, weather risk, sovereign risk, and government policy risk.
It is important to recognize that all of these risks directly impact
the commercial operations of a merchant and ultimately affect the value
of the merchant's commercial enterprises and the price merchants pay or
receive for their product. Merchants must be able to make a decision on
how not only to price these risks in a commercial transaction, but also
how to manage these risks. The ability to manage these risks not only
benefits the merchants, but also the supplier and ultimate consumer of
the finished good.
In negotiating a forward contract with a potential counterparty,
the merchant must take into consideration all of the above risks to
make the most appropriate decision regarding if, when, and how to
utilize exchange traded futures to hedge multiple risks that are
present--as each risk ultimately affects price. This means both the
price to the seller of the raw commodity and the price to the consumer
of the final product. The Commission is taking a narrow view of risk,
focusing solely on the absolute price risk of a transaction with a
counterparty, and is not considering the multiple risks that exist in a
commercial operation or enterprise. The logical result of such an
approach is that bid offer spreads and credit risk spreads will widen
and liquidity will be reduced. This will lead to wider risk premiums
throughout the business channel, which will ultimately be passed along
to end consumers who will bear the costs.
B. Economically Appropriate Test
The language of the ``economically appropriate'' test has been in
the law and regulations for a long time, but the proposal's new
interpretation is different. The proposal suggests that to qualify for
the economically appropriate test, an entity has to consider all of its
exposures when doing a risk reducing transaction and the entity itself
cannot take into account exposures on a legal entity, division, trading
desk, or even on an asset basis. Rather, all exposure has to be
consolidated and then analyzed as to whether or not the transaction
reduces the risk to the entire enterprise. This new interpretation
substitutes a governmentally imposed one-size-fits-all risk management
paradigm for a company doing its own prudent risk management business
in light of its own facts and circumstances. Such an interpretation
would require commercial entities to build a system to manage risk this
way--a system that does not exist today because it does not provide
risk management value.
C. Enumerated Hedges
The proposal changes current CFTC rule 1.3(z), which states that
enumerated hedges or bona fide hedges include, but ``are not limited
to,'' a list of enumerated hedging transactions. The proposal lists
permitted enumerated hedging transactions and provides little
flexibility to market participants. Having a finite list is difficult
for market participants who must manage risk because no one can be
expected to understand or anticipate every type of hedge that can be
done or that fits all markets or market participants. Also, the
enumerated hedges that are listed in the proposed rule discount the
importance of merchandising and anticipatory hedging. The concept of
enumerated hedging transactions focuses much more on the absolute fixed
price risk with a counterparty, and inappropriately so. The majority of
energy and agricultural merchandising transactions, and associated risk
management are generally done on a relative (i.e., not fixed) price
basis. The examples set forth below illustrate this principle.
D. Merchandising
Merchandising should not be pinned into a specific hedge category
as it is a broad concept and connects the two ends of the value chain,
production and consumption. One example provided at the February 26,
2015 roundtable that is illustrative of this concept is as follows:
Take for example a commodity (i.e., gas oil/diesel) that is
being priced at a level in New York (``NY'') that demonstrates
to the merchandiser that the commodity is in greater demand in
that area than and in another area (i.e., Europe). The
underlying is traded on ICE Europe as a gas oil contract and in
NY Harbor as a CME ULSD (Ultra Low Sulfur Deisel) contract.
For purposes of example, on January 19th, gas oil was trading
at about $1.51 in Europe and diesel was trading at $1.66 in NY
Harbor. On January 19th, a NY importer would buy physical gas
for forward delivery on a floating price basis against the ICE
futures. The importer has not yet located a buyer for the
product in NY, but intends to ship the gasoline to NY and sell
it on a floating price basis and capture that price
differential. The importer locks in the ULSD gas oil
differential of 15 by buying the ICE Feb gas oil futures at
$1.51 and selling to NYMEX at $1.66. The short NY ULSD futures
would not qualify for bona fide hedging treatment under the
proposed rule, even though it is an essential component of the
transaction that allows the importer to take the gas oil from
Europe where it is in relatively excess supply and bring it to
NY where the prices in the market are dictating that it ought
to be sold and delivered.
On January 26th the importer finds a buyer in NY Harbor and
sells it on a floating price basis. At that point, he has a
floating price buy and a floating price sale, and the rules
would permit it as a bona fide hedge. But for that interim
period (a week in this example), it is not a bona fide hedge.
On January 29th, both counterparties to the importer agreed to
price the commodity, and take the indexes that they agreed to
use for pricing, and they look at the prices and establish them
as the prices for their physical transactions--in this case,
the importer could buy actual physical gas oil at $1.5268, sell
physical in NY at $1.6184 and have revenue from that
transaction of 9 a gallon. At the same time, the importer
would liquidate the futures spread and (in this case) recognize
again on the futures transactions 6 a gallon. The revenue of
the two together is about 15 , and when you take out the costs
that he anticipated (about 14.5 ), it yields the expected gain
of about \3/4\ per gallon--exactly what he hoped to accomplish
by hedging and moving the product where it was needed. So even
though the price of ULSD dropped by about 40% relative to the
price of gas oil in Europe, and dropped by 5 in absolute
terms, through the use of this hedge the importer was able to
preserve the economics of his transaction and move the cargo.
The one week transaction (where he had an unfixed purchase in
Europe and had not yet established his unfixed price sale in
NY) should qualify as a bona fide hedge because it meets all of
the statutory requirements. Namely, the transaction: (1) was a
substitute for a transaction to be made at a later time in a
physical marketing channel, i.e., the sale of physical product
in NY Harbor; (2) was economically appropriate to the reduction
of his risk in that the relative value of the product in NY
Harbor could drop before he sold the product on a floating
price basis; (3) arose from the potential change in value of an
asset (gas oil) that the importer owned after he made the
purchase in Europe; and (4) the consumer benefits from this
transaction because gas oil was imported to the U.S. in
response to market signals, ultimately reducing the cost of
fuel in the U.S. The importer would not have entered into this
transaction without the ability to hedge his risk.
Another illustrative example provided at the February 26, 2015
roundtable involving winter storage of natural gas:
A natural gas supplier in April 2013, leases storage in order
to store and provide gas during the 2015-2016 winter season.
Assume the supplier leased storage and his expected cost for
storage is 38 per MMBTU, but in June 2013, market conditions
are such that he is able to lock in a profit associated with
that storage by using the futures markets. The supplier can buy
October 2015, gas on the market for $4.299 per MMBTU and can
sell gas, which would come out of storage in January 2016, for
$4.69 per MMBTU. The supplier enters into that transaction in
the futures markets by buying October natural gas futures and
selling January natural gas futures, and locks in that
differential. Neither the October nor the January futures
contracts would qualify for bona fide hedge treatment under the
proposed rule. But in September 2015, when the natural gas
physical market is active, the supplier is going to buy the gas
that he will use to fill his storage in October 2015. When this
occurs, the supplier will liquidate his October natural gas
futures contract. In December 2015, when the supplier needs to
supply his customers (i.e., local utilities), he will sell the
gas to be withdrawn from storage and liquidate the January
natural gas futures contracts.
This storage transaction should be given bona fide hedging
treatment because it satisfies the statutory standards
established by Congress--it was a substitute for transactions
to be made at a later time in a physical marketing channel,
i.e., the purchase of natural gas to fill storage and a sale to
withdraw from storage--which was economically appropriate to
the reduction of the supplier's risk that he will be able to
recover the cost of its storage obligation and separately that
he can profit from his business of supplying gas in the winter.
This arose from the potential change in the value of an asset
(natural gas storage) that the supplier owned and the gas
itself that he anticipated owning. Consumers benefit from this
transaction because it assures that gas will be in storage
during the winter heating season in 2015-2016. The supplier
would not have entered into the transaction to commit to
storage without the ability to hedge its risk. The supplier
wants to hedge the value of his storage not yet leased. If the
prices move against him, he will not lease that storage but the
futures markets allow him to lock in the value of his asset by
hedging in the futures markets.
CMC members are very concerned by the Commission's view of unfixed
price commitments. The Commission has failed to recognize hedging needs
of unfixed price contracts (i.e., basis contracts) as bona fide
hedging. The business of merchandising is conducted substantially in
the form of basis contracts and merchants must be allowed to utilize
hedging strategies, including calendar spread hedging to manage this
risk. One of the main reasons for hedging is to turn flat price risk
into relative risk, and by taking flat price risk and offsetting it
with a futures position, a commercial firm creates exactly unfixed or
basis positions, the same positions the Commission does not want to
recognize as a bona fide hedge. Although basis risk is generally less
volatile than flat price risk, it is not always the case--basis and
unfixed positions still maintain risk and must be allowed to be hedged,
managed and recognized.
Recognizing unfixed price transactions in the marketplace is
essential to protect market participants, banks, consumer and
producers. Unfixed price contracts exist for several reasons, one to
minimize the transaction risk from the time that the original
transaction is made until closer in time to the ultimate delivery.
Unfixed price contracts provide for much greater security with regard
to counterparty, credit and default risk by allowing the parties to
remain unfixed until closer in time to the period of the final
execution of the contract, thereby minimizing the effect of potential
price variance that could take place. If the hedging of these contracts
were not allowed to be recognized as bona fide hedges, the Commission
would force commercial enterprises to move toward a fixed price regime
with offsetting hedges in the commodity futures market at great expense
to suppliers, merchandisers and consumers.
CMC's concern with the Commission's view of unfixed price contracts
is not limited to energy markets. Agriculture markets will also be
adversely affected by the inability to hedge unfixed price contracts.
Below is an example of an unfixed price commitment by a merchandiser of
soybeans in the international grain market:
On January 23, 2015, Merchant enters into a contract to sell
4 cargoes (vessels) of soybeans to a counterpary in Asia
(``Customer''). The total number of bushels of soybeans sold to
Customer is 8 million, or the equivalent of 1,600 futures
contracts. Terms of the contract are as follows:
FOB Vessel--New Orleans, Louisiana (i.e., shipper is
responsible for
getting a boat to the port of New Orleans and getting the
soybeans on
the boat).
First half May 2015 delivery.
Price: 75 over the May 2015 CBOT Soybean futures
contract.
Customer has the option to fix the price by delivery of
May 2015 futures
to Merchant via an ``Exchange for Physical'', or EFP,
prior to May 1, 2015.
Merchant will need to purchase four cargoes of soybeans and
transport them to the export elevator in New Orleans, Louisiana
in time to load four vessels in the first half of May 2015.
Merchant must decide how best to procure the soybeans for the
sale to Customer. The May 2015 futures contract will not
provide supply protection for Merchant's commitment to Customer
because the CBOT futures delivery for May 2015 soybeans is not
in time to satisfy Merchant's contractual commitment. Merchant
therefore needs time protection to cover its sale and decides
that the March 2015 futures contract is the best solution. On
the date of the sale to Customer, the CBOT futures price for
March 2015 soybeans was $9.72 per bushel and the CBOT futures
price of May 2015 soybeans was $9.79 per bushel. Thus, the
March 2015 contract was priced 7 per bushel below the May 2015
contract. Since Merchant's best supply protection is the March
2015 futures contract and the commitment to Customer is indexed
to the May 2015 futures contract, Merchant is exposed to
calendar spread risk. If the March futures contract were to
narrow or go above the May futures contract, the transaction
with Customer could incur large losses. Merchant decides to
protect its commitment to Customer and lock in the discounted
price of the March futures contract compared to the May futures
contract by purchasing 1,600 March 2015 futures and selling
1,600 May 2015 futures.
Merchant will eventually receive 1,600 long May 2015 futures
from Customer via an EFP whenever Customer decides to fix its
purchase contract prior to May 1, 2015. Merchant's short May
2015 futures position will be offset by the long futures
received from Customer.
Merchant begins purchasing soybeans in the most economically
appropriate manner. Merchant procures from various sources in
the physical market. As Merchant purchases soybeans on fixed
price basis and as unfixed price sellers fix their sales,
Merchant sells March 2015 futures to offset its long March 2015
futures.
As Merchant approaches March 2015 futures delivery, the
physical market for soybeans begins to trade at price levels in
excess of the CBOT delivery value for March 2015. Merchant
takes delivery of 1,000 contracts through the March 2015 CBOT
delivery process and uses the soybeans to supplement other
soybeans purchased in the physical market in order to fulfill
its sales commitment to Customer.
On April 23, Customer delivers 1,600 futures contracts to
Merchant via an EFP. The contract pricing between Merchant and
Customer is now fixed prior to the time specified in the
contract between the parties.
The above transaction is an example of what has been the
standard of international grain merchandising for many years.
However, under the proposed rule, Merchant would not be allowed
to enter into the calendar spread transaction to hedge its
risk, thus it would not be able to hedge its contractual
physical supply commitment to Customer. This could impede
convergence of futures and physical markets. The Commission's
reasoning for denying bona fide hedging treatment is based on
the sole fact that the sales contract to Customer was not a
fixed price commitment at the time of the hedge by the
Merchant. The consequences of the Commission's narrow
interpretation of bona fide hedging will force Merchant to
change the manner in which it merchandises to end-users.
Merchant, in order to protect its ability to utilize futures as
a hedge against physical supply commitments, may be forced to
contractually require Customer to fix its May 2015 soybean
contract by ``first notice day'' of the March 2015 soybean
futures contract. Thus, in effect, the unintended consequence
of this rule change may be that the Commission is mandating the
date by which the end-user prices its soybeans.
Similar to the energy examples listed above, the agricultural
merchandising example should be given bona fide hedging treatment
because it satisfies the statutory standards established by Congress
(it was a substitute for transactions to be made at a later time in a
physical marketing channel and was economically appropriate to the
reduction of risks in the commercial enterprise as the hedge protected
the potential change in value of soybeans being merchandised).
Comments Related to the Revised Table 11a Position Limits
In previous comment letters, CMC, along with its members, has
advised the CFTC that at whatever level single month and all months
combined limits are set, parity should be maintained among the three
primary U.S. wheat contracts--CBOT Wheat, KCBT Hard Winter Wheat, and
MGEX Hard Red Spring Wheat. Under the Proposed Rule, each of the three
contracts will be subject to different single month and all months
combined limits, doing away with the parity approach that has worked
for decades.
Revised Table 11a illustrates the destructive effects that the
elimination of wheat parity will have in the marketplace. A comparison
of Table 11 and Revised Table 11a reveals that while the unique persons
holding positions in KCBT Hard Winter Wheat and CBOT Wheat remain
relatively constant, the unique persons holding positions in MGEX Hard
Red Spring Wheat skyrocket in every identified category, to a factor
far in excess of the other two contracts.
The disproportionate impact of the Proposed Rule impedes legitimate
risk management strategies across the three wheat contracts, such as
cross-hedging and spread trading. It forces a hedger seeking to spread
CBOT Wheat and MGEX Hard Red Spring Wheat to either (1) limit their
spread trading to the lowest threshold; (2) apply for bona fide hedge
exemptions in certain contracts, or; (3) cease using the futures
markets for risk management. None of these options are desirable.
Wheat parity has proved effective for decades, and the CFTC has not
put forth any evidence that would warrant a move away from wheat parity
in the Proposed Rule. Given the adverse implications of the divergent
single month and all months combined limits for the three major U.S.
wheat contracts, CMC urges the CFTC to maintain the historical success
of wheat parity at whatever quantitative limit is established.
III. Conclusion
Thank you for the opportunity to provide comments on the commercial
impacts of these rulemakings. If you have any questions or concerns,
please do not hesitate to contact Kevin Batteh at
[email protected].
Sincerely,
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Kevin K. Batteh,
General Counsel,
Commodity Markets Council.
attachment 2
December 2, 2014
Christopher Kirkpatrick,
Secretary,
Commodity Futures Trading Commission,
Washington, D.C.
Re: Margin Requirements for Swap Dealers and Major Swap Participants,
79 Fed. Reg. 59898 (October 3, 2014); RIN 3038-AC97
Dear Mr. Kirkpatrick:
INTL FCStone, Inc. and its affiliates (collectively, ``INTL
FCStone'' or the ``Company'') thank the Commodity Futures Trading
Commission (the ``Commission'' or ``CFTC'') for the opportunity to
comment on the proposed rule regarding Margin Requirements for Swap
Dealers and Major Swap Participants (the ``Proposed Margin Rules'' or
``Proposed Rules'').\1\
---------------------------------------------------------------------------
\1\ Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants; Proposed Rule, 79 Fed. Reg. 59898 (October 3,
2014).
---------------------------------------------------------------------------
INTL FCStone is a financial services company that provides its
20,000+ customers across the globe with execution and advisory services
in commodities, capital markets, currencies, and asset management. INTL
FCStone Markets, LLC (``IFM'') is a wholly-owned subsidiary of INTL
FCStone and a provisionally registered swap dealer.
Through its international network of more than 1,000 employees,
IFM's core business is helping mid-sized commodity producers,
processors, merchants and end-users understand and mitigate their
commodity price risk. Unlike many of the big banks and other financial
institutions that have and are likely to register as swap dealers,
IFM's counterparties are largely farmers, elevators, processors and
merchants of agricultural commodities. Mitigation of commodity price
risk is critical to the success of these market participants and non-
centrally cleared swaps play an important role in these mitigation
strategies. For a number of reasons, including the relatively smaller
size of their commercial operations and related hedging transaction
needs, and their dispersed geographic locations, these mid-market
commercial clients typically do not have access to the risk management
services of swap dealers that are affiliated with Bank Holding
Companies. Nevertheless, this mid-sized commercial customer base in
aggregate produces, processes, merchandises and/or uses a significant
portion of U.S. domestic agricultural production. Without the changes
to the Proposed Margin Rules discussed in this letter, the risk
management services provided by IFM and other mid-market non-bank Swap
Dealers may be too cost prohibitive to the smaller and mid-market end-
users. As a result, many of the risks of these end-users are likely to
remain un-hedged.
For the reasons explained in greater detail below, IFM respectfully
requests that the Commission make the following specific revisions to,
or clarifications of, the Proposed Margin Rules:
Calculation of Initial Margin. The Commission should limit
the posting and segregation of excess margin by allowing swap
dealers and major swap participants (collectively, ``Covered
Swap Entities'' or ``CSEs'') to submit margin methodology
filings as self-executing filings if the methodologies have
previously been approved on behalf of their affiliates by other
regulators, including foreign regulators that have implemented
margin regimes consistent with the BCBS-IOSCO Margin
Requirements for Non-Centrally Cleared Derivatives (the ``BCBS-
IOSCO Framework'').\2\ In addition, the Commission should
encourage the use of standardized models developed by industry
groups by allowing CSEs to submit such models as self-executing
filings if they have been approved for use by another market
participant.
---------------------------------------------------------------------------
\2\ Basel Committee on Banking Supervision and Board of the
International Organization of Securities Commissions, Margin
Requirements for Non-Centrally Cleared Derivatives, September 2013,
available at http://www.bis.org/publ/bcbs261.pdf.
Threshold for Material Swaps Exposure: The Proposed Rules
incorporate a ``material swaps exposure'' (``MSE'') threshold
of $3 billion, which is substantially lower than the $11
billion (=8 billion) volume-based exception included in the
BCBS-IOSCO Framework and the margin proposal issued by the
European Supervisory Authorities (the ``European
Proposal'').\3\ We do not believe that the analysis contained
in the Proposed Rules provides sufficient support for this
difference because the analysis implicitly assumes that
financial end-users trade with only a single counterparty, when
in practice such concentration of trading activity is rare.
Accordingly, the Commission should conform to the BCBS-IOSCO
Framework and European Proposal or, in the alternative, defer
final adoption of the MSE definition until the Commission has
conducted a more thorough analysis of the uncleared swap
markets.
---------------------------------------------------------------------------
\3\ Consultation Paper on the Draft regulatory technical standards
on risk-mitigation techniques for OTC-derivative contracts not cleared
by a CCP under Art. 11(15) of Regulation (EU) No. 648/2012 published by
the European Securities and Markets Authority, the European Banking
Authority and the European Insurance and the Occupational Pensions
Authority on April 14, 2014.
Re-Use of Posted Margin. The Proposed Rules do not permit
initial margin, which must be held by a third-party custodian,
to be rehypothecated, re-pledged, or reused. The margin rules
should instead provide that reuse of posted margin is
acceptable if the relevant model were to meet the standards
proposed in the BCBS/IOSCO Framework. In addition, the
Department of the Treasury, the Federal Reserve and other
prudential regulators (the ``Prudential Regulators'') and the
Securities and Exchange Commission may permit reuse of posted
margin,\4\ and if so, a prohibition by the Commission will
create a competitive disadvantage for market participants
subject to the Commission's rules.
---------------------------------------------------------------------------
\4\ See Margin and Capital Requirements for Covered Swap Entities;
Proposed Rule, 79 Fed. Reg. 573458 at 57374 (September 24, 2014).
Cross-Border Application. The Commission should apply the
Proposed Rules as transaction-level requirements under the
CFTC's previously published Interpretive Guidance and Policy
Statement Regarding Compliance with Certain Swap Regulations
(the ``Cross-Border Guidance''),\5\ consistent with its
statements in the Cross-Border Guidance, to prevent differences
in the extraterritorial application of the clearing rules and
the margin rules. In addition, the Commission should not apply
the Proposed Rules to swaps that are cleared by foreign
clearinghouses that have been determined to be in compliance
with the CPSS-IOSCO Principles for Financial Market
Infrastructures (the ``PFMIs''),\6\ in order to avoid over-
margining and a potential flight from such clearinghouses.
---------------------------------------------------------------------------
\5\ 78 Fed. Reg. 45292 (July 26, 2013).
\6\ Committee on Payment and Settlement Systems and Technical
Committee of the International Organization of Securities Commissions,
Principles for Financial Market Infrastructures, April 2012, available
at http://www.bis.org/cpmi/publ/d101a.pdf.
---------------------------------------------------------------------------
Discussion
I. Calculation of Initial Margin
While it is important to require the posting of margin in amounts
that are sufficient to mitigate risk and protect market integrity,
requiring the posting and segregation of excess margin as proposed in
the rule will have the counterproductive effect of reducing market
liquidity at the very times when liquidity is key to the continued
functioning of the global financial markets. The BCBS-IOSCO
quantitative impact study \7\ estimates that using a standardized
schedule for calculating initial margin would require the posting and
segregation of 11 times more initial margin (``IM'') than that required
under a models-based calculation approach.\8\
---------------------------------------------------------------------------
\7\ See BCBS-IOSCO, Second Consultative Document, Margin
requirements for non-centrally cleared derivatives (Feb. 2013).
\8\ It is also important to note that the BCBS-IOSCO study was
conservative in its calculations, given that it assumed an =8 billion
standard exposure threshold for financial end-users rather than the
Commissions proposed $3 billion threshold.
---------------------------------------------------------------------------
Use of models would prevent excessive amounts of liquid assets from
being unavailable for use in the markets generally, as sophisticated
models are generally better able to determine risk levels of particular
transactions and when netting is appropriate. Of course, this does not
mean that CSEs should be permitted to use internal models that have not
been reviewed by a regulator. However, when one regulator has approved
the use of a model, it would be an inefficient use of resources both at
the regulator level and at the market participant level to prohibit
that model's use by other market participants until it has been
reviewed and approved by a second regulator.
For this reason, we recommend that the Commission allow CSEs to
submit margin methodology filings as self-executing filings if the
methodologies have already been approved on behalf of their affiliates
by other regulators, including foreign regulators that have implemented
margin regimes consistent with the BCBS-IOSCO Framework. This would
further Congress' stated goal, as described in the Dodd-Frank Wall
Street Reform and Consumer Protection Act (``Dodd-Frank''), that the
margin requirements of the Commission, the Prudential Regulators, and
the Securities and Exchange Commission be comparable.\9\ Such
comparability would be undermined if all regulators did not accept the
same margin methodologies.
---------------------------------------------------------------------------
\9\ Commodity Exchange Act 4s(e)(3)(D)(ii).
---------------------------------------------------------------------------
Allowing for automatic approval of margin methodologies that have
already been vetted and approved by another regulator would allow
affiliated groups to maintain the consistency of their risk management
programs--for example, an affiliated swap dealer and security-based
swap dealer should be permitted to use the same margin methodology,
whether the agency that reviewed the methodology is the Commission or
the SEC. Permitting affiliated entities to use the same margin
calculation model would further the stated goals of the Internal
Business Conduct Standards, which require CSEs to have a risk
management program related to swaps activity that is integrated into
risk management at the consolidated entity level.\10\
---------------------------------------------------------------------------
\10\ 17 CFR 23.600.
---------------------------------------------------------------------------
We also recommend that the Commission take steps to facilitate the
use of standardized models for the calculation of IM. The use of such
models would increase transparency as all market participants will have
access to the model's calculation methodologies, and market
participants that are not otherwise regulated would not have to rely on
their regulated counterparties to produce appropriate models. In
addition, the use of standardized models would reduce the potential for
disputes among market participants using such a model. Thus, we suggest
that the proposed rule be modified to allow that a model that has been
developed by industry groups and the Commission or another regulator
and has been approved for use by one market participant, such model
should be automatically approved for all market participants.
Finally, we recommend that CSEs be permitted to determine IM by
netting based on risk sensitivities of their portfolios, instead of
based on specific types of asset class. Requiring netting based on
asset class could present operational difficulties for CSEs--for
example, an OTC swap could have exposure to both rates and foreign
exchange risk, and there would be no guidance for the CSE to classify
that swap--or to ensure that its counterparties classified the swap in
the same manner. Requiring netting based on a rigid set of asset-class
based categories could cause market participants to forego swaps that
are difficult to categorize, leading to imperfect hedging and increased
overall risks in the financial markets.
II. Material Swaps Exposure Threshold
The Proposed Rules would define MSE as $3 billion in average
monthly gross notional amount of swaps, SBS, FX swaps and FX forwards.
This represents a decrease of almost 75% from the =8 billion ($11
billion) month-end gross notional amount threshold contained in the
BCBS-IOSCO Framework and the European Proposal, thereby substantially
expanding the class of U.S. financial end-users that are subject to the
IM rules. In the Proposed Rules, the Commission explains that the lower
threshold is based on a rough comparison of the amount of margin
required for certain cleared swap portfolios against the proposed $65
million IM threshold.\11\ Based on this comparison, the Commission
expressed concern that the BCBS-IOSCO Framework's =8 billion aggregate
gross notional threshold would exclude financial end-users whose IM
requirements would exceed the $65 million ``minimum collection amount''
(``MCA'') threshold.\12\
---------------------------------------------------------------------------
\11\ The Prudential Regulators made a similar calculation. 79 Fed.
Reg. 573458 at 57367 (September 24, 2014).
\12\ The BCBS-IOSCO Framework, the European Proposal and the
Proposed Rules do not require entities to actually exchange IM
collateral until their non-cleared swaps exposures to one another would
necessitate $65 million in IM.
---------------------------------------------------------------------------
We believe that the Proposed Rules diverge from international
standards in the use of MCA to calculate MSE. An analysis by the
Commission found that financial end-users with total MSE exceeding $3
billion and less than $11 billion would, on average, be required to
post more than the $65 million MCA. The Commission reasoned that the
Basel Committee intended the MSE threshold to be aligned with the MCA
threshold, so they lowered the $11 billion MSE threshold to $3 billion.
However, we consider the two thresholds as distinct in their scope
and purposes and believe that the Commission (and the Prudential
Regulators) have, in fact, adopted an approach inconsistent with the
BCBS-IOSCO Framework, which does not reflect the intent to align these
two thresholds.
The IM threshold of $65 million or MCA is a bilateral threshold
which is intended to alleviate the operational burdens related to
collecting and posting small amounts of IM for all parties subject to
the IM requirements. In contrast, the MSE threshold is an entity
threshold meant to identify and exclude from the margin requirements
those financial end-users whose swaps activity is limited and who do
not pose systemic risk to the financial markets. The BCBS-IOSCO
Framework defined and provided levels for the two different thresholds
and did not relate the two.
The MCA threshold ensures that IM is only exchanged for large
exposures between counterparties. For example, two large swaps dealers
are not required to exchange IM until their exposures to one another
exceed the level where the failure of one entity could deplete the
capital of the other entity by this specified amount. As an entirely
separate matter, a financial end-user that uses only $3 billion total
in non-cleared swaps to hedge risk does not comprise meaningful
proportion of the total non-cleared swaps market and thus its hedging
costs should not be increased by a minimum IM requirement. Thus, the
Basel Committee thought that the $11 billion threshold was the right
threshold for imposing initial margin requirements. Thus, given the
materially different motivation behind each threshold, the BCBS-IOSCO
Framework reflects no need to align them; one exempts small exposures
between two covered swaps entities and the other exempts financial end-
users with minimal total swaps exposure.
For this reason, we recommend that the Commission revise the MSE
threshold of $3 billion, so that it is consistent with the BCBS-IOSCO
Framework and the European Proposal of $11 billion. If the Commission
fails to make this change, U.S. financial entities that seek to use
non-cleared swaps to hedge financial risks will have increased hedging
costs and be at a competitive disadvantage to foreign financial
entities. Practically speaking, applying a lower MSE threshold to U.S.
CSEs will cause harm to both financial end-users based in the United
States and those U.S.-based CSEs. U.S. financial end-users that fall
under the $11 billion notional threshold but exceed a $3 billion
threshold, if they continue to transact with U.S. CSEs, will face
higher hedging costs than their foreign counterparts, since those
foreign counterparts will not be required to post margin in their
trades with foreign swap entities. However, if U.S. financial end-users
view the increased margin costs as prohibitive, they could also turn to
unregulated entities in order to avoid compliance with the margin rules
entirely, or could cease to hedge certain risks, thus increasing
overall systemic risk.
We are also concerned that a lower MSE threshold will increase the
pro-cyclicality of the margin requirements. In times of stress in the
financial markets, volatility rises, which results in increased demand
for IM, leading to increased demand and prices for eligible collateral,
adding to the stress in the financial markets. The risk of pro-
cyclicality will be even greater with a MSE threshold of $3 billion
instead of $11 billion. The number of counterparties that will be
subject to the margin requirements will be greater with the lower
threshold and the population on the cusp that moves above the threshold
in any given period will be greater, compounding the pro-cyclicality
risk. For this reason, we support ISDA's request for a study to be
performed to determine the pro-cyclical effects of using a threshold of
$3 billion instead of $11 billion.
The Commission has time to conduct this analysis because the MSE
exception will not become relevant until the last compliance date for
IM requirements. The Commission, therefore, should defer adoption of a
final volume-based exception until after it has also completed a study
of the liquidity and cost impact of different exceptions and a related
cost-benefit analysis. This approach would be similar to the one taken
by the Commission when it adopted its final Swap Dealer de minimis
exception.
In addition to the foregoing, we recommend that the Commission make
several technical clarifications related to the calculation of material
swaps exposure. First, the Commission should use its standard
definition of ``affiliate'' to determine whether an entity and its
affiliates collectively have material swaps exposure, looking to
majority ownership.\13\ The definition used by the Commission in the
Proposed Rules reaches to a broader universe, stating that control of
25% of an entity's voting securities leads to affiliate status. The
Notice of Proposed Rulemaking does not explain this departure, and it
creates several issues that the Commission must address either by
returning to its original definition or clarifying the Proposed
Rules.\14\
---------------------------------------------------------------------------
\13\ For example, see the Inter-Affiliate Exemption, 17 CFR
50.52(a)(1)(i).
\14\ Note that this is also a departure from the BCBS-IOSCO
Framework, which determines material swaps exposure and other
thresholds on a consolidated group basis.
---------------------------------------------------------------------------
The Proposed Rules do not make clear how entities should be treated
if they are 25% owned or controlled by more than one entity. For
example, should the swap transactions entered into by a joint venture
that is 25% controlled by four otherwise unaffiliated financial end-
users be taken into account by all four financial end-users? Using the
Commission's standard majority-based definition would negate this lack
of clarity. If the Commission does not wish to use the standard
definition, we recommend that the swaps exposure of affiliates where no
majority ownership is present be taken into account only where the swap
transactions of the less-than-majority-owned affiliate are guaranteed
by its purported affiliate. Otherwise, taking into account exposures of
the same entity multiple times would result in financial end-users
having to post and collect excessive amounts of margin.
Another technical issue that the Commission must address is how a
CSE will identify counterparties that have material swaps exposure. We
recommend that the Commission clarify that a CSE may rely on
representations by its counterparties as to their material swaps
exposure. CSEs should not be responsible for making this calculation,
as it is possible that the required information will not be publicly
available. Permitting such reliance would be consistent with other
Commission regulations, where CSEs are permitted to reasonably rely on
counterparty representations as to end-user status \15\ and special
entity safe harbor status,\16\ unless the CSE has reason to believe
such representations are incorrect. In addition, CSEs should be
permitted to rely on counterparty representations regarding the
identity of a financial end-user's affiliates, which is an integral
portion of the calculation of material swaps exposure.
---------------------------------------------------------------------------
\15\ For an example, see the End-User Exception to the Clearing
Requirement for Swaps, 77 Fed. Reg. 42560 at 42570 (July 19, 2012).
\16\ 15 CFR 23.450(d).
---------------------------------------------------------------------------
III. Re-use of Posted Margin
According to the BCBS-IOSCO Framework,\17\ IM collateral that has
been posted to a CSE may be re-used by the CSE to finance a hedge
position associated with a counterparty's transaction, so long as
applicable insolvency law gives the posting counterparty protection
from risk of loss of IM in the event the CSE becomes insolvent. If such
protections exist, and a financial end-user consents to having its IM
reused, then a CSE may re-use IM provided by a financial end-user or
another CSE one time to hedge the CSE's exposure to the initial swap
transaction.
---------------------------------------------------------------------------
\17\ See Basel Committee on Banking Supervision and Board of the
International Organization of Securities Commissions, Margin
Requirements for Non-Centrally Cleared Derivatives, September 2013,
available at http://www.bis.org/publ/bcbs261.pdf.
---------------------------------------------------------------------------
The reuse of IM collateral can efficiently reduce the cost of non-
cleared swaps for U.S. financial end-users, because it allows CSEs to
hedge their exposures. For example, a CSE selling non-cleared credit
swap protection to a financial end-user counterparty could re-use the
IM that it receives from that transaction to buy noncleared credit swap
protection from another counterparty. As a result, allowing for the
reposting of IM can reduce the liquidity burden on CSEs when they enter
into offsetting positions, thereby reducing transaction costs for
derivatives users. Moreover, because U.S. bankruptcy laws protect U.S.
financial entities in the case of an insolvency of the covered swaps
entity, and the collateral may only be reused once for hedging
purposes, aligning the Proposed Rules with the BCBS-IOSCO Framework in
this respect would not expose U.S. financial entities to any undue
risk.
The ability to reuse margin in this manner is particularly
important for mid-market non-bank swap dealers like IFM. Such mid-
market swap dealers would not reuse margin to engage in proprietary
trading or securities lending, but need the ability to use margin to
finance hedges directly related to their client-facing trades. Such
hedges are beneficial to clients, as they are entered into in order to
enable the swap dealer to fulfill its obligations under client-facing
transactions. Thus, we believe that a restriction on re-use of posted
margin will actually add to market risk. On the other hand, if mid-
market swap dealers are permitted to use IM to finance hedge activity,
on the condition that the hedge is directly related to the underlying
client and the specific trade at hand, then this activity will mitigate
transaction risk and market risk.
If mid-market non-bank swap dealers are required to independently
post IM to an exchange or counterparty, rather than utilize clients'
IM, then such swap dealers would have to borrow from external sources,
at a cost, in order to fund the posting of the IM. The cost to the swap
dealers, would in turn, be passed on to their counterparties. Although
the margin rule is intended to manage systemic risk, an unintended
consequence of the rule for mid-market swap dealers and their end-user
clients would be that transaction costs will increase. As a result, the
Proposed Rules may cause certain market participants to be squeezed out
or otherwise unwilling to tie up capital, leaving those market
participants with un-hedged risk.
For the forgoing reasons, we suggest that the Commission revise the
Proposed Rules to be consistent with the BCBS-IOSCO Framework and
permit the reuse of IM under certain circumstances, in particular,
where the counterparty consents, applicable insolvency law gives the
counterparty protection from risk of loss of IM in the case that the
covered third party becomes insolvent, where the hedge is directly
related to the underlying client and the specific trade at hand, and
where the reuse is not in connection with proprietary trading.
IV. Cross-Border Application
A. The Commission Should Apply the Proposed Rules as Transaction-Level
Requirements Under the Cross-Border Guidance
The reach of Dodd-Frank extends not only to activities that take
place in the U.S. markets, but also to activities that ``have a direct
and significant connection with activities in, or effect on, commerce
of the United States'' or that ``contravene such rules or regulations
as the Commission may prescribe or promulgate as are necessary or
appropriate to prevent the evasion'' of the Dodd-Frank regulatory
regime.\18\ Thus, the Commission has the authority to regulate swap
transactions outside the United States, but must consider whether such
activities meet the thresholds described in Dodd-Frank.
---------------------------------------------------------------------------
\18\ Commodity Exchange Act 2(i).
---------------------------------------------------------------------------
In its Cross-Border Guidance, the Commission divided the major
Dodd-Frank requirements into ``entity-level'' requirements and
``transaction-level'' requirements.\19\ The entity-level requirements
are obligations that would be difficult to separate out on a
transaction-by-transaction basis, such as risk management, capital
adequacy, having a chief compliance officer, and reporting requirements
for which registered entities are likely to have set up automated
processes. The transaction-level requirements are more easily separated
by transaction, and include clearing and execution, trade confirmation,
and the external business conduct standards (such as the requirement to
provide a daily mark or scenario analysis). The Cross-Border Guidance
correctly classified margin as a transaction-level requirement.\20\ As
with the clearing requirement, it is practicable to separate out
transactions which are subject to the margin requirements and
transactions which are not.
---------------------------------------------------------------------------
\19\ Cross-Border Guidance, 78 Fed. Reg. 45292 at 45331 (July 26,
2013).
\20\ Cross-Border Guidance, 78 Fed. Reg. 45292 at 45334 (July 26,
2013).
---------------------------------------------------------------------------
The fact that the clearing and trade execution requirements were
determined to be transaction-level, and not entity-level, requirements
should inform the Commission's decision regarding the classification of
the margin requirement. Dodd-Frank requires the posting of margin for
uncleared swaps to make up for the fact that such swaps are not able to
take advantage of the risk mitigation that clearing offers. It would be
an odd result if the Commission were to determine that the reach of the
clearing requirement was not as great as that of the margin
requirement, given that both requirements are intended to address
counterparty credit risk.
It is also instructive to review the transactions which would be
subject to the Proposed Rules, were they treated as an entity-level
requirement, in contrast to the transactions that would be subject to
the Proposed Rules as a transaction-level requirement. For example, if
the Proposed Rules were treated as an entity-level requirement, they
would apply (with substituted compliance available only if the
Commission so determined) to transactions between non-U.S. CSEs and
their non-U.S. counterparties, whether or not those non-U.S.
counterparties were affiliated with or guaranteed by a U.S. person.\21\
---------------------------------------------------------------------------
\21\ 79 Fed. Reg. 59917.
---------------------------------------------------------------------------
It is difficult to conclude that transactions between two non-U.S.
entities would have the direct and significant effect on U.S. commerce
necessary to invoke the Commission's authority on such transactions.
While, for example, a non-U.S. swap dealer's failure at the entity
level to maintain adequate capital or to have in place a proper risk
management policy could have a significant impact on its U.S.
counterparties, thus necessitating the application of those rules at
the entity level, a non-U.S. swap dealer's failure to margin
transactions with its non-U.S. counterparties should not have a similar
direct and significant impact as long as the swap dealer is otherwise
complying with the entity-level requirements for capital adequacy and
risk management.
B. Swaps that Are Cleared by Foreign Clearinghouses that Have Been
Determined To Be in Compliance with the PFMIs Should Not Be
Subject to the Proposed Rules
In a number of circumstances, the Commission has acknowledged that
U.S. parties may satisfy their clearing obligations by using clearing
organizations that are compliant with the PFMIs. For example, in the
Clearing Exemption for Swaps Between Certain Affiliated Entities (the
``Inter-Affiliate Exemption''),\22\ the Commission requires electing
affiliates to clear all outward-facing swaps on a registered DCO or a
clearinghouse that is subject to supervision by appropriate government
authorities in the clearinghouse's home country and has been assessed
to be in compliance with the PFMIs.\23\ Similarly, all contracts that
an FBOT makes available for trading by direct access in the United
States are subject to a clearing requirement. This clearing requirement
can be satisfied either by the FBOT's clearing through a registered DCO
or through another clearing organization that is in good regulatory
standing in its home country and observes the PFMIs.\24\
---------------------------------------------------------------------------
\22\ 78 Fed. Reg. 21750 (April 11, 2013).
\23\ 17 CFR 50.52(b)(4)(B).
\24\ 17 CFR 48.7(d).
---------------------------------------------------------------------------
Given that Principle 6 of the PFMIs includes margin requirements
very similar to the requirements of the Proposed Rules,\25\ the
Commission should not subject parties that elect to use such clearing
organizations to additional margin requirements. The costs of such
excessive margining would clearly outweigh its benefits. First,
requiring the posting of margin in addition to that required by the
related clearing organization would result in an unnecessary drain on
liquidity in markets. And more importantly, counterparties could
determine that the costs of clearing (including posting the margin
required by such clearing agencies) in addition to posting bilateral
margin are too great and turn to uncleared swaps in order to avoid the
additional costs. This would result in increased risk to the financial
system, rather than avoiding risk in accordance with the goals of Dodd-
Frank.
---------------------------------------------------------------------------
\25\ Committee on Payment and Settlement Systems and Technical
Committee of the International Organization of Securities Commissions,
Principles for Financial Market Infrastructures, April 2012, available
at http://www.bis.org/cpmi/publ/d101a.pdf.
---------------------------------------------------------------------------
V. Conclusion
INTL FCStone and IFM generally support the Proposed Margin Rules
and are grateful that the Commission is again consulting the public on
the implementation of margins for uncleared swaps. IFM welcomes the
progress that has been made on this issue but urges the Commission to
reconsider its position on the threshold for material swaps exposure,
rehypothecation, the calculation of initial margin and the application
of the Proposed Rules to cross-border transactions as described in this
letter.
If you have any questions about any of the comments outlined in
this letter, please do not hesitate contact me for more information at
212.379.5449 and e-mail at [email protected].
Sincerely,
Catherine E. Napolitano,
Deputy General Counsel.
REAUTHORIZING THE COMMODITY FUTURES TRADING COMMISSION
(MARKET PARTICIPANT VIEWS)
----------
WEDNESDAY, MARCH 25, 2015
House of Representatives,
Subcommittee on Commodity Exchanges, Energy, and Credit,
Committee on Agriculture,
Washington, D.C.
The Subcommittee met, pursuant to call, at 1:34 p.m., in
Room 1300 of the Longworth House Office Building, Hon. Austin
Scott of Georgia [Chairman of the Subcommittee] presiding.
Members present: Representatives Austin Scott of Georgia,
Lucas, LaMalfa, Davis, Emmer, Conaway (ex officio), David Scott
of Georgia, Vela, Maloney, Kirkpatrick, and Aguilar.
Staff present: Caleb Crosswhite, Haley Graves, Jackie
Barber, Jessica Carter, Paul Balzano, Faisal Siddiqui, John
Konya, Matthew MacKenzie, and Nicole Scott.
OPENING STATEMENT OF HON. AUSTIN SCOTT, A REPRESENTATIVE IN
CONGRESS FROM GEORGIA
The Chairman. Well, good afternoon. This hearing of the
Subcommittee on Commodity Exchanges, Energy, and Credit
regarding reauthorization of the CTFC as it relates to market
participants' views, will come to order. Thank you for joining
us for our second meeting of the Commodity Exchanges, Energy,
and Credit Subcommittee of the House Committee on Agriculture.
Yesterday we kicked off the work of this new Subcommittee by
hearing from several representatives from the community of
derivatives and end-users on their thoughts regarding the CFTC
reauthorization process this Committee will be undertaking in
the days ahead.
Today we will continue that examination with a focus on
perspectives from the futures and swap marketplaces. We are
fortunate to be joined by a panel of distinguished witnesses,
who are here to share their perspectives as derivatives market
participants. The industry is well represented today by two of
the largest derivative exchanges, a key self-regulatory
organization, and two important industry trade associations. We
hope to come away with a greater understanding of the
challenges that each of them face.
Derivatives markets have changed in the 5 years since the
passage of Dodd-Frank, both because of and in response to the
new rules written by the Commission. Many of the witnesses
before us today have seen daunting changes in regulatory
burdens and business practices, perhaps none more so than Mr.
Bernardo, who testified in front of our Committee a little over
4 years ago, in February of 2011. At that time, the rules
governing his soon to be SEF had not yet been written. They
wouldn't be proposed until June of 2011, and they were not
finalized until August of 2013.
In the 18 months since the rules were finalized, the CFTC
still has not finalized the registration of a single SEF. Mr.
Bernardo has seen the entire process of creating the SEF rules
structure rise, and set--and yet he is still facing
considerable uncertainty about the business he operates.
Likewise, the further into implementation we get, the more
cross-border jurisdictional issues seem to arise. Today we will
hear testimony from five witnesses, four of whom will mention
the confusion and difficulty they are facing following
competing, often conflicting, rules for these international
markets. The continuing uncertainty and ambiguity in the rules,
compounded by the sweeping nature of these regulatory changes,
pose challenges for the witnesses before us today and their
customers, the end-users who rely on access to derivatives
markets.
My goal throughout this process is to ensure that we have a
healthy balance between market integrity and market access.
Derivatives markets exist for those who have a need to hedge.
Hedgers need markets that are safe, but also need markets with
affordable execution, available counterparties, and consistent
liquidity. This Subcommittee will continue to look for that
healthy balance. Thank you to the witnesses for appearing
before you today. We look forward to hearing your perspective
on these issues, and I appreciate the time and effort that you
have put forward to be here.
[The prepared statement of Mr. Austin Scott of Georgia
follows:]
Prepared Statement of Hon. Austin Scott, a Representative in Congress
from Georgia
Good afternoon. Thank you for joining us for our second meeting of
the Commodity Exchanges, Energy, and Credit Subcommittee of the House
Committee on Agriculture.
Yesterday, we kicked off the work of this new Subcommittee by
hearing from several representatives from the community of derivatives
end-users on their thoughts regarding the CFTC reauthorization process
this Committee will be undertaking in the days ahead.
Today, we will continue that examination with a focus on
perspectives from the futures and swaps marketplace. We are fortunate
to be joined by a panel of distinguished witnesses who are here to
share their perspectives as derivatives market participants. The
industry is well-represented today by two of the largest derivatives
exchanges, a key self-regulatory organization, and two important
industry trade associations. We hope to come away with a greater
understanding of the challenges that each of them face.
Derivatives markets have changed in the 5 years since the passage
of Dodd-Frank, both because of and in response to the new rules written
by the Commission. Many of the witnesses before us today have seen
daunting changes in regulatory burdens and business practices. Perhaps
none more so than Mr. Bernardo, who testified in front of our Committee
a little over 4 years ago, in February of 2011.
At that time, the rules governing his soon-to-be SEF had not yet
been written. They wouldn't be proposed until June of 2011, and they
were not finalized until August of 2013. In the 18 months since the
rules were finalized, the CFTC still has not finalized the registration
of a single SEF. Mr. Bernardo has seen the entire process of creating
the SEF rule structure rise and set, and yet he is still facing
considerable uncertainty about the business he operates.
Likewise, the further into implementation we get, the more cross-
border jurisdictional issues that seem to arise. Today, we will hear
testimony from five witnesses, four of who will mention the confusion
and difficulty they are facing following competing, often conflicting,
rules for these international markets.
The continuing uncertainty and ambiguity in the rules, compounded
by the sweeping nature of these regulatory changes, pose challenges for
the witnesses before us today and their customers--the end-users who
rely on access to derivatives markets.
My goal throughout this process is to ensure that we have a healthy
balance between market integrity and market access. Derivative markets
exist for those who have risks to hedge. Hedgers need markets that are
safe, but they also need markets with affordable execution, available
counterparties, and consistent liquidity. This Subcommittee will
continue to look for that healthy balance.
Thank you to the witnesses for appearing before us today. We look
forward to hearing your perspectives on these issues and appreciate the
time and effort you've put forward to be here.
With that, I'll recognize our Ranking Member, Mr. Scott, for any
remarks he'd like to make.
The Chairman. With that, I will recognize our Ranking
Member, Mr. Scott, for any comments that he may have.
OPENING STATEMENT OF HON. DAVID SCOTT, A REPRESENTATIVE IN
CONGRESS FROM GEORGIA
Mr. David Scott of Georgia. Thank you, Chairman Scott, and
it is indeed a pleasure to have these distinguished witnesses
before us. As we all know, derivatives are just an
extraordinarily exploding growth sector of our world economy.
It is right up there now around $700 trillion worth of the
world's economy. It is a very complex, complicated issue.
There are many issues that we need to address as we go
through this reauthorization. Paramount, of course, is to make
sure that the CFTC has adequate funding to do the job. If that
is not in place, then we create another series of problems that
prohibit us from having a clear vision of where we need to go.
So I am pleased that we are continuing a strong series of
hearings to discuss the reauthorization of the Commodity
Exchange Act.
And as I mentioned yesterday, in the last Congress we put
together a very good bill, a very robust bipartisan package,
and that was H.R. 4413. Unfortunately, it passed out of here by
voice vote, it passed on the House floor, but the Senate did
not take that up. And we refer to it as, of course, the
Customer Protection and End User Relief Act.
It is common-sense legislation, and we need to continue to
move in that direction with new legislation as quickly as we
can. So this year we are going to put forth a bill that
basically mirrors much of what we had in H.R. 4413, and
yesterday I highlighted some of the essential points that
related to our end-users, and the critical component of
providing much-needed clarity, and easing some of the
unnecessary burdens, which include reporting requirements.
And it is very important that we realize that many of our
end-users, most of which had nothing to do with the financial
meltdown, and certainly we need to look with a very clear eye
to make sure that we are not putting them at a competitive
disadvantage without understanding that differentiation. So
today I am pleased that we have representatives of our market
participants, very fine exchanges that we have worked with over
the years, and I am confident that we will have a very
productive discussion regarding the reauthorization of the
Commodities Exchange Act.
So, Mr. Chairman, I look forward to hearing from our
witnesses regarding their thoughts on last year's bill, any
improvements that you think we can make, going forward, that we
can add to what we did with H.R. 4413, areas of interest that
may require further examination. You all are market
participants. You are the ones that have to make this work. So
we can make the law, but you are the ones that have to make it
work, and so we are very interested in having a very candid,
forthright conversation, two-way with you, as to how we can
certainly improve the situation.
There have been points of concern that have arisen, to
include personnel location tests, the European Union's
recognition of U.S. clearinghouses, the U.S. recognition of
foreign clearinghouses, cross-border guidance, and the U.S.
person definition, to mention certainly just a few. And so, Mr.
Chairman, I was very pleased when we dealt with many of these
issues in H.R. 4413, and I am very confident that we will
address them again in a very bipartisan issue.
And finally, Mr. Chairman, I want to re-emphasize my call,
that we really strengthen the CFTC, and give the agency the
adequate funding that they need, and support that is required
in order for the CFTC to fulfill its mandated mission, which is
to protect market users and their funds, consumers, and the
public from manipulation and abusive practices related to
derivatives.
We have an awful lot of issues that are still out there:
cross-border, to make sure that we are doing the proper thing.
And the CFTC is that arbiter there. It is very important that,
where possible, where we have to make joint rules between CFTC
and the SEC that that go forward. So we have quite a bit on our
plate. We are looking forward to a very interesting hearing.
Thank you very much for coming, and Mr. Chairman, I yield back.
The Chairman. Thank you, Mr. Scott. The chair would request
that other Members submit their opening statements for the
record so the witnesses may begin their testimony, and to
ensure that there is ample time for questions. The chair would
like to remind Members that they will be recognized for
questioning in order of seniority for Members who were present
at the start of the hearing. After that, Members will be
recognized in the order of their arrival. I appreciate Members
understanding. Witnesses are reminded to limit their oral
presentations to 5 minutes. All written statements will be
included in the record.
I would like to welcome our witnesses to the table, Mr.
Terrence Duffy, Executive Chairman and President of the CME
Group, Chicago, Illinois, Mr. Benjamin Jackson, President and
Chief Operative Officer, ICE Futures U.S., New York, New York,
Mr. Daniel Roth, President and CEO, National Futures
Association, Chicago, Illinois, Mr. Gerald F. Corcoran,
Chairman of the Board and Chief Executive Officer, R.J. O'Brien
and Associations, LLC, Chicago, Illinois, on behalf of the
Futures Industry Association, and Mr. Shawn Bernardo, Chief
Executive Officer, tpSEF, Tullett Prebon, Jersey City, New
Jersey, on behalf of the Wholesale Market Brokers Association
of Americas.
Mr. Duffy, please begin when you are ready.
STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN AND
PRESIDENT, CME GROUP, CHICAGO, IL
Mr. Duffy. Thank you very much, Chairman Scott, Ranking
Member Scott, and Members of the Committee, for allowing the
CME the opportunity to present our perspective on the CFTC
reauthorization. I have addressed several things in my written
testimony, but today I have one overriding issue. It is among
the most critical facing the U.S. derivatives markets today. It
can be summed up in just one word, and Chairman--and Mr. Scott
said it a moment ago, which is equivalence.
Under European law, U.S. clearinghouses and exchanges, like
CME, must be recognized by their European regulations. This
recognition can only happen if the European Commission first
determines that the regulations in the United States are
equivalent to European Union regulations. Without these
actions, European clearing firms, and market participants, will
be subject to a prohibitive cost if they clear or trade in the
United States, or they may be denied access to U.S.
clearinghouses and exchanges altogether.
This could harm U.S. clearinghouses and exchanges
competitively. It would also harm both U.S. and EU market
participants. It would drive down participation in the U.S.
futures markets. It would reduce liquidity. It would impede the
ability of farmers, ranchers, and other U.S. and EU businesses
to conduct critical risk management needs. Because no prudent
business wants to be caught in a regulatory game of chicken, we
are already seeing firms taking steps to consider alternatives
outside of the United States.
After more than 2 years of negotiation and delays, the
European Union has refused to grant the United States
equivalence. Since his arrival at the CTFC, Chairman Timothy
Massad has been a tremendous leader in working towards a
solution, a solution that avoids market disruption, and affords
U.S. and foreign-based markets equal flexibility. Yet the
European Union continues to hold up the U.S. equivalence
determination over a single issue, our margining standards,
while, at the same time, they have approved other countries,
including Singapore, which uses the same margining standards we
do in the United States. The United States should not be
required to have identical margining standards to the EU. The
specific U.S. margin standards in question are an important
component, but not the only component, of a robust regulatory
structure under the CFTC's oversight.
What is puzzling is that the U.S. rules generally require
equal, if not more, margin to be posted with clearinghouses
than they do in the European Union. We call upon the European
Commission to take a balanced approach. It should allow the
United States and Europe to recognize each other's regulatory
regimes, including margin rules. Time is of the essence.
On June 16 of this year, if the U.S. is not granted
equivalence, U.S. clearinghouses will not be deemed qualified
central counterparties under European law. As a result,
customers will be subject to significant and inappropriate
capital cost if they are to use U.S. clearinghouses.
Furthermore, a European clearing mandate, which is similar to
our Dodd-Frank mandate, will also go into effect in the fourth
quarter of this year. Without the U.S. being recognized,
European market participants will be prohibited from using U.S.
clearinghouses to clear mandated derivatives.
Today the CFTC rules and policies grant European-based
foreign boards of trade and clearinghouses full access to the
U.S. marketplace. At the same time, the CFTC has many tools at
its disposal to deny such generous access. For example, the
CFTC could terminate the no action relief under which foreign
boards of trade are currently operating in the U.S. I hope this
does not prove necessary, but all options must be considered at
this time. We urge this Committee to take any and all
appropriate actions to support the CFTC's position and reach a
solution as soon as possible.
There is one other issue that I would like to mention
today, and that is the threat to how commercial market
participants manage their risk. The position on this proposal
that is currently pending before the CFTC would impose overly
narrow restrictions on the hedging and on commercial market
participants. It would limit them to a narrow list of
transactions. This approach would prevent businesses from
continuing their traditional hedging operations. It would
introduce unnecessary risk and cost, which could ultimately
fall upon the consumer.
There is a simple solution, however. The rule should be
amended to accommodate all reasonable commercial risk reduction
strategies that satisfies the statutory criteria. This flexible
approach would recognize traditional hedging practices. It
would also prevent the Commission from needlessly tying up its
limited resources.
I want to thank the Committee for its time and attention
today, and look forward to answering your questions.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman and
President, CME Group, Chicago, IL
Good morning, Chairman Scott and Ranking Member Scott. I am Terry
Duffy, Executive Chairman and President of CME Group.\1\ Thank you for
the opportunity to offer market perspectives on the future of the
Commodity Futures Trading Commission (``CFTC'' or ``Agency''). As this
Committee considers reauthorization of the Agency, I would like to
highlight five critical issues to the future of the Agency: EU
equivalency standards, position limits, agency funding, customer
protection, and central counterparty risk.
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\1\ CME Group Inc. is the holding company for four exchanges, CME,
the Board of Trade of the City of Chicago Inc. (``CBOT''), the New York
Mercantile Exchange, Inc. (``NYMEX''), and the Commodity Exchange, Inc.
(``COMEX'') (collectively, the ``CME Group Exchanges''). The CME Group
Exchanges offer a wide range of benchmark products across all major
asset classes, including derivatives based on interest rates, equity
indexes, foreign exchange, energy, metals, agricultural commodities,
and alternative investment products. The CME Group Exchanges serve the
hedging, risk management, and trading needs of our global customer base
by facilitating transactions through the CME Group Globex electronic
trading platform, our open outcry trading facilities in New York and
Chicago, and through privately negotiated transactions subject to
exchange rules.
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EU Equivalency Standards
Among the most critical issues facing the Commission today is the
potential for the United States to be denied status as a country whose
regulations are equivalent to Europe's. CME operates futures exchanges,
clearinghouses and reporting facilities in the U.S. and UK, and our
U.S. futures products reach over 150 jurisdictions across the globe.
Cross-border access is a core part of our global business strategy. CME
has long been an unabashed supporter of mutual recognition regimes that
(i) eliminate legal uncertainty, (ii) allow cross-border markets to
continue operating without actual or threatened disruption and (iii)
afford U.S.-based and foreign-based markets and market participants
equal flexibility. Historically, both the U.S. and EU have mutually
recognized each other's regulatory regimes to promote cross-border
access.
Recently, however, the European Commission has taken a different
approach. Under European law, U.S. clearinghouses and exchanges--like
CME--must first be recognized by European regulators in order to be
treated the same as EU clearinghouses and exchanges. The European
Commission is conditioning its recognition of U.S. derivatives laws as
equivalent to European law on demands for harmful regulatory changes by
the U.S. that would impose competitive burdens on U.S., but not EU,
clearinghouses and exchanges, and would harm both U.S. and EU market
participants.
After more than 2 years of negotiation and delay, the EU still has
refused to grant U.S. equivalence. Since his arrival at the CFTC,
Chairman Massad has been a tremendous leader in working toward a
solution that avoids market disruption and affords U.S. and foreign-
based markets equal flexibility. Yet, the EU continues to hold up the
U.S. equivalence determination over the single issue of differing
initial margining standards for clearinghouses. The specific U.S.
margin standards in question are an important component, but not the
only component, of a robust regulatory structure under the CFTC's
oversight. And even considering just this component of the margin
standards, the U.S. rules generally require equal, if not more, margin
to be posted with clearinghouses to offset exposures than is the case
under the EU rules. Nonetheless, the European Commission has thus far
insisted that the U.S. accept EU margin requirements, and has not
agreed to any compromise. They have rejected a solution that would
allow the U.S. and EU to apply whichever margin requirement is higher,
rather than imposing the EU standards on the U.S., or vice-versa.
By contrast, the European Commission recently granted
``equivalent'' status to several jurisdictions in Asia, including
Singapore, which has the same margin regime as the U.S. Treating the
U.S. as not equivalent when the European Commission has deemed the same
margin requirements equivalent in Singapore is inconsistent and should
be unacceptable to the U.S.
In stark contrast to the EU approach, U.S. regulations currently
allow European based futures markets full access to U.S. market
participants. Today, a foreign board of trade may provide direct
electronic access to persons located in the U.S. by registering with
the CFTC as a Foreign Board of Trade (``FBOT''). The CFTC grants FBOT
status if it finds that the board of trade and its clearinghouse are
subject to comparable regulation in its home jurisdiction. Although the
CFTC has not yet approved all FBOT applications, it has granted no-
action relief to several foreign boards of trade with pending FBOT
applications, permitting them to continue to access U.S. market
participants without disruption until the CFTC completes its review of
the FBOT applications.
The European Commission's discriminatory approach to U.S. access to
EU markets is creating significant competitive disadvantages for U.S.
markets and the participants that use those markets. Without an EU
recognition of equivalence, U.S. clearinghouses will not be able to
clear EU-mandated derivatives. As market participants need to prepare
for the impending effectiveness of Europe's swaps clearing mandate by
year-end, already we are seeing European clearing members and other
market participants taking steps to consider alternatives to U.S.
exchanges and clearinghouses.
This regulatory game of ``chicken'' also is causing disruptions to
U.S. futures markets because, without equivalence, the cost of clearing
futures on U.S. markets will increase significantly on June 15, 2015.
Under EU laws, non-EU clearinghouses must be recognized as ``qualified
central counterparties'' or QCCPs by June 15. To be QCCP eligible, the
European Commission must determine that the clearing regulations in the
applicable non-EU country are ``equivalent'' to EU regulation.
Accordingly, without an EU equivalence determination by June 15, U.S.
clearinghouses, like CME, will no longer be treated as ``QCCPs'' from a
capital perspective, significantly increasing the costs for European
clearing firms to use U.S. clearinghouses.
The EU's resistance to recognizing U.S. exchanges as equivalent
also has driven commercial participants away from U.S. exchanges
because their trades are treated as OTC trades unless they are executed
on an exchange in an equivalent jurisdiction. Commercial end-users
appropriately want to avoid the extra regulatory obligations that come
with being deemed ``NFC+'' entities in Europe--a byproduct of trading a
certain amount of non-hedging OTC derivatives--so they are leaving U.S.
exchanges or reducing their trading on U.S. exchanges until U.S.
equivalence is granted. Make no mistake that a continued decrease in
participation in U.S. futures products will harm both EU and U.S.
market participants, reducing liquidity and impeding the ability of
farmers, ranchers and other U.S. and EU businesses to conduct prudent
risk management.
Insisting on only the EU margin standards makes no sense when
principles governing margin have already been issued by global standard
setters, and have been implemented by the U.S. and jurisdictions
throughout the world. The U.S. should not be the only nation that is
required to have identical margin standards to the EU. Time is of the
essence. It is imperative that the European Commission take a balanced
approach and allow the U.S. and Europe to recognize each other's
regulatory regimes, including margin standards, equally--and soon. If
the U.S. continues to be excluded from the European marketplace, the
CFTC has many tools at its disposal to deny the generous access to U.S.
markets that foreign boards of trade and clearinghouses now have.
Indeed, it would be entirely logical for the CFTC to terminate the no-
action relief under which FBOTs in Europe are currently operating until
the EU recognizes U.S. derivatives regulations as equivalent and U.S.
clearinghouses as QCCPs. I hope this does not prove necessary, but all
options must be considered. We urge this Committee to take any and all
appropriate actions to support the CFTC's position and reach a solution
as soon as possible.
Position Limits
Perhaps no other post-Dodd-Frank rulemaking has been more
controversial than the Agency's position limits proposal. The Agency
currently is considering public comments on rules that were re-proposed
at the end of 2013. Despite a total of over 4 years of public comments,
four notices of proposed rulemakings, and one final rule that was
vacated by a Federal court, the industry is still awaiting answers to
some of the most fundamental questions regarding how a Federal position
limits regime under Dodd-Frank will work.
Significantly, the currently-proposed bona fide hedging exemption
would force a dramatic step back from historical market practices by
disallowing many reasonable commercial hedging strategies. There is no
evidence that Congress intended for the Agency to make it more
difficult through position limits rules for farmers, ranchers, and
other commercial end-users to hedge their price risks. By limiting the
exemption to a rigid and narrow list of enumerated hedges, the Agency's
proposal threatens to inject considerable risk into commercial
operations. Rather than refuse to give commercial end-users the
latitude to continue using reasonable commercial hedging practices for
fear that a few bad actors could abuse the system, the Agency should
rely on its anti-evasion powers to enforce the limits. CME supports
allowing exchanges to administer non-enumerated hedge exemptions that
meet the statutory criteria. Such legislation would alleviate the
Agency from needlessly tying up its limited resources responding to
requests for non-enumerated hedge exemptions.
Several other critical points remain in flux. We encourage this
Committee to carefully consider the following issues:
It remains to be seen which deliverable supply estimates the
Agency will use as a baseline for setting Federal spot-month
limits. CME continues to advocate for using the most up-to-date
deliverable supply estimates that are available from a physical
delivery market. To date, CME is the only U.S. exchange to have
provided the Agency with current deliverable supply estimates
for the core referenced futures contracts that would be covered
by the Agency's re-proposal. The Agency must identify for the
public the deliverable supply estimate baseline it will use
prior to finalizing any Federal limits, and require all
exchanges to use those same deliverable supply estimates for
purposes of establishing exchange-set limits.
Consistent with past policy, the Agency should not impose
spot month limits based on an absolutist approach to the 25% of
deliverable supply formula across all referenced contracts. No
sound economic theory or analysis supports such a uniform
approach. Rather, the Agency should use 25% of deliverable
supply as a ceiling and work with the exchange(s) listing the
physical-delivery benchmark contract to set the Federal spot-
month level below this ceiling on a contract-by-contract basis,
recognizing the unique market characteristics of each commodity
that is traded.
Limits for physical delivery and cash-settled ``look-alike''
contracts should be equal for the same underlying commodity.
The proposed conditional limit exemption for cash-settled
contracts threatens to drain liquidity away from the physical
delivery markets to the cash-settled markets during the spot
month as contracts approach delivery, thus causing harm to the
price discovery process and opening the door to potential
market misconduct. The Agency should not seek to artificially
tip the scale in favor of cash-settled markets and increase the
risk of possible price manipulation or distortion.
Position accountability levels should apply in lieu of hard
limits outside of the spot month for non-legacy agricultural
commodity derivatives. Nothing in the Agency's statute or any
legislative history should foreclose the possibility of using
this more flexible position accountability approach in the out
months as a reasonable alternative to Federal hard cap limits.
Such an approach would better serve market integrity and
protect the price discovery process in the out months when
diminished liquidity can have a severe negative impact.
Exchanges have successfully relied upon accountability levels
for decades to safeguard against market congestion and abusive
trading practices. Based on this experience, exchanges are well
positioned to partner with the Agency to administer a Federal
position accountability program, thus preventing any further
drain on the Agency's limited resources.
Agency Funding
The Administration's FY 2016 budget proposal requested a $72
million increase in Agency funding over the current fiscal year. The
Administration also signaled continued support for legislative efforts
to fund the Agency's budget through ``user fees'' assessed on
transactions that the Agency oversees. While CME supports sufficient
funding for the Agency to carry out its critical legislative mandates,
we do not support securing this funding through the imposition of what
amounts to an additional tax on the backs of America's farmers,
ranchers, and other end-users who hedge commodity price risks. As we
all know, American consumers ultimately are the ones to pay the higher
price when it costs more for producers to hedge.
In order to fully fund the CFTC at the requested level, the
Administration's proposal mistakenly assumes that a user fee will not
chase trading volume away to lower cost jurisdictions. This assumption
is unrealistic, particularly in an age of electronic, interconnected
markets where participants can and will shift their business. As
financial reform legislation continues to be implemented around the
world, CME is concerned that ample reasons already exist to support the
flight of liquidity from U.S. markets overseas. Less liquidity at home
will lead to a diminished price discovery process. Now more than ever,
we believe it would be shortsighted for Congress to artificially tip
the scale in favor of other jurisdictions by imposing a transaction tax
to fund the CFTC.
Customer Protections
SRO Structure
CME continues to reject calls to dismantle the system of self-
regulatory organization (``SRO'') oversight that has governed the U.S.
futures markets for decades. Today, the SRO construct no longer
consists solely of a single entity governed by its members regulating
its members; rather, exchanges, most of which are public companies,
oversee the market-related activities of all of their participants--
members and non-members--subject to corollary oversight by the CFTC and
National Futures Association (``NFA''). An exchange's ground-floor
vantage point into its markets provides a unique level of expertise
that the CFTC alone is not equipped to have. This is not to suggest
that hard lessons have not been learned in recent years and there is no
room for improvement. To the contrary, CME, along with the NFA and
other exchanges, have buttressed systems over the past 2 years to
better detect and deter another MF Global or Peregrine Financial
situation from occurring.
The financial incentives of SROs also benefit the safety and
soundness of the markets which they oversee. Effective SRO regulation
is necessary to ensure that an exchange clearinghouse that is required
to have ``skin in the game'' does not have to tap into these reserve
funds in the event of a member default, which would in turn harm
shareholders. To accomplish this, exchanges devote substantial
resources to their self-regulatory responsibilities. CME alone spends
more than $40 million annually carrying out its regulatory functions,
which includes employing over 200 financial regulatory, IT, and
surveillance professionals to monitor its markets and detect financial
misconduct before it occurs.
Residual Interest
CME remains fully committed to protecting Futures Commission
Merchants (``FCM'') customers against the full range of wrongful FCM
misconduct that may result in loss of customer funds. In 2012, the CFTC
proposed a rule that, under a phased-in schedule, would have required
an FCM to maintain at all times a sufficient amount of its own funds
(``residual interest'') in customer-segregated accounts to equal or
exceed the total amount of its customers' margin deficiencies. As noted
in prior testimony, no system exists to enable an FCM to continuously
and accurately calculate customer margin deficiencies in real time. The
net result would be that either FCMs would be forced to post their own
collateral into customer accounts, or customers would be forced to
over-collateralize their margin accounts at all times. Neither outcome
constitutes an efficient use of capital and would effectively render
derivatives markets prohibitively expensive and unusable for end-users.
We applaud the CFTC for moving away from the ``at all times''
requirement and further eliminating last week the automatic
acceleration in 2018 of the posting deadline to a time occurring
earlier than 6:00 p.m. the day of settlement. This Committee codified
in the Reauthorization Bill passed by the House last Congress a
provision that would permanently establish the residual interest
posting deadline at the end of each business day, calculated as of the
close of business the previous business day. CME again supports the
inclusion of such a provision in any Reauthorization Bill considered by
the Committee during the current Congress.
Central Counterparty Risk
Clearinghouse Capital Contributions
Much attention recently has been paid to how much capital a
clearinghouse such as CME should contribute to manage a default by one
or more of its clearing members. We could not agree more with the
general principles on this topic outlined by CFTC Chairman Massad 2
weeks ago in his keynote address to the annual meeting of the Futures
Industry Association. There, Chairman Massad recognized that any
discussion of clearinghouse capital contributions must take stock of
the purpose clearinghouses are meant to serve--risk management--versus
the purpose served by clearing members--trading, lending, or other
types of risk creation. In other words, risk is concentrated not at the
clearinghouse, but rather within a clearing member through the
exposures it brings to the clearinghouse.
CME recognizes the role of clearinghouse capital in managing risk.
As a systemically important clearinghouse, CME must have financial
resources available that are sufficient to meet its obligations to all
of its clearing members despite a default by the two clearing members
that could create the largest potential loss at any point in time. CME
can meet this standard through any allocation of initial margin, its
own capital, and clearing member default fund contributions. In making
this allocation, CME has provided a larger capital contribution to its
waterfall to date than any of its U.S. competitors. CME commits to
using its capital contribution, in a first loss position, before any
non-defaulted clearing member assets.
By contributing first-loss capital to the waterfall, CME has a
greater incentive to prudently manage its clearing members'
concentrations. However, CME also understands that arbitrary,
excessively large clearinghouse capital contributions introduce
negative incentives. For example, if CME were to increase its capital
contribution to the CME waterfall to cover the shortfall for the
largest potential defaulting clearing member, this would allow clearing
members to increase their risk exposures by over 40% for the same level
of default fund contributions they make today, with CME subsidizing the
additional risk with its own funding. As a result, CME's increased
contribution would significantly diminish the incentives of clearing
members to manage their own risk by maintaining balanced portfolios,
manage the risks of their clients and actively participate in the
default management process to ensure their default fund contributions
are not used in a fellow clearing member default.
Recent history illustrated for us the moral hazard issues created
by lenders repackaging and offloading the risk of their loans via
securitizations. By separating the risk from the responsibility of
bearing that risk in the event of the loans not being repaid, these
lenders lacked incentive to conduct appropriate due diligence on their
loans. We should learn from the mistakes of securitization lenders by
continuing to balance clearinghouse capital contributions in a manner
that ensures that market participants are sufficiently incentivized to
manage the risks they create.
U.S. Regulatory Oversight of Clearinghouses
Due to the critical role clearinghouses like CME play in mitigating
systemic risk to the U.S. economy, certain market participants recently
have called upon the Financial Stability Oversight Council (``FSOC'')
to play a greater oversight role. Congress, however, should resist the
urge to heed these calls by injecting FSOC into an existing regulatory
framework that does not need ``fixing.'' The CFTC and SEC already
provide robust oversight of U.S. clearinghouses. Furthermore, the rules
and regulations already imposed by these agencies facilitate adherence
to many of the principles that critics mistakenly complain are
currently absent from clearinghouse governance.
First, clearinghouses, including CME, are extremely transparent to
their clearing members, regulators, and the general public.
Clearinghouses post their rulebooks, rule submissions, and written
policies and procedures online. Clearinghouses publish public reports
detailing how they comply with the international ``Principles for
Financial Market Infrastructures,'' as well as participate in a
standardized financial reporting structure through the Fed's Payments
Risk Committee that allows clearing members to compare among multiple
clearinghouses the financial resources, collateral, central
counterparty investments, and back-testing and stress-testing results
of each clearinghouse. With respect to stress testing specifically,
additional detailed reports already are submitted to each
clearinghouse's risk committee and regulators for purposes of providing
even greater transparency into the resiliency of each clearinghouse's
financial safeguards.
Next, clearinghouse rules such as those of CME detail precisely
what financial obligations may be incurred, now and in the future, by
clearing members in the form of margin payments, default fund
requirements, and assessments. These rules also detail a
clearinghouse's capital contributions and waterfall structures and any
changes to these rules are subject to a transparent review process that
is open to the public. Clearing members can rest assured that the
current regulatory framework provides certainty as to how much capital
is required of each market participant and the order in which these
resources will be used to cure any deficiency in a clearinghouse's
funding under a clearing member default scenario.
Last, current regulations already require CME and other
systemically important clearinghouses to prepare credible recovery and
wind-down plans in the event that the viability of the clearinghouse is
threatened. While CME believes that its existing default management
framework is sufficient to handle multiple concurrent member defaults
under normal circumstances, we appreciate the value of worst-case-
scenario planning given the importance of our services. We are actively
working with our Clearing House Risk Committee, clearing members, and
regulators to enhance our plans that are designed to continue CME's
clearing operations, and if needed, conduct an orderly wind-down,
without causing systemic risk to the larger financial system. As every
clearinghouse's risk profile and risk management framework is unique
and the facts and circumstances of any doomsday scenario could vary
widely, CME believes it would be imprudent for regulators or Congress
to impose a one-size-fits-all approach to these plans or stress tests.
Conclusion
We appreciate the Committee's consideration of the views expressed
in this testimony. We stand ready to assist the Committee as a resource
in finalizing legislation that ensures the U.S. will remain a
competitive player in the global derivatives marketplace while
enhancing the safety and soundness of futures and derivatives markets
at home through a principles-based CFTC regulatory regime.
The Chairman. Thank you. Mr. Jackson?
STATEMENT OF BENJAMIN JACKSON, PRESIDENT AND CHIEF OPERATING
OFFICER, ICE FUTURES U.S., NEW YORK, NY
Mr. Jackson. Chairman Scott, Ranking Member Scott, I am Ben
Jackson, President and COO of ICE Futures U.S. I appreciate the
opportunity to discuss the reauthorization of the Commodity
Futures Trading Commission, and I am going to comment today on
two specific topics. First, ICE Futures U.S., and our self-
regulatory functions. As background, ICE Futures U.S. is a
designated contract market owned by the
IntercontinentalExchange, which is the leading global network
of regulated exchanges and central counterparty clearinghouses
for financial and commodity markets. ICE Future U.S. has a
strong history of overseeing position limits, accountability
levels, and exemption requests.
Our market regulation teams employ decades of surveillance
and compliance expertise in working with the derivatives
markets and the derivatives markets participants that they
oversee. This extensive direct experience has guided our self-
regulatory functions. In particular, the rules and procedures
developed and used by our exchange to perform this important
function were designed to incorporate the specific needs and
differing practices of the commercial participants in each of
our markets as those needs and practices have developed over
time. In revisiting the CEA, the Committee should encourage the
CFTC to re-examine the position limit proposal, and in
particular the effects of narrowing the definition of what
qualifies as a bona fide hedge, and the move toward hard
position limits in the non-spot month.
For administering hedge exemptions, given the CFTC's
constrained resources, and the significant time and resources
that such an undertaking would require, we believe that the
existing current structure reflects an efficient allocation of
resources that ensures commercial market participants will be
able to continue to hedge their risks in a timely manner.
In regard to position limits in the non-spot months, the
current accountability regime has proven to be effective at
balancing liquidity in nearby month expiries and future month
expiries. We believe that the current regime is effective, from
a resource standpoint, and has proved to result in well-
functioning markets. Therefore, the current regulatory regime,
which is overseen by the CFTC, and incorporates rules subject
to CFTC review, should remain in effect.
The second topic I want to touch on is where we are, in my
view, on global financial reform efforts. Over the past 2
years, regulators in the United States and Europe have been
working to address conflicts in the two major financial reform
efforts, Dodd-Frank in the U.S., and EMIR in Europe. ICE
Futures U.S. appreciates the hard work that the CFTC and its
staff, as well as their counterparts in Europe, are putting
into achieving true equivalence. The derivatives markets are
global, and in addressing these conflicts, we encourage
regulators to reach this equivalence. Widely varying rules will
only serve to increase complexity for the people that use our
markets every day.
The CFTC has historically relied on foreign regulators to
regulate foreign transactions, and worked with regulators to
adopt common principles that all regulated markets should
adopt. European regulators took a similar approach to U.S.
markets. This approach was very successful, as it led to a
greater harmonization of regulation, yet allowed foreign
regulators to oversee their institutions. We strongly encourage
a return to this approach.
In conclusion, I would like to note our appreciation of
Chairman Massad, and the CFTC's efforts to address many of the
issues that I have noted today through re-examining some of the
rules affecting the futures markets. We also appreciate the
efforts of this Committee to re-examine the CEA, and the impact
of Dodd-Frank. Thank you.
[The prepared statement of Mr. Jackson follows:]
Prepared Statement of Benjamin Jackson, President and Chief Operating
Officer, ICE Futures U.S., New York, NY
Chairman Scott, Ranking Member Scott, I am Ben Jackson, President
and Chief Operating Officer of ICE Futures U.S. I appreciate the
opportunity to discuss the reauthorization of the Commodity Futures
Trading Commission (CFTC).
Over the past 5 years, ICE Futures U.S. and other derivatives
markets participants have been implementing U.S. and global financial
reform rules. While the overall intent of financial reform was to
regulate the over the counter swaps markets, many of the rules, both in
the United States and globally, have made significant changes to the
futures markets, which were the model of regulation for the Dodd-Frank
Act. At this point, reexamining the Commodity Exchange Act (CEA) and
Dodd-Frank is of critical importance to make sure that the important
risk management and price discovery functions provided by the futures
markets are not constrained by regulation. My testimony today will
focus on the self-regulatory functions ICE Futures U.S. undertakes and
the overlap, particularly regarding position limits, with the CFTC. In
addition, I would like to discuss the recent conflicts in the global
financial reform process.
ICE Futures U.S. Self-Regulatory Functions
As background, ICE Futures U.S. is a designated contract market
owned by IntercontinentalExchange which is the leading global network
of regulated exchanges and central counterparty clearinghouses for
financial and commodity markets.
ICE Futures U.S. lists a broad array of contracts on the exchange
including North American power and natural gas, and international
agricultural commodities such as sugar, coffee, cocoa and cotton.
ICE Futures U.S. and its predecessor exchanges, which date back to
1870, have a strong history of overseeing position limits,
accountability levels and exemption requests. We have market regulation
teams in New York and Chicago. These teams employ market experts with
decades of surveillance and compliance experience working in the
derivatives markets that they oversee. This extensive, direct
experience has guided our self-regulatory functions. In particular, the
rules and procedures developed and used by our exchange to perform this
important function were designed to incorporate the specific needs and
differing practices of the commercial participants in each of our
markets as those needs and practices have developed over time.
Self-Regulation Functions and Bona Fide Hedging
ICE Futures U.S.' flexibility and market expertise are very
important in the context of bona fide hedge exemptions. In addition to
the swap market reforms, Dodd-Frank made changes to long standing
position limit and hedge exemption rules in futures. The CFTC, in
interpreting these rules, is broadly transforming the role of the CFTC
in the daily administration of position limits and the granting of
hedge exemptions, from an oversight role to direct regulation of
markets over which the futures exchanges currently exercise such
authority. As outlined in recent CFTC meetings of the Agriculture
Advisory Committee and the Energy and Environmental Markets Advisory
Committee, these changes to the current exchange structure and the
limiting of bona fide hedge exemptions will likely cause risk
management issues for commercial users of the derivatives markets. As
one example, the prohibitions or limitations on anticipatory hedging
are likely to greatly constrain the risk management practices of energy
and agricultural firms. It is worth pointing out that limiting hedging
and risk management by commercial firms was obviously not the intent of
the Dodd-Frank financial reforms.
In revisiting the CEA, we believe that the Committee should
encourage the CFTC to reexamine the position limit proposal and in
particular the effects on bona fide hedging and position limits in the
non-spot month. For administering hedge exemptions, the CFTC's
constrained resources and the significant time and resources that such
an undertaking would require coupled with the time sensitive nature of
exemption requests, we believe that the existing current structure
reflects an efficient allocation of responsibility and resources that
ensures commercial market participants will be able to continue to
hedge their risks in a timely manner. In regard to position limits in
non-spot months, the current position accountability regime has proven
to be effective at balancing liquidity both in nearby month expiries
and future month expiries. Our concern is that the implementation of
limits that will apply in any month and all months may have the
unintended consequence of concentrating volume and liquidity toward the
prompt delivery months only. This would constrain an end-user's ability
to effectively hedge a long dated exposure. We believe that the current
regime is efficient from a resource standpoint and has proved to result
in well-functioning markets that aid the price discovery and risk
management needs of end-users. Therefore the current regulatory regime,
which is overseen by the CFTC and incorporates rules subject to CFTC
review, should remain in effect.
Conflicts in Global Financial Reform Efforts
Over the past 2 years, regulators in the United States and Europe
have been working to address conflicts in the two major financial
reform efforts: Dodd-Frank in the U.S. and EMIR in Europe. Currently,
the negotiations are focused on harmonizing the clearing rules between
the two jurisdictions. ICE Futures U.S. appreciates the hard work that
the CFTC and its counterparts are putting into equivalence; however, we
note that many of these issues arise from the implementation of very
prescriptive financial reform rules. After addressing the conflicts on
clearing regulation, U.S. and European regulators must address
conflicts in a number of other areas as the EU finishes its financial
reform legislation. Each of these conflicts, if left unresolved, could
seriously hamper the operation of the derivatives markets, given their
inherently international nature.
Before financial reform, these conflicts in regulation were the
exception, not the norm, because financial regulation was based on a
common set of regulatory principles. For example, since 1984, Section
4(b) of the Commodity Exchange Act expressly excluded foreign
transactions from CFTC jurisdiction. The CFTC relied on foreign
regulators to regulate foreign transactions and worked with regulators
to adopt common principles that all regulated markets should adopt.
Likewise, European regulators took a similar approach to U.S. markets.
This approach was very successful, as it led to greater harmonization
of regulation, yet allowed foreign regulators to oversee their
institutions. We strongly encourage a return to this approach.
I would like to mention one more regulatory conflict: the one
between global financial reform's commitment to derivatives clearing
and the implementation of the Basel III capital requirements by
international regulators. As noted by this Committee, the
implementation of Basel III penalizes clearing by assessing a capital
charge on initial margin collected by banks operating as clearing
firms. Due to the way the capital charge is calculated, the impacts
will be particularly acute on firms that hedge, given their directional
exposure to the clearing firm. In addition, perversely, the capital
rules discourage the collection of initial margin, which is the biggest
risk mitigation of a derivatives transaction. Finally, the Basel
Committee has delayed implementation of capital rules for uncleared
transactions, which further disadvantages clearing.
Conclusion
In conclusion, I would like to note our appreciation of Chairman
Massad's and the CFTC's efforts to address many of the issues I have
noted today through reexamining some of the rules affecting the futures
markets. We also appreciate the efforts of this Committee to reexamine
the CEA and the impact of Dodd-Frank.
Mr. Chairman, thank you for the opportunity to share our views with
you. I would be happy to answer any questions you may have.
The Chairman. Mr. Roth?
STATEMENT OF DANIEL J. ROTH, PRESIDENT AND CHIEF
EXECUTIVE OFFICER, NATIONAL FUTURES ASSOCIATION, CHICAGO, IL
Mr. Roth. Thank you, Mr. Chairman, and thank you very much
for the opportunity to appear here today. This Committee is
taking up the issue of reauthorization at a particularly
critical time. Implementing all the changes mandated by Dodd-
Frank has been very challenging for regulators, like NFA, and I
am sure even more so for the members that we regulate. What I
would like to do this morning if--or this afternoon, if I
could, would be to describe briefly some of the changes we have
made at NFA to cope with those changes, and also talk about a
couple of provisions in last year's bill that we strongly
advocated last year, and we continue to support this year.
At NFA--the one thing that hasn't changed at NFA is our
basic mission. To put it in a nutshell, our job is to help the
CFTC. We are the industry-wide self-regulatory body. Regulation
is all we do, and we are there to help the CFTC. We do that in
a number of different ways. For example, in certain areas the
CFTC actually delegates certain responsibilities to NFA, and in
those areas of delegated responsibility, NFA acts as an agent
on behalf of the CFTC. So, for example, the entire registration
process, the CFTC has delegated that to NFA, and we act on
behalf of the CFTC. Similarly, for commodity pool operators and
commodity trading advisors, they are required to submit their
disclosure documents to the CFTC. Well, NFA reviews those
documents on behalf of the CFTC. Pool operators are--will
submit 5,000 financial statements to us in the next few weeks
for the pools that they operate, and those are required to be
the submitted to the CFTC. NFA will review those on behalf of
the CFTC.
In other areas, though, we don't act as an agent for the
Commission, but rather as a self-regulatory body, like the CME,
and ICE, and others. And in those areas, we basically perform
examinations of our members and take enforcement actions when
necessary, where we find members not in compliance with the
rules. In that area the biggest change that has occurred in NFA
involves swap dealers. Dodd-Frank required swap dealers to
register with the CFTC. The CFTC, in turn, required them to
become members of NFA. I should mention we have about a little
over 100 swap dealers right now. And over the last 4 years we
basically had to build from scratch a self-regulatory
infrastructure for those swap dealers.
So we have added--our staff is almost 100 now, devoted
solely to swaps compliance. We have a staff of almost 100. We
are projecting additional hiring in our next fiscal year. Those
people have been very busy. They have been busily engaged in
reviewing hundreds of thousands of pages of policies and
procedures that those firms were required to submit to the
Commission, and we reviewed on the Commission's behalf. We have
also prepared examination modules for each of the rulemaking
areas where the Commission has completed its rulemaking, and we
have begun performing on-site examinations of those members to
monitor them for compliance.
All of this, as you might gather, has had a pretty
significant impact on our resources. Our staff over the last 4
years has grown from about 300 to 480, and, again, we are
projecting further growth next year. Our budget has more than
doubled, from about $42 million 4 years ago to--it is going to
be over $85 million in the next fiscal year. Those are pretty
dramatic increases, but our board felt that each and every one
of those increases in our budgets was mandatory, was essential
for us to carry out our function.
With respect to last year's bill, if I could just mention
briefly, there were a couple of provisions in last year's bill
that were very important to us, from a customer protection
point of view. One of them involved FCM insolvencies. The CFTC,
a long time ago, had adopted a rule that provided that if an
FCM was in bankruptcy, and if there was a shortfall in
segregated funds, then customers received priority over all the
other creditors of the FCM, and that was a good rule. That rule
has served the industry well, it has served the customers well.
Unfortunately, a few years ago a lower court opinion cast
some doubt on the validity of that rule. The court had
questioned the CFTC's authority to adopt the rule that it had
adopted. Last year's bill contained language to clarify that
point, and to make clear that the Commission did have the
authority to adopt that rule. We supported that rule--that
provision then, we support it now. We hope it is in the bill
that comes out of this Committee this year.
There were also some significant customer protection
provisions in last year's bill codifying some of the work that
NFA, and CME, and others had done with respect to the daily
confirmation of customer segregated funds, increased
transparency about FCM financial data, and other matters along
those lines, and that was included in the bill. We support
codification of those provisions, and hope they are included
again this year.
Mr. Chairman, I would be happy to answer any questions.
Thank you very much, again, for the opportunity.
[The prepared statement of Mr. Roth follows:]
Prepared Statement of Daniel J. Roth, President and Chief Executive
Officer, National Futures Association, Chicago, IL
Chairman Scott, Ranking Member Scott, Members of the Subcommittee,
thank you for the opportunity to testify here today. I am President of
National Futures Association. For those new to the Subcommittee, NFA is
the industrywide self-regulatory organization for the derivatives
industry. Our membership includes Swap Dealers, Futures Commission
Merchants (FCM), Commodity Pool Operators (CPO), Commodity Trading
Advisors (CTA), Introducing Brokers and all of the Associated Persons
in the futures industry. NFA's responsibilities include registration of
all industry professionals on behalf of the CFTC, passing rules to
ensure fair dealing with customers, monitoring Members for compliance
with those rules and taking enforcement actions against those Members
that violate our rules.
In a nutshell, our job is to help the CFTC. For example, besides
the registration process, NFA also reviews all CPO and CTA disclosure
documents, CPO annual pool financial statements, and all of the
policies and procedures that Swap Dealers are required to file with the
CFTC. In addition, we immediately notify the CFTC if any of our exams
uncover emergency situations and coordinate our responses with the
Commission. We also meet regularly with the Division of Enforcement to
avoid duplication of effort and also with the Division of Swaps and
Intermediary Oversight on our exam process and rule development issues.
More recently, at Chairman Massad's request, we have discussed other
ways in which the Commission can take advantage of the regulatory
resources of NFA and the CME. The Commission faces a huge job and we
will continue to help in any way we can.
Reauthorization is always an important process for the industry as
a whole and for NFA in particular. That's never been more true than it
is today. NFA was pleased that key customer protections we supported
were included in last year's bill, and I would like to address those
provisions and reiterate why we support them. Let me begin, though, by
discussing some of the challenges NFA has had to meet as a result of
Dodd-Frank and other changes in the industry.
In some ways, NFA today is a very different organization than it
was just a few short years ago. The most obvious change at NFA is size.
Four years ago we had a staff of 300; today we have a staff of 480.
Four years ago we operated on a budget of $42 million; this year our
budget was over $80 million and we project another significant budget
increase next year. We have always recognized that increased spending
on regulation is not a virtue in and of itself. However, our Board was
convinced that changes in the industry and in the scope of NFA's
responsibilities made these increases essential. There are three main
forces driving these changes at NFA, two of them related to Dodd-Frank.
Swap Dealer Membership
Dodd-Frank required certain Swap Dealers to register with the CFTC,
and the CFTC required them to become Members of NFA. We have over 100
Swap Dealer Members, the vast majority of whom are either large U.S.
banks or financial institutions, foreign banks or affiliates of one of
those groups. Over the last several years we have built our Swaps
Compliance Department from scratch. We began by building our senior
management team and were lucky enough to recruit a team of six
talented, experienced and dedicated individuals who have a total of
over 100 years of experience in the swaps area. We have continued to
build our staff and now have almost 100 individuals working exclusively
on swaps compliance issues. We have reviewed hundreds of thousands of
pages of policies and procedures that Swap Dealers were required to
file with the CFTC, have begun the development of NFA's internal risk
management guidelines to monitor Swap Dealer Members and developed
examination modules for all of the rules adopted by the CFTC. This year
we began conducting on-site examinations of Swap Dealer Members.
Much has been done in this area but much more work remains. We are
working with the CFTC and other regulators to maximize our coordination
and minimize duplication of effort. We are also working with the
Commission to sort out the extent of NFA's responsibilities to monitor
foreign firms that the CFTC has allowed to comply with comparable rules
from their home jurisdiction. In this area, again, our primary goal is
to limit wasting resources by duplicating the work of other regulators.
Swap Execution Facilities
Dodd-Frank also allowed for the creation of Swap Execution
Facilities, electronic trading platforms for swaps. These SEFs have
their own self-regulatory responsibilities to conduct surveillance of
their markets. Of the 22 registered SEFs, 16 have contracted with NFA
to perform certain surveillance functions on their behalf. As a result,
NFA has tripled the size of our Market Regulation Department. We began
our work in this area by developing a comprehensive set of the data
elements NFA would need to receive from SEFs to perform our
responsibilities. In doing so, we consulted extensively with both the
industry and the CFTC. The result of those deliberations was a document
listing the 150 data elements SEFs must provide to NFA. When SEF
trading was launched on October 2, 2013, we were ready. The CFTC
adopted our data elements as the industry standard, and with the CFTC
we have begun discussions with international regulators to ensure
uniform international standards.
Changes in Rules and Regulatory Practices
The third force driving change at NFA has nothing to do with Dodd-
Frank. Following the failures of two FCMs, MF Global and Peregrine, a
special committee of NFA's public directors commissioned an independent
review of NFA's examination procedures. The study was conducted by a
team from the Berkeley Research Group that included former SEC
personnel who conducted that regulator's review of the SEC's practices
after the Madoff fraud. The report stated that NFA's exams of Peregrine
were conducted in a competent manner but also included a number of
recommendations designed to improve the operations of NFA's regulatory
examinations. The recommendations included areas such as hiring,
training, supervision, risk management and continuing education. All of
the committee's recommendations have been implemented and they have
certainly made NFA a better regulator. Those changes come with a price
tag, however, and we have increased the size of NFA's Futures
Compliance Department by 33% since MF Global and Peregrine.
Improving examination procedures and increasing the size of the
staff were helpful but they were not enough to accomplish the changes
that we felt had to be made. Our Board also approved a wide range of
new rules designed to prevent future FCM failures. Most importantly,
rule changes adopted by NFA and CME now provide for the daily
confirmation of balances for segregated customer funds held in over
2,000 accounts. We compare the confirmation from the depository with
the daily information we receive from FCMs and immediately note and
follow up on any material discrepancies. This rule change, and others
I've described in previous testimony, mark a huge step in the
protection of customer funds.
As I mentioned earlier, NFA was pleased that key customer
protections we supported were included in the reauthorization bill
approved by this Subcommittee last year. There were several provisions
of that bill that were of particular importance to NFA, and I would
like to briefly restate our support for those measures.
Strengthening Customer Protections in FCM Bankruptcy Proceedings
Over 30 years ago the CFTC adopted rules regarding FCM
bankruptcies. Among other things, those rules provided that if there
was a shortfall in customer segregated funds, the term ``customer
funds'' would include all assets of the FCM until customers had been
made whole. Several years ago, a district court decision cast doubt on
the validity of the CFTC's rule. That decision was subsequently vacated
but a cloud of doubt lingers on. This Committee attempted to remove
that doubt in last year's bill by proposing to amend the Act to clarify
the CFTC's authority to adopt the rule that it did. I believe there is
a broad base of industry support for that approach, and we urge you to
include that provision in any reauthorization bill that moves this
year.
Codification of Customer Protection Rules
As I mentioned earlier, NFA, CME and other self-regulatory
organizations adopted a number of very effective customer protection
rules in the wake of MF Global and Peregrine. Two of the most
significant rules involved the daily confirmation of customer
segregated fund balances and additional requirements any time an FCM
withdraws more than 25% of its own funds from segregated accounts. Last
year's bill ensured that those protections could not be peeled back by
requiring SROs to maintain those rules. We fully support that concept
and, again, hope that this year's reauthorization bill contains similar
provisions.
Changes to the De Minimis Level for Swap Dealer Registration
The current de minimis level of swap dealing that triggers swap
dealer registration is $8 billion, but under the current structure that
level will automatically be reduced to $3 billion without any
affirmative rule making by the CFTC. The time may well come when it is
appropriate to adjust the threshold up or down, but the consequences of
doing so could be very significant for both market participants and
regulators, including NFA. A change of that magnitude should not happen
by default. Last year's bill provided that the de minimis level could
only be changed by the CFTC taking the affirmative step of amending its
rules. We continue to support that provision and urge its inclusion in
this year's bill.
Before I close let me also mention one issue that is of critical
importance to all of us--Congress, regulators, market participants and
the general public--cybersecurity. At NFA we need both an internal and
an external focus on this important issue. Internally, we continue to
do everything we can to protect the confidentiality of all of the data
we hold, including all of the registration data we hold on behalf of
the CFTC. Our security measures are constantly reviewed by our own
staff, by the CFTC and by consultants we hire to try to penetrate our
defenses. We believe that our security measures reflect the state of
the art, but we take no particular comfort in that. We recognize that
the risk of penetration will always be present no matter how extensive
our defenses. Therefore, we are implementing countermeasures like
enhanced monitoring and encryption across our systems to further
protect our data in the event of a breach.
Our external focus is on providing our Members with the guidance
they need to ensure that their security measures satisfy their
regulatory responsibilities. Our Members range in size from huge
multinational corporations with ultra sophisticated defenses to one
person shops. We are working with the CFTC and the industry to develop
guidance that would provide meaningful protections and be flexible
enough to apply to all of our Members.
Mr. Chairman, I recognize both how difficult and how important the
reauthorization process is for the derivatives industry and all of the
end-users that depend on these markets for their hedging needs. I agree
with Chairman Massad that we must always be sensitive to the costs
imposed by regulation. This is particularly true as the number of FCMs
continues to dwindle, concentrating more risk in fewer FCMs and
limiting the FCMs that serve agricultural end-users. We look forward to
working with the Subcommittee to strike the difficult balance that must
be achieved and will be happy to answer any questions the Subcommittee
may have.
The Chairman. Thank you. Mr. Corcoran?
STATEMENT OF GERALD F. CORCORAN, CHAIRMAN OF THE BOARD AND
CHIEF EXECUTIVE OFFICER, R.J. O'BRIEN &
ASSOCIATES, LLC, CHICAGO, IL; ON BEHALF OF FUTURES
INDUSTRY ASSOCIATION
Mr. Corcoran. Chairman Scott, Ranking Member Scott, Members
of the Subcommittee, thank you for the opportunity to appear
before you today. I would first like to commend the Agriculture
Committee for continuing the bipartisan approach to developing
legislation. It is the spirit that resulted in the House
passing a good CFTC reauthorization bill during the last
Congress, and we look forward to a collaborative bipartisan
process again in 2015.
The reauthorization legislation developed by the House
Agriculture Committee during the last Congress contained
several customer protection enhancements that FIA continues to
support, including two key clarifications, one relative to the
timing of an FCM's residual interest obligations, and another
restoring legal certainty as to the utilization of property
outside of the segregated customer accounts to ensure that
customers are the highest priority in the event of an FCM
bankruptcy.
In addition to the recent customer protection improvements,
the entire clearing ecosystem has undergone major regulatory
changes since enactment of the Dodd-Frank Act in the U.S. and
the EMIR in Europe. When policymakers determine to extend
clearing beyond futures and options to certain over-the-counter
swaps, the role of the FCM also expanded. FCMs play a critical
role in ensuring that cleared transactions are secured with
appropriate margin to facilitate this clearing process. We
operate in global markets, and if global regulations are not
well coordinated, the markets will fragment within regulatory
jurisdictions, and become far less liquid, to the detriment of
the ultimate end-users.
I would like to highlight one global regulatory
coordination challenge we are currently facing. Europe and the
U.S. have developed differing requirements relative to
margining methodologies that clearinghouses must apply. As
clearing members of clearinghouses in each country, we are
perplexed by recent suggestions that the competing
methodologies should be run simultaneously, with clearing
members and clients then subjected to the model resulting in
the highest margin requirement on any given day. This overly
complex and operationally risky policy seems to overlook the
implications to those who post the margin, the client and the
clearing member. Assuming that each regulatory jurisdiction is
unlikely to prescribe identical requirements, the practicality
of requiring dual registration or recognition hinges upon the
various jurisdictions' ability to acknowledge regulatory
differences and coordinate a reasonable path going forward.
I also want to briefly mention new reporting requirements
that fall to clearing members. FCMs serve as the responsible
party for the submission of various data sets to the CFTC, both
for our own entities, as well as for our customers. Recent CFTC
regulations require FCMs to collect certain customer data that
has never been expected before. Not all customers are willing
to provide this new information, which presents challenges to
FCMs, who are then put in an untenable position of either
ceasing to do business with the customer, or incurring
regulatory risk. While we were happy to work with the
Commission to improve the process surrounding new ownership and
control reporting, some regulatory refinements are likely
necessary in order for the data to be available and useful.
Additionally, the Dodd-Frank Act requires new Chief
Compliance Officer annual reports that are quite extensive.
These reports are linked to the filing of annual financial
reports, even though the two reports are very different, and
require different inputs from different parts of the
organization. Given the complexity of compiling the Chief
Compliance Officer's filings, it may be prudent to de-link the
two filings.
Another critical area focus for the FIA is Basel III
capital requirements for our prudentially regulated members.
While my clearing firm is not affiliated with a bank, those
FCMs who are face a real challenge relative to excessive
capital costs for their client clearing businesses, making it
increasingly expensive for many clearing member banks to offer
clearing services to their clients.
At issue is the recently finalized leverage ratio, which
treats client margin posted to a bank affiliated clearing
member as a resource that can be used to leverage the bank, an
assumption that seems to conflict with requirements in the
Commodity Exchange Act and CFTC regulations that require client
margin to be segregated for the protection of the customer, and
thereby unable to be leveraged by the bank.
The lack of recognition of the CFTC requirements in the
context of the banking regulator's new capital rules results in
increased cost to the clearing system, including clients of
bank affiliated clearing members, capital costs that exceed
tens of billions of dollars today, and hundreds of billions of
dollars once more products are required to clear under the new
swap clearing mandate.
These numbers are staggering, and, frankly, will result in
fewer FCMs to support the overall clearing system, and fewer
choices for customers who need to hedge their risk, all effects
which, ironically, seem contrary to the principles of the G20
and the Dodd-Frank Act, which were intended to encourage more
risk mitigation for the practice of clearing.
Over the 10 year period between 2004 and 2014, the pool of
FCMs registered with the CFTC decreased by more than 50
percent, from 190 FCMs to 76 FCMs. The new capital requirements
on bank affiliated FCMs will only serve to further consolidate
the pool of clearing services available to customers, at the
very time when more clearing is mandated.
In closing, I would like to remind the Subcommittee that
the FCM function has proven to be an essential foundation for
managing risk in the futures markets, and is integral for
advancing the goals of the new trading and clearing
requirements for swaps as well. We want to continue supporting
the risk management needs of our customers in a productive way.
This is a goal I know the Members of this Committee share, and
I look forward to working with you as you consider the CFTC's
role in achieving this mutual objective. Thank you.
[The prepared statement of Mr. Corcoran follows:]
Prepared Statement of Gerald F. Corcoran, Chairman of the Board and
Chief Executive Officer, R.J. O'Brien & Associates, LLC, Chicago, IL;
on Behalf of Futures Industry Association
Chairman Scott, Ranking Member Scott, and Members of the
Subcommittee, thank you for the opportunity to discuss matters
affecting the cleared derivatives industry. I am testifying today in
both my roles as Chairman and CEO of R.J. O'Brien and Chairman of the
Futures Industry Association (FIA). As you consider reauthorizing the
Commodity Futures Trading Commission (CFTC), FIA and its members stand
ready to assist in any way we can. FIA is the leading trade
organization for the futures, options and over-the-counter cleared
derivatives markets. Our membership includes derivatives clearing
firms, customers and exchanges from more than 20 countries. FIA's core
constituency consists of futures commission merchants (FCMs), such as
R.J. O'Brien that I manage in Chicago. As a trade association, our
primary focus is the global use of exchanges, trading systems and
clearinghouses for derivatives transactions.
I would first like to commend the Agriculture Committee for
continuing the bipartisan approach to reauthorizing the CFTC. It is
this spirit that resulted in the House passing a good bill during the
last Congress. As derivatives markets are adapting and responding to
major regulatory transformations, they need stability and certainty to
thrive, and the House Agriculture Committee recognized this as they
developed H.R. 4413 during the 113th Congress. This legislation
contained provisions designed to make the CFTC operationally more
effective, and FIA supports those enhancements to cost-benefit analysis
and internal risk controls.
Customer Protection
One of the most important aspects of any legislation reauthorizing
the CFTC is enhanced customer protection. As you know, the failures of
MF Global Inc. and Peregrine Financial Group resulted in severe and
unacceptable consequences for futures customers and the markets
generally. The entire industry has been working collaboratively to
identify and improve procedures required to better protect the
integrity of these markets. A number of changes are already being
implemented, many of which were recommended by FIA in the aftermath of
these insolvencies: \1\
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\1\ See Futures Industry Association, Futures Markets Financial
Integrity Task Force--Initial Recommendations for Customer Funds
Protection: https://americas.fia.org/articles/fia-task-force-issues-
initial-recommendations-enhancing-customer-funds-protections.
The industry's principal self-regulatory organizations
(SROs) have adopted rules that subject all FCMs to enhanced
recordkeeping and reporting obligations. For example, chief
financial officers or other appropriate senior officers are now
required to authorize in writing and promptly notify the FCM's
designated SRO whenever an FCM seeks to withdraw more than 25
percent of its excess funds from the customer segregated
account in any day--these are funds deposited by the FCM into
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customer accounts to guard against customer defaults.
The National Futures Association (NFA) is also collecting
additional financial information from FCMs and posting the
information onto its online Background Affiliation Status
Information Center (Basic) system, a key step in giving
customers the tools they need to monitor the assets they
deposit with their FCMs. The new service provides the public
with access to specific information about an FCM, such as the
firm's adjusted net capital, the amount of funds held in
segregated, secured, and cleared swaps accounts, and the types
of investments that the FCM is making with those customer
funds.
A newly developed segregation confirmation system allows
SROs to run comparisons of the balances in customer segregated,
secured, and cleared swaps accounts at the depositories with
the daily reports they receive from FCMs, and identify any
discrepancies.
A set of frequently asked questions on customer funds
protection \2\ has also been developed by FIA, which is being
used by FCMs to provide their customers with increased
disclosure on the scope of how the laws and regulations protect
customers.
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\2\ See Protection of Customer Funds, Frequently Asked Questions:
https://americas.fia.org/articles/fia-issues-fourth-version-guide-
customer-fund-protections.
In November 2013, the CFTC finalized new regulations for
``Enhancing Protections Afforded Customers and Customer Funds
Held by Futures Commission Merchants and Derivatives Clearing
Organizations''. FIA supports the vast majority of the
comprehensive regulatory reforms contained therein and wishes
to specifically applaud the Commission and the Agriculture
Committee for devoting much time and attention to the
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appropriate timing of residual interest requirements.
The reauthorization legislation developed by the House Agriculture
Committee during the last Congress contained several customer
protection enhancements that FIA continues to support including two key
clarifications--one relative to the timing of an FCM's residual
interest obligations and another restoring legal certainty as to the
utilization of property outside of the segregated customer accounts to
ensure that customers are the highest priority in the event of an FCM
bankruptcy.
Clearing Infrastructure Challenges
Clearing ensures that parties to a transaction are protected from a
failure by the opposite counterparty to perform their obligations, and
FIA's FCM members play a critical role in ensuring that transactions
are secured with appropriate margin to facilitate this clearing
process. Under the ``Dodd-Frank Act'' in the U.S. and the ``European
Market Infrastructure Regulation'' (EMIR) in Europe, policymakers
determined to extend clearing beyond futures and options to certain
over-the-counter swaps, and as such the role of the FCM has also
expanded. Because FCMs play a critical role in achieving and sustaining
the clearing system, we would like to offer our thoughts on the ongoing
development of various new regulatory initiatives.
Cross-Border Coordination
We operate in global markets and to assume otherwise is very
dangerous given that market participants are best served with deep
liquidity. If global regulations are not well coordinated the markets
will fragment within regulatory jurisdictions and become far less
liquid, to the detriment of the ultimate end-users. To date, much of
the public regulatory scrutiny has focused on the cross-border
regulation of trade execution parties, both the client and the swap
dealers, but there are also cross-border challenges within the
regulation of the infrastructure that is expected to support the
clearing of derivatives. For example, the ``Dodd-Frank Act''
specifically provides the CFTC with the ability to exempt comparably
regulated foreign clearinghouses from registration with the U.S.
regulator yet the CFTC has never established a means by which
clearinghouses, also known as central counterparties (CCPs), might seek
such exemptions. Thus any foreign CCP clearing swaps for U.S. entities
must register with the CFTC, as well as their home country regulator.
U.S. based CCPs who are registered with the CFTC and do business with
European participants are required under EU law to be ``recognized'' by
having equivalent regulations to those in Europe. Assuming that each
regulatory jurisdiction is unlikely to prescribe identical
requirements, the practicality of such dual registration or recognition
hinges upon the various jurisdictions' ability to acknowledge
regulatory differences and rely upon each other as front line
regulators. I would like to highlight one specific example of a current
regulatory coordination challenge we are facing: Europe and the U.S.
have developed differing requirements relative to margin methodologies
that CCPs must apply. As clearing members of CCPs in each country, we
are perplexed by recent suggestions that the competing methodologies
should be run simultaneously. As such, clearing members and their
clients would be subjected to the model resulting in the highest margin
requirement on any given day. This overly-complex and operationally
risky policy seems to overlook the implication to those who post
margin--the client and the clearing member. There has been very little
transparency or involvement of the clearing members to date in the
discussion between the CFTC and EU authorities.
Clearing Member Reporting Requirements
I also want to briefly mention new reporting requirements that fall
to clearing members. FCMs serve as the responsible party for the
submission of various data sets to the CFTC--both for our own entities,
as well as our customers. Recently, the CFTC has modified the manner in
which information on large positions is reported to the regulator by
broadening both the scope of reportable positions and the amount of
data required for the reports. The new Ownership and Control Reporting
(OCR) rules require FCMs to collect certain customer data that has
never been required before and not all customers are willing to provide
this new information. This presents challenges to FCMs who are required
by regulation to gather data from customers who are under no regulatory
obligation to provide such information. The current OCR Rule puts FCMs
in an untenable position of either ceasing to do business with
customers or incurring regulatory risk. In addition, privacy laws in
foreign countries raise legal ramifications for reporting entities and
their customers located outside the U.S. While we are happy to work
with the Commission to improve this process, some regulatory
refinements are likely necessary in order for the customer data to be
available to the FCM and useful to the regulator.
Additionally, the ``Dodd-Frank Act'' requires new chief compliance
officer annual reports that are quite extensive. These reports are
linked to the filing of annual financial reports even though the two
reports are very different and require different inputs from different
parts of the business. Given the complexity of compiling the chief
compliance officer filings, it may be prudent to delink the two
filings.
Basel III Capital Implications for Cleared Derivatives
Another critical area of focus for the FIA is Basel III capital
requirements for our prudentially regulated bank members. While my
clearing firm is not affiliated with a bank, those FCMs who are face a
real challenge relative to excessive capital costs for their client
clearing businesses. This result seems at odds with the principles of
the G20 and the ``Dodd-Frank Act,'' which were intended to encourage
more clearing for its risk mitigating effects. Rather, these increased
capital costs have made it increasingly expensive for many clearing
member banks to offer clearing services to their clients. At issue is
the recently finalized leverage ratio, which treats client margin
posted to a bank-affiliated clearing member as a resource that can be
used to leverage the bank. This assumption runs counter to the
Commodity Exchange Act and CFTC regulations that require client margin
to be segregated for the protection of the customer and thereby unable
to be leveraged by the bank. The lack of recognition of the CFTC
requirements in the context of the banking regulators' new capital
rules results in increased costs to the clearing system (including
clients of bank-affiliated clearing members) exceeding tens of BILLIONS
of dollars today and hundreds of BILLIONS of dollars once more products
are subjected to clearing under new swap clearing mandates.
Conclusion
These numbers are staggering and frankly will result in fewer FCMs
to support the overall clearing system and fewer choices for customers
who need to hedge their risk. Over the 10 year period between 2004 and
2014, the FCM community shrunk from 190 FCMs to 76 FCMs. The current
number of FCMs registered with the CFTC has been reduced to less than
half of those registered 10 years ago and is down from nearly 100 at
the end of 2013. These new capital requirements on bank-affiliated FCMs
will only serve to further consolidate the pool of clearing service
providers. The FCM function has proven to be an essential foundation
for managing risk in the futures markets, and is integral for advancing
the goals of the new trading and clearing requirements for swaps as
well. As the Committee considers how best to ensure these markets are
properly regulated, we encourage a holistic view of the clearing
infrastructure and its sustainability.
I am fortunate to represent a wide array of stakeholders in the
derivatives industry--all of whom want to see this industry continue to
support the risk management needs of its customers in a productive way.
This is a goal I know the Members of this Committee share and I look
forward to working with you as you consider the CFTC's role in
achieving this mutual objective.
The Chairman. Mr. Bernardo?
STATEMENT OF SHAWN BERNARDO, CHIEF EXECUTIVE
OFFICER, tpSEF, INC. AT TULLETT PREBON, JERSEY CITY, NJ; ON
BEHALF OF WHOLESALE MARKET BROKERS
ASSOCIATION, AMERICAS
Mr. Bernardo. Thank you, Chairman Scott, Ranking Member
Scott, and Members of the Subcommittee. My name is Shawn
Bernardo. I am the Chief Executive Officer of tpSEF, Tullett
Prebon's Temporarily Registered Swap Execution Facility, or
SEF. Tullett Prebon is a founding member of the Wholesale
Market Brokers' Association, Americas, an independent industry
body whose membership includes the largest North American
inter-dealer brokers. I appear before you today in my capacity
as a WMBAA Officer and Board Member. I am pleased to share with
you the SEF perspective on CEA reauthorization and Dodd-Frank
implementation.
By way of background, I have spent nearly 20 years in the
inter-dealer broker industry. My career began in 1996 as a U.S.
Treasury broker. I have spent the vast majority of my career
building various electronic and hybrid platforms in fixed
income markets. As SEFs, WMBAA member firms are the trading
platforms that help foster liquidity. We do not hold securities
or customer funds. SEFs are regulated intermediaries that work
to match buyers and sellers of swaps.
Congress fashioned the newly regulated swap market to force
the competition between trading platforms in order to ensure
that end-users seeking to manage risk can do so effectively.
There are 22 temporarily registered SEFs, with three additional
applications pending before the CFTC. Furthermore, SEFs compete
against one another for their customers' trades on price,
service, and liquidity. I would like to share two main points
with you today.
First, since the CFTC adopted final SEF rules in June 2013,
the WMBAA member firms have been working diligently to
implement the new requirements and meet the standards necessary
to obtain permanent registration. This, however, has not been
an easy task. Second, the WMBAA is encouraged by recent
speeches by the CFTC Chairman and Commissioners, including
Commissioner Giancarlo's white paper on swap trading rules,
suggesting that the agency may consider adjusting various
aspects of its SEF rules and swap trading regulations.
Let me briefly describe WMBAA member firm experiences as
they relate to SEF registration. SEF applications have been
pending before the CFTC since the summer of 2013. WMBAA member
firms have each filed registration forms, participated in many
staff visits and calls, and responded to document requests,
exhaustive questionnaires, and rulebook inquiries. And let me
also say that the CFTC staffers are hardworking, dedicated, and
have been fully engaged in this process.
The WMBAA remains hopeful that the SEF registration will be
issued later this year so that we can dedicate more of our
resources to providing competitive, vibrant, and transparent
markets. But SEF compliance remains challenging because the
regulatory landscape continues to shift as the CFTC issues
numerous no action letters, guidance, and interpretations of
the rules. I would like to share one example from my written
testimony that illustrates our concern with not only the nature
of the CFTC's rulemaking process to date, but also the
impractical burdens imposed by certain CFTC regulations.
To the surprise of the market participants, a footnote to
the final SEF rules, Footnote 195, imposed an obligation on
SEFs to collect the underlying master agreements between
counterparties. In response to market participants' concerns to
this footnote, CFTC staff ultimately issued no action relief,
which in turn imposed another unforeseen obligation on SEFs,
which has proven to be unworkable.
In sum, the no action relief failed to provide meaningful
relief to the industry. We continue to engage the CFTC staff on
this point, and hope the agency will resolve the issue shortly,
but this approach to regulation fails to provide the legal
certainty and stability needed for SEFs and swap trading to
flourish.
Second, as it relates to altering, or fine tuning the SEF
and swap trading rules, in addition to the problems from
Footnote 195 I just referenced, there remain other pressing
implementation areas that continue to frustrate the SEF's
registration and swap trading process. My prepared statement
includes a list of pending implementation issues that continue
to delay the registration process.
When SEF rules were adopted 2 years ago, Commissioners
demonstrated a commitment to reassessing the policy judgments
as the markets evolve, and the CFTC gains more experience and
new information. We urge the agency to, as both Chairman Massad
and Commissioner Bowen have said, enhance the rules to fit the
current market structure.
Finally, as the Congress considers CEA reauthorization, the
WMBAA urges the Committee to ensure that the agency remain true
to the CFTC's principle based approach to regulation. Overly
prescriptive rules will artificially restrict the flexibility
that benefits all market participants, including the end-users,
and inhibit U.S. financial markets from remaining the most
competitive and liquid in the world.
Thank you for the opportunity to comment on these very
important issues. I would be happy to answer any questions.
[The prepared statement of Mr. Bernardo follows:]
Prepared Statement of Shawn Bernardo, Chief Executive Officer, tpSEF,
Inc. at Tullett Prebon, Jersey City, NJ; on Behalf of Wholesale Market
Brokers Association, Americas
Introduction
Thank you, Chairman Scott, Ranking Member Scott, and Members of the
Subcommittee for providing this opportunity to participate in today's
hearing.
My name is Shawn Bernardo. I am the Chief Executive Officer of
tpSEF, Inc., Tullett Prebon's temporarily-registered swap execution
facility (SEF). Tullett Prebon is a founding member of the Wholesale
Markets Brokers Association, Americas (WMBAA), an independent industry
body whose membership includes the largest North American inter-dealer
brokers.\1\
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\1\ The WMBAA is an independent industry body representing the
largest inter-dealer brokers. The five founding members of the group--
BGC Partners, GFI Group, ICAP, Tradition, and Tullett Prebon--operate
globally, including in the North American wholesale markets, in a broad
range of financial products, and have received temporary registration
as swap execution facilities. The WMBAA membership collectively employs
approximately 4,000 people in the United States; not only in New York
City, but in Stamford, Connecticut; Chicago, Illinois; Louisville,
Kentucky; Jersey City, New Jersey; Raleigh, North Carolina; and Houston
and Sugar Land, Texas. For more information, please see www.wmbaa.org.
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I appear before you today in my capacity as a WMBAA Officer and
Board Member.
Tullett Prebon is a leading global inter-dealer broker of over-the-
counter (OTC) financial products.\2\ My company has a global presence
and the business covers money market and foreign exchange products,
fixed income, interest rate derivatives, equities, and energy products,
and offers voice, hybrid, and electronic broking solutions for these
products. Tullett also offers a variety of market information services
through its inter-dealer broker market data division, Tullett Prebon
Information.
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\2\ For more information, please see www.tullettprebon.com.
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My career began in the inter-dealer broker industry in 1996 as a
U.S. Treasuries broker. As you may know, the secondary market in U.S.
Treasuries trades exclusively over-the-counter, both electronically and
via voice, and stands as an example of one of the most liquid and
efficient markets in the world. My experience as a broker allowed me to
help create electronic brokering systems for U.S. Treasuries, U.S.
repurchase agreements, credit default swap index products, and interest
rate swaps. I have spent the vast majority of the past 15 years
building various electronic and hybrid brokering platforms to promote
more efficient markets in Fixed Income, Energy, Credit, FX Options, and
Interest Rates.
WMBAA Supports Recent CFTC Statements to Revisit Issues Related to SEF
and Swap Trading Rules
The WMBAA is encouraged by recent statements by the Commissioners
of the Commodity Futures Trading Commission (CFTC or Commission)
suggesting that the Commission may consider potential revisions to
various aspects of its swap regulations promulgated pursuant to the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
Act), including reforms specifically related to SEFs and swap trading.
We support these efforts and continue to support steps to preserve and
promote the clear Congressional intent for SEFs to operate ``through
any means of interstate commerce.'' \3\
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\3\ The term ``swap execution facility'' means 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.
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As the Congress considers Commodity Exchange Act reauthorization,
the WMBAA urges legislators to ensure that the implementing agencies
honor the statute's expectation that swap trading rules will,
consistent with the CFTC's ``principles-based'' approach to regulation,
allow for the flexibility that benefits all types of market
participants and ensure that U.S. financial markets remain the most
competitive and liquid in the world. In reviewing the evolution of the
SEF definition throughout the legislative debate, one can see that each
of the words was measured and selected with extreme precision.\4\
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\4\ See Letter from Stephen Merkel, Chairman, and Shawn Bernardo,
Vice Chairman, WMBAA, to the Honorable Michael Dunn, Commissioner,
CFTC, dated June 21, 2011, available at http://www.wmbaa.com/wpcontent/
uploads/2012/01/14_Letter_MDunn_SEF_06-21-11.pdf.
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Recently, before the full House Committee on Agriculture, Chairman
Tim Massad expressed an openness ``to looking at how [the CFTC] can
fine-tune and improve rules to enhance trading.'' \5\ Calls for the
Commission to consider potential revisions to its Dodd-Frank Act
regulations have also been raised by Commissioner Mark Wetjen,\6\
Commissioner Sharon Bowen,\7\ and Commissioner J. Christopher Giancarlo
with the recent release of his white paper on these topics.\8\
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\5\ 2015 Agenda for CFTC: Hearing Before the House Committee on
Agriculture, 114th Cong. (Feb. 12, 2015).
\6\ See Remarks of Commissioner Wetjen, Nov. 14, 2014 (suggesting
certain actions that the CFTC should consider related to trade
execution in order to minimize fragmentation), available at http://
www.cftc.gov/PressRoom/SpeechesTestimony/opawetjen-10.
\7\ See Statement of Commissioner Bowen, Dec. 1, 2014 (stating that
``the best way of viewing changes to [the CFTC's Dodd-Frank Act
rulemakings] is not that [the CFTC is] tweaking them, but rather that
[the CFTC is] enhancing them. Sometimes that may mean making the rules
more cost-effective and leaner, but at other times that will mean
making them stronger than before. Enhancing a rule can mean reducing
burdens to business while strengthening protections for the public''),
available at http://www.cftc.gov/PressRoom/SpeechesTestimony/
bowenstatement120114.
\8\ See Commissioner Giancarlo White Paper, ``Pro-Reform
Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank''
(Jan. 29, 2015), available at http://www.cftc.gov/ucm/groups/public/
@newsroom/documents/file/sefwhitepaper012915.pdf.
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The WMBAA appreciates the Commission's careful and deliberative
approach to the regulation of SEFs. The implementation of the SEF
regime has not been without its challenges and, given the unique
characteristics of the OTC swap market, certain requirements have
proven to be impracticable to implement or detrimental to market
liquidity. Accordingly, the WMBAA supports the Commissioners'
recognition that the regulations should be reassessed on an ongoing
basis and appropriately modified based on its experience.\9\
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\9\ See remarks by CFTC Commissioner Mark Wetjen, Open Meeting on
the 29th Series of Rulemakings Under the Dodd-Frank Act, May 16, 2013,
available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/
dfsubmission/dfsubmission_051613-trans.pdf (``The Commission,
therefore, must remain open to reassessing the policy judgments in
these final rules as the markets evolve, as the Commission has provided
new information, and as the Commission benefits from its experience
overseeing the new SEF market structure. In short, the Commission must
remain open to course correction where necessary and ensure that the
swap regulatory regime keeps pace with the markets that it governs.'').
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Since the Commission's adoption of final SEF regulations in June
2013, the WMBAA member firms have been working diligently to implement
various requirements and have actively engaged Commission staff
throughout the implementation process. The WMBAA continues to be
committed to working with the Commission and its staff to ensure that
the regulations are implemented in accordance with the underlying
statutory intent of the Dodd-Frank Act and seeks to accomplish the
legislation's goal to ``promote the trading of swaps on swap execution
facilities.''
Committed Focus on Permanent SEF Registration
While each of the WMBAA member firms' SEFs has received temporary
registration, our members recognize the importance of permanent SEF
registration to providing the market with the certainty and stability
needed for swap trading to flourish.\10\ Accordingly, the WMBAA is
hopeful that continued active engagement with the Commission and its
staff on these implementation issues will serve to expedite the
permanent registration process.
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\10\ In 2014, SEF average daily notional volumes accounted for
52.4% of reported rates volume and 62.3% of reported credit volume. In
addition, cleared interest rate and cleared CDS index transactions grew
as a percentage of total volume in 2014, accounting for 76.5% of
notional volume in rates and 74.7% of notional volume in CDS index
trades. See ISDA SwapsInfo 2014 Year in Review (Mar. 2015), available
at http://www2.isda.org/functionalareas/research/research-notes/.
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SEF applications have been pending with the CFTC since the summer
of 2013. Our association's members have each filed a Form SEF and
associated registration materials with the Commission; participated in
a series of staff visits and conference calls; and responded to
document requests, exhaustive questionnaires, and rulebook provision
inquiries. We continue to treat these requests with the seriousness and
attention they deserve as each company strives to attain permanent
registration. We have been working very closely with the staff to
address these issues, and the WMBAA remains hopeful that SEF
registrations will be issued later this year so that we can dedicate
more of our resources to providing competitive, vibrant, and
transparent trading platforms.
Concern about CFTC Policymaking through Staff Guidance and No-Action
Relief
WMBAA SEFs have dedicated significant resources over the last few
years to ensure that OTC swap trading remains competitive and
transparent. Our association was encouraged that the final rules were
adopted in a ``technology neutral'' manner that would foster future
innovation in the industry.\11\
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\11\ See remarks by CFTC Chairman Gary Gensler, Open Meeting on the
29th Series of Rulemakings under the Dodd-Frank Act, May 16, 2013,
available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/
dfsubmission/dfsubmission_051613-trans.pdf (``In addition, as Congress
said in the definition of a swap execution facility that it could be by
any means of interstate commerce. This rule is technology neutral.
Telephones work. Maybe it's because I'm 55 years old, but Congress made
the decision, and we're just implementing that decision that this rule
is technology neutral. As long as there is an order book and somebody
can do the minimum functionality around requests for quotes, have an
audit trail and the other provisions of the rule, it's technology
neutral.'').
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However, notwithstanding the promulgation of final Part 37 rules,
the SEF regulatory landscape continues to shift as CFTC staff continues
to issue numerous no-action letters and interpretive guidance and
develops new interpretations to the preamble (and footnotes to preamble
discussion) of the Part 37 rules. To be clear, we appreciate the hard
work and dedication of the CFTC staff engaged on these issues. Our
concern is that the Commission's actions, in their entirety, have been
difficult to comply with and lack the permanence needed to build
systems and platforms to their requirements.
I'd like to share one example that demonstrates some of the
concerns we have about how certain requirements have been implemented.
CFTC regulation 37.6 requires a SEF to ``provide each counterparty to a
transaction that is entered into on or pursuant to the rules of the
[SEF] with a written record of all of the terms of the transaction
which shall legally supersede any previous agreement and serve as a
confirmation of the transaction. The confirmation of all terms of the
transaction shall take place at the same time as execution.''
In the preamble, the Commission explains how it has considered and
responded to the many comments submitted in response to its proposed
rule before adopting the final regulation. However, in a corresponding
footnote in the preamble--footnote 195--the Commission states that
``[t]here is no reason why a SEF's written confirmation terms cannot
incorporate by reference the privately negotiated terms of a
freestanding master agreement for these types of transactions, provided
that the master agreement is submitted to the SEF ahead of execution
and the counterparties ensure that nothing in the confirmation terms
contradict the standardized terms intended to be incorporated from the
master agreement.''
When SEFs discovered this footnote buried in the preamble
discussion of the final rule, they joined other market participants in
immediately engaging the CFTC and its staff to determine how a SEF
could demonstrate compliance with this statement. Following a series of
conversations and three separate formal industry petitions for relief,
the Division of Market Oversight ultimately issued no-action relief
allowing a SEF to incorporate the underlying terms by reference and
waiving the requirement that a SEF must receive or maintain each
underlying agreement on record. At the same time, however, the no-
action relief imposed a new obligation on SEFs to ``glean all
confirmation data'' from executed swaps ``[w]here a SEF has
incorporated the swap's governing documents by reference.'' \12\ The
Division of Market Oversight and the Commission did not provide any
guidance on how a SEF could comply with its new duty to ``glean'' this
information and, as a result, fell short in providing meaningful
relief.
---------------------------------------------------------------------------
\12\ See CFTC Letter No. 14-108 (Aug. 14, 2014), available at
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/
letter/14-108.pdf.
---------------------------------------------------------------------------
There remain several other pressing implementation issues that
continue to frustrate the SEF registration and swap trading process.
For example, other issues relate to the time between a SEF
disseminating trade data to its participants and reporting the trade to
a swap data repository, referred to as the ``Embargo Rule''; specific
audit trail requirements for voice-based platforms; the calculation of
financial resources that a SEF must maintain; the ``made available to
trade'' or ``MAT'' process; SEF monitoring for position limits
violations; the disparate regulatory treatment of economically
equivalent swaps and futures products; how to resolve swaps executed
with operational or clerical errors; and a series of questions related
to the cross-border application of SEF and swap trading rules.
Conclusion
The WMBAA thanks the Subcommittee for the opportunity to comment on
these very important issues. I would be happy to answer any questions
you may have.
The Chairman. Gentlemen, thank you for your testimony, and
I yield myself 5 minutes for the first questions, and then we
will move through to Mr. Scott, and then rotate through the
Committee.
Mr. Jackson, this Committee has been examining growing
difficulties with the cross-border application of new
derivatives regulations for several years now. Do you see any
cause for optimism that the CFTC and foreign regulators may
come to any agreement?
Mr. Jackson. Thank you for your question, and the short
answer is yes, I do. The long answer is the reason I believe
that is that the regulators, both in Europe, as well as
Chairman Massad and his team, are focused on the right thing,
which is true equivalence. Because without true equivalence,
you have an outcome where you can, unfortunately, create global
disruption in the way that people are trading on these markets,
both in Europe and the U.S., because they are truly global
markets. And second, an outcome could be what Mr. Corcoran
referenced, in terms of the operational inefficiencies, and
headaches that it can create if you don't have true
equivalence.
One other comment I would make there is that when we are
talking about true equivalence, where we are today, it is not
the same. The margin methodologies that are used in the
clearinghouses are different, and can create different
outcomes. In the U.S., the model that is used is 1 day gross.
In Europe, it is 2 day net. And there are scenarios where those
do give you the same answer, or very close to the same answer.
If you are a very large FCM, and you have a portfolio of
trades that have a lot of offsets, that can be net against each
other, yes, you get much closer to that 1 day gross answer. If
you have a portfolio of customers that are market-makers, that
tend to have positions that offset in their portfolios, your
answer will be very close in 1 day gross, 2 day net. Where they
are very different is if you are a much smaller FCM, if you are
a much smaller clearing member that may have directional
portfolio that doesn't net. There you are not going to get the
benefit of netting, and they will be very different. Or if you
are an FCM or clearing member that provides specialized
services for hedgers, commercial hedgers, because those
commercial hedgers, at the end of the day, are directional in
nature, when you look at their futures positions, because they
are offsetting it against physical risks that they have.
So for entities that have that type of exposure, they are
not going to be able to net, and the impact of where Europe
versus where the U.S. is going to be is going to be quite
significant.
The Chairman. Thank you. Mr. Duffy, I would ask you that
same question.
Mr. Duffy. Okay. I will try not to say the same thing as
Mr. Jackson said, but he is correct, except for 1 day gross is
without collection of higher margin than 2 day net. And for
some of the examples he gave you in the portfolios, but when
you run most of these portfolios, which we have done for the
European Union, we have showed them that we collect more money
here in the United States under our margining regime. And for
us not to be deemed equivalent, some of this cross-border
nonsense, for lack of a better term, that has been going on for
the last 2 years is becoming ridiculous.
I think we are getting into a competitive trade issue, Mr.
Scott. I think that entities in the European Union are looking
for a leg up on U.S. institutions. I think that is
inappropriate. There is no question that we will get this
resolved. The question is when. But we should not let it go to
a point where we keep pushing dates certain out in order to
give one particular entity a leg up on another entity in a
different jurisdiction. That is my concern, Mr. Scott, and I am
concerned that is where we are headed right now. So I am not as
optimistic as Mr. Jackson that we will get there as soon as we
should.
The Chairman. So with regard to preventing the regulators
from finding common ground, it is a matter of, in your opinion,
regulators trying to give an advantage to European----
Mr. Duffy. European regulators said to us, sir, we went to
them, and what Mr. Corcoran said earlier, we want to have this
higher of issue, but we even went to them and said, ``We will
accept the higher of, whatever you want, just tell us what you
want.''
The Chairman. Yes.
Mr. Duffy. We will accept that margining regime, the higher
of 1 day gross versus 2 day net. They came back to us and said,
``That is fine, as long as it only applies to the United
States.'' So when you get a response like that, there is
nothing more than a competitive issue that nobody has an
interest in settling until you can get the entities in your
jurisdiction a leg up on the U.S.
The Chairman. Mr. Jackson, what do you think is preventing
the international regulators from finding that common ground?
Mr. Jackson. I think they realize that at the end of the
day, we need to have true equivalence, what the exact models
are that we use in the U.S., and when we determine what is the
margin that is established for a particular futures position
should be the same as what it is in Europe. And they are
focused on getting to that end goal. And I know that Chairman
Massad, from the conversations I have had with him, and that
our team and our staff has had with the European regulators,
that is the end goal that people are trying to get to. When it
comes to the----
The Chairman. My time has expired, so let me have the
courtesy for the other Members. Let me turn it over to my
colleague, Mr. Scott.
Mr. David Scott of Georgia. Thank you very much, Chairman
Scott. Our Committee here is very concerned about the
importance of, and the impact of, the Basel III capital rule on
clearing, especially the supplemental leverage ratio. I would
like to ask the panel to weigh-in on this. Do you think that
the supplemental leverage ratio will impact the futures
business?
Mr. Corcoran. I will be glad to answer that question, and
provide you the FIA feedback. The FIA that represents the
futures commission merchants in this country has done extensive
data collection from our members, and the answer to your
question is yes, the supplemental leverage ratio is going to
impact the ability to serve customers, and the cost to
customers in the United States, and we see that today already,
that there is increasing price changes going to the end line
client based on the leverage test.
The leverage ratio, and I believe the Agriculture Committee
has already sent a letter to the Treasury on it, is punitive to
the bank owned FCMs in the sense that it doesn't recognize that
the margin funds on hand at FCMs are in no way able to be
leveraged by the banks. And although the Basel Committee has
taken many, many meetings with our constituents from the
banking industry, we have, to date, have had no relief on this
matter. But it certainly is, and will, have an impact on the
ability for bank FCMs to provide customer service and customer
products to their bank customers.
Mr. David Scott of Georgia. So could you tell us again what
would be the greatest impact--where is that--will it be felt in
the market? Real quick.
Mr. Corcoran. I think likely that there will be bank
affiliated FCMs exiting the marketplace, and therefore we will
have fewer FCMs. It is just very, very difficult to get the
return on capital that a bank is interested in receiving when
you double the size of the capital contributed to the FCM for
this product.
Mr. David Scott of Georgia. Thank you very much. Mr. Duffy,
let me turn to you. I read your testimony, which was very good.
You mentioned an important point that I am working on, and that
is to make sure that the CFTC is funded. And in your statement,
you mentioned the importance of the CFTC having proper funding.
Could you expand on that just a little bit and tell us why a
fully funded Commission is very important, in terms of
regulating this market?
Mr. Duffy. First of all, we talked earlier, and in both of
your opening statements you talked about the growth of the
derivatives industry, especially here in the United States, but
globally. In order for the United States to remain in this
competitive world that we live in, and to prosper in this
world, for people that do the risk management, we always need
to have a regulator that has the utmost credibility to the
marketplace. I am a big, big believer in that, sir. And then to
have them properly, funded from a revenue standpoint, and also
to have a full complement of Commissioners is also just as
important to the credibility of that agency.
The question has always been, Mr. Scott, as you know, how
do we get there? How do you fund these agencies? Who is going
to pay for these agencies? When you are looking at a
multitrillion dollar a year budget that the government has
today, I will tell you that, for several hundred million
dollars, this serves a great public service, to fund this
agency at an adequate level, because if these spreads were ever
to widen, the cost that that would bear on the consumers,
because the spreads widen, and then the prices get skewed, it
could cost billions of dollars----
Mr. David Scott of Georgia. Correct.
Mr. Duffy.--to consumers. So it is important to fully fund
them. It is important, from a credibility standpoint, on the
global scale that we operate under today.
Mr. David Scott of Georgia. And would you care to--I know
you follow this very closely. Would you say at this point that
the CFTC is adequately funded, or would need more funding?
Mr. Duffy. It is not for me to determine what is adequately
funded. I will tell you that they have done a remarkable job
through its history in regulating. Business has been growing at
20 to 25 percent on an annual basis over the last 30 years, so
I will say they have done a great job.
Mr. David Scott of Georgia. All right. Let me go to you,
Mr. Roth. You mentioned in your statement that--I guess it
would be sort of outsourcing--that you do some outsourcing work
for the CFTC. I want to put that in this context of funding,
and making sure the CFTC is operating. Given the fact that you
do both regulating your own, and enforcing your own members for
your group, you also work--and do work for the CFTC. How would
you juxtapose this in light of the funding appropriateness for
CFTC?
Mr. Roth. Well, it is interesting, Congressman, if you take
a historical perspective, back when NFA was first formed, the
very purpose of forming it was to relieve the Commission of
some of the stresses that it was feeling back 30 years ago, and
that was part of our original design, and our original purpose,
and it has remained one throughout our existence, so we work
very closely with the Commission. All the divisions of the
Commission, not just on those where we have formal delegations.
We are in daily contact with the Commission, including the
Chairman's office. We have had recent discussions with the
Chairman's office, initiated by Mr. Massad, looking for other
ways in which the Commission can make better use of the
resources of NFA, and the CME, and other SROs.
Mr. David Scott of Georgia. My time is getting short. I
wonder if you might care to just say, given your intimate
working with them as staffing, you would have some insight
knowledge in terms of your own thought as to their funding
level being sufficient or not?
Mr. Roth. And, Mr. Chairman, again, they are our oversight
agency, we are not theirs, but I can tell you these are very
challenging times for regulators. Like, you can just look what
has happened to our budget, where our budget has doubled over
the last 4 years. So I understand the stresses that they are
going through.
Mr. David Scott of Georgia. Thank you.
The Chairman. Mr. Lucas.
Mr. Lucas. Thank you, Mr. Chairman, and I appreciate you
and the Ranking Member for holding this meeting. I agree with
both of you, we accomplished a great deal in the efforts to try
and reauthorize CFTC in the last session of Congress, and that
was a period of time it was a little bit difficult to get
anything done, the farm bill being a classic example. In this
case we did our work, but the other body couldn't quite get
there, so that means, to our panelist friends, we have to start
all over again. A certain amount of these questions and
observations you have discussed time and again through the
whole process, but one more time.
And I know, Mr. Duffy, that you are a mild mannered timid
fellow, but I believe in the reauthorization process, when the
phrase user fee or transaction tax came up, I watched your eyes
dilate. Could you, for the record, as we begin this process
again, if you have any kind of a timid opinion of that, offer
it to us.
Mr. Duffy. Well, again, sir, user fee transaction taxes are
the most penny wise, dollar foolish thing you could ever have
in an industry such as ours. We are not talking about millions
of market-maker participants, like they have in securities,
where you could charge a fraction on a trade that is going to
go on for days, weeks, months, or years, and so it really
hasn't hit. We have people creating liquidity so folks could do
risk transfer. And we are talking about a very small universe
of those people creating that liquidity.
If you take their cost of business and add 30 to 40 percent
in order to fund an agency, I assure you they will take those
spreads and widen them. That would damage the markets immensely
for the good folks of Oklahoma, for other people around this
world that are trying to put food on the tables of American
people, and shipping it overseas at a cost-effective rate.
I will give you an example today, the corn yield in Iowa
and the corn yield in Illinois last year alone were record
levels. We could take corn to $3.30 a bushel, add $1\1/2\ on
it, and send it to China for \1/2\ the price they are growing
it today. We didn't do that, but if we don't have efficient
marketplaces, this markets will get skewed, and we will have
the same prices in other countries around the world.
So it is incredibly foolish to go down a path of trying to
introduce a tax on--a small tax on a very small population of
people which will damage the spreads immensely. Thank you for
the question.
Mr. Lucas. Thank you for clarifying that process. And I
will go back to you again, Mr. Duffy, and anyone else who wants
to comment on this, but let us talk for a moment about the
equivalency issue. And you mentioned June 16 as being a
critical moment. If this issue is not addressed, capital is a
very fluid thing in the world we live in. How fast does the
situation begin to deteriorate?
Mr. Duffy. We are already seeing clients today, sir, look
for alternatives outside of the United States. That is not a
good thing when you are in a global market, especially when
they are looking at alternatives that are in Singapore, or
other parts of the world that are no different than what the
United States is offering today.
To me, this is a very large slap in the face to the United
States of America by the European Union by not granting this
equivalence when they are prepared to grant the equivalence to
much smaller nations, with the same type of regimes that we
have here in the United States. This is a big deal for us. We
need to get it done. The uncertainty of it, sir, is more
important.
You are going to hear how we are going to push a date out,
not to worry about, we will get it done, we are making
progress. That doesn't do an end-user any good when he needs a
date-certain, because he knows there is another date yet to
come. It is no different than Dodd-Frank, sir. We addressed
this when you were Chairman of the Committee. We have to have
certainty. Whatever the rules are going to be, let us have
certainty. And to have this uncertainty around what the
regulations are going to be, and who can play at what cost, is
not good.
Mr. Lucas. Therefore, if we don't manage it well, we could
damage what has traditionally been a very strong industry in
this country for a generation.
Mr. Duffy. It doesn't take much to take a kink out of the
armor in any particular market, especially something like our
market. It is based upon an ecosystem that includes all, and
when you start to take pieces out of it, it becomes less
efficient. When it becomes less efficient, the costs go up. So
it doesn't take much, sir.
Mr. Lucas. Sounds like, Mr. Chairman, on a lot of things,
time is of the essence, and I am proud we have a good pair of
leaders on the Subcommittee. I yield back the balance of my
time.
The Chairman. Thank you, Mr. Chairman. Mrs. Kirkpatrick.
Mrs. Kirkpatrick. Thank you, Mr. Chairman, Ranking Member
Scott. Gentlemen, thank you for your testimony here today. I am
a former prosecutor, and so my questions are going to be about
enforcement. How much of the Commission's enforcement actions
do you think are seen just as the cost of doing business? Do
you know what I mean? Is it still that bad actors can just
factor it into the cost of doing business.
Mr. Roth. Yes, maybe I could talk about that a little bit.
Obviously, I can't speak for the Commission, but I can tell you
that it is way more than the cost of doing business, because
the CFTC and NFA together meet on a quarterly basis with
representatives of the U.S. Attorney's office and the FBI and
Postal inspectors to tell them all about the fraud cases that
we have worked up, and to try to get--the most effective thing
you can do for a fraud is put people in jail.
Prosecutorial resources, as you know, are so scarce, but we
have worked very hard to build those relationships, and we have
had a significant increase in the number of criminal
prosecutions that are resulting from violations of the
Commodity Exchange Act. So for those people that are committing
fraud, they are risking more than the cost of doing business.
They are risking their liberty.
Mrs. Kirkpatrick. How effective do you think the
enforcement actions have been since 2009, then?
Mr. Roth. Well, that is always hard to measure, isn't it?
From my own perspective, sometimes I would prefer to see
enforcement cases go down if it meant that compliance was going
up, rather than cases that are just being missed. But overall,
certainly the Commission's cases on LIBOR have had tremendous
impact around the world, as motivating further reform. The
Commission's done a fine job in that area, and overall the
enforcement cases are having an impact.
Mrs. Kirkpatrick. Any other members on the panel wish to
comment on that?
Mr. Corcoran. I would, if you will.
Mrs. Kirkpatrick. Mr. Corcoran, yes.
Mr. Corcoran. On behalf of the FIA, and also our
organization, R.J. O'Brien and Associates, in no way do we
think enforcement is the cost of doing business. We respect the
rules, and we invest greatly in the law and compliance factors
in our organizations, and I know our member firms at FIA do as
well. Our brand name, and our brand value, is important to us,
it is important to our clients, and running a business
according to the rules is paramount to how we operate.
So I don't see this as an issue in the industry as
enforcement is a cost of doing business. It is taken very, very
seriously. No one wants to see their name in a press release
from the CFTC enforcement action. The enforcement actions that
have taken place since 2009 have reinforced the need for all
FCMs to take a strong look at how they operate their business
and take responsibility for it.
Mrs. Kirkpatrick. Do any of you see ways that the
enforcement actions can be improved? Any comments on that?
Mr. Roth. I don't mean to----
Mrs. Kirkpatrick. It is open to the whole panel. I just----
Mr. Roth. Yes.
Mrs. Kirkpatrick.--if anybody has any thoughts, I would
like to hear from all of you.
Mr. Roth. Sometimes I just talk more than everybody else. I
am sorry to be self-serving here, but the building of those
relationships with prosecutors all around the country is
really, really key. In our experience, sometimes, when you
would have a good case of fraud, and you bring it to a local
prosecutor, when you mention the Commodity Exchange Act, and
derivatives trading, their eyes glaze over, and they quickly
lose interest.
So part of it is educational. And it is not just working
with the individual prosecutors on individual cases, we are
also part of an anti-fraud working group that the Justice
Department puts together so that we can meet as a collective
body frequently throughout the year, and try to educate them,
because these cases--a fraud case is a fraud case--and we hope
they are not deterred, because it can sometimes be a little bit
arcane. We have made a lot of progress in that.
Mrs. Kirkpatrick. Would more training for prosecutors help,
is what you are saying? These are somewhat complex cases.
Mr. Roth. We don't want them to panic at the phrase
derivatives trading. It is fraud. And if you can get certain
jurisdictions, like Chicago, they are very comfortable with
these cases because they have done them. You just have to
overcome those barriers in jurisdictions where they haven't
brought as many cases.
Mrs. Kirkpatrick. I have about 40 minutes left, any--I mean
seconds left. Did anybody else want to comment: 40 minutes, I
wish, Mr. Chairman: 40 seconds. Anyone else on improvements?
Okay. I yield back my time. Thank you.
The Chairman. Thank you. Mr. LaMalfa.
Mr. LaMalfa. Thank you, Mr. Chairman. Of course, one of the
key issues we are concerned with is the ability for end-users
to have the access to the market, and the difficulty we are
seeing with many of the rules that Dodd-Frank has offered, and
CFTC is trying to sort out. But let me come back to Mr. Roth,
and we will follow up with Mr. Corcoran too, on the issue of
the number of FCMs that are available, that are in place,
declining. And so, if you are concentrating more and more work,
more and more risk, into fewer and fewer, that limits options
for end-users, as well as everybody in the market. What
problems does that really pose that we can hear today here in
the Committee?
Mr. Roth. Well, Congressman, that is an honest to God
issue. Mr. Corcoran made a reference to the consolidation that
has occurred over the last few years. If you go back--well,
again, I started at NFA a long time ago. We had over 340 FCMs.
So the consolidation has been dramatic----
Mr. LaMalfa. Three hundred forty?
Mr. Roth. Three hundred forty.
Mr. LaMalfa. What do you think that number is today?
Mr. Roth. Well, Jerry mentioned, it is about 73.
Mr. LaMalfa. Seventy three was it? Okay.
Mr. Roth. And it is very scary because you are
concentrating more risk in fewer firms, and if you take a look
at your constituents, the number of FCMs that serve as ag
producers, and ag end-users, that is a real small subset of the
73. So they have fewer and fewer choices, which isn't healthy
for them from either their choices or their risk.
As regulators we have to be very, very sensitive to the
regulatory costs that we impose with any sort of rule. Chairman
Massad, I have had conversations with him on this topic, and I
know he feels the same way. So, consolidation, when it is a
result of business evolution and business competition, that is
one thing. I never want to see the regulation having an undue
impact on consolidation.
Mr. LaMalfa. Mr. Corcoran?
Mr. Corcoran. Yes, thank you very much for this. It has
been very difficult times for FCMs. As far as R.J. O'Brien
goes, we are an independent FCM, so we are not owned by a bank
affiliate or any other large corporation, so we have to make
ends meet on our own. I would say that law, and compliance, and
regulation has been a big, big investment of ours over the last
3 or 4 years the rules have evolved. And I would say many of
the rules were tremendous rules when it came to customer
enhancement and protection.
However, the burden of continuing compliance with the rules
is ongoing, and we find ourselves investing millions of dollars
in law and compliance in our organization just to meet, in some
cases, very mundane regulation. But I would also add that it
just isn't law and compliance that is a challenge to
independent FCMs. It is technology investment as well. This
industry has become very, very technology focused and
intensive, and cybersecurity is now, obviously, a very, very
important part of the food chain as well, and so it is
difficult.
I don't see how we are going to get new participants in
this industry, because it takes large scale to----
Mr. LaMalfa. Yes.
Mr. Roth.--be able to cover the cost structures of an FCM
today. And so what we want to do is make sure we don't lose any
more FCMs, because the capital structure of FCMs is the
foundation of this industry, and it is important not to lose
any more members.
Mr. LaMalfa. Right. Thank you. Mr. Jackson, yesterday in
our Subcommittee, amongst different subjects, was the hedge
exemptions. We want to have bona fide hedge exemptions that--
please talk a little about the process in the granting of
those, but also please follow up too with the interpretation
that is happening by CFTC of that. Is that a problem area, and
do you think Congress should be intervening on that in helping
to be more explicit on what a bona fide hedge is? Would you
touch on those two things, please?
Mr. Jackson. Yes. Thanks for the question, and the answer
to your second question is yes. I think that Congress should
get involved in making sure that what is being interpreted now
in the rulemaking of the narrowing of what qualifies as a bona
fide hedge is a deep concern to commercial market participants.
And let me give you a very specific example. Just a couple of
weeks ago I brought around to the CTFC to meet each of the
Commissioners a gentleman from Hershey's. So cocoa is one of
the products that trades on our exchange.
You think about Hershey's. And what they were talking about
in bringing forward to the Commission is the unintended
consequence of a typical hedge that they do, a chocolate
company, what are the times of the year where they make most of
their money? They make most of their money selling products
around Halloween, Christmas and the holidays, Easter,
Valentine's Day. And when they negotiate contracts with the big
shops, like, Walmart or Costco, they are negotiating those
agreements 18 to 24 months in advance. And one of the
interpretations that is being done to narrow it is that you
can't hedge your risk, consumption or production risk, more
than 12 months into the future. And for them Hershey Company is
sitting here today negotiating contracts not for what a
chocolate pumpkin is going to look like, and what it is going
to be priced at for Halloween this year, they are talking about
2016 and 2017.
That is one example, as it relates to chocolate. You can go
through, and I am sure Terry can do the same, and go through
examples in every single one of our industries around what this
narrowing definition of what constitutes a bona fide hedge, and
what the material impact is going to be to standard practices
that have been used for a long, long time. And at the end of
the day, that means higher prices for consumers for these
goods.
Mr. LaMalfa. So the flexibility you need to plan your
product is taken away because of the short window?
Mr. Jackson. Yes.
Mr. LaMalfa. Yes. Okay. Thank you. I had better yield back.
Thank you, Mr. Chairman.
The Chairman. Thank you. We will get a second round of
questions, if any of you have more questions. I have a couple
for you, Mr. Bernardo. Someone suggested that laying futures
market style rules over the unregulated swaps market was a
mistake. Do you agree with this assessment, and how are swaps
markets different from futures markets?
Mr. Bernardo. I would agree that you can't take futures
market regulation and lay it on top of the OTC derivative swaps
market. The markets are very, very different. In futures you
have a number of--a lot of clients trading much smaller amounts
or sizes, and the the number of transactions per day is very,
very high.
In the OTC swaps market, you have a number of--not as many
clients trading very, very large sizes, and it trades much less
frequently. You could have products that trade a couple of
times in a week, you could have products that trade a couple of
times in a month. So taking the regulation from futures and
putting it into, and attempting to put it into the swaps market
has not worked out very, very well.
The Chairman. You have commended the Commissioners for
their willingness to consider potential revisions to its Dodd-
Frank Act regulations. Could you please share with the
Committee specific recommendations that a Commissioner has
offered which you think should be implemented, and why that
should be implemented?
Mr. Bernardo. I think the fact that the Commissioners are
willing to further review the rules, and realize the impact
that some of the current regulations are having on the
marketplace is terrific, and we welcome that. We have been
working with staff over the past several years, and will
continue to work with them on the issues that we are
experiencing with the implementation of these rules.
The Chairman. The no action relief letters, and
interpretive guidance, those types of things, compliance
would--in those areas, I would think they would be pretty
difficult to know----
Mr. Bernardo. It is difficult----
The Chairman.--exactly what you were supposed to do.
Mr. Bernardo. Agreed. It is the fact that it creates the
uncertainty in the marketplace, and it creates instability,
one, it will push what it can push, liquidity, offshore, which
it has, because if we have prescriptive rules, which we
currently have, what happens is you are dislocating the global
financial markets, so liquidity that would have remained here
in the U.S. is being pushed offshore. By that happening,
inevitably, less liquidity in the market, the pricing is not as
good, and inevitably the end-user is going to be impacted by
that.
Euro interest rate swaps is a perfect example. I think in
the past 15 months--has done a review of that particular
market, and roughly 77 percent of that volume has moved
offshore. So inevitably that is going to impact the end-user
because less liquidity means worse pricing.
The Chairman. Thank you for that. I am going to yield the
remainder of my time, and then I am going to go to Mr. Davis,
allow him to ask questions, and then we will come back to Mr.
Scott as well for a second round. Mr. Davis?
Mr. Davis. Thank you, Mr. Chairman. Thanks for having this
hearing. It is great to see many of you on the panel again in
front of this Subcommittee, and also when you appeared in front
of our Committee, but your presence also means that there are
still issues that we have to address as Congress, and that is
why the testimony of each and every one of you today is
extremely important to what we can do when we craft our
proposal. So, with that, I will get right into the questioning.
Mr. Duffy, good to see you again, sir.
Mr. Duffy. Nice seeing you, sir.
Mr. Davis. I want to ask about the issue of clearinghouse
risk. Some market participants are calling for clearinghouses
to increase their contribution, or their skin in the game, to
the so-called default waterfall in the event of a clearing
member default. For the benefit of the Committee, can you
describe to us what sort of cost impact an increased
contribution requirement would have on your clearinghouse, or
any clearinghouse?
Mr. Duffy. Well, today we already do have a contribution to
our default fund. We have the largest contribution of any
exchange in the world. We are roughly around $400 million of
our money into that default fund. And it also comes before any
of the clients, so if there was a default, it is the default,
the client, the CME, and then it comes to the clients behind
them, so we are in front of all the other clients.
What is interesting about some of the calls for increased
skin in the game, as they are referring to it, Congressman, is
it could cause a bunch of different issues. First of all, we
don't introduce risk as exchanges, we manage risk as exchanges,
so we don't bring it, we manage it. There is an inherent
difference right there about how we should have it. You have to
look at the entire regulatory regime that we operate under.
Chairman Massad said it well in a recent speech, there is more
to skin in the game than the whole regulatory regime.
The other thing that always concerns me about when you put
more skin in the game is always there is a potential moral
hazard. So if I was to put up more money, and you were able to
trade bigger against my dollars, does that induce you to act in
bad behavior because you are not putting your funds at risk,
you are putting my funds at risk first? That is a concern. That
is a moral hazard. That is a moral hazard to the other
participants that are in the default fund below me also.
So these are all things that are very concerning when
people call for this, just saying that they should--CCPs, or
clearinghouses, such as ours or the IntercontinentalExchange,
should have more skin in the game. We have, as I said, close to
$400 million today. We think we have adequate skin in the game.
We don't introduce risk, and this would put a huge burden on
our system, because we don't even know what the number people
are saying is, ``Put more into that system is.''
Mr. Davis. Thank you, Mr. Duffy. Mr. Corcoran, I had a
brilliant question set up for you, but somebody else asked it,
so you got a----
Mr. Corcoran. Am I off the hook, then?
Mr. Davis. You are off the hook. I am actually going to go
back to Mr. Duffy. So, Terry, yesterday we had a hearing in
this Subcommittee, and an end-user witness testified that he
believed futures exchanges were opposed to position limits
because such limits would reduce trading volume, and therefore
an exchange's revenue. Is there any merit to this claim?
Mr. Duffy. No, absolutely not. Futures exchanges are not
opposed to position limits. Matter of fact, today, sir, we have
hard limits on all of our agricultural products because they
are government mandated. On our energy contracts we have hard
limits in a spot month to make sure that we manage--so there is
no congestion, and then we have accountability levels. So for
someone to say that we would be opposed to position limits
because we want to put the trade in front of the credibility of
the marketplace is ridiculous.
I have said this since I have been Chairman of this firm,
for 14 years, if we don't have a credible marketplace, we don't
have a company. And that is the most important factor to the
CME group, and me as the Chairman and President of the firm,
that I will always say throughout the organization. We put
nothing in front of the credibility of our marketplace, and
position limits and accountability levels are a component of
that.
Mr. Davis. Well, thank you. And, Mr. Jackson, you run a
futures exchange. What is your response?
Mr. Jackson. Thank you. I would echo a lot of what Mr.
Duffy said, as he is spot on there, at the end of the day, one
of the most important roles that we have as exchange operators
is to make sure that our futures contracts facilitate
convergence, convergence for the futures price to where the
physical prices are. So we are incented to not have
manipulative activity going on. We are incented to have an
orderly market. And, like Mr. Duffy has position limits in
place, we do as well at the IntercontinentalExchange.
Mr. Davis. Well, thank you very much. Thank you to each and
every one of you. Again, great to see many of you again, and I
yield back the balance of my time, Mr. Chairman.
The Chairman. Four seconds, thank you. Mr. Scott.
Mr. David Scott of Georgia. Thank you, Mr. Chairman. Over a
period of time we have had this issue of the definition of U.S.
person, dealing with cross-borders. I mentioned in my opening
remarks this derivatives swaps market is global. And about a
year and a half ago, it was in July of 2013, the CFTC issued
its final guidance, setting out the scope of the term U.S.
person, the general framework for swap dealer and MSP
registration determinations, the treatment of swaps involving
certain foreign branches of U.S. banks, and the treatment of
swaps involving a non-U.S. counterparty guaranteed by a U.S.
person, or affiliate conduit.
Now, I would like to get your thoughts on this definition
of U.S. person. How have you all, and the market itself, been
affected by the Commission's guidance defining who is a U.S.
person?
Mr. Bernardo. I guess I will start on that. And to your
point, Congressman, the markets are global, so by having a
distinction between a U.S. person and a non-U.S. person, what
we have experienced is an impact on the liquidity in the
marketplace, and what we have seen is clients and/or firms that
are also global, and have a U.S. presence as well as presence
overseas, they will opt to do business under a less
prescriptive regime in Europe and/or in Asia.
And we have seen that happen across multiple products, and
we have actually been told by those very customers that the
reason they are not trading in the U.S. with us at this point
is because the rules are less prescriptive away. So the markets
are global, as you said, and inevitably you are dislocating the
marketplace. So those liquidity pools that were operating 24
hours, and the U.S. looked upon as one of the liquidity pools
where they could get business done, they----
Mr. David Scott of Georgia. Yes.
Mr. Bernardo.--now choose to do that business overseas.
Mr. David Scott of Georgia. And so, going forward, what
recommendations could you make to the CFTC to give greater
clarity on this whole definition of U.S. person? It just keeps
coming up.
Mr. Bernardo. I think it is important not to just do it for
the definition of U.S. person or non-U.S. person. It is
important that the rules overall are flexible. So if we have
flexible rules in the U.S., as we currently do overseas, you
wouldn't see as much liquidity move away from our shores, which
inevitably will hurt the U.S. economy. It will take away jobs.
I think that the staff, although working very, very hard as it
is now, needs to consider more flexible rules, which, again, we
welcome.
Mr. David Scott of Georgia. All right. Thank you. Let me
ask the panel: there comes up, all the time, about enforcement
and the CFTC, many complaints that any enforcement action of
the Commission have yet to produce any prosecutions for senior
managers of any of the major financial firms that have been
engaged in misconduct. There is public awareness, and public
pressure that, with all that has happened within this area
since the meltdown of our financial system, and there has been
wrongdoing, but there is been no prosecution. No one has gone
to jail. And you all have heard that as well. So let us weigh
in on that.
How much are the Commission's enforcement action seen, for
example, as the cost of doing business, and how do we rectify
this situation? How do we improve the enforcement strength of
the CFTC?
Mr. Roth. Thank you. I think the CFTC's enforcement program
has been very vigorous, obviously, over the last several years.
And you are right, and a little discussion we had earlier just
mentioned that, from my point of view, the ultimate deterrent
to violations of rules, where it involves fraud, is legal
enforcement action, prosecutions. Criminal prosecutions have
infinitely more impact, from a deterrent point of view, than
civil sanctions.
Now, the CFTC has the authority to bring civil actions, but
obviously they have to work with criminal prosecutors to bring
those types of criminal prosecutions. And, obviously, those
burdens are difficult. It is intentionally a difficult burden
to prove, to deny somebody their liberty. I am not privy to the
proof the Commission has in those cases, but I know that their
overall sentiment is to build the strongest case they can, and
work with prosecutors to achieve prosecution where they can,
and--but those----
Mr. David Scott of Georgia. Yes.
Mr. Roth.--there is inherently a difficult burden of proof
in bringing a criminal case.
Mr. David Scott of Georgia. The personal liability regime
for a senior manager, for example, at a clearing members who do
nothing to stop reckless manipulative behavior on their watch?
Now, in England right now they are setting a rule that they are
contemplating to deal with a situation like this. Are you all
aware of that?
Mr. Duffy. Congressman, I am aware of the failure to
supervise, and that is kind of what you are referring to here a
little bit, what some of the FCMs have done historically, and
we have seen charges brought against FCMs historically over the
last 20 years against failure to supervise, even when they have
people out in the country that they are supposed to be
overseeing, which sometimes they don't have a hands-on ability.
Mr. Corcoran, obviously, has a lot of offices throughout the
country. He has to supervise those, and he has an obligation to
do so.
It is a very difficult process, but I do think we are
seeing the enforcement of the CFTC, to Mr. Roth's point, take
hold, when you look at what happened at Peregrine Financial,
when you look at what happened in other instances. But the
public, to your point, is looking for someone to stand up and
accept blame, and someone has to put them in jail. So whether
it would happen with MF Global, whether it has happened with
the fixing of LIBOR, foreign exchange, and every other
benchmark, what is going to happen with this?
And I am not a prosecutor, I don't know. I think Mr. Roth
is right, it is a little out of the CFTC's realm, and they need
to work with the government to prosecute these people.
The Chairman. I need to move on to the next round of
questions, if we may. Mr. Davis.
Mr. Davis. Mr. Corcoran, my brilliance is back. I found a
question for you. You have expressed concern regarding the U.S.
and foreign regulators' failure to coordinate the regulation of
your markets. Do you believe that dual registration and
cooperative oversight is a viable means to regulate
clearinghouses?
Mr. Corcoran. Dual registration is not necessary, in my
opinion. Mr. Duffy and Mr. Jackson are better suited to speak
to this, but it seems that we are very, very close to solving
the equivalence issues, and it has boiled down to how we
collect margins from customers. Just the recognition that each
of the jurisdictions have adequate safeguards for CCPs, it
should be able to recognize the ability to get this done.
Mr. Davis. Yes. Okay. Does the CFTC staff's use of letters
to issue individual exemptions to a limited number of foreign
clearinghouses provide enough clarity and certainty to market
participants? Is there a better solution?
Mr. Corcoran. Not necessarily. These letters do not provide
absolute certainty to the participants on a going forward
basis, and sometimes come far too late for the market
participants to anticipate approval or non-approval. And so it
is better to be done at the senior levels of the regulatory
regimes, and get this done without letters.
Mr. Davis. Okay. Well, thank you. Actually, we will start
with Mr. Roth, and then, Mr. Duffy, if you would like to jump
in, and Mr. Jackson too, obviously the CFTC is an agency that
we know. We have to go through the reauthorization process, and
part of our job as policymakers is to ensure that any mandates
that are imposed by us are working correctly.
And, in an effort to help free up some resources at the
CFTC, we are--Congress--we are able to eliminate mandates that
may not be necessary, and shift more responsibilities to more
appropriate parties, like yours, Mr. Roth. Are you aware of any
obligations that Congress has required of the CFTC, or what
they have undertaken which may no longer be needed?
Mr. Roth. Congressman, what we have been doing, in
conversations with Chairman Massad, and with the Commission
staff, and with the CME, is trying to identify those situations
where there are activities that are being performed by both the
CFTC and NSRO, whether it--involving reviewing monthly
financial statements--there is a myriad of activities that the
CME and NFA both engage in on a daily basis, and the Commission
staff expends resources in those areas as well.
And what we are trying to do is eliminate duplication of
effort, and that is multifaceted. It is not just between the
CFTC and NFA, or the CME. It is also in the swaps area, for
example. We are trying to coordinate with other--so many of our
swap dealer members are banks, regulated by several different
bank regulators. We are trying to coordinate activities with
them so that we don't duplicate efforts.
No matter how we fund the CFTC, regulatory resources are
always going to be precious, and we can't afford to duplicate
efforts when we can avoid it. And so we are trying to work with
the Commission to eliminate that. We are trying to work with
bank regulators to achieve the same goal.
Mr. Davis. Has Chairman Massad been cooperative in reducing
some of these duplicative efforts?
Mr. Roth. He is been more than cooperative. He has
initiated the discussions, in some cases.
Mr. Davis. Great.
Mr. Roth. I mean, he is certainly aware of the constraints
on his budget, and looking for creative ways to deal with them.
We have had a great working relationship.
Mr. Davis. Thank you. Mr. Jackson?
Mr. Jackson. To add another--when it goes to the
interpretation of what is the role of the CTFC, especially in
granting hedge exemptions for non-enumerated commodities, in
the proposed rules, now the CFTC would take that responsibility
away from the exchanges, like mine, and from Mr. Duffy's
exchange.
In the comments that I made up front, the decades of
experience it takes in working and interfacing with each one of
our commodity market participants to understand the nuances of
each one of those, it is a big undertaking that the CFTC would
need to undertake to ensure that they are not disrupting a
commercial entity's ability to hedge in a timely manner by
taking on that responsibility. And, by doing that, they are
going to need more funds, and substantially more staff, if that
is the way this lands, as opposed to the way it works today.
Mr. Duffy. If I could just add real quick, Congressman, two
things. I will say something that former Chairman Frank said in
the Financial Services Committee to me one day several years
ago. He asked why should the exchanges have a DSRO at all? I
said, we have to have a DSRO to do the risk management. So even
if you gave it to somebody else, you will duplicate the cost,
because we are going to do it just for the risk management
needs. So there is certain proposals that Congress, or a
government agency, may think of that somebody else should do,
and not us, that adds a burden of cost to the government that
doesn't need to happen--that has not happened.
Second of all, on the position limits regime is a great
example. We have the expertise--these position limits--it goes
back to your earlier question. The credibility of our
institutions are out there, for everybody to see. We need to
make sure that we continue to manage this position limits
issue, and do it in an effective way that takes the burden away
from the government, and the cost away from the taxpayer.
Mr. Davis. Thank you. My time has expired.
The Chairman. Mrs. Kirkpatrick.
Mrs. Kirkpatrick. Mr. Bernardo, I want to follow up on your
statement earlier about the fact that clients and customers are
going to other countries, rather than staying in the U.S.
market. Can you expand a little bit more specifically for me on
why that is happening?
Mr. Bernardo. Well, it is happening for several reasons.
One, because of the prescriptive nature of the execution rules
that are in place----
Mrs. Kirkpatrick. Is that the CFTC rules----
Mr. Bernardo. Correct.
Mrs. Kirkpatrick.--primarily? Okay.
Mr. Bernardo. Because of the uncertainty that is been
created, and the constant letters that are coming out from the
CFTC staff, it makes it very, very difficult for them to
consider executing in our marketplace, going forward, as
opposed to going overseas, where the regulation is not as
stringent, or not as prescriptive, or if they want to be
considered a swap dealer, or whatever the case may be, they are
going to go and execute their business where the rules and the
regulations are much more flexible. So, by having prescriptive
rules, we are actually pushing business offshore.
Mrs. Kirkpatrick. What would be your top three
recommendations to this Committee of something we could do to
help level the playing field for our companies?
Mr. Bernardo. I think the top thing to do is to what has
been said that we are going to do, which is they are going to
look at the rules again and create more flexible rules so you
can take some of that uncertainty and instability out of the
marketplace.
Mrs. Kirkpatrick. Anyone else want to compliment that?
Ideas about how we can make our companies more competitive?
Could you give me some examples of what kind of flexibility you
would like to have in the CFTC rules?
Mr. Bernardo. For instance, to continue to follow the
interstate commerce rules, where your means of execution are
flexible. There are multiple modes of execution that we
currently use now. If you limit those modes of execution, you
could limit the innovation that is to come in years to--years
ahead of us.
So right now we use voice, electronic, and hybrid means of
execution. We use auction platforms, algorithmic matching
engines to transact business. If you tie prescriptive rules
around those execution modes, we are going to hurt innovation,
and, inevitably you will hurt liquidity.
Mrs. Kirkpatrick. Okay. Thank you for offering us this
guidance, and I look forward to working with you as we go
through this process to make it better. Thank you very much. I
yield back.
The Chairman. Thank you. And before we adjourn, I invite
the Ranking Member to make any closing remarks he has.
Mr. David Scott of Georgia. Well, thank you, Mr. Chairman.
This has been a very interesting and very important hearing for
us all. We look forward to putting together our legislation
coming up that will be very similar to H.R. 4431. We have many,
many issues to deal with, to grapple with, to make sure we are
clear. We have the cross-border, we have to work with the areas
in getting the SEC and the CFTC to jointly rule appropriately.
And, of course, as I mentioned before, we want to keep our eye
on making sure the appropriations level is there for the CFTC.
And as I said at the very beginning, you all out there,
CME, ICE, all of the exchanges, the clearinghouses, you are the
guys on the playing field, and we are more like the referees
and the umpires here, so we have to work together. We look
forward to it. And, Mr. Chairman, it is a pleasure working with
you on this Committee, and we look forward to moving this
issue, and handling Section VII of Dodd-Frank with good
progress moving forward. Thank you, Mr. Chairman.
The Chairman. Thank you. I want to thank all of you for
coming. These are complex issues, and, as you have said, the
integrity of the markets are extremely important to you. They
are extremely important to us. We need the people who are using
those markets to believe in them. And so, as we work to balance
that integrity, and access of those markets, we will be
continuing to rely on experts like yourselves for that input.
I think that, and I have every hope that we will have a
very good piece of legislation that will be bipartisan that
will be allowed to move through the House of Representatives,
and hopefully through the Senate that reaches that balance
between access and integrity.
With that said, under the rules of the Committee, the
record of today's hearing will remain open for 10 calendar days
to receive additional materials and supplementary written
responses from the witnesses to any questions posed by a
Member. This Subcommittee on Commodity Exchanges, Energy, and
Credit hearing is now adjourned.
[Whereupon, at 3:05 p.m., the Subcommittee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Questions
Response from Hon. Terrence A. Duffy, Executive Chairman and President,
CME Group
Questions Submitted by Hon. Austin Scott, a Representative in Congress
from Georgia
Question 1. Mr. Duffy, under the CFTC's proposed Position Limits
rule, several current methods of bona fide hedging will no longer be
available to market participants. What is the impact of limiting bona
fide hedging exemption beyond what has been available in the past? Does
this interject risk into the hedging plans of end-users?
Answer. Yes, the Agency's currently-proposed bona fide hedging
exemption would force a dramatic step back from historical market
practices by disallowing many reasonable commercial hedging strategies.
By limiting the exemption to a rigid and narrow list of enumerated
hedges, the Agency's proposal threatens to inject considerable risk
into commercial operations.
There is no evidence that Congress intended for the Agency to make
it more difficult through position limits rules for farmers, ranchers,
and other commercial end-users to hedge their price risks. In fact,
this aspect of the Agency's proposal is directly at odds with the CEA's
stated purpose of promoting ``sound risk management'' and Congress'
clear intent that CEA section 4a(c)(2) was intended to preserve a
hedger's pre-Dodd-Frank risk management tools.\1\
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\1\ See, e.g., Floor Statement by the Hon. Frank D. Lucas, Ranking
Member, House Com. On Ag., Re: H.R. 4173, the Wall Street Reform and
Consumer Protection Act (Dec. 10, 2009) (``[W]e were able to improve
areas most important to end-users--the manufacturers, the energy
companies and food processors that use swap agreements to manage price
risk so they can provide consumers the lowest cost products''); Letter
from Sen. Christopher Dodd and Sen. Blanche Lincoln to Rep. Barney
Frank and Rep. Colin Peterson (June 30, 2010) (cautioning the
Commission to ``not make hedging so costly it becomes prohibitively
expensive for end-users to manage risk'').
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CME Group supports allowing exchanges to administer non-enumerated
hedge exemptions that meet the statutory criteria. This is consistent
with current practices and would alleviate the Agency from needlessly
tying up its limited resources responding to requests for non-
enumerated hedge exemptions. Many market participants that would need
to rely on non-enumerated hedges are already familiar with these
practices, meaning fewer market disruptions should be expected from
hedgers being forced to exit the markets or having to fundamentally
remake their businesses and hedging practices due to the sudden
inability to use existing commercially-reasonable risk-reduction
strategies.
Rather than refuse to give commercial end-users the latitude to
continue using reasonable commercial hedging practices for fear that a
few bad actors could abuse the system, the Agency should rely on its
special call and anti-evasion authorities to enforce the limits.
Question 2. Mr. Duffy, the CME has important obligations as an SRO.
Can you share with the Committee what those obligations are? How do you
ensure that your regulatory obligations are not influenced by the need
to make money for shareholders?
Answer. The regulatory structure of the modern U.S. futures
industry involves a comprehensive network of regulatory organizations
that work together to ensure the effective regulation of all industry
participants. The Commodity Exchange Act (``CEA'') establishes the
Federal statutory framework that regulates the trading and clearing of
futures and futures options in the United States, as well as swaps
other than security-based swaps (which fall under the regulatory
purview of the Securities Exchange Commission), pursuant to Dodd-Frank.
The CEA is administered by the CFTC, which establishes regulations
governing the conduct and responsibilities of market participants,
exchanges and clearinghouses.
Thus, the SRO construct no longer consists solely of a single
entity governed by its members regulating its members; rather,
exchanges, most of which are public companies, oversee the market-
related activities of all of their participants--members and non-
members--subject to corollary oversight by the CFTC and National
Futures Association (``NFA'').
Moreover, an exchange's ground-floor vantage point into its markets
provides a unique level of expertise that the CFTC alone is not
equipped to have. Direct regulation by the exchange offers our
regulators unique proximity to the markets, market participants and the
broader resources of the exchange in ways that foster the development
of expertise that not only helps to make our regulatory staff more
effective, but also assists Federal regulators in our common objective
of preserving the integrity of the markets. Exchange sponsored
regulation also allows for more expedient identification of potential
issues given our knowledge of and proximity to the markets, as well as
the ability to react more quickly and flexibly to potential market and
regulatory issues.
The financial incentives of SROs also benefit the safety and
soundness of the markets which they oversee. Effective SRO regulation
is necessary to ensure that an exchange clearinghouse that is required
to have ``skin in the game'' does not have to tap into these reserve
funds in the event of a member default, which would in turn harm
shareholders.
To accomplish this, exchanges devote substantial resources to their
self-regulatory responsibilities and programs. Also, the exchanges have
established a robust set of safeguards to insure these functions
operate free from conflicts of interest or inappropriate influences.
CME alone spends more than $40 million annually carrying out, adapting
and improving its regulatory functions, which includes employing over
200 financial regulatory, IT, and surveillance professionals.
Question 3. Mr. Duffy, in reference to the position limits rule,
former Commissioner Dunn said ``no one . . . presented this agency any
reliable economic analysis to support either the contention that
excessive speculation is affecting the market we regulate or that
position limits will prevent the excessive speculation.'' Do you share
Commissioner Dunn's views?
Answer. CME Group shares the Agency's regulatory mission of
ensuring liquid, fair and financially secure markets.
For many years, CME Group has supported and imposed speculative
position limits for physical commodity contracts in the spot months
based on a formula grounded in CFTC-accepted estimates of deliverable
supply. We recently sent our updated and preliminary 2015 estimates of
deliverable supply for core referenced futures contracts to the
Commission for acceptance. We have also applied position accountability
limits outside the spot months as an effective tool in balancing
regulatory concerns over market congestion and manipulation with the
need to facilitate liquidity in the out months in order to support
price discovery and risk management functions.
The Agency's proposal begins with a CFTC statutory interpretation
finding that Congress mandated the imposition of physical commodity
position limits even if unnecessary to prevent the supposed burdens
associated with excessive speculation. When considered closely, the
Proposal does not cite any evidence that Congress intended to mandate
the CFTC to impose limits that the CFTC believed to be unnecessary. The
law is clear that, since 1936, position limits for a commodity contract
could not be imposed unless the regulator found them to be
``necessary.'' \2\ In Dodd-Frank, Congress did not amend that statutory
requirement. Absent evidence of unambiguous Congressional intent to
repeal by implication that longstanding ``necessary'' finding
requirement as it relates to physical commodity derivatives, the
requirement still stands.\3\
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\2\ CEA section 4a(a)(1); 7 U.S.C. 6a(a)(1).
\3\ See Hunter v. FERC, 711 F.3d 155, 160 (D.C. Cir. 2013).
---------------------------------------------------------------------------
At a minimum, the CFTC's regulations, unlike the current proposal,
must establish a framework that promotes the public interest purposes
of CEA section 4a--to prevent and deter excessive speculation and
manipulation while ensuring sufficient liquidity for bona fide hedgers,
and protecting price discovery in the underlying benchmark futures
contract.
As the Agency is currently considering public comments on these
proposed rules, we encourage careful consideration of the following
issues:
Establishing Federal Spot Month Limits
CME Group continues to believe that the Agency cannot set necessary
and appropriate Federal spot limits unless it applies the most current
deliverable supply estimates available. The Commission should rely upon
current, up-to-date deliverable supply estimates from the exchange
listing the physical delivery contract where available and acceptable.
The exchange listing the physical delivery contract had the most direct
knowledge of the factors described by the Commission as relevant to
calculating deliverable supply, and has been making those calculations
for decades as part of their own exchange-administered position limit
program.
Once a deliverable supply baseline has been identified, we agree
with prior Commission statements that speculative position limits
should ``be based upon the individual characteristics of a specific
contract market.'' \4\ Consistent with past policy, the Agency should
not impose spot month limits based on an absolutist approach to the 25%
of deliverable supply formula across all referenced contracts. No sound
economic theory or analysis supports such a uniform approach. Rather,
the Agency should use 25% of deliverable supply as a ceiling and work
with the exchange(s) listing the physical-delivery benchmark contract
to set the Federal spot-month level below this ceiling on a contract-
by-contract basis, recognizing the unique market characteristics of
each commodity that is traded.
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\4\ See Revision of Federal Speculative Position Limits, 52 Fed.
Reg. 6812, 6815 (proposed March 5, 1987).
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Limits for physical delivery and cash-settled ``look-alike''
contracts should be equal for the same underlying commodity. The
proposed conditional limit exemption for cash-settled contracts
threatens to drain liquidity away from the physical delivery markets to
the cash-settled markets during the spot month as contracts approach
delivery, thus causing harm to the price discovery process and opening
the door to potential market misconduct. The Agency should not seek to
artificially tip the scale in favor of cash-settled markets and
increase the risk of possible price manipulation or distortion.
Administering a Position Accountability Regime
Position accountability levels should apply in lieu of hard limits
outside of the spot month for non-legacy agricultural commodity
derivatives. Nothing in the Agency's statute or any legislative history
should foreclose the possibility of using this more flexible position
accountability approach in the out months as a reasonable alternative
to Federal hard cap limits. Such an approach would better serve market
integrity and protect the price discovery process in the out months
when diminished liquidity can have a severe negative impact. Exchanges
have successfully relied upon accountability levels for decades to
safeguard against market congestion and abusive trading practices.
Based on this experience, exchanges are well positioned to partner with
the Agency to administer a Federal position accountability program,
thus preventing any further drain on the Agency's limited resources.
Administering Non-Enumerated Hedge Exemptions
As referenced in my response to Question 1, CME Group believes the
Agency should provide exchanges with discretion to administer non-
enumerated bona fide hedge exemptions in core referenced futures
contracts, consistent with their current practices. Many market
participants that would need to rely on non-enumerated hedges are
already familiar with these practices, meaning fewer market disruptions
should be expected from hedgers being forced to exit the markets or
having to fundamentally remake their businesses and hedging practices
due to the sudden inability to use existing commercially-reasonable
risk-reduction strategies.
Under such an approach, the Commission could instead focus its
limited resources on enforcement efforts that utilize existing special
call and anti-evasion authorities.
Response from Benjamin Jackson, President and Chief Operating Officer,
ICE Futures U.S.
Questions Submitted by Hon. Austin Scott, a Representative in Congress
from Georgia
Question 1. Mr. Jackson, recently, the Committee heard Chairman
Massad testify about his concerns over the supplemental leverage ratio.
Chairman Massad said: ``I am very concerned that this [the supplemental
leverage ratio] could have a negative effect on clearing.'' Do you
share his concerns? What do you foresee as the result of regulators
continuing to penalize bank FCMs for holding margin?
Answer. I share Chairman Massad's concern over the supplemental
leverage ratio as part of the Basel III standards and consider it a
major problem for clearing members and their customers. While Dodd-
Frank implementation continues, and our banking system works to comply
with Basel standards, futures market customers continue to be hit with
multiple, new compliance costs and risks for simply accessing these
markets as necessary to hedge exposures to price risk. The current SLR
interpretation is a great example of this cost increase.
These markets serve critical hedging needs for many of your
constituencies, and I worry that they could be hit especially hard with
additional costs and less choice in clearing should firms ultimately
bear the cost of compliance with the current SLR proposal. Under the
current proposal, banks have a dis-incentive to provide directional
hedges to their customers because of high capital charges for doing
business with commercial hedgers. This could easily lead to negative
outcomes that we, along with most commercial participants, would hate
to see. As for the results of this proposal; should its current
interpretation continue, we will see an exacerbation of the negative
trends we hear and read about today: fewer FCMs , higher costs and more
incentive not to clear.
Question 2. Mr. Jackson, you believe the CFTC should return to a
system where it relied on ``foreign regulators to regulate foreign
transactions'' and it ``worked with regulators to adopt common
principles that all regulated markets should adopt.'' How is that
different than the process the CFTC is currently pursuing? What are the
implications of the regulatory strategy it is pursuing?
Answer. Historically, the CFTC exempted transactions on foreign
markets and relied on foreign regulators to regulate their own markets.
For example, in 1996, the CFTC allowed Eurex to offer direct access to
its futures markets.\1\ In doing so, the CFTC relied upon Eurex's
regulators, whose oversight the CFTC saw as comparable to U.S.
regulation because they recognized the IOSCO Principles for Oversight
of Screen-Based Trading Systems for Derivatives Products. This openness
led to great market innovations such as electronic trading and clearing
of OTC derivatives. At the same time, relying on foreign regulators was
far more efficient for the CFTC.
---------------------------------------------------------------------------
\1\ http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/
documents/letter/99-48.pdf.
---------------------------------------------------------------------------
Historically, the CFTC exempted transactions on foreign markets and
relied on foreign regulators to regulate their own markets. For
example, in 1996, the CFTC allowed Eurex to offer direct access to its
futures markets. In doing so, the CFTC relied upon Eurex's regulators,
whose oversight the CFTC saw as comparable to U.S. regulation because
they recognized the IOSCO Principles for Oversight of Screen-Based
Trading Systems for Derivatives Products.\2\ This openness led to great
market innovations such as electronic trading and clearing of OTC
derivatives. At the same time, relying on foreign regulators was far
more efficient for the CFTC.
---------------------------------------------------------------------------
\2\ http://www.iosco.org/library/pubdocs/pdf/IOSCOPD4.pdf.
---------------------------------------------------------------------------
Dodd-Frank greatly changed this dynamic by extending U.S.
regulation internationally. In addition, the CFTC issued its rules
earlier than other jurisdictions; for example, the CFTC's clearing
rules \3\ came out before the IOSCO Principles for Financial Market
Infrastructures.\4\ Finally, U.S. and international regulators put in
more prescriptive rules, where, historically, derivatives regulators
had used a principles based approach. The timing gap and the more
prescriptive approach have forced regulators to harmonize their rules
line by line, lest they leave room for regulatory arbitrage.
---------------------------------------------------------------------------
\3\ http://www.cftc.gov/ucm/groups/public/@lrfederalregister/
documents/file/2011-27536a.pdf (November 8, 2011).
\4\ http://www.bis.org/cpmi/publ/d101a.pdf (April 2012).
---------------------------------------------------------------------------
We can see the implications now, as U.S. and European regulators
work to harmonize their clearing rules. The process has taken nearly 2
years and costs thousands of hours of time spent by U.S. and EU
regulators working through this one issue. Importantly, this is just
one of several issues that U.S. and EU regulators will have to
harmonize.
Question 3. Mr. Jackson, you run a futures exchange that has long
imposed position and accountability limits on your contacts. In your
view, what is the purpose of exchange imposed limits? How does an
exchange's use of position and accountability limits differ from what
the Commission is trying to accomplish?
Answer. Currently, the Exchange imposes spot month position limits
in all contracts \5\ and position accountability for non-spot months.
Single month and all month position limits currently exist for certain
agricultural and stock index products.
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\5\ With the exception of certain futures based on major foreign
currencies, stock indices and natural gas options, which are exempted
under Commission Regulations.
---------------------------------------------------------------------------
The CEA grants the Commission discretion to adopt accountability
levels rather than hard limits with respect to non-spot months.
Exchanges have successfully used position accountability levels for
over a decade to deter excessive speculation and manipulation while
allowing the markets to continue to serve their price discovery and
hedging purposes in non-spot months.
Position limits and accountability levels are two of many functions
that an Exchange employs to ensure that markets operate orderly and are
not subject to undue influence. Where position accountability differs
from position limits is that it allows an Exchange to proactively
require a market participant to reduce a position not established in
accordance with sound commercial practices or that may have a negative
impact to the market. Conversely, accountability levels allow positions
to be maintained if they are established in an orderly manner and are
positively contributing to the price discovery function. A position
limit regime is static and simply disallows positions to be greater
than a predetermined amount. The Commission has not suggested that
accountability levels are ineffective at deterring excessive
speculation or manipulation. Moreover, it is widely acknowledged,
including by the Commission, that the threat of manipulation outside of
the spot month is greatly diminished. Accordingly, the current regime,
with spot month position limits and non-spot month accountability
levels, successfully achieves liquidity across many contract months
while helping to ensure orderly expirations.
Question 3a. In your testimony, you comment that the implementation
of limits in any month may ``concentrat[e] volume and liquidity toward
the prompt delivery months only.'' Why is that a problem?
Answer. The implementation of hard position limits in any single
month and all months combined will potentially reduce liquidity in
every month because traders that currently hold positions in excess of
the limit will be forced to reduce them unless the positions meet the
very stringent proposed definition of bona fide hedging. Traders could
potentially hold positions equal to the all months combined limit in
the front month, where liquidity is concentrated, and consequently
would not be permitted to hold a position on the same side of the
market in a contract month further in the future because doing so would
cause them to exceed the all months position limit. In such case,
liquidity and volume will be reduced in those more distant contract
months as firms are forced to choose between taking positions in spot
and distant months. Many commercial market participants (producers,
end-users and merchants) in Exchange markets currently employ risk
management programs that require hedging positions in contract months
that are further in the future. For example, sugar cane plants have a
3-6 year life cycle and producers need to manage their risk beyond 12
months of production, which requires establishing hedges in back
months. Implementing position limits in such months will restrict
needed liquidity and as a result, commercial market participants may
find that their risk management programs are less effective. In
addition, the price discovery function of the markets could be
negatively impacted. This is important because the prices of the
contract months that are further out the curve provide critical
information to producers, for example, that may be making planting
decisions based on such prices.
Question 3b. Are there other market disruptions that may result
from CFTC imposed position limits?
Answer. The proposed rules will prevent commercial market
participants from using many of the risk management strategies employed
for years and that have not been detrimental to the market. The risk
management strategies that are not recognized by the proposed rules
include establishing positions to manage the risk of unfixed price
commitments, anticipatory hedging beyond 12 months of unfilled
anticipated needs and unsold production and anticipated merchandizing.
The failure to recognize these strategies as bona fide hedging could
significantly disrupt the markets as positions are required to be
reduced, resulting in less liquidity and a less effective price
discovery function.
While the Commission has indicated that market participants may
apply for non-enumerated hedge exemptions, if it cannot provide a
timely response to such exemption requests, then uncertainty will be
created for market participants as they will not know if they can
continue to use the risk management strategies that they have used
successfully for years. The Exchange has recommended that the current
structure--whereby the Commission oversees certain domestic
agricultural commodities while the listing exchanges oversee their
other products--reflects an efficient allocation of responsibility and
resources that ensures commercial market participants will continue to
be able to manage their risks in a timely manner.
Response from Daniel J. Roth, President and Chief Executive Officer,
National Futures Association
Question Submitted by Hon. Austin Scott, a Representative in Congress
from Georgia
Question. Mr. Roth, in your testimony, you stated that the NFA is
working with the CFTC to determine the extent of NFA's responsibilities
to monitor foreign firms that the CFTC has allowed to comply with
comparable rules from their home jurisdiction. Could you please
elaborate on the NFA's oversight of foreign firms?
Answer. To provide some background, NFA has a little over 4,000
members, about 600 of those members are non-U.S. firms. NFA monitors
all of its members (both U.S. and non-U.S.), for compliance with its
rules and applicable CFTC regulations. The monitoring program includes
financial analysis, investigations, exams and many other oversight
functions.
However, we should note that the scope of NFA's responsibilities in
the substituted compliance regime that has been established for swap
dealers remains unclear. About 50% of NFA's 103 swap dealer members are
non-U.S. firms. Questions have been raised as to whether NFA would be
required to monitor swap dealer members for compliance with the rules
of foreign jurisdictions. Given that the CFTC has found certain rule
areas of six jurisdictions to be sufficiently comparable to permit
substituted compliance, presumably the foreign regulator would be
responsible for monitoring for compliance with those local laws. We
continue to discuss with the CFTC an approach to oversight of non-U.S.
SDs that is both meaningful and practical.
Response from Gerald F. Corcoran, Chairman of the Board and Chief
Executive Officer, R.J. O'Brien & Associates, LLC; on behalf of
Futures Industry Association
Questions Submitted by Hon. Austin Scott, a Representative in Congress
from Georgia
Question 1. Mr. Corcoran, in your testimony, you commend the CFTC
for its efforts to determine the appropriate residual interest
deadline. But, in its final rule, the CFTC left the door open to
revisit the issue. Do you believe that a statutory fix, such as the one
included in H.R. 4413, is still necessary? Why?
Answer. The CFTC, under Chairman Massad's leadership, recently took
the necessary steps to ensure that any abbreviated residual interest
deadline be subjected to a thorough public review. The recently
finalized rule amends Commission Regulation 1.22 by removing December
31, 2018 as the automatic termination date of the phased-in compliance
period which would have resulted in an earlier residual interest
deadline. As a result, the deadline will remain 6:00 p.m. Eastern Time
pending the possibility of future Commission rulemaking. The statutory
directive included in previously passed House legislation would ensure
that any future rulemaking not further condense the deadline.
Question 2. Mr. Corcoran, we have heard a lot about position limits
this week. Do you think the exchanges do a sufficient job of setting
and policing position limits in their markets? Are speculators
necessary for derivative markets? Are there potential consequences to
reducing their ability to transact these markets?
Answer. Because the exchanges are close to the products and monitor
all of the activity on their markets, they are well-suited to police
for position limits. In particular, the exchanges have a long history
of managing accountability levels in the non-spot month by monitoring
positions when they approach the levels and working with the trader if
the position needs to be reduced. They also have managed well the
process for granting certain bona fide hedge exemptions, also by
relying upon their knowledge of markets and market participants. We
have recommended that the CFTC continue to rely on the exchanges to
manage accountability levels and police position limits.
Liquid markets are the most successful markets. Restricting one
class of market participant beyond what is necessary to address
excessive speculation can have an impact on markets by restricting
liquidity required by those bona fide hedgers needing to lay off risk.
Often speculative traders will be the most natural buyer to a bona fide
hedger in a seller position. If regulations unnecessarily reduce a
speculators ability to transact in the market, it can impact a bona
fide hedger's ability to transact in that same market by reducing the
number of potential counterparties in that market.
Question 3. Mr. Corcoran, why are last-minute CFTC ``no-action''
letters issued on the eve of arbitrarily set deadlines not helpful from
a regulatory compliance standpoint? Does the uncertainty cost your
companies or member firms valuable capital?
Answer. Prudent regulatory compliance requires market participants
to make informed business decisions, long prior to the effective date
of any regulation. No-action relief granted just prior to the
compliance date of any regulation thereby creates an enormous amount of
inefficiency as those subject to the regulation are forced to make
implementation decisions even as questions remain about their
compliance obligations. Yes, this costs valuable capital in the form of
technology builds and legal costs even in the presence of incomplete
information from the regulator.
Question 3a. What kind of internal processes would you like the
CFTC to develop to improve their function as a major market regulator?
Answer. FIA supports the legislation passed by the House last year
to ensure that the cost-benefit analysis conducted by the CFTC closely
follows President Obama's Executive Order for the entire Executive
Branch. Requiring more quantitative cost-benefit analysis would seek to
identify many of the cost-prohibitive regulatory challenges, or at
least reveal such, long prior to the finalization of regulations.
Response from Shawn Bernardo, Chief Executive Officer, tpSEF, Inc. at
Tullett Prebon; on behalf of Wholesale Market Brokers
Association, Americas
Questions Submitted by Hon. Austin Scott, a Representative in Congress
from Georgia
May 26, 2015
Hon. Austin Scott,
Chairman,
Subcommittee on Commodity Exchanges, Energy, and Credit,
House Committee on Agriculture,
Washington, D.C.
Re: Public Hearing on ``Reauthorizing the CFTC: Market Participant
View'' (Mar. 25, 2015)
Dear Chairman Scott, Ranking Member David Scott, and Members of the
Subcommittee on Commodity Exchange, Energy, and Credit:
On behalf of the Wholesale Markets Brokers' Association, Americas
(``WMBAA'' or ``Association''),\1\ thank you for the opportunity to
testify before the Subcommittee on March 25, 2015 regarding the swap
execution facility (``SEF'') perspective on the implementation progress
of reforms under the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank Act'').
---------------------------------------------------------------------------
\1\ The WMBAA is an independent industry body representing the
largest inter-dealer brokers operating in the North American wholesale
markets across a broad range of financial products. The five founding
members of the group are: BGC Partners; GFI Group; ICAP; Tradition; and
Tullett Prebon. The WMBAA membership collectively employs approximately
4,000 people in the United States; not only in New York City, but in
Stamford, Connecticut; Chicago, Illinois; Louisville, Kentucky; Jersey
City, New Jersey; Raleigh, North Carolina; and Houston and Sugar Land,
Texas. For more information, please see www.wmbaa.org.
---------------------------------------------------------------------------
We are pleased to provide responses to the questions submitted by
Chairman Scott following the conclusion of the hearing in the attached
Appendix. Please feel free to contact me with any questions you may
have on the WMBAA's responses.
Sincerely,
Shawn Bernardo,
Chief Executive Officer, tpSEF, and Board Member, WMBAA.
appendix
Question 1. Mr. Bernardo, why are CFTC's interpretive guidance and
no-action relief letters ``difficult to comply with and lack the
permanence needed to build systems and platforms to their
requirements?'' How have these staff decisions made the SEF
registration process more difficult?
Answer. While the WMBAA appreciates the hard work and dedication of
the staff of the Commodity Futures Trading Commission (``CFTC'' or
``Commission''), the WMBAA is concerned that the Commission's numerous
staff no-action letters and guidance releases have been unproductive
from market participants' compliance and business planning
perspectives. In order to confidently build business processes and
infrastructure to implement SEF related requirements and ultimately
receive permanent registration, SEFs require clear and consistent
regulatory requirements. There have been multiple instances, however,
in which staff no-action letters and guidance have altered the impact
of a regulatory requirement and increased uncertainty among market
participants.
The multiple staff no-action relief letters pertaining to single
issues highlight the shifting nature of the Commission's approach to
implementation issues. As noted, SEFs require regulatory certainty to
confidently invest resources to build the appropriate systems and
platforms required for permanent registration. The following examples
involving multiple no-action relief letters, for example, while
arguably necessary for immediate relief, lack permanence and do not
provide market participants with regulatory certainty.
SEF Confirmations and Footnote 195
For example, staff has issued two no-action relief letters related
to CFTC rule 37.6, which requires in part that a SEF ``provide each
counterparty to a transaction that is entered into on or pursuant to
the rules of the [SEF] with a written record of all of the terms of the
transaction which shall legally supersede any previous agreement and
serve as a confirmation of the transaction.'' In the associated
preamble discussion pertaining to this requirement, the Commission
stated that SEFs could satisfy such requirement by incorporating by
reference terms in previously negotiated agreements by the
counterparties, provided that such agreements had been submitted to the
SEF before execution.
This requirement and associated preamble discussion were
problematic for market participants from a compliance perspective for
various reasons. In response to market participant concerns, the
Commission's Division of Market Oversight (``DMO'') issued a no-action
relief letter in August 2014, which contained conditions that caused
the letter to fall short of providing meaningful relief to SEFs.\2\
Most recently, in April 2015, in response to renewed market participant
calls for Commission resolution of this issue, DMO released a second
no-action relief letter regarding this requirement, among others,
providing relief until March 2016.\3\
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\2\ CFTC Letter No. 14-108 (Aug. 18, 2014), available at http://
www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-
108.pdf.
\3\ CFTC Letter No. 15-25 (Apr. 22, 2015), available at http://
www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/15-
25.pdf.
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While the WMBAA appreciates staff's continued engagement with
market participants on this issue, this particular requirement based in
the preamble discussion is impracticable, overly burdensome, very
costly to implement, and does not appear to provide meaningful public
policy benefits to regulators or the public. Accordingly, the WMBAA
believes that permanent relief is needed through a formal rule change,
rather than temporary relief through a time-limited no-action letter.
Operational or Clerical Error Trades
CFTC staff's response to ``error trades'' in the form of no-action
relief letters has injected unnecessary regulatory complexity into the
trade execution process.
In September 2013, the CFTC staff issued joint guidance regarding
obligations related to ``the clearing of swaps that are traded on or
through the facilities of SEFs or [designated contract markets
(`DCMs')] and cleared at [derivatives clearing organizations (`DCOs')
by [futures commission merchants (`FCMs')] that are clearing members of
the DCO'' (``STP Guidance'').\4\ Among other aspects of the clearing
process, staff discussed the ``effect of rejection from clearing,''
stating that ``any trade that is executed on a SEF or DCM and that is
not accepted for clearing should be void ab initio.'' \5\
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\4\ Staff Guidance on Swaps Straight-Through Processing, Sept. 26,
2013, available at http://www.cftc.gov/ucm/groups/public/@newsroom/
documents/file/stpguidance.pdf.
\5\ Id. at 5.
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Market participants expressed concern, however, that trades would
be rejected by DCOs for flaws that are readily correctable, e.g., due
to an operational or clerical error. In response to such concerns, CFTC
staff issued no-action letters in October 2013 and in April 2015, which
allow a SEF to permit a new trade, with terms and conditions that match
the terms and conditions of the original trade, other than any error of
the original trade and the time of execution, to be submitted for
clearing.\6\ The no-action relief effectively permits SEFs ``to
implement rules that establish a `new trade, old terms' procedure.''
\7\
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\6\ See CFTC Letter no. 13-66 (Oct. 25, 2013); CFTC Letter no. 15-
24 (Apr. 22, 2015).
\7\ See CFTC Letter no. 13-66 at 3.
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Rather than permit the ``new trade, old terms'' procedure, the
WMBAA believes that the Commission has an opportunity to simplify the
error trade correction process by permitting SEFs to send a correction
message for a transaction that has been cleared by a DCO. As noted by
CFTC staff, ``if an error is identified after a swap has cleared, any
correction or cancellation necessarily would have to be undertaken by
the DCO because only the DCO is able to make corrections or
cancellations to swaps carried on its books.'' \8\ Some DCOs, however,
currently ``decline or are unable to correct or cancel the swaps
carried on their books.'' \9\
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\8\ CFTC Letter no. 15-24.
\9\ Id.
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While the ``new trade, old terms'' procedure may be necessary for
immediate relief in handling error trades, this process should serve
only as an interim solution. Before the expiration of the most recent
no-action relief, the Commission should work with DCOs to devise a less
complex process, whereby SEFs can send a correction to a trade cleared
by a DCO rather than execute a new trade.
Package Transactions
As described by the Commission, a package transaction ``is a
transaction involving two or more instruments: (1) that is executed
between two or more counterparties; (2) that is priced or quoted as one
economic transaction with simultaneous or near simultaneous execution
of all components; (3) that has at least one component that is a swap
that is made available to trade and therefore is subject to the CEA
section 2(h)(8) trade execution requirement; and (4) where the
execution of each component is contingent upon the execution of all
other components.'' \10\
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\10\ CFTC Letter no. 14-62 (May 1, 2014).
---------------------------------------------------------------------------
In response to market participant concerns that the application of
the trade execution requirement to package transactions would present
challenges for FCMs and DCOs in processing such transactions, as well
as for SEFs and DCMs in facilitating trade execution for such
transactions, CFTC staff issued no-action letters to provide a phased
compliance timeline for entities and counterparties with respect to
package transactions. Confusion remains, however, regarding how to
execute those products that may be included in a package transaction,
yet are not under the CFTC's regulatory jurisdiction, e.g., Treasury
spreads.\11\
---------------------------------------------------------------------------
\11\ For example, market participants' confusion regarding Treasury
spreads is amplified by potential Commission action to require post-
trade anonymity, as a counterparty requires knowledge of the other
counterparty to exchange the Treasury spread.
---------------------------------------------------------------------------
Without additional clarity from the Commission regarding the
execution of such transactions, SEFs and other market participants are
unable to confidently invest in resources to develop implementation
solutions for package transactions. This will have serious negative
consequences for market participants, including asset managers and end-
users, as has been noted by other swap market participants.\12\
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\12\ See Securities Industry and Financial Markets Association,
Asset Management Group, letter to CFTC (May 11, 2015), available at
http://www.sifma.org/issues/item.aspx?id=8589954630.
Question 2. Mr. Bernardo, can you explain how the Commission's
proposed position limits and aggregation rules would impact SEFs? From
your perspectives, is it possible to comply with them as they have been
proposed?
Answer. Under the Commission's proposed position limits rules, SEFs
would be required to adhere to various requirements in setting position
limits for both contracts that are subject to the Federal position
limits and contracts that are not subject to Federal position limits.
In terms of statutory provisions for SEFs related to position
limits, the Dodd-Frank Act established core principles for SEFs,
including Core Principle 6 regarding position limits or accountability,
which requires SEFs to set position limits or accountability levels,
``as is necessary and appropriate,'' for participants and customers of
their facilities. In addition, the core principle requires that the
SEF: (1) establish a position limit no higher than a CFTC position
limitation; and (2) monitor positions established on or through the SEF
for compliance with the limit set by the Commission and the limit, if
any, set by the SEF.
As a preliminary matter, SEFs are ill-equipped to establish
position limits for swaps, as they do not have access to the necessary
market-wide information.\13\ Further, the WMBAA does not believe that a
SEF should be required to monitor and enforce position limits or
accountability levels due to the inherent limits to a SEF's ability to
monitor participant positions. Position limits or accountability levels
apply market-wide to an entity's overall position in a given swap,
commodity, or instrument subject to limits and ownership and control
provisions. To monitor an entity's positions and take action to enforce
such a market-wide requirement, a SEF would need to have access to
information about an entity's overall positions in the swap and
underlying instrument or commodity, which it does not have.
---------------------------------------------------------------------------
\13\ Position limit information is collected by market
participants, DCOs, and swap data repositories (``SDRs''). However,
even a DCO or SDR would only have information about traders' cleared
positions or reported positions at its individual organization. Only
the participants themselves would have information about their overall
cleared and uncleared swaps position in a market.
---------------------------------------------------------------------------
A SEF does not have access to such information because a SEF does
not own the swap contracts traded on its facility. Rather, swaps can be
traded on various facilities and the contracts are fungible. In other
words, a swap that is listed on one SEF can be, and currently is,
listed and traded on other SEFs and designated contract markets
(``DCMs''). Such swaps may also be, and currently are, traded
bilaterally off-facility between counterparties away from any SEF or
DCM. As a result, SEFs and DCMs listing swaps do not possess complete
information about a trader's position in any given swap. Instead, a SEF
only has information about swap transactions that take place on its
execution venue and has no knowledge of whether a particular trade on
its facility adds to an existing position or whether it offsets all or
part of an existing position in that swap.
In terms of a SEF position accountability regime, the WMBAA
believes that position accountability is meaningful as a market
surveillance tool only in the context of centralized marketplaces such
as exchanges, due to the fact that they own the products traded and
possess information about traders' actual positions in the relevant
derivatives marketplace. Because SEFs do not own products, and
therefore do not possess the same position information, it would not be
appropriate for SEFs to adopt position accountability. While there have
been suggestions that SEFs adopt, in effect, ``trading accountability''
provisions as a means of complying with Core Principle 6 (i.e., SEFs
would institute enhanced oversight of and data gathering from a trader
based solely on trading activity or the size of transactions), this
would be problematic for two reasons. First, the Commodity Exchange
Act, as amended by the Dodd-Frank Act, does not contemplate a trading
activity-based accountability regime, but rather contemplates a
position management-focused component. Furthermore, there is no clear
metric available for SEFs to conduct a position accountability
framework.
In contrast, the WMBAA believes that the CFTC--or a market--
encompassing self-regulatory organization (``SRO'') such as the NFA
that has been deputized by the CFTC--would have access to complete
information about an entity's positions; be able to effectively analyze
and police the swap market to detect position limit and accountability
level breaches; and institute meaningful enforcement actions to address
violations.
The WMBAA recently delivered a White Paper to the CFTC on this
topic. We look forward to further engagement with the agency on this
issue.
Question 3. Mr. Bernardo, you testified that certain CFTC's swaps
``requirements have proven to be impracticable to implement or
detrimental to market liquidity.'' What requirements are causing
problems and how are the impacts to the markets you operate in?
Answer. In addition to the aforementioned implementation issues
noted in response to Questions 1 and 2, the WMBAA offers the following
additional examples of CFTC requirements that have been problematic for
market liquidity.
Embargo Rule
According to CFTC rule 43.3, a SEF is prohibited from disclosing
swap transaction and pricing data related to public reportable swaps
before public dissemination of such swap data by a swap data repository
(``SDR'') unless certain conditions are met, including that ``such
disclosure is made no earlier than the transmittal of such data to a
registered [SDR] for public dissemination.''
As a result of the embargo rule, however, SEFs and DCMs that would
like to continue to permit work-ups may face workflow issues because
they cannot share trade information with their customers until such
information is transmitted to an SDR. Due to the discontinuous nature
of derivatives transactions, the work-up process is a vital price
discovery mechanism. Under this model, once a price is agreed for
trading, the resulting trade is reported to market participants, who
are offered the opportunity to ``join the trade'' and trade additional
volume at the recently-established market price, which in turn
increases liquidity. Work-up enables traders to assess the markets in
real-time and make real-time decisions on trading activity and, without
such a mechanism, fewer transactions would likely be executed on
facility. In addition, those SEFs that rely on a third party to
transmit information to SDRs are further hindered by the embargo rule
in their ability to make available to all market participants current
market information. Such delays can have a material effect on market
liquidity and are detrimental to a SEF's ability to provide liquidity
on a real-time basis to its participants.
The embargo rule is also disruptive to the functioning of
electronic markets. To operate efficiently and competitively,
information which reflects current market activity must be available to
all market participants without any disruptive pauses for the
occurrence of other regulatory activities. Every market participant
must have real-time information on executed trades for the entire
marketplace to ensure effective price discovery so that they can make
informed trading decisions. This allows the venue to operate properly
as a single liquidity pool.
Cross-Border Concerns
In November 2013, the CFTC's Division of Swap Dealer and
Intermediary Oversight (``DSIO'') issued staff advisory 13-69, which
responded to certain inquiries from swap market participants regarding
the applicability of the Commission's Transaction-Level Requirements in
the cross-border context.\14\ Transaction-Level Requirements include,
among other rules, mandatory trade execution, requiring that a swap be
executed on a DCM or SEF.
---------------------------------------------------------------------------
\14\ CFTC Staff Advisory No. 13-69 (Nov. 14, 2013), available at
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/
letter/13-69.pdf.
---------------------------------------------------------------------------
To the surprise of market participants, the guidance stated that
``a non-U.S. [swap dealer (`SD')] (whether an affiliate or not of a
U.S. person) regularly using personnel or agents located in the U.S. to
arrange, negotiate, or execute a swap with a non-U.S. person generally
would be required to comply with the Transaction-Level Requirements.''
It further stated that this approach would apply to ``a swap between a
non-U.S. SD and a non-U.S. person booked in a non-U.S. branch of the
non-U.S. SD if the non-U.S. SD is using personnel or agents located in
the U.S. to arrange, negotiate, or execute such swap.''
Following the release of staff advisory 13-69, Commission staff
received from non-U.S. SDs requests for time-limited relief from
compliance with the Transaction-Level Requirements when engaging in
swaps with non-U.S. persons using personnel or agents located in the
United States to arrange, negotiate, or execute such swaps. In
response, the Commission issued and extended time-limited no-action
relief on four separate occasions, including most recently through no-
action letter 14-140 in November 2014.\15\ In addition, in January
2014, the Commission issued a request for public comment on staff
advisory 13-69.\16\
---------------------------------------------------------------------------
\15\ CFTC Letter No. 14-140 (Nov. 14, 2014), available at http://
www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-
140.pdf.
\16\ Request for Comment on Application of Commission Regulations
to Swaps Between Non-U.S. Swap Dealers and Non-U.S. Counterparties
Involving Personnel or Agents of the Non-U.S. Swap Dealers Located in
the United States, 79 Fed. Reg. 1,347 (Jan. 8, 2014).
---------------------------------------------------------------------------
The WMBAA believes that the scope of the Commission's cross-border
approach in staff advisory 13-69 is far reaching, as it may subject to
SEF execution even a permitted transaction involving two non-U.S.
counterparties. Currently, there is a lack of clarity regarding who is
a U.S. person for mandatory trade execution purposes and, relatedly,
what types of transactions may be conducted away from a SEF.
In addition, this staff guidance has bifurcated markets based on a
market participant's jurisdiction, which in turn has impeded liquidity
and redirected trading activity away from SEFs. In effect, U.S. persons
are being limited to less liquid venues for their trade executions, as
non-U.S. persons have displayed a strong preference for trading on
facilities other than SEFs, particularly with respect to non-U.S.
dollar markets. The WMBAA believes that the impact of this staff
guidance runs counter to the transparency goals underlying Dodd-Frank,
as it is currently causing more trading to occur away from the U.S.
markets and the oversight of U.S. regulators.
REAUTHORIZING THE COMMODITY FUTURES TRADING COMMISSION
(COMMISSIONERS' PERSPECTIVES)
----------
TUESDAY, APRIL 14, 2015
House of Representatives,
Subcommittee on Commodity Exchanges, Energy, and Credit,
Committee on Agriculture,
Washington, D.C.
The Subcommittee met, pursuant to call, at 10:00 a.m., in
Room 1300 of the Longworth House Office Building, Hon. Austin
Scott of Georgia [Chairman of the Subcommittee] presiding.
Members present: Representatives Austin Scott of Georgia,
Lucas, LaMalfa, Davis, Emmer, Conaway (ex officio), David Scott
of Georgia, Vela, Maloney, Kirkpatrick, and Aguilar.
Staff present: Caleb Crosswhite, Haley Graves, Jackie
Barber, Jessica Carter, Mollie Wilken, Paul Balzano, Scott
Graves, Ted Monoson, Kevin Webb, John Konya, Liz Friedlander,
Matthew MacKenzie, and Nicole Scott.
OPENING STATEMENT OF HON. AUSTIN SCOTT, A REPRESENTATIVE IN
CONGRESS FROM GEORGIA
The Chairman. Well, good morning. We had to wait on the
hammer. Good morning, this hearing of the Subcommittee on
Commodity Exchanges, Energy, and Credit, regarding the
reauthorization of the CFTC as it relates to perspectives of
the Commissioners, will come to order.
Good morning, and thank you for joining us for this hearing
of the Commodity Exchanges, Energy, and Credit Subcommittee as
we continue the Agriculture Committee's work toward CFTC
reauthorization.
Thus far, we have appreciated the opportunity to hear
perspectives on reauthorization from end-users and market
participants. Their testimony has been vital to helping us gain
a better and more complete understanding of ways in which our
regulatory structure could better serve the markets that it is
designed to regulate. Today we will continue our examination of
the reauthorization of the CFTC with the important step of
hearing from the Commission itself.
I am glad to welcome Commissioner Mark Wetjen, Commissioner
Sharon Bowen, and Commissioner Chris Giancarlo to the
Committee. This marks the first appearance before Members of
this Committee for Commissioner Bowen, so we extend a warm
welcome to her. And we thank each of you for taking time to
appear before us today and share your perspectives on the
Commission, what works and, perhaps, what doesn't work.
Guided by our principles that regulatory requirements be
both minimized and justified, and that regulations provide
clarity and certainty, we hope this reauthorization process
will illuminate areas in which we can help the Commission
function more efficiently.
Collectively, the Commissioners represent a wide breadth
and depth of experience and insight, and we appreciate their
willingness to use their talents in service to the public.
Accordingly, one of our goals in this Committee is to ensure
that each Commissioner at the CFTC is adequately empowered
within his or her role.
It has been noted many times before this Committee, but
always bears repeating, that derivatives markets are essential
not only to the farmers, ranchers, and end-users who utilize
them, but to our broader economy. We will continue to look for
a healthy balance between market access and market integrity,
so that the markets meet the needs of those who use them to
hedge.
Thank you again to our witnesses for joining us here today,
and thank you for the important work you do at the Commission.
You serve our nation well, and we appreciate your choice to do
so.
[The prepared statement of Mr. Austin Scott of Georgia
follows:]
Prepared Statement of Hon. Austin Scott, a Representative in Congress
from Georgia
Good morning. Thank you for joining us today for this hearing of
the Commodity Exchanges, Energy, and Credit Subcommittee as we continue
the Agriculture Committee's work toward CFTC reauthorization.
Thus far, we've appreciated the opportunity to hear perspectives on
reauthorization from end-users and market participants. Their testimony
has been vital to helping us gain a better and more complete
understanding of ways in which our regulatory structure could better
serve the markets that it is designed to regulate. Today we will
continue our examination of the reauthorization of the CFTC with the
important step of hearing from the Commission itself.
I'm glad to welcome Commissioner Mark Wetjen, Commissioner Sharon
Bowen, and Commissioner Chris Giancarlo to the Committee. This marks
the first appearance before Members of this Committee for Commissioner
Bowen, so we extend a warm welcome to her. We thank each of you for
taking the time to appear before us today and share your perspectives
on the Commission, what works and, perhaps, what doesn't.
Guided by our principles that regulatory requirements be both
minimized and justified, and that regulations provide clarity and
certainty, we hope this reauthorization process will illuminate areas
in which we can help the Commission function more efficiently.
Collectively, the Commissioners represent a wide breadth and depth
of experience and insight, and we appreciate their willingness to use
their talents in service to the public. Accordingly, one of our goals
in this Committee is to ensure that each Commissioner at the CFTC is
adequately empowered within his or her role.
It has been noted many times before this Committee, but always
bears repeating, that derivatives markets are essential not only to the
farmers, ranchers, and end-users who utilize them, but also to our
broader economy. We will continue to look for a healthy balance between
market access and market integrity, so that the markets meet the needs
of those who use them to hedge risk.
Thank you again to our witnesses for joining us here today, and
thank you for the important work you do at the Commission. You serve
our nation well, and we appreciate your choice to do so.
With that, I'll turn to our Ranking Member, Mr. Scott.
The Chairman.With that, I will turn to Ranking Member
Scott.
OPENING STATEMENT OF HON. DAVID SCOTT, A REPRESENTATIVE IN
CONGRESS FROM GEORGIA
Mr. David Scott of Georgia. Thank you very much, Mr.
Chairman. And to our distinguished Commissioners, welcome.
As the Democratic Ranking Member, I want to emphasize how
pleased I am with the work that we have been able to accomplish
so far as we examine the critical issues that affect our
markets and our ability to continue in a very good bipartisan
process of reauthorizing the Commodity Exchange Act, commonly
referred to as the CEA.
So far, we have had several robust Committee hearings in
which we have examined the concerns of both our market
participants, and we have heard the concerns of our end-users.
So, Mr. Chairman, I am pleased with the level of discussion and
knowledge that we have had so far in our hearings, and I am
delighted today that we will hear from those who handle the
infrastructure, those who have to deal with making sure we have
a level playing field for both our end-users and our market
participants, and protect the best interests of the American
people and our fine, outstanding financial system.
Commissioner Wetjen, Commissioner Bowen, and Commissioner
Giancarlo, I want to thank you for being here today. You have
great perspective. We value your input, we value your views,
and we know that you will provide a critical foundation for the
work that this Committee must undertake in the reauthorization
of the Commodity Exchange Act, but not only that, we really,
really respect your involvement and understanding of the deep
complexity of this entire issue as we move forward, for it is
both your charge and this Committee's charge to have the
jurisdiction of the complete Section VII of Dodd-Frank.
Mr. Chairman, I would like to again commend the Committee's
previous work where we worked last year on H.R. 4413, which
will provide the basis for what we do today. And I am looking
forward to hearing from our distinguished panel regarding their
thoughts on that particular bill as a framework for us, going
forward, but also on some very critical issues like the EU
recognition of U.S. clearinghouses, and vice-versa, the
recognition by the U.S. of foreign clearinghouses. The U.S.
definition of U.S. person, position limits, cross-border, so
many issues that are ratcheting up for us. And as we all know,
I have mentioned in every hearing regarding the CEA
reauthorization, the importance of providing the CFTC with the
adequate level of funding that we need because all of what we
deal with, all of what I have just said, means almost virtually
nothing if you do not have the funds with which to do the job.
And I have continually stressed as we have evolved in this
issue of derivatives and swaps, I mean the mission, the clarity
and purpose of the CFTC and your workload has increased 400
percent. So I am anxious to hear from each of you that fact,
that you do have enough funding, you need more funding, only
you are in the best position to tell us the answers to those
critical questions on funding.
So finally, let us not forget what the CFTC's primary
mission is. It is to foster open, transparent, competitive and
financially sound markets, and avoid systemic risk, and protect
the market users and their funds, consumers and the public from
fraud or manipulation. What a task. We are looking forward to
hearing from you.
Thank you, Mr. Chairman.
The Chairman. Thank you, Mr. Scott.
And I see that the full Committee Chairman has joined us,
Mr. Conaway from Texas. I would like to recognize you if you
have any opening statement.
OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE
IN CONGRESS FROM TEXAS
Mr. Conaway. Well, I don't, other than to say I thank you
and David for holding the hearing, and also thank you to our
witnesses. You are going to be an integral and important part
of the reauthorization process, and so your comments today will
be taken very seriously as we move forward on the full
reauthorization.
I look forward to the hearing, and I yield back.
The Chairman. The chair would request that other Members
submit their opening statements for the record so that
witnesses may begin their testimony, and to ensure that there
is ample time for questions.
[The prepared statement of Mr. Goodlatte follows:]
Prepared Statement of Hon. Bob Goodlatte, a Representative in Congress
from Virginia
The Commodity Futures Trading Commission's (CFTC) mission is to
foster open transparent, competitive and financially sound markets;
avoid systemic risk; and to protect the market users and their funds,
consumers and the public from fraud, manipulation and abusive
practices.
Toward that end, I appreciate the opportunity for the Subcommittee
on Commodity Exchanges, Energy, and Credit to hear from the CFTC
Commissioners testifying before us as these markets impact the daily
lives of most Americans and the products they consume. In the words of
CFTC Chairman Massad, ``we must create a regulatory framework that
promotes efficiency and competition, while preventing manipulation and
fraud, to ensure that markets continue to able a strong, dynamic engine
for economic growth.''
As you are aware, the CFTC was last reauthorized under the Food,
Conservation, and Energy Act of 2008, the 2008 Farm Bill, for a period
of 5 years and its authority expired on September 30, 2013. The
Customer Protection and End User Relief Act approved in the 113th
Congress was aimed at ensuring that the Federal agency tasked with
regulating the multi-trillion dollar market is working in the most
efficient and effective way, as well as bringing into play key
protections for futures customers while mitigating the regulatory load
on America's job creators.
In an effort to help the CFTC achieve its mission, I have been
actively engaged with the Commission regarding their authority to
regulate and investigate concerns about the aluminum supply, and
potential manipulation of pricing. Toward that end, I appreciate the
recent efforts of the CFTC to respond to these critical matters.
Aluminum users from across the county have voiced their strong
concerns in recent years as the restrictive flow of aluminim metal out
of London Metal Exchange (LME) warehouses has completely distorted the
free market system. Users are seeking regulatory and legislative
oversight of the LME to ensure a transparent, balanced, and functional
market for buyers and sellers.
Last year, I worked with then-Chairman Lucas to incorporate into
CFTC reauthorization language requesting a Commission report to
Congress on actions undertaken to address concerns relating to aluminum
pricing and manipulation. I remain extremely concerned about
manufacturers being able to take timely delivery of aluminum for
production at a fair price for uses such as common drink cans, which
many American's utilize on a daily basis, as well airplane parts, and
for other purposes.
Regulatory clarity is needed regarding the jurisdictional roles of
the CFTC and the London Metal Exchange. The aluminum warehouses in
question are regulated through the LME and are certified in the United
States. The LME is said to have regulations in place, but contend they
do not have full authority regarding warehouses located in the U.S. In
the past, the CFTC has acknowledged that they have some authority to
regulate and investigate concerns about the aluminum supply. In
addition, the CFTC has authority over unfair trading and price
manipulation, and as such has an obligation of oversight or should
advise Congress of the tools needed to carry out this mission. Even the
Senate Select Permanent Subcommittee on Investigations issued a
bipartisan report last year that raised significant concerns regarding
aluminum market practices.
I am encouraged by the CTFC's recent attention to this vital issue
as Chairman Massad testified on February 12, ``another issue of concern
to end-users that we are focused on pertains to the long queues for
delivery of aluminum at warehouses in this country licensed by the
London Metal Exchange (LME), the relationship of those queues to the
pricing and delivery of aluminum, and how these issues impact market
integrity and market participants.''
Furthermore, the Commission's letter to the London Metal Exchange
(LME) of March 24 is to be commended, in which the Division of Market
Oversight notified the LME that it is exercising its authority under
Section 4(b)(1) of the Commodity Exchange Act regarding the LME's
application for registration as a foreign board of trade. The CFTC
formally deferred review to permit the continued review of LME's
activities as it addresses issues surrounding LME-licensed aluminum
warehouses that have caused concerns in the market, particularly with
respect to pricing in the U.S for aluminum, due or related to the
length of warehouse queues.
The CFTC noted, that while LME has made progress in reducing
queues, ``the results attained to date indicate that more progress is
needed'' and staff will continue to review LME's actions and well as
the implementation of alternatives to reduce the queues at LME licensed
aluminum warehouses.
Again these efforts are steps in the right direction and I look
forward to working with this Subcommittee, as well as the CFTC, to
ensure a regulatory framework that promotes efficiency and competition,
while guarding against manipulation and fraud, to be sure markets
continue to promote economic growth for their users.
The chair would also like to remind Members that they will
be recognized for questioning in order of seniority for Members
who were present at the start of the hearing, after that,
Members will be recognized in order of their arrival. I
appreciate Member's understanding.
Witnesses are also reminded to limit their oral
presentation to 5 minutes. All written statements will be
included in the record.
I would like to welcome our witnesses to the table. The
Honorable Sharon Bowen, Commissioner, Commodity Futures Trading
Commission, Washington, D.C.; the Honorable Chris Giancarlo,
Commissioner, Commodity Futures Trading Commission, Washington,
D.C.; and the Honorable Mark Wetjen, Commissioner, Commodity
Futures Trading Commission, Washington, D.C.
Commissioner Bowen, please begin when you are ready.
STATEMENT OF HON. SHARON Y. BOWEN, COMMISSIONER, COMMODITY
FUTURES TRADING COMMISSION,
WASHINGTON, D.C.
Ms. Bowen. Good morning. Chairman Scott, Ranking Member
Scott, Chairman Conaway, Ranking Member Peterson, and Members
of the Subcommittee, thank you for inviting me to testify this
morning on the reauthorization of the Commodity Futures Trading
Commission, on which I serve as a Commissioner. It is an honor
and a privilege to appear before you today.
First, I would like to express my gratitude to our
extremely hard-working staff. If Members of this Subcommittee
leave this hearing with only two new pieces of information
today, I hope that it is first, our staff truly are the hardest
working, most professional staff in a government agency.
Second, that while our staff can accomplish a great deal with
limited resources, the agency desperately needs additional
funding and staff to carry out our mission of regulating and
protecting the swaps and futures markets.
If there was some way in this reauthorization to allow the
CFTC to set fees on registrants or a de minimis fee on trades,
as the SEC is empowered to do so, that would be extremely
helpful.
I would like to extend my appreciation and thanks to my two
fellow Commissioners, Mark Wetjen and Chris Giancarlo,
testifying with me today. I am fortunate to serve with them and
Chairman Massad. I want to extend my gratitude to our Chairman
for addressing a number of concerns of end-users and other
stakeholders.
While some of us may disagree about the status of systemic
risk to the swaps and futures market, or the wisdom of a
particular Dodd-Frank requirement, I hope we can all agree on
this: the Commodity Futures Trading Commission should be
reauthorized. Its role in overseeing the derivatives market is
critical to protecting global financial stability and the U.S.
economy, and thus, assuring the American people that their
voices and interests are heard.
To that end, I would like to offer a few recommendations to
you as you begin this effort to reauthorize this agency. The
first, of course, is self-funding, which I mentioned
previously. The CFTC was last reauthorized by Congress in
August 2008, and as we all know only too well, the world had
changed greatly since then.
Second, I believe it is time to reevaluate how our system
of self-regulatory organizations is functioning. It will be
wise to take a comprehensive look at this system, and to ensure
that it is set up to work efficiently, cohesively, and
effectively. If a part of it isn't working, or if there is an
area of regulation that needs to be addressed, I hope we will
do that. In particular, I believe it is prudent to establish a
separate SRO just for swaps and market participants. In his
recent white paper, Commissioner Giancarlo proposed an
established system of professional standards for the swaps
market. I think that is a good proposal, and a new SRO for the
swaps market will be well positioned to implement this.
Establishing standards of eligibility and accountability will
enhance and strengthen investor protections.
Third, I believe it would be wise for us to have stricter
regulations on the retail foreign exchange swaps industry. As I
have previously said, it is ironic that following the enactment
of Dodd-Frank, the retail foreign exchange industry is the
least regulated part of the derivatives market. I continue to
hold this view. In fact, I believe we should make retail
foreign exchange swaps, which directly involve retail
investors, at least as regulated as the rest of the swap
markets. I also continue to believe that the Commission can and
should take action on this subject.
Fourth, I believe we should issue new regulations on
cybersecurity, but I hope the Commission acts on this on our
own very soon. As I recently said in a speech before many
operational risk professionals, the fact that trading is now
effectively entirely electronic brings with it the risk of
cyberattack. As a result, financial actors have become
storehouses of massive amounts of data, much of it incredibly
sensitive. We have to have protections in place, not only
against thieves trying to steal data, but also entities that
may be trying to hack into our system just to try and disrupt
our financial markets and damage our economy.
Finally, we should increase our enforcement penalties. Put
simply, some of our current enforcement penalties really
require updating. They should not convey the message that it is
just the cost of doing business to pay these penalties. I would
support updating these enforcement penalties so they are tough,
fair, and fit the scope and scale of the markets we regulate.
Our financial markets are the lifeblood of our economy.
They allow capital to be more efficiently invested, and help to
allow newer, leaner, and more innovative enterprises and
investors to thrive. But without fair, rigorous rules in place,
the system breaks down, harming investors, businesses and our
overall economy. The CFTC has changed greatly in the last few
years, and it is in the best interest of the industry,
investors, and the public that the Commission's authorizing
legislation is up-to-date so that the CFTC can meet today's
challenges, and those that are likely to unfold in the future.
Thank you, and I look forward to your questions.
[The prepared statement of Ms. Bowen follows:]
Prepared Statement of Hon. Sharon Y. Bowen, Commissioner, Commodity
Futures Trading Commission, Washington, D.C.
Chairman Scott, Ranking Member Scott, Chairman Conaway, Ranking
Member Peterson, and Members of the Subcommittee, thank you for
inviting me to testify this morning on the reauthorization of the
Commodity Futures Trading Commission, on which I serve as a
Commissioner. It is an honor and a privilege to appear before you
today.
First, I would like to express my gratitude to our extremely hard-
working staff. Despite suffering from significant funding and resource
constraints and the massive new mission of regulating and policing the
swaps market, their performance has been exemplary. I remain impressed
with their invaluable expertise and professional commitment to
fulfilling our vastly increased Congressional mandate. At present, the
CFTC has completed a greater percentage of its Dodd-Frank rules than
other domestic financial regulatory agencies. That record of
accomplishment is entirely thanks to our staff, who have shared their
perspectives and insights with me in these last 10 months. If Members
leave this hearing with only two new pieces of information today, I
hope it is that first, our staff truly are the hardest-working, most
professional staff in a government agency. Second, that while our staff
can accomplish a great deal with limited resources, the agency
desperately needs additional funding and staff to carry out our mission
of regulating and protecting the swaps and futures markets.
I would also like to extend my appreciation and thanks to my two
fellow Commissioners testifying with me here today. Commissioner
Giancarlo brings with him a wealth of private sector experience in the
swaps industry and he makes use of it in every open meeting, every
roundtable, and every discussion we have. Commissioner Giancarlo and I
experienced the confirmation process together; sometimes, we would even
have joint meetings with individual Senators, and that gave us a bond
that I believe has made it easier for us to reach consensus on some of
our mandates. Commissioner Wetjen, who now has the longest tenure of
the four of us, has been an invaluable source of expertise and insight
to the rest of us. He has been able to inform us of why certain actions
were taken prior to our arrival. But beyond merely being a repository
of institutional memory, he also deserves immense praise for serving as
Acting Chairman for approximately 6 months last year and for his many
piercing questions and insights about potential risks and impacts of a
proposed CFTC action. I am fortunate to serve with my fellow
Commissioners.
I also want to extend my gratitude to our Chairman, Tim Massad, who
has worked hard to address a number of concerns of end-users and other
stakeholders. He brings an incredibly detail-oriented viewpoint, a
steel-trap memory of the evolution of the markets we regulate, and a
formidable intellect. I've seen Chairman Massad tell our staff that the
CFTC should be the most interesting, professional, and all-around best
financial regulator in the government and I know that's a goal he
strives to fulfill. It is a goal I share and I am glad we can work
together to make it a reality.
My experience and what I bring to the table is broad both
professionally and personally. I have a 32 year career as a lawyer on
Wall Street and a 58 year career as a consumer and investor. I am also
someone who personally witnessed families and friends lose their jobs,
homes, and retirement accounts during the financial crisis. Frankly,
they believed that they would be okay because they worked hard, had the
right education, and made personal sacrifices.
While some of us may disagree about the state of systemic risks to
the swaps and futures markets or the wisdom of particular Dodd-Frank
requirements, I hope we can all agree on this: the Commodity Futures
Trading Commission should be reauthorized. Its role in overseeing the
derivatives market is critical to protecting global financial stability
and the U.S. economy and thus assuring the American people that their
voices and interests are being heard.
The CFTC was last reauthorized by Congress in August 2008, and as
we all know only too well, the world has changed greatly since then.
The last reauthorization occurred before Lehman crashed, before the
national unemployment rate hit 10%, and before the Dodd-Frank Wall
Street Reform Act was enacted into law, giving the CFTC new powers and
responsibilities, including jurisdiction over the vast majority of the
swaps market.
It is in fact nearly 5 years even since Dodd-Frank. In markets as
dynamic as these, where trading practices and strategies are dynamic
and can change within quarters, weeks, or even days, 5 years is a
lifetime. I have a few recommendations I believe will enhance the
ability of the CFTC to protect markets, investors, and consumers.
First, and most importantly, there is the issue of resources. Much
has been said about the topic of funding of course, but I believe a
little more discussion is needed. Frankly, I believe it would be
prudent to establish some kind of mechanism that allows the Commission
to self-fund. We are grateful for the $35 million increase in
appropriations we received in last December's legislation to fund the
government, which raised our annual budget from $215 million in Fiscal
Year 2014 to $250 million for Fiscal Year 2015. However, that $35
million is a drop in the bucket considering the scope of our mission to
regulate the swaps and futures markets. According to the most recent
numbers I've seen, the futures market in the United States, which was
the primary market we regulated prior to Dodd-Frank, is estimated to be
more than $30 trillion total at present.\1\ Meanwhile, the U.S. swaps
market is estimated to be approximately $400 trillion today.\2\ As a
point of comparison, the legislation that funded the entire government
last December, the so-called ``Cromnibus,'' appropriated just over $1
trillion, and the entire U.S. gross domestic product in 2014 was
estimated as just over $17.4 trillion.\3\ So, by mandating in Dodd-
Frank that we regulate the domestic swaps market, Congress increased
our overall jurisdiction by over 1,300%.
---------------------------------------------------------------------------
\1\ See Bank for International Settlements, ``Derivatives Financial
Instruments Traded on Organized Exchanges,'' available at http://
www.bis.org/statistics/r_qa1503_hanx23a.pdf & Commodity Futures Trading
Commission, FY 2014 Annual Performance Report & FY 2016 Annual
Performance Plan, February 2015, at page 6, available at http://
www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/2014apr.pdf.
Note, figures are in gross notional dollars. Please note that in 2009,
the futures market was also smaller, being estimated at approximately
$22 trillion. Commodity Futures Trading Commission, Budget and
Performance Estimate for FY 2010, May 7, 2009, available at http://
www.cftc.gov/reports/presbudget/2010/2010presidentsbudget01.html.
\2\ Commodity Futures Trading Commission, FY 2014 Annual
Performance Report & FY 2014 Annual Performance Plan, April 10, 2013,
at page 6, available at http://www.cftc.gov/ucm/groups/public/
@aboutcftc/documents/file/2014apr.pdf. Note, even if one looks at gross
market value instead of gross notional, the global swaps market was
still valued at over $17 trillion in mid-2014. See Bank for
International Settlements, ``Amounts of Outstanding Over-the-Counter
(OTC) Derivatives,'' available at http://www.bis.org/statistics/
dt1920a.pdf.
\3\ Federal Reserve Bank of St. Louis, ``Gross Domestic Product,''
available at http://research.stlouisfed.org/fred2/series/GDPA. Note--
GDP as valued in chained 2009 dollars is just over $16 trillion.
Federal Reserve Bank of St. Louis, ``Real Gross Domestic Product,''
available at http://research.stlouisfed.org/fred2/series/GDPCA.
---------------------------------------------------------------------------
While our budget has increased in recent years, it has not kept
pace with that massive increase in our mission. In Fiscal Year 2009,
the entirety of which was prior to Dodd-Frank's passage but which did
cover the heart of the 2008 financial crisis, our budget was $146
million.\4\ For Fiscal Year 2015, our budget is $250 million, an
increase of $104 million since Fiscal Year 2009.\5\ So, we've now got
$104 million to regulate an additional $400 trillion of jurisdiction,
and $250 million to regulate the combined, greater-than $430 trillion
domestic swaps and futures markets. To use the language of finance, the
government is currently making an investment that is leveraging $1 of
regulatory funding for every $1,720,000 of the swaps and futures
markets.
---------------------------------------------------------------------------
\4\ Commodity Futures Trading Commission, Budget and Performance
Estimate for FY 2010, May 7, 2009, available at http://www.cftc.gov/
reports/presbudget/2010/2010presidents
budget01.html.
\5\ Commodity Futures Trading Commission, President's Budget--
Fiscal Year 2016, February 2, 2015, at pages 1 & 7, available at http:/
/www.cftc.gov/ucm/groups/public/@newsroom/documents/file/
cftcbudget2016.pdf.
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Our staffing levels have failed to keep pace with our duties. In
May 2009, we had 500 people employed at the CFTC.\6\ In Fiscal Year
2014, we had 647 full time employees, an increase of 29%.\7\ Yet, it's
worth noting that we actually had fewer staff in Fiscal Year 2014 than
we had just 2 years earlier; in Fiscal Year 2012, we had 687 full-time
employees.\8\ Despite weathering that nearly 6% cut in staffing levels,
our staff has continued to complete our major rulemakings, such as the
recent re-proposal of the margin rule, and engaged in major successful
enforcement actions, such as the more than $6 billion in fees and
penalties the Commission collected in actions against various entities
for manipulating notable international benchmark rates.\9\ The CFTC
staff has literally done more with less.
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\6\ See Commodity Futures Trading Commission, Budget and
Performance Estimate for FY 2010, May 7, 2009, available at http://
www.cftc.gov/reports/presbudget/2010/2010presidents
budget01.html.
\7\ Commodity Futures Trading Commission, President's Budget--
Fiscal Year 2016, at page 8, available at http://www.cftc.gov/ucm/
groups/public/@newsroom/documents/file/cftcbudget
2016.pdf.
\8\ Commodity Futures Trading Commission, President's Budget and
Performance Plan--Fiscal Year 2014, April 10, 2013, at page 8,
available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/
file/cftcbudget2014.pdf.
\9\ Commodity Futures Trading Commission, President's Budget--
Fiscal Year 2016, at page 38, February 2, 2015, available at http://
www.cftc.gov/ucm/groups/public/@newsroom/documents/file/
cftcbudget2016.pdf.
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Yet, while we have been able to survive on our current funding
levels, our lack of resources has not just been a challenge for us, it
has also been an obstacle to industry, including end-users. With a
staff that is stretched so extremely thin, reviews of various
applications by derivatives clearing organizations and exchanges can
take longer, delaying those organizations' efforts to improve and
enhance trading for market participants. With a staff that is stretched
so extremely thin, examinations of registrants are more infrequent.
That slower rate of regulatory examinations will increase the
likelihood that errors and problems that develop at a registrant will
not be found and corrected quickly, resulting in greater risk for
investors and greater compliance costs for the registrants. And with a
staff that is stretched so extremely thin, our rulemaking process will
move much more slowly. Not only does that invite additional regulatory
uncertainty into the markets we regulate, but it also means that we are
less able to craft exemptions for end-users or market participants in a
timely fashion, even for those entities who have a critical and real
need for them.
Our lack of resources is hampering our ability to function, and it
is indirectly slowing down the business of trading, including for the
purposes of hedging. Last month, I met with a number of industry
participants who praised the excellent job the CFTC's staff was doing
under the circumstances but also understood that the lack of funding
posed risks both to their businesses and our broader financial system.
In fact, they asked what they could do to get us additional funding. I
urged them, like I urge all persons with similar views, to make those
views known.
Obviously, this is not an appropriations bill and the House
Agriculture Committee is not empowered to simply grant us additional
money. However, if there was some way in this reauthorization to allow
the CFTC to set fees on registrants or a de minimis fee on some trades,
as the SEC is empowered to do, that would be extremely helpful.\10\ The
industry participants who engage with the CFTC the most are typically
entities asking us to revise a regulation or grant some kind of
regulatory relief. Allowing the CFTC to fund itself via the collection
of extremely small fees from industry would effectively be allowing the
industry to pay a de minimis amount of money to receive substantially
faster service. Such a funding rubric would have the added benefit of
no longer asking American taxpayers to directly foot the bill of
setting regulations on the swaps and futures markets. I know that bills
have been introduced during the last few Congresses that grant us some
kind of fee-setting authority, and the Wall Street Accountability
Through Sustainable Funding Act introduced by Reps. DeLauro, Welch, and
Courtney last Congress is the best one I've seen to date.\11\ I should
add that there are many ways to structure such a fee, including
establishing de minimis fees on all trades, fees on certain riskier
trades, or annual fees for registrants. While I may prefer one self-
funding mechanism over another, I certainly prefer just about any of
them over the status quo.
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\10\ Securities and Exchange Commission, ``Fee Rate Advisory #3 for
Fiscal Year 2015,'' January 15, 2015, available at http://www.sec.gov/
news/pressrelease/2015-8.html#.VQCsQzYpAyE.
\11\ Introduced September 16, 2014, available at https://
www.congress.gov/113/bills/hr5490/BILLS-113hr5490ih.pdf.
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Second, I believe it is time to reevaluate how our system of self-
regulation is functioning. Currently, our system of self-regulation
doesn't reflect the current market realities or some of the core
principles of Dodd-Frank. In the futures space, we require exchanges,
such as the IntercontinentalExchange (ICE) or the Chicago Mercantile
Exchange (CME), to be SROs. Therefore, they must enforce certain
minimum reporting and financial requirements on their members.\12\ The
National Futures Association (NFA), which is the sole registered
futures association, is also an SRO, and it can set minimum rules and
standards for their members, which include futures commission merchants
(FCMs), introducing brokers (IBs),\13\ and retail foreign exchange
dealers (RFEDs).\14\
---------------------------------------------------------------------------
\12\ 17 CFR 1.52, available at http://www.gpo.gov/fdsys/pkg/CFR-
2012-title17-vol1/pdf/CFR-2012-title17-vol1-sec1-52.pdf.
\13\ Commodity Futures Trading Commission, ``Futures Commission
Merchants (FCMs) & Introducing Brokers IBS),'' available at http://
www.cftc.gov/IndustryOversight/Intermediaries/FCMs/fcmib.
\14\ National Futures Association, ``Retail Foreign Exchange Dealer
(RFED),'' available at https://www.nfa.futures.org/nfa-registration/
rfed/index.HTML.
---------------------------------------------------------------------------
This system, which is admittedly complex, was made more complicated
in the wake of Dodd-Frank when we added the swaps market to this
rubric. Under CFTC rules, each of the more than twenty swap execution
facilities in existence today, is an SRO.\15\ As a result, the National
Futures Association, which has spent the vast majority of its more than
30 year existence focused almost entirely on the futures industry,
serves as the SRO for the swaps industry.\16\
---------------------------------------------------------------------------
\15\ Commodity Futures Trading Commission, ``Core Principles and
Other Requirements for Swap Execution Facilities,'' 17 CFR Part 37,
June 4, 2013, at page 33521, available at http://www.cftc.gov/ucm/
groups/public/@lrfederalregister/documents/file/2013-12242a.pdf.
(``[T]he Commission notes that it views SEFs as SROs, with all the
attendant self-regulatory responsibilities to establish and enforce
rules necessary to promote market integrity and the protection of
market participants.'' (citation omitted)).
\16\ National Futures Association, ``NFA's Role in the U.S. Futures
Industry,'' available at http://www.nfa.futures.org/nfa-about-nfa/who-
we-are/NFAs-role-US-futures-industry.HTML.
---------------------------------------------------------------------------
It would be wise to take a comprehensive look at this system and
ensure that it is set up to work efficiently, cohesively, and
effectively. If a part of it is not working or there is an area that is
not receiving the appropriate level of regulation, it should be
addressed. In particular, I believe it may be prudent to establish a
separate SRO just for market participants who engage in swaps activity.
After all, while futures and swaps may be similar in many ways,
including the fact that market participants are, with a few notable
exceptions, rarely retail investors, they remain quite distinct. I
believe a number of the Members here today are familiar with
Commissioner Giancarlo's white paper on potential improvements that
might be made to our swaps rules. One of his suggestions is that we
``establish standards that would enhance the knowledge, professionalism
and ethics of personnel in the U.S. swaps markets that exercise
discretion in facilitating swaps execution, as well as certain
supporting compliance and operations personnel.'' \17\ Commissioner
Giancarlo proposed to establish these standards, at least in part, via
``an examination regime for interdealer brokers and other personnel . .
. .'' \18\ I support this particular proposal of Commissioner
Giancarlo's and believe we should consider whether a new SRO for the
swaps market would be better positioned to craft and maintain such an
examination regime. And I believe it is in the best interests of
protecting customers to do so. Establishing standards of eligibility
and accountability will enhance and strengthen investor protections.
---------------------------------------------------------------------------
\17\ Commissioner J. Christopher Giancarlo, Commodity Futures
Trading Commission, ``Pro-Reform Reconsideration of the CFTC Swaps
Trading Rules: Return to Dodd-Frank,'' at pages 72-73, January 29,
2015, available at http://www.cftc.gov/ucm/groups/public/@newsroom/
documents/file/sefwhitepaper012915.pdf.
\18\ Id. at page 73.
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Third, I believe it would be wise to establish stricter regulations
on the retail foreign exchange swaps industry. I have previously said
that ``[i]t is ironic, that following the enactment of Dodd-Frank, the
retail foreign exchange industry is the least regulated part of the
derivatives industry.'' \19\ I continue to hold that view.
---------------------------------------------------------------------------
\19\ Commissioner Sharon Y. Bowen, Commodity Futures Trading
Commission, ``Statement of U.S. Commodity Futures Trading Commissioner
Sharon Bowen Regarding Recent Activity in the Retail Foreign Exchange
Markets,'' January 21, 2015, available at http://www.cftc.gov/
PressRoom/SpeechesTestimony/bowenstatement012115.
---------------------------------------------------------------------------
Yet, I increasingly think my prior statements on this industry
understate the risks within the current retail foreign exchange regime.
As Bloomberg Markets reported in December 2014, ``the two biggest
publicly traded over-the-counter forex companies--FXCM Inc. and Gain
Capital Holdings, Inc., show that, on average, 68 percent of investors
had a net loss from trading in each of the past four quarters.'' \20\
Despite the likelihood that the average investor will lose money, this
is an industry where leverage ratios remain at fifty-to-one, meaning
that a person with a $500 account is allowed to trade $25,000. In other
words, the outsized risks at play in this market can quickly cause an
investor to be wiped out. And while this industry may not be as large
as the broader dollar currency markets, where trillions of dollars are
exchanged every day, the retail foreign exchange market is not small by
any stretch of the imagination.\21\ One analyst at the Aite Group
estimated that twenty million individual investors globally trade $400
billion a day, ``some making bets of just a few hundred dollars . . .
.'' \22\
---------------------------------------------------------------------------
\20\ David Evans, ``Leverage as High as 50-1 Lures OTC Forex
Traders Who Mostly Lose,'' Bloomberg.com, November 12, 2014, available
at http://www.bloomberg.com/news/articles/2014-11-12/leverage-as-high-
as-50-1-lures-otc-forex-traders-who-mostly-lose.
\21\ Id.
\22\ Id.
---------------------------------------------------------------------------
We do not have to surmise about the possibility of an event
occurring in this market that causes risks to individual investors and
the broader financial system--we already experienced one. On January
15th, the Swiss National Bank announced that it would no longer cap the
exchange rate of the Swiss Franc versus the Euro, triggering chaos in
the currency markets.\23\ In particular, one U.S. dealer of retail
foreign exchange, the aforementioned FXCM, nearly went out of business
after its customers lost more than $200 million, placing the company on
the hook for those losses.\24\
---------------------------------------------------------------------------
\23\ Neil MacLucas & Brian Blackstone, ``Swiss Move Roils Global
Markets,'' Wall Street Journal, January 15, 2015, available at http://
www.wsj.com/articles/switzerland-scraps-currency-cap-1421320531.
\24\ Reuters, ``FXCM to Forgive Most Clients' Negative Balances on
Swiss Franc Surge,'' January 28, 2015, available at http://
www.reuters.com/article/2015/01/28/fxcm-forex-idUSL4N0V759V20150128.
---------------------------------------------------------------------------
To ward off the risk of such a future event, I would recommend
rulemaking requirements to bring the level of regulation on the retail
foreign exchange markets at least up to the level of the rest of the
swaps market. In fact, I believe retail foreign exchange swaps, which
directly (and uniquely for the CFTC) involve retail investors, should
be more regulated than the rest of the swaps market. There are a number
of regulatory tools that can be utilized, from higher capital standards
to best execution requirements, and from segregated customer accounts
to stricter margin requirements.
Fourth, I believe it is time for us to issue new regulations on
cybersecurity. President Obama eloquently spoke about this topic at our
State of the Union as it applies to our economy more broadly and I
discussed this topic at a recent conference in New York on operational
risk.
As I said then, the fact that so much of trading is now entirely
electronic brings with it the risk of cyberattack. As a result,
``financial actors have become storehouses for massive amounts of data,
much of it incredibly sensitive. From information about trading
strategies to clients' social security numbers, the damage that could
be done via a major cyberattack on an exchange, clearinghouse, Swap
Execution Facility (SEF), or systemically important financial
institution is considerable.'' \25\ And the days of cyberattacks being
primarily lone wolves interested in making money are gone. We have to
have protections in place not only against such thieves but also
against entities that may be trying to hack into a system just to try
and disrupt our financial markets and thereby damage our economy.
---------------------------------------------------------------------------
\25\ Commissioner Sharon Y. Bowen, Commodity Futures Trading
Commission, ``Remarks of CFTC Commissioner Sharon Y. Bowen Before the
17th Annual OpRisk North America,'' March 25, 2015, available at http:/
/www.cftc.gov/PressRoom/SpeechesTestimony/opabowen-2.
---------------------------------------------------------------------------
As I said in my conference speech last month, ``standardization is
not necessarily our friend'' with regards to cybersecurity--if there is
one single national or industry wide-standard, ``that just means we've
created a blueprint for all our registrants to be hacked.'' \26\ Thus,
it would be prudent to establish cybersecurity regulations on futures
and swaps market participants that are more rigorous than regulations
on the rest of the private sector and to establish even more rigorous
regulations on key market participants, such as extremely large trading
entities and exchanges. The regulations on key market participants
should not be one-size-fits-all prescriptions, but instead mostly a
series of principles that firms should meet via their own, bespoke
cybersecurity protections. In other words, it would be a tiered regime
of cybersecurity protections--a baseline level of protections for all
futures and swaps market participants and a higher level of additional,
specifically tailored protections for the most at-risk firms.
---------------------------------------------------------------------------
\26\ Id.
---------------------------------------------------------------------------
Finally, we should increase our enforcement penalties. Put simply,
some of our current enforcement penalties require updating; they should
not convey the message that it is just a cost of doing business to pay
these penalties. For instance, if an entity engages in market
manipulation that is very disruptive to the market but makes very
little profit itself (or even loses money in the effort), the damages
we could assess civilly could be capped at $1 million.\27\ That is a
sizable sum, but given the size of these markets and some of the
institutions who are registered with us, the cap is too low. Similarly,
if a person provides false information to the Commission in a filing,
the damages could be capped at just $140,000.\28\ I would support
updating these enforcement penalties so that they are tough but fair
and fit the scope and scale of the markets we regulate.
---------------------------------------------------------------------------
\27\ 7 U.S.C. 9(10).
\28\ Id.
---------------------------------------------------------------------------
I am a firm believer in robust enforcement of our rules and laws,
but I also believe that we have to take a multi-pronged approach to
protecting consumers and investors. Beyond having rigorous enforcement,
we also need to be educating consumers about the market and making it
possible for them to make smart, safe choices when they choose to
invest. To that end, we have established a new national campaign,
called CFTC SmartCheck, to provide consumers with tools to check the
backgrounds of their financial professionals and thereby protect
themselves from financial fraud.\29\
---------------------------------------------------------------------------
\29\ http://smartcheck.cftc.gov/.
---------------------------------------------------------------------------
I agree with Chairman Massad that ``The United States has the best
financial markets in the world. They are the strongest, most dynamic,
most innovative, and most competitive--in large part because they have
the integrity and transparency that attracts participants. They have
been a significant engine of our economic growth and prosperity. The
CFTC is committed to doing all we can to strengthen our markets and
enhance those qualities.'' \30\
---------------------------------------------------------------------------
\30\ Chairman Timothy G. Massad, Commodity Futures Trading
Commission, ``Testimony of Chairman Timothy G. Massad Before the U.S.
House Committee on Agriculture,'' February 12, 2015, at page 25,
available at https://agriculture.house.gov/sites/
republicans.agriculture.house.gov/files/images/committee-photo-
archives/Testimony%20-%20CFTC
%20-%20House%20Ag%20-%20Feb%2012%202015.pdf.
---------------------------------------------------------------------------
If anything, I would go a step farther--our financial markets are
the lifeblood of our economy. They allow capital to be more efficiently
invested and help allow newer, leaner, and more innovative enterprises
and investors to thrive. But without fair, rigorous rules in place, the
system breaks down, harming investors, businesses, and our overall
economy. The CFTC has changed greatly in the last few years and it is
in the best interest of the industry, investors, and the public that
the Commission's authorizing legislation is up-to-date so that the CFTC
can meet today's challenges and those that are bound to unfold in the
future. Thank you, and I look forward to your questions.
The Chairman. Thank you.
Commissioner Giancarlo.
STATEMENT OF HON. J. CHRISTOPHER GIANCARLO,
COMMISSIONER, COMMODITY FUTURES TRADING
COMMISSION, WASHINGTON, D.C.
Mr. Giancarlo. Good morning, Chairman Scott, Ranking Member
Scott, and Chairman Conaway, thank you for the very kind
introduction, and thank you for the opportunity to testify.
I want to first thank the CFTC staff for their hard work
and dedication, and I also thank my fellow Commissioners. It is
a privilege to work with such fine colleagues in service to the
American people.
This is my first appearance before you as a Commissioner.
Let me briefly say that I have been a consistent advocate for
the three pillars of Title VII of Dodd-Frank; enhanced swaps
transparency, regulated swaps execution, and increased central
counterparty clearing. My support for these reforms is based on
over a dozen years as an operator of global marketplaces for
swaps trading. I believe that balanced and well-crafted
regulatory oversight should go hand in hand with vibrant,
transparent, and competitive markets essential to American
prosperity.
As you know, the passage of the Dodd-Frank Act was made
possible by the promise to exempt commercial end-users, yet
over the past few years, end-users have been caught up in the
CFTC's rule writing. As I elaborate on in my written testimony,
there are several important provisions that the Committee can
include in reauthorization to provide relief to the farmers,
ranchers, energy companies, utilities, and manufacturers who
rely on our derivative markets.
I am pleased that last fall the Commission provided relief
to not-for-profit, taxpayer-owned utilities to manage risks in
the production of electricity and natural gas. We also provided
relief with respect to when residual interest was calculated so
as not to overly burden the customers of future commission
merchants who use futures to manage their everyday business
risk. Yet we must do more. My fellow Commissioners and I are at
work on changing burdensome recordkeeping requirements under
our rule 1.35, and improving our guidance on when forwards with
embedded volumetric optionality are excluded from treatment as
swaps. And I am hopeful that we can all agree that trade
options should not be subject to position limits.
We have not yet resolved all of these end-user issues, but
what is noticeable is that we are working together as a
Commission to achieve a better outcome. Still, CFTC rules on
position limits remain a work in progress. They were meant to
curb excessive speculation that was arguably present in the
market when the Dodd-Frank Act was written, yet market
conditions today have dramatically changed, especially in U.S.
energy markets where speculation appears to show no presence at
all in the decline in energy prices.
Unfortunately, the CFTC's rule proposal would impose the
most complex and restrictive position limits rule you can
imagine. It would reject the successful experience of U.S.
futures exchanges in managing position accountability levels.
Instead, it would impose one-size-fits-all hard limits, with
sharply reduced and narrowed exceptions for bona fide hedging.
It would substitute Washington regulatory dictates for the
commercial judgment of America's farmers, ranchers, and
manufacturers when it comes to everyday business risk
management. We must be sure that in curbing excessive
speculation, we do not place costly burdens on hedgers, end-
users, and American consumers; the very ones that Congress
intended to protect in the first place.
Earlier this year, I published a white paper analyzing the
CFTC's swaps trading rules. I believe that Congress got it
right with a straightforward and flexible legislative framework
well suited to inherent market dynamics. Unfortunately, the
CFTC's rules did not follow Congress' simple outline. These
rules have produced enormous regulatory complexity without
meaningful market benefit, wasting taxpayer money at a time
when the agency is seeking additional funding. Instead, I have
proposed a pro-reform swaps trading regulatory framework built
upon five key tenets: comprehensiveness, cohesiveness,
flexibility, professionalism, and transparency.
The 2009 Pittsburgh Accords call for global financial
reform through coordinated regulatory action, yet for some
time, unsatisfactory relations between the CFTC and its
overseas counterparty regulators threatened a modern day trade
war in financial services. Regulators on both sides of the
Atlantic continue to erect separate complex regulatory
protocols that struggle to interact with each other, and
meanwhile, Asian authorities take a wait-and-see approach. The
result is fragmentation of global financial service markets
into distinct national and continental sectors. This will slow
worldwide economic growth. This will not reduce systemic risk,
but increase it. I am pleased to note, however, that Chairman
Massad and CFTC staff, especially the Division of Clearing and
Risk, are working constructively with our international
counterparts.
The CFTC has accomplished much since the passage of the
Dodd-Frank Act, yet it must do more to reduce regulatory
burdens on end-users. It must also match its oversight of U.S.
exchange traded derivatives with excellence and regulating
swaps markets, while addressing growing global market
fragmentation.
I look forward to working with this Committee and with my
CFTC colleagues to complete these important tasks. Thank you.
[The prepared statement of Mr. Giancarlo follows:]
Prepared Statement of Hon. J. Christopher Giancarlo, Commissioner,
Commodity Futures Trading Commission, Washington, D.C.
Good morning, Chairman Scott, Ranking Member Scott, and Members of
the Subcommittee. Thank you for the opportunity to testify on the
reauthorization of the Commodity Futures Trading Commission (CFTC). I
am honored to testify alongside my fellow Commissioners Mark Wetjen and
Sharon Bowen and provide my perspective on the CFTC's reauthorization.
I want to first thank the CFTC staff for their hard work and
dedication. I also want to thank my fellow Commissioners. It is a
privilege to work with them in service to the American people. I
believe the CFTC has a new spirit of cooperation and professionalism
under Chairman Massad, not only internally within the CFTC, but also
externally with other regulators and market participants. Before I
continue, I make the standard disclaimer that my remarks reflect my own
views and do not necessarily constitute the views of the CFTC, my
fellow CFTC Commissioners or of the CFTC staff.
As this is my first appearance before you as a Commissioner, let me
briefly say by way of professional introduction that I have been a
consistent advocate for practical and effective implementation of the
three key pillars of Title VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act): \1\ enhanced swaps
transparency through data reporting, regulated swaps execution and
increased central counterparty (CCP) clearing. My support for these
reforms is based on over a dozen years' of practical experience as a
business professional and operator of global marketplaces for swaps
trading. I believe that balanced and well-crafted regulatory oversight
goes hand-in-hand with vibrant, transparent and competitive markets, a
growing U.S. economy and American job creation.
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\1\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
---------------------------------------------------------------------------
In my first year on the Commission, I have focused on four major
issue sets:
I. Commercial end-user concerns;
II. Derivatives trading position limits;
III. CFTC swaps trading rules; and
IV. Cross-border impact of derivatives regulation.
I am pleased by this opportunity to update you on concerns in each
of these areas.
I. Commercial End-User Concerns
As a supporter of the Dodd-Frank swaps reforms, I am disappointed
that traditional commodity and energy markets and the end-users who
depend on them for a variety of uses have been saddled with a range of
unintended consequences of implementation of several of the Dodd-Frank
reforms. Derivatives end-users were not the source of the financial
crisis. That is why Congress undertook to exempt end-users from the
reach of swaps regulation. It is our job at the CFTC to make sure that
our rules do not treat them as though they were the cause of the
crisis.
A. Proposed Changes to Rule 1.35
In a number of key areas that I will discuss, CFTC action in the
wake of Dodd-Frank in both the futures and swaps markets is overly
burdening end-users. For example, in 2012, the CFTC revised rule
1.35.\2\ The revised rule requires retention of all oral and written
records that lead to the execution of a transaction in a commodity
interest and related cash or forward transaction in a form and manner
``identifiable and searchable by transaction.'' \3\ This recordkeeping
must be done (with certain carve-outs) by intermediaries known as
futures commission merchants (FCMs), retail foreign exchange dealers,
introducing brokers (IBs) and members of exchanges and platforms, known
as designated contract markets (DCMs) and swap execution facilities
(SEFs).\4\
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\2\ Adaptation of Regulations To Incorporate Swaps--Records of
Transactions, 77 FR 75523 (Dec. 21, 2012).
\3\ Id. and 17 CFR 1.35(a).
\4\ Id.
---------------------------------------------------------------------------
The revised rule 1.35 has proved to be unworkable. Its publication
was followed by requests for no-action relief and a public roundtable
at which entities covered by the rule voiced their inability to tie all
communications leading to the execution of a transaction to a
particular transaction or transactions. End-user exchange members
pointed out that business that was once conducted by telephone had
moved to text messaging, so the carve-out in the rule for oral
communications gave little relief. They pointed out that it was simply
not feasible technologically to keep pre-trade text messages in a form
and manner ``identifiable and searchable by transaction.''
Last fall, I voted against a proposed CFTC rule fix that did not do
enough to ease this unnecessary burden on participants in America's
futures markets.\5\ That proposal was a well-intentioned but
insufficient attempt to provide relief from unworkable rule 1.35
requirements. Rather than facilitating the collection of useful records
for investigations and enforcement actions, the rule imposes senseless
costs that fall especially hard on small FCMs that serve as
intermediaries between American farmers and manufacturers and U.S.
futures markets and members of exchanges that are not required to
register with the CFTC.
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\5\ Records of Commodity Interest and Related Cash or Forward
Transactions, 79 FR 68140 (proposed Nov. 14, 2014).
---------------------------------------------------------------------------
Many of the small and medium-sized FCMs assist America's farmers
and producers to control their costs of production. Unfortunately,
today we have around \1/2\ the number of FCMs serving our farmers that
we had a few years ago. FCMs, particularly smaller ones, are being
squeezed by the current environment of low interest rates and increased
regulatory burdens. They are barely breaking even. Just this past
Thursday, April 9, another FCM exited the futures markets when U.S.-
based Jefferies Group announced the sale of its storied Bache Futures
business to French bank Societe Generale.\6\ Like many FCMs, Bache
Futures had been struggling with falling fees and high operating costs,
including costs of regulatory compliance.
---------------------------------------------------------------------------
\6\ Peter Rudegeair and Angela Chen, Jefferies to Sell Bache
Futures Unit, Buy Forex Ops, Wall Street Journal, Apr. 9, 2015,
available at http://www.wsj.com/articles/jefferies-to-sell-bache-
futures-unit-buy-forex-ops-1428582402.
---------------------------------------------------------------------------
The requirement to retain all written communications that lead to
the execution of a transaction in a commodity interest or related cash
or forward transaction under rule 1.35 effectively requires commercial
end-users that are exchange members to retain every communication
connected to a cash market transaction because their cash market
transactions may eventually become part of the net exposure of a hedged
portfolio. This expanded oversight of the cash market activity of
commercial end-users was not called for by Dodd-Frank and discourages
exchange membership. It was recently reported that end-users have
avoided doing business on Nodal Exchange, a Virginia-based, non-
intermediated futures exchange that specializes in electric congestion
contracts, due to the rule 1.35 requirements.\7\
---------------------------------------------------------------------------
\7\ Alexander Osipovich, US Record-keeping Rule Hits Commodity
Derivatives End-Users, Risk.net, Mar. 12, 2015, available at http://
www.risk.net/energy-risk/feature/2399028/us-record-keeping-rule-hits-
commodity-derivatives-end-users.
---------------------------------------------------------------------------
We should not be further squeezing American agriculture and
manufacturing with increased costs of complying with rules such as
1.35, if we can avoid it. The stated purpose of the Dodd-Frank Act was
to reform ``Wall Street.'' Instead, we are burdening ``Main Street'' by
adding new compliance costs onto our farmers, grain elevators and small
FCMs. Those costs will surely work their way into the everyday costs of
groceries and winter heating fuel for American families, dragging down
the U.S. economy. I am supportive of both regulatory and legislative
changes to ensure this does not happen.
B. End-Users Captured As ``Financial Entities''
Another example of an unreasonable burden placed on end-users is
the CFTC interpretation of the Dodd-Frank definition of ``financial
entity.'' It has led to the inadvertent capture of many energy firms as
``financial entities.'' As we have seen, imposing banking law concepts
onto market participants that are not banks and that did not contribute
to the financial crisis is not only confusing, but also adds more risk
to the U.S. financial system. It has the practical effect of preventing
certain energy firms from taking advantage of the end-user exemption
for clearing or from mitigating certain types of commercial risk.
Again, let us not punish market participants who played no role in the
financial crisis.
C. Swap Dealer De Minimis Level
Requiring that the Commission take a vote before a major shift in
its regulations takes effect seems like a basic tenet of proper
administrative law. However, in the CFTC's final rule defining who
would be captured as a ``swap dealer,'' the Commission abdicated this
responsibility. Instead, the rule allows the ``de minimis'' threshold
of $8 billion of swap business per year to automatically lower to $3
billion in only a few short years without any affirmative vote of the
Commission. This automatic lowering may occur regardless of the
conclusions of a formal study of the matter required by the
Commission--even if the study concludes that lowering the threshold is
a bad thing to do!
Unquestionably, an arbitrary 60 percent decline in the swap-dealer
registration threshold from $8 billion to $3 billion creates
significant uncertainty for non-financial companies that engage in
relatively small levels of swap dealing to manage business risk for
themselves and their customers. It will have the effect of causing many
non-financial companies to curtail or terminate risk-hedging activities
with their customers, limiting risk-management options for end-users
and ultimately consolidating marketplace risk in only a few large swap
dealers. Such risk consolidation runs counter to the goal of Dodd-Frank
to reduce systemic risk in the marketplace. The CFTC must not
arbitrarily change the swap dealer registration de minimis level
without a formal rulemaking process.
D. Dodd-Frank Act Indemnification Requirements
Under Sections 725, 728 and 763 of the Dodd-Frank Act, when a
foreign regulator requests information from a U.S. registered swap data
repository (SDR) or derivatives clearing organization (DCO), the SDR or
DCO is required to receive a written agreement from the foreign
regulator stating that it will abide by certain confidentiality
requirements and will ``indemnify'' the CFTC for any expenses arising
from litigation relating to the request for information. In short, the
concept of ``indemnification''--requiring a party to contractually
agree to pay for another party's possible litigation expenses--is only
well established in U.S. tort law, and does not exist in practice or in
legal concept in many foreign jurisdictions, thereby introducing
complications to data-sharing arrangements with foreign governments and
raising the possibility of data fragmentation at the international
level.
Correcting this unworkable framework in the Dodd-Frank Act is not
controversial, and Congress should absolutely provide a legislative fix
to this issue, just as the Securities and Exchange Commission (SEC) has
endorsed in testimony before Congressional Committees in the 112th
Congress. Similarly, in the 113th Congress, H.R. 742 was introduced to
provide a narrow fix on this issue and passed the House on June 12,
2013, by a vote of 420-2. The same provision should be included in any
CFTC reauthorization legislation introduced by this Congress.
E. Contracts with Volumetric Optionality
Another topic of concern is risk-management contracts that allow
for an adjustment of the quantity of a delivered commodity. These types
of contracts, known as ``Forward Contracts with Embedded Volumetric
Optionality,'' or EVO Forwards, are important to America's economy.
They provide farmers, manufacturers and energy companies with an
efficient means of acquiring the commodities they need to conduct their
daily business--at the right time and in the right amounts. This
includes providing affordable sources of energy to millions of American
households. EVO Forwards do not pose a threat to the stability of
financial markets. They should not be regulated in the same manner as
financial derivatives.
Forwards are expressly excluded from the definition of a ``swap''
under the Commodity Exchange Act. The CFTC's original guidance on how
to determine when an EVO Forward should also be considered a forward,
and thus excluded, using a ``Seven-Factor Test'' has been burdensome,
unnecessary and duplicative. The CFTC captured a large swath of
transactions that were not and should not be regulated as ``swaps,''
including EVO Forwards.
Fortunately, the Commission last fall proposed through regular
order an amended interpretation of the Seven-Factor Test.\8\ That
proposal is a good start for providing some sensible relief from the
problems arising from the test. I believe the best approach would be a
new and more practical product definition. Short of that, I am
listening carefully to recommendations by consumers and industry for a
better interpretation.
---------------------------------------------------------------------------
\8\ Forward Contracts With Embedded Volumetric Optionality, 79 FR
69073 (proposed Nov. 20, 2014).
---------------------------------------------------------------------------
If not corrected, the regulation of these transactions will have
the effect of increasing companies' costs of doing business. It will
force some businesses to curtail market activity and thereby
consolidate risk in the marketplace rather than transfer and disperse
it. That will ultimately raise costs for consumers. Such expensive and
unnecessary regulation thwarts the intent of Congress under the Dodd-
Frank Act.
F. Special Entity Utilities
The Dodd-Frank Act requires that American towns and municipalities
be labeled as ``special entities'' when they enter into swaps
transactions. The purpose was to provide specific protections for
municipalities who used complex financial swaps of the type that
ensnared Jefferson County, Alabama, and led it to file what--at the
time--was the largest municipal bankruptcy in U.S. history. Congress
never intended, however, and Dodd-Frank does not include requirements
to limit the ability of our not-for-profit utilities to manage ordinary
risks associated with generating electricity or producing natural gas.
Unfortunately, the CFTC's first shot at the ``special entity'' rule
contained onerous restrictions on ordinary risk management activities
by America's not-for-profit taxpayer-owned utilities. It generated an
enormous amount of public comment. Many commenters asserted that the
rule would cause trading counterparties to avoid dealing with special
entity utilities due to the increased regulatory compliance and
registration burdens of being labeled as a swap dealer. That meant that
these utilities would have had far fewer tools to control fluctuations
in operational costs or supply and demand, resulting in increased
electricity and other energy costs for American consumers.
The CFTC's original special entity proposal also led to two
identical pieces of legislation to correct the CFTC's action in
Congress, one passed the House unanimously, and the other was
introduced in the Senate with 14 cosponsors evenly split between both
political parties.
Fortunately, in September of last year, the Commission finalized a
rule change that recognized Congressional concern. It provided the
relief that our not-for-profit taxpayer-owned utilities need to manage
risks in the production of natural gas and electricity. Without the
rule change, a regulatory action inspired by the Dodd-Frank Act would
have increased utility rates for millions of Americans. In times of
economic uncertainty, that would have been an unacceptable result. The
legislative solutions offered during the last Congress, however, would
still provide added certainty to the marketplace, and I support making
the CFTC's regulatory changes permanent in statute.
G. Margin Requirements for Uncleared Swaps
The CFTC's proposed rules on margin for uncleared swaps are
inconsistent with the European and IOSCO approach of exempting swaps
transactions between certain affiliates from having to post initial
margin.\9\ As a result, the cost of such initial margin in internal
risk transfer trades will likely be borne by end-users. This added cost
will discourage end-users from entering into swaps transactions with
international swaps dealers that, in turn, look to offset the hedge in
markets outside of the U.S.
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\9\ Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants, 79 FR 59898 (proposed Oct. 3, 2014).
---------------------------------------------------------------------------
An example is a U.S. auto manufacturer looking to hedge U.S.
Dollar/Japanese Yen interest-rate risk through the use of an interest-
rate swap provided by a Japanese-headquartered dealer. The added cost
of initial margin on that dealer's internal risk transfer trades will
likely make that transaction cost-prohibitive for the U.S. end-user,
which will instead turn to a domestic dealer without access to the
global market offering a necessarily wider bid-offer price spread.
The CFTC's unwillingness to exempt dealer affiliates from having to
post margin on uncleared swaps will have two adverse impacts on U.S.
end-users: First, it will subject U.S. end-users to higher costs and
wider bid-offer price spreads. Second, it will have the effect of ring-
fencing financial risk in the U.S. by increasing the costs of risk-
hedging in broader global markets.
So, to those who asserted that the CFTC rules were designed to be a
barrier to importing risk into the U.S., the effect of the CFTC's
unwillingness to exempt internal risk management swaps from initial
margin is to encapsulate risk in the U.S. marketplace increasing,
rather than decreasing systemic hazard in American financial markets.
H. JOBS Act Harmonization
In letters to the CFTC, stakeholders representing a wide variety of
market participants, such as SIFMA, the Managed Funds Association, and
the Financial Services Roundtable requested that the Commission
harmonize its ``private offering'' requirements in CFTC rules 4.7 and
4.13(a)(3) with the broadened scope of solicitation permitted by the
SEC after it proposed amendments to Rule 506 of Regulation D and Rule
144A under the Securities Act of 1933. The SEC's proposed changes to
the solicitation rules for securities offerings came about after the
Jumpstart Our Business Startups Act (JOBS Act) was signed into law in
April 2012,\10\ which allows for solicitation of accredited investors
for private securities offerings in order to raise needed capital for
companies to expand and create jobs. While the JOBS Act mandates
consistent treatment of Regulation D, Rule 506 offerings across the
Federal securities laws, it unintentionally omitted harmonizing changes
to the CFTC's regulations, which created an inconsistency between the
SEC's rules and the CFTC's rules governing solicitation.
---------------------------------------------------------------------------
\10\ Jumpstart Our Business Startups Act, Public Law 112-106, 126
Stat. 306 (2012).
---------------------------------------------------------------------------
Because relief was needed quickly so as to not impede use of the
JOBS Act by the marketplace, I welcomed CFTC staff letter 14-116 issued
on September 9, 2014, to provide relief to market participants from
certain provisions of CFTC Regulations 4.7(b) and 4.13(a)(3)
restricting marketing to the public.\11\ However, because permanent
changes to our regulations via statutory language provides the most
certainty to the marketplace, I support the inclusion of the language
from H.R. 4413 and H.R. 4392 from the last Congress which would provide
an exemption for any registered commodity pool operator parallel to the
exemption provided for general solicitation of securities under the
JOBS Act.
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\11\ CFTC Letter No. 14-116, Exemptive Relief from Provisions in
Regulations 4.7(b) and 4.13(a)(3) Consistent with JOBS Act Amendments
to Regulation D and Rule 144A (Sep. 9, 2014), available at http://
www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-
116.pdf.
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I. Residual Interest Calculation
In March, I welcomed a change to CFTC Rule 1.22 that impacted when
residual interest for FCMs would be calculated.\12\ Without the recent
rule change, the so-called and, perhaps, misnamed ``customer
protection'' rule finalized in October 2013 would likely have resulted
in significant harm to the core constituents of this Commission: the
American agriculture producers who use futures to manage the everyday
risk associated with farming and ranching.
---------------------------------------------------------------------------
\12\ Residual Interest Deadline for Futures Commission Merchants,
80 FR 15507 (Mar. 24, 2015).
---------------------------------------------------------------------------
Without the rule change, farmers and ranchers would likely have
been forced to prefund their futures margin accounts due to onerous
requirements forcing FCMs to hold large amounts of cash in order to pay
clearinghouses at the start of trading on the next business day. The
increased costs of pre-funding accounts would likely have driven many
small and medium-sized agricultural producers out of the marketplace.
It would likely have forced a further reduction in the already strained
FCM community that serves the agricultural community.
When I visited a grain elevator in southern Indiana and a family
farm in rural Kentucky last November, I had lunch with around a dozen
small family farmers, some of whom use futures products to manage price
and production risk. Simply put, they could not fathom why the CFTC
would adopt a rule requiring them to pre-fund margin accounts. They saw
the former version of our rule as insuring that they would actually
lose MORE of their money--not less--in the event of a future failure of
another MF Global or Peregrine Financial.
After a significant amount of public comment, and two identical and
bipartisan pieces of legislation in both the House and the Senate last
Congress, the Commission fortunately amended CFTC Rule 1.22 so that the
residual interest deadline does not automatically adjust to the start
of business the next morning after a trade, and instead would remain at
the close of business the next day following a trade. While the change
to this deadline can now only take place after a rulemaking following a
public comment period, the legislative solutions offered in H.R. 4413
and S. 2601 during the 113th Congress would go one step further and
provide added certainty to the marketplace by not allowing residual
interest to be calculated any earlier than the close of business on the
next business day following a trade. This approach is especially
important given the potential impact on smaller FCMs and the farmers
and ranchers who depend on their risk management services.
J. Futures Customer Protections
In H.R. 4413 from the last Congress, there were several provisions
that would have made several CFTC and National Futures Association
(NFA) regulatory changes permanent in statute to help protect futures
customers following the failure of Peregrine Financial and MF Global.
Similar to the Commission's recent change improving when residual
interest is calculated, I support the important changes H.R. 4413
sought to make requiring that FCMs strengthen their controls over the
treatment and monitoring of funds held for customers trading in the
U.S. and foreign futures and options markets. In addition, codifying
the electronic confirmation of customer funds, which was first proposed
by futures industry self-regulatory organizations, and codifying when
an FCM must notify regulatory authorities when it faces an
undercapitalization scenario would help to protect futures customers
from another failure similar to MF Global. Finally, I also support
clarifying the definition of customer property to bolster CFTC
Regulation 190.08 to ensure farmers and ranchers are not left waiting
for months or years to recover their funds held in legally segregated
accounts in the event of an FCM insolvency.
II. Derivatives Trading Position Limits
When I joined the Commission 10 months ago, the Energy and
Environmental Markets Advisory Committee (EEMAC) had not met since
2009. EEMAC is the only CFTC advisory committee that was formalized in
the Dodd-Frank Act. Clearly, Congress believed that it was important to
make EEMAC a permanent forum to examine CFTC actions affecting U.S.
energy markets. Since the passage of Dodd-Frank, we have had a sea
change in the CFTC's influence on U.S. energy markets. At the same
time, the markets themselves are undergoing the largest technological
and structural changes in a generation. That fact makes EEMAC a
critical facility for examining how CFTC regulations impact energy
companies, utilities and everyday American consumers.
The CFTC's position-limits proposals are so complex and concerns
about them so widespread by stakeholders in U.S. energy markets that
they occupied the entire discussion at the first EEMAC meeting on
February 26, 2015. The meeting focused on three topics: (1) the data
supporting position limits; (2) the likely impact of this rulemaking on
liquidity; and (3) the proposed redefinition of bona fide hedging.
A. Data Raises Serious Questions
Compelling evidence presented at the EEMAC meeting supports the
contention that additional Federal position limits are not necessary in
energy markets. The EEMAC heard evidence that the run-up in oil prices
before the financial crisis did not bear any of the signs of excessive
speculation.\13\ This discussion aligns with the same findings made by
the CFTC's chief economist in 2008.\14\ Similarly, the EEMAC heard
powerful evidence that speculators are not responsible for the
significant declines in oil prices over the last 9 months.\15\
---------------------------------------------------------------------------
\13\ EEMAC Transcript (Feb. 26, 2015) (EEMAC Tr.) at 29-34.
\14\ Dr. Jeffrey Harris, the CFTC's then-Chief Economist, testified
before Congress that there was ``little evidence that changes in
speculative positions are systematically driving up crude oil prices.''
Tom Doggett, Congress Told Speculators Not Driving Up Oil Price,
Reuters, Apr. 3, 2008, available at http://uk.reuters.com/article/2008/
04/03/us-cftc-oil-speculators-idUKN0337748220080403.
\15\ EEMAC Tr. at 36-38.
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In fact, Energy Information Administration Administrator Adam
Sieminski aptly pointed out that ``something had to happen'' when the
supply of oil in the markets became out of balance with global demand
and that ``something'' was price decline. Both he and University of
Houston Professor Craig Pirrong indicated that non-fundamental market
factors, such as speculation, played only a negligible, if any, role in
the recent sharp decline in domestic and global energy prices.
Similarly, another well-informed presenter's analysis asserted that
index investors, managed money and swap dealers all had ``no
discernible impact [or] influence'' on oil prices from approximately
January 2011 through January 2015.\16\
---------------------------------------------------------------------------
\16\ See Thomas LaSala, EEMAC Panel I (Feb. 26, 2015) at 4-7,
available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/
generic/eemac022615_lasala1.pdf; see also EEMAC Tr. at 73-78.
---------------------------------------------------------------------------
In addition, the EEMAC heard persuasive testimony that sudden and
unreasonable changes in commodity prices flowing from excessive
speculation are the ones the CFTC can most readily identify and
prosecute using existing tools, such as the ban on manipulation and
disruptive trading practices.\17\
---------------------------------------------------------------------------
\17\ EEMAC Tr. at 40.
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1. ``Excessive Speculation''
The CFTC has attempted to cast its proposed rules as necessary to
curb excessive speculation. Yet, the evidence adduced at the EEMAC
meeting suggests otherwise. The CFTC primarily relies on two ``black
swan'' episodes of market manipulation (the Hunt Brothers and Amaranth)
in two commodities (silver and natural gas) to find that position
limits are necessary in 28 commodities. It is critical to note,
however, that market manipulation is generally distinct from excessive
speculation. Respected economists highlighted the simple fact that
these concepts are ``very different.'' \18\ The CFTC has ample tools
not only to detect manipulation, but also to punish it.\19\
---------------------------------------------------------------------------
\18\ Id. at 16. See also id. at 30.
\19\ See, e.g., id. at 30. See also Position Limits for
Derivatives, 78 FR 75,680, 75691 and n. 101 (proposed Dec. 13, 2013)
(Proposal) (noting complaint against and eventual settlement with
Amaranth and Brian Hunter); Kurt Eichenwald, 2 Hunts Fined and Banned
from Trades, New York Times, Dec. 21, 1989, available at http://
www.nytimes.com/1989/12/21/business/2-hunts-fined-and-banned-from-
trades.html.
---------------------------------------------------------------------------
EEMAC members offered concrete suggestions to address many of the
aspects of the proposed rules that simply will not work for the energy
markets. These discussions centered on two main concerns: (1) that
proposed CFTC position limits may reduce liquidity for hedging
purposes; and (2) that the CFTC's approach to bona fide hedging is
flawed and could put hedgers at risk.
B. Disappearing Liquidity
Exchanges that list energy derivatives explained that, although
markets are working well, liquidity is starting to become shallower,
particularly along points farther out the curve. Where liquidity is
available, wide bid-ask spreads make it increasingly costly and harder
to hedge.\20\ EEMAC members reported that liquidity is often scarcest
in some of the smaller markets, such as regional power and gas markets,
where liquidity has started to dry up completely.\21\ This reduction of
liquidity has resulted from the withdrawal of speculators from the
markets.\22\
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\20\ E.g., id. at 81-82, 91-92, 95-96, 103-04, 174-76.
\21\ Id. at 220-22.
\22\ Id. at 81-83.
---------------------------------------------------------------------------
To prevent further erosion of liquidity at the most critical
points, the EEMAC discussed two potential changes to address the
negative impact the CFTC's proposal would have on liquidity:
accountability and updated deliverable supply.
1. Accountability
The first of these changes would call on the CFTC to utilize a
system of position accountability. Position accountability is a process
long utilized by futures exchanges--and approved not only by the CFTC
but also by Congress \23\--to obtain more detailed information from
futures market participants that have reached specified position
thresholds. Based on that and other information, the exchange may order
the market participant to cap, reduce or even liquidate a position.\24\
This tool is essential because, as it was explained at the meeting,
``as you get further out the curve, there's naturally less liquidity,
less players,'' while adequate liquidity at those points in the market
remains quite important to hedgers.\25\
---------------------------------------------------------------------------
\23\ See 7 U.S.C. 7(d)(5).
\24\ E.g., id. at 106.
\25\ Id. at 107.
---------------------------------------------------------------------------
To guard against concentration risk, futures exchanges monitor
market participants--and the market as a whole--carefully when they
reach certain levels.\26\ Under this careful supervision, market
participants may be allowed to exceed the position-limit levels the
Commission has proposed. As an added safeguard for use of position
accountability, the CFTC also periodically evaluates the adequacy of
exchange implementation of position accountability.\27\ The exchanges
and the CFTC collaborate to ensure that positions across markets are
monitored and policed under a position-accountability regime.\28\
---------------------------------------------------------------------------
\26\ Id. at 107-08.
\27\ E.g., Rule Enforcement Review of the Chicago Mercantile
Exchange and the Chicago Board of Trade at 39-50 (Jul. 26, 2013),
available at http://www.cftc.gov/ucm/groups/public/@iodcms/documents/
file/rercmecbot072613.pdf.
\28\ EEMAC Tr. at 139-40.
---------------------------------------------------------------------------
The CFTC's position limits proposal gives short shrift to the
exchanges' long experience and expertise using position accountability
methods to assess the propriety of market participants' positions in
light of conditions in the market as a whole, including the depth and
shallowness of available liquidity. Indeed, it appears that dismantling
this system and replacing it with the CFTC's proposed hard limit levels
would undoubtedly harm liquidity in the spot month and beyond, without
commensurate enhancement of market integrity.\29\
---------------------------------------------------------------------------
\29\ See EEMAC Tr. at 108-12; Proposal, 78 FR at 75839-40 (proposed
App. D); Proposal, 78 FR at 75766.
---------------------------------------------------------------------------
2. Updated Deliverable Supply
Second, the EEMAC discussed the necessity for the CFTC to review
and update its deliverable-supply estimates. The CFTC's proposed
deliverable-supply estimates appear deficient in several respects. They
must be improved to have any hope of creating a viable position-limits
regime. EEMAC heard compelling evidence that deliverable-supply
calculations, like so many other aspects of position limits, cannot be
done on a ``one-size-fits-all'' basis. Energy markets have unique
characteristics that must be specially considered in calculating
deliverable supply.\30\
---------------------------------------------------------------------------
\30\ Id. at 99-100, 112.
---------------------------------------------------------------------------
The CFTC's proposed method of calculating deliverable supply is
particularly deficient as to natural gas and electricity because it
ignores--and does not permit the exchanges to consider--``supply that
is in a different location but can still serve demand in a certain area
through transportation of that commodity.'' \31\ This deficiency
underscores the need for the CFTC to exercise great care when imposing
concepts that may work for agricultural markets, for example, but do
not work for energy markets, which function quite differently.\32\
---------------------------------------------------------------------------
\31\ Id. at 100, 131-33.
\32\ See, e.g., id. at 130-33.
---------------------------------------------------------------------------
In addition, the deliverable supply estimates the Commission
proposes to use are terribly out of date. The Commission proposes to
use 1983-vintage deliverable-supply estimates in setting silver and
gold spot-month position limits, and 1996-era deliverable-supply
estimates for natural gas.\33\ We have had a revolution in natural gas
exploration and production since the mid-nineties, so it is critical
that the CFTC adopt contemporary deliverable-supply estimates.
---------------------------------------------------------------------------
\33\ CME Comment Letter at 3 (Feb. 20, 2014).
---------------------------------------------------------------------------
C. Bona Fide Hedging: Risk Management at Risk
Importantly, the EEMAC meeting also focused closely on the CFTC's
sweeping proposals to circumscribe the bona fide hedging exemption to
position limits. Congress intended that position limits target those
who engage in ``excessive speculation,'' while leaving hedgers to their
task of reducing risk in their businesses. Unfortunately, the EEMAC
heard evidence that the CFTC's proposal unduly focuses on ``limiting
the activity of commercials in hedging in the markets,'' which in turn
increases the risk of pricing commodities, the cost of which ``is
ultimately borne by consumers.'' \34\
---------------------------------------------------------------------------
\34\ EEMAC Tr. at 157-58, 183.
---------------------------------------------------------------------------
Let me briefly summarize a few elements of the CFTC's significant
reduction of the bona fide hedging exemption:
1. Storage Transactions
In a reversal from its 2011 proposal, the CFTC no longer recognizes
as bona fide transactions used to hedge risk from storage, transmission
or generation of commodities. The EEMAC learned that these transactions
form the ``bread and butter'' of energy industry efforts to hedge
risks--and thereby pass along the best possible prices to
consumers.\35\ Although the CFTC once recognized the legitimacy of this
sort of hedge, the new proposal apparently denies bona fide hedge
treatment because of the fear of abuse in the agricultural sector,
where a storage bin could be used for multiple commodities \36\--
soybeans and corn, for example. Yet, the proposed rule does not explain
why this transaction is unavailable in the energy space, where storage,
transmission and generation are obviously not fungible in the same
way.\37\ I recently toured the Valero refinery in Houston, and it was a
fascinating and educational experience. But I did not need to have a
chemical engineering degree to understand that liquefied natural gas or
generated electricity cannot be stored in a gasoline tank farm. The
CFTC rules need to recognize that as well.
---------------------------------------------------------------------------
\35\ Id. at 170-76.
\36\ Id. 174-75.
\37\ E.g., id. at 178-79.
---------------------------------------------------------------------------
2. Merchandising and Anticipatory Hedging
EEMAC members expressed considerable frustration that the CFTC's
proposal does not recognize the importance of merchandising and its
role in connecting the two ends of the value chain: production and
consumption.\38\ Moreover, merchandising promotes market convergence,
an important component of price discovery and market health.\39\ EEMAC
members explained that unfixed price contracts are frequently used in
merchandising transactions and argued forcefully that the CFTC should
re-evaluate its approach to basis contracts.
---------------------------------------------------------------------------
\38\ E.g., id. at 161-62, 190-91, 209.
\39\ E.g., id. at 191.
---------------------------------------------------------------------------
3. Cross-Commodity Hedges
EEMAC members also raised significant concerns with the CFTC's
application of the hedge exemption to cross-commodity hedges. Cross-
commodity hedging, such as hedging jet fuel with ultra-low sulfur
diesel futures contracts, is currently permitted in the spot month and
is critical to the price-discovery process, but would not be permitted
under the position-limits proposal.\40\ Similarly, EEMAC members stated
that the proposed quantitative restriction on cross-commodity hedges
was deeply problematic.\41\ This proposed quantitative restriction
would kill long-used, tried-and-true cross-commodity hedges, including
hedging electricity with natural gas and fuel oil with crude oil.\42\
---------------------------------------------------------------------------
\40\ Id. at 115-16.
\41\ E.g., id. at 191, 200-03; see also Proposal, 78 FR at 75717-18
(describing quantitative factor and suggesting it should not apply to
electricity-natural gas cross commodity hedging).
\42\ EEMAC Tr. at 200-03.
---------------------------------------------------------------------------
4. Gross versus Net Hedging
Finally, EEMAC members raised concerns regarding the CFTC's
proposed approach of permitting hedging only on an enterprise-wide
level. The EEMAC heard evidence that this approach substitutes
regulatory edict for the common-sense business judgments that underlie
existing risk-management procedures and hedging programs.\43\ The risk-
management systems and procedures on which so many hedgers depend were
built in reliance on long-standing CFTC interpretations, which this
proposal changes suddenly and with questionable justification.\44\ In
some cases, the CFTC's proposed approach is in tension with other state
or Federal regulatory requirements with regard to hedging or
reliability.\45\
---------------------------------------------------------------------------
\43\ E.g., id. at 158-60, 186-87, 216-18.
\44\ See id.
\45\ Id. at 216-18.
---------------------------------------------------------------------------
In short, the Commission and the staff have to think carefully
about many aspects of the proposed bona fide hedge exemption. I am very
concerned that the effect of the CFTC's proposed narrow list of
exemptions is to impose a Federal regulatory edict in place of business
judgment in the course of risk-hedging activity by America's commercial
enterprises. The CFTC instead must allow for greater flexibility. It
must encourage commercial enterprises to adapt to developments and
advances in hedging practices, not impede their efforts to do so. The
CFTC needs to take special care that in chasing excessive speculation,
it does not needlessly add unnecessary burdens on hedgers, end-users
and consumers--the very participants that Congress intended to protect
against excessive speculation.
The position-limits rulemaking is a significant undertaking and
both the Commission and its staff are struggling to get it right. I
continue to keep an open mind on how the difficult questions raised
before the EEMAC should be resolved. I am guided in this endeavor by
two major principles. First, we need to follow the data. Considering
the data and research in the record, significant questions remain as to
whether additional Federal position limits are necessary. Even if one
accepts that additional Federal limits are necessary, these limits must
be appropriate. The only way to make this determination is to draw upon
current and accurate data and confirm that the rule proposal will
facilitate price discovery, maintain liquidity and not unduly disrupt
markets that by all accounts are functioning fairly well. We should all
agree that basing such important rule making on twenty or thirty year
old data is simply unacceptable in a modern, well-regulated economy.
Second, the Commission must be attentive to the costs and benefits
of its rulemaking. There is no doubt that this rule will be very
expensive and that hedgers will bear a significant share of the costs.
Moreover, as an EEMAC member observed, this rule is likely to result in
higher costs for consumers of energy and will be felt most heavily by
low-income Americans.\46\ Before making a shaky necessity finding,
construing an ambiguous statute or even putting in place individual
aspects of its proposal, the CFTC needs to undertake a clear-eyed
assessment of the costs and benefits associated with expanding the
position-limits rule.
---------------------------------------------------------------------------
\46\ Id. at 196-99.
---------------------------------------------------------------------------
III. CFTC Swaps Trading Rules
In January of this year, I issued an extensive white paper
analyzing the mismatch between the CFTC's swaps trading regulatory
framework and the distinct liquidity and trading dynamics of the global
swaps markets.\47\
---------------------------------------------------------------------------
\47\ CFTC Commissioner J. Christopher Giancarlo, Pro-Reform
Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank
(Jan. 29, 2015), available at http://www.cftc.gov/ucm/groups/public/
@newsroom/documents/file/sefwhitepaper012915.pdf.
---------------------------------------------------------------------------
The white paper asserts that Congress got much of Dodd-Frank's
swaps trading rules right. Congress laid out a straightforward and
flexible swaps trading regulatory framework well-suited to the episodic
nature of swaps liquidity and swaps market dynamics.
Unfortunately, the CFTC's implementation of the swaps trading rules
widely misses the Congressional mark. I believe the rules are
fundamentally flawed for a number of reasons:
Because they inappropriately adopt a U.S.-centric futures
regulatory model that supplants human discretion with overly
complex and highly prescriptive rules;
Because they are largely incompatible with the distinct
liquidity, trading and market structure characteristics of the
global swaps markets;
Because they fragment swaps trading into numerous artificial
market segments and drive global market participants away from
transacting with entities subject to CFTC swaps regulation;
Because they exacerbate the already inherent challenge in
swaps trading--maintaining adequate liquidity--and thus
increase market fragility and the systemic risk that the Dodd-
Frank reforms were predicated on reducing; and
Last, but foremost, because they do not do what Dodd-Frank
expressly required them to do. They simply do not comply with
the clear provisions of the law.
A. The CFTC's Flawed Swaps Trading Regulatory Framework
Let me highlight a few of the key flaws in the swaps rules,
starting with:
1. Limits on Methods of Trade Execution
CFTC rules for SEFs create two categories of swaps transactions:
Required Transactions \48\ and Permitted Transactions.\49\ Required
Transactions must be executed in an order book (Order Book) \50\ or an
RFQ system in which a request for a quote is sent to three participants
operating in conjunction with an Order Book (RFQ System).\51\ Permitted
Transactions allow for any method of execution,\52\ but SEFs must also
offer an Order Book for such transactions.\53\
---------------------------------------------------------------------------
\48\ 17 CFR 37.9(a)(1).
\49\ 17 CFR 37.9(c)(1).
\50\ 17 CFR 37.3(a)(2), 37.3(a)(3) and 37.9(a)(2).
\51\ 17 CFR 37.9(a)(2) and 37.9(a)(3).
\52\ 17 CFR 37.9(c)(2).
\53\ 17 CFR 37.3(a)(2); Core Principles and Other Requirements for
Swap Execution Facilities, 78 FR 33476, 33504 (Jun. 4, 2013) (SEF
Rule).
---------------------------------------------------------------------------
There is simply no statutory support for the CFTC's ``required''
and ``permitted'' distinction. There is no support for segmenting swaps
into two categories or for limiting one of those categories to two
methods of execution. Rather, Congress's SEF definition encompasses a
platform where multiple participants have the ability to execute swaps
with multiple participants through any means of interstate commerce,
including a trading facility.\54\ This broad and flexible definition
allows execution methods beyond an Order Book or RFQ System for all
swaps, not just some swaps. The statutory language contains a multiple-
to-multiple participant trading requirement, not an all-to-all trading
requirement. The CFTC Order Book obligation is, simply, made up out of
thin air.
---------------------------------------------------------------------------
\54\ CEA section 1a(50); 7 U.S.C. 1a(50).
---------------------------------------------------------------------------
Congress further permitted SEFs to offer swaps trading ``through
any means of interstate commerce.'' \55\ The CFTC rules acknowledge
this phrase but construe it narrowly to allow for voice and other
``means'' of execution only within the limited Order Book and RFQ
System execution methods.\56\ Yet, the phrase ``interstate commerce''
has a rich and well-developed constitutional history, which U.S.
Federal courts have interpreted to cover almost an unlimited range of
commercial and technological enterprise.\57\ The CFTC's narrow
construct is disingenuous and not supported by the courts' long-
established interpretation of the Commerce Clause.
---------------------------------------------------------------------------
\55\ Id.
\56\ 17 CFR 37.9(a)(2)(ii); SEF Rule at 33501-02. The Commission
states that ``in providing either one of the execution methods for
Required Transactions in 37.9(a)(2)(i)(A) or (B) of this final
rulemaking (i.e., Order Book or RFQ System that operates in conjunction
with an Order Book), a SEF may for purposes of execution and
communication use `any means of interstate commerce,' including, but
not limited to, the mail, internet, email, and telephone, provided that
the chosen execution method satisfies the requirements provided in
37.3(a)(3) for Order Books or in 37.9(a)(3) for Request for Quote
Systems.'' SEF Rule at 33501.
\57\ See, e.g., Gonzales v. Raich, 545 U.S. 1, 17 (2005);
Katzenbach v. McClung, 379 U.S. 294, 302 (1964); Wickard v. Filburn,
317 U.S. 111, 125 (1942).
---------------------------------------------------------------------------
Congress could have required SEFs to offer certain limited
execution methods but chose not to do so. Congress could have limited
swap execution to the trading facility execution method that futures
exchanges are required to use.\58\ Congress did not do so. Congress
could have preserved references to ``electronic execution'' included in
early drafts of the Dodd-Frank Act, but it did not do so in the final
statutory text.\59\
---------------------------------------------------------------------------
\58\ CEA section 1a(51); 7 U.S.C. 1a(51).
\59\ Compare S. 3217, 111th Cong. 720 (as reported by S. Comm. on
Banking, Housing, and Urban Affairs, Apr. 15, 2010) (defining a SEF as
``an electronic trading system'' and discussing electronic execution of
trades), with 7 U.S.C. 1a(50) (defining a SEF as ``a trading system or
platform'' without reference to electronic execution).
---------------------------------------------------------------------------
Electronic order books may be the standard method of trade
execution in the futures markets, but that is not the case with swaps.
The SEF definition reflects an understanding that, given swaps'
generally episodic liquidity, a broad variety of execution methods are
necessary. The Dodd-Frank Act did not seek to alter swaps' natural
trading and execution dynamics, so we at the CFTC do not have the
authority to do otherwise.
2. Block Transactions
The CFTC block trade definition, specifically, the ``occurs away''
requirement, is another example of artificial market segmentation. The
CFTC defines a block trade as ``a publicly reportable swap transaction
that: (1) involves a swap that is listed on a registered SEF or DCM;
(2) `occurs away' from the registered SEF's or DCM's trading system or
platform; and (3) has a notional or principal amount at or above the
appropriate minimum block size applicable to such swap . . . .'' \60\
---------------------------------------------------------------------------
\60\ 17 CFR 43.2.
---------------------------------------------------------------------------
The block trade definition is a holdover from the futures
model.\61\ In the futures market, block trades occur away from the
DCM's trading facility as an exception to the centralized market
requirement given the price and liquidity risk of executing these
large-sized trades.\62\
---------------------------------------------------------------------------
\61\ See Alternative Executive, or Block Trading, Procedures for
the Futures Industry, 64 FR 31195 (Jun. 10, 1999); Chicago Board of
Trade's Proposal To Adopt Block Trading Procedures, 65 FR 58051 (Sep.
27, 2000).
\62\ 17 CFR 38.500; Execution of Transactions: Regulation 1.38 and
Guidance on Core Principle 9, 73 FR 54097, 54099 (proposed Sep. 18,
2008).
---------------------------------------------------------------------------
In today's global swaps market, however, there are no ``on-
platform'' and ``away-from-platform'' execution distinctions. Over-the-
counter (OTC) swaps trade in very large sizes. These swaps are not
constrained to trading facilities, but trade through one of a variety
of execution methods appropriate for the product's trading liquidity.
Again, the Dodd-Frank Act recognized these differences by not
imposing on SEFs an open and competitive centralized market
requirement. Rather, Congress expressly authorized delayed reporting
for swap block transactions.\63\ Congress got it right.
---------------------------------------------------------------------------
\63\ CEA section 2(a)(13)(E); 7 U.S.C. 2(a)(13)(E).
---------------------------------------------------------------------------
We at the CFTC have the swaps block trade definition wrong. There
is no statutory support for the ``occurs away'' requirement. The
requirement creates an arbitrary and confusing segmentation between
non-block trades ``on-SEF'' and block trades ``off-SEF.'' The ``off-
SEF'' requirement undermines the legislative goal of encouraging swaps
trading on SEFs.\64\ In short, it needs to be changed.
---------------------------------------------------------------------------
\64\ CEA section 5h(e); 7 U.S.C. 7b-3(e).
---------------------------------------------------------------------------
3. Made Available to Trade
Congress included a trade execution requirement in the Commodity
Exchange Act that requires SEF execution for swaps subject to the
clearing mandate.\65\ In an innocuous exception to this requirement,
Congress stated that the trade execution requirement does not apply if
no SEF ``makes the swap available to trade.'' \66\
---------------------------------------------------------------------------
\65\ CEA section 2(h)(8); 7 U.S.C. 2(h)(8).
\66\ Id.
---------------------------------------------------------------------------
Based on nothing other than these six words, the CFTC has created
an entire new regulatory mandate that is now known as the ``made
available to trade'' or MAT process.\67\ Yet, a plain reading of Dodd-
Frank's trade execution requirement shows that Congress never intended
to create such a regulatory framework around these six words. Unlike
the clearing mandate, the trade execution requirement provided no
regulatory process for moving some swaps on-SEF and keeping others
off.\68\
---------------------------------------------------------------------------
\67\ CEA section 2(h)(8); 7 U.S.C. 2(h)(8); 17 CFR 37.10, 37.12,
38.11 and 38.12; Process for a Designated Contract Market or Swap
Execution Facility To Make a Swap Available to Trade, Swap Transaction
Compliance and Implementation Schedule, and Trade Execution Requirement
Under the Commodity Exchange Act, 78 FR 33606 (Jun. 4, 2013).
\68\ Compare CEA section 2(h)(1), 2(h)(2) and 2(h)(3); 7 U.S.C.
2(h)(1), 2(h)(2) and 2(h)(3), with CEA section 2(h)(8); 7 U.S.C.
2(h)(8).
---------------------------------------------------------------------------
Congress could have specified a regulatory process for the trade
execution requirement as it did for the clearing mandate, but it chose
not to. Unlike futures, which begin life on an exchange where they may
or may not attract liquidity, newly developed swaps products are
initially traded bilaterally and only move to a platform once trading
liquidity is assured. Congress's trade execution requirement merely
reflects the simple logic that a clearing-mandated swap must be
executed on a SEF provided that the particular swap is sufficiently
liquid that some SEF makes it available to trade (i.e., offers the swap
for trading). This logical condition was not meant to serve as the
basis for a new CFTC regulatory process.
This MAT process would not even be necessary if the CFTC allowed
SEFs to offer swaps trading through ``any means of interstate
commerce,'' exactly as Congress authorized. In short, the MAT process
is not supported by the text of Dodd-Frank or the inherent nature of
global swaps trading.
Congress should not support the CFTC in any assertion of greater
control over the MAT process. Rather, the CFTC should withdraw its MAT
regulations and, instead, conform its rules to the express
Congressional text of Title VII, permitting SEFs to conduct their
operations using such ``means of interstate commerce'' as they deem
most suitable to serve their customer needs in the particular swaps
products and marketplaces in which they operate.
4. Impartial Access
Dodd-Frank requires SEFs to have rules to provide market
participants with impartial access to the market and to establish rules
regarding any limitation on access.\69\ For some reason, CFTC staff
appear to view these provisions as requiring SEFs to serve every type
of market participant in an all-to-all market structure. Given the
Dodd-Frank Act's reference to limitations on access and its flexible
SEF definition, however, efforts to require SEFs to serve every type of
market participant in all-to-all marketplaces are unsupportable.
---------------------------------------------------------------------------
\69\ CEA section 5h(f)(2); 7 U.S.C. 7b-3(f)(2).
---------------------------------------------------------------------------
Impartial access must not be confused with open access. Impartial
access, as the CFTC noted in the preamble to the final SEF rules, means
``fair, unbiased, and unprejudiced'' access.\70\ This means that a SEF
should apply this standard to its participants; it does not mean that a
SEF is forced to serve every type of participant in an all-to-all
futures-style marketplace. Only Congress could have imposed an all-to-
all trading mandate; it chose not to do so.
---------------------------------------------------------------------------
\70\ SEF Rule at 33508.
---------------------------------------------------------------------------
5. Void Ab Initio
CFTC staff has issued guidance stating that any swap trade that is
executed on a SEF and that is not accepted for clearing is invalid from
the beginning or ``void ab initio.'' \71\
---------------------------------------------------------------------------
\71\ Division of Market Oversight and Division of Clearing and
Risk, Staff Guidance on Swaps Straight-Through-Processing (Sep. 26,
2013), available at http://www.cftc.gov/ucm/groups/public/@newsroom/
documents/file/stpguidance.pdf.
---------------------------------------------------------------------------
The CFTC's void ab initio policy has no support in the Dodd-Frank
Act. There are legitimate reasons, such as operational or clerical
errors, that cause trades to be rejected from clearing. The void ab
initio policy creates a competitive disadvantage for the U.S. swaps
market relative to the U.S. futures market, which does not have such a
policy. Further, the void ab initio policy may well introduce
additional risk into the system when a participant enters into a series
of swaps to hedge its risk but one or more swaps is declared void ab
initio. In this case, the participant will not be correctly hedged,
which creates additional market and execution risk.
6. Core Principles
Congress provided a core principles-based framework for SEFs.\72\
Unfortunately, the Dodd-Frank Act missed the mark with respect to the
SEF core principles, most of which are based on the DCM core
principles.\73\ The futures regulatory model is an inappropriate
template for SEF core principles. This problem has been magnified by
unwarranted amendments to CFTC rules making SEFs self-regulatory
organizations (SROs) \74\ and requiring them to comply with very
prescriptive rules modeled after futures exchange practices that are
unsuitable for the way swaps trade. Although the SEF core principles
contain certain regulatory obligations, Dodd-Frank did not instruct the
CFTC to make SEFs SROs or take a prescriptive rules-based approach. In
fact, the statute provides SEFs with reasonable discretion to comply
with the core principles.\75\ The CFTC should draw on its long and
successful experience as a principles-based regulator to implement a
flexible core principles-based approach for SEFs that aligns with
inherent swaps market dynamics.
---------------------------------------------------------------------------
\72\ CEA section 5h(f); 7 U.S.C. 7b-3(f).
\73\ CEA section 5(d); 7 U.S.C. 7(d).
\74\ 17 CFR 1.3(ee). Adaptation of Regulations to Incorporate
Swaps, 77 FR 66288, 66290 (Nov. 2, 2012).
\75\ CEA section 5h(f)(1)(B); 7 U.S.C. 7b-3(f)(1)(B).
---------------------------------------------------------------------------
I recommend the following changes to the SEF core principles set
out in Title VII of the Dodd-Frank Act.
Monitoring of trading and trade processing. SEF Core Principle 4
requires SEFs to monitor trading in swaps to prevent manipulation,
price distortion and disruptions of the delivery or cash settlement
process, among other things.\76\ Certain rules promulgated under Core
Principle 4 require a SEF to look beyond its own market to gain the
information necessary to perform these functions. For example, CFTC
Regulation 37.404(a) requires a SEF to ``demonstrate that it has access
to sufficient information to assess whether trading in swaps listed on
its market, in the index or instrument used as a reference price, or in
the underlying commodity for its listed swaps is being used to affect
prices on its market.'' \77\ In other words, a SEF that executes a
credit default swap on a Ford Motor Company bond must also monitor
trading in the underlying Ford Motor Company bonds to prevent
manipulation, price distortion and disruption in its market. While a
SEF has the ability to monitor trades it executes, asking it to monitor
manipulation in another marketplace in which it may provide no
execution services is an undue, unfair and unwarranted burden.
---------------------------------------------------------------------------
\76\ CEA section 5h(f)(4); 7 U.S.C. 7b-3(f)(4).
\77\ 17 CFR 37.404(a).
---------------------------------------------------------------------------
The CFTC acknowledges this challenge. Its website regarding market
surveillance states that only the CFTC itself can ``consolidate data
from multiple exchanges and foreign regulators to create a seamless,
fully-surveilled marketplace'' due to its unique space in the
regulatory arena.\78\ The surveillance ``requires access to multiple
streams of proprietary information from competing exchanges, and as
such, can only be performed by the Commission or other national
regulators.'' \79\ The CFTC correctly states that the surveillance
``cannot be filled by foreign and domestic exchanges offering related
competing products,'' \80\ and there is no reason to believe that a SEF
is better situated. And yet, despite this broad disclaimer, each SEF
that fails to fulfill this sort of surveillance function will be in
violation of SEF Core Principle 4 and CFTC rules.
---------------------------------------------------------------------------
\78\ CFTC Market Surveillance Program, available at http://
www.cftc.gov/IndustryOversight/MarketSurveillance/
CFTCMarketSurveillanceProgram/tradepracticesurveillance.
\79\ Id.
\80\ Id.
---------------------------------------------------------------------------
Congress should clarify SEF Core Principle 4 to make clear that a
SEF is not required to monitor markets beyond its own.\81\ The CFTC
should also revise its rules to this effect. As the CFTC admits on its
website, only it can perform cross-market surveillance.
---------------------------------------------------------------------------
\81\ CEA section 5h(f)(4); 7 U.S.C. 7b-3(f)(4).
---------------------------------------------------------------------------
Position limits. SEF Core Principle 6 places the burden for
position limits and position accountability levels on SEFs that are
trading facilities.\82\ The Dodd-Frank Act got this core principle
wrong.
---------------------------------------------------------------------------
\82\ CEA section 5h(f)(6); 7 U.S.C. 7b-3(f)(6).
---------------------------------------------------------------------------
The setting of position limits or position accountability levels by
SEFs is very problematic. As I explained in my white paper, SEFs do not
own swaps products, which trade on multiple competing SEFs and
bilaterally off-SEFs. SEFs lack knowledge of a market participant's
activity on and off other venues. SEFs only have information about
swaps transactions that occur on their platforms and thus do not know
whether a particular transaction on their platform adds to, or offsets
all or part of, a participant's existing position. Therefore, SEFs are
not able to calculate the total position of a market participant or
monitor it against any position limit. As explained in the Core
Principle 4 discussion above, only a markets regulator, such as the
CFTC, that has a full picture of the market can perform cross-market
monitoring and surveillance functions. Position-limit monitoring and
surveillance is another such area.
Congress should revise Core Principle 6 to reflect that the CFTC,
or possibly a designee, should set and monitor swaps position limits or
accountability levels. Until Congress revises this futures-based core
principle, the CFTC staff should continue to work with SEFs to derive a
solution that ameliorates this burden on SEFs. Any regulatory demand
that SEFs set or monitor limits or levels is an impossible exercise
that adds extraordinary costs.
Emergency authority. SEF Core Principle 8 requires a SEF to ``adopt
rules to provide for the exercise of emergency authority . . .
including the authority to liquidate or transfer open positions in any
swap . . . .'' \83\ In its current form, this futures-based core
principle places an impossible burden on SEFs. Congress should revise
it to better suit the realities of the swaps market.
---------------------------------------------------------------------------
\83\ CEA section 5h(f)(8); 7 U.S.C. 7b-3(f)(8).
---------------------------------------------------------------------------
A SEF does not have the ability to liquidate or transfer open swaps
positions because SEFs do not hold positions on behalf of their
participants. As several commenters to the final SEF rules have
explained, a SEF is not the appropriate entity to order the liquidation
or transfer of these positions in an emergency because it does not have
the ability or legal right to do so.\84\ The CFTC or a DCO, for cleared
swaps, for example, are more appropriate entities to exercise this
authority. Until Congress revises this futures-based core principle,
the Commission and its staff should work to revise CFTC guidance under
SEF Core Principle 8 to at most require a SEF to adopt rules for
coordination with a DCO or the CFTC to facilitate the liquidation or
transfer of open positions in an emergency.\85\
---------------------------------------------------------------------------
\84\ SEF Rule at 33536.
\85\ Id.
---------------------------------------------------------------------------
Financial resources. SEF Core Principle 13 requires a SEF to have
``financial resources [in an amount that] exceeds the total amount that
would enable the [SEF] to cover the operating costs of the [SEF] for a
1 year period, as calculated on a rolling basis.'' \86\
---------------------------------------------------------------------------
\86\ CEA section 5h(f)(13); 7 U.S.C. 7b-3(f)(13).
---------------------------------------------------------------------------
The market impact of a SEF failure is not nearly comparable to the
effect of a DCM failure, so it does not make sense for a SEF to hold 1
year of financial resources. A SEF failure will not likely create a
liquidity crisis because most swaps trade on multiple SEFs, and there
are multiple liquidity pools available in which to trade. Participants
can easily trade on another SEF in the event of a failure. This is in
contrast with the futures market, where the impact on market liquidity
is of greater concern in the event of a DCM failure because a DCM owns
its products and those products only trade on that specific DCM. Thus,
there is one liquidity pool. The failure of one DCM will likely harm
this liquidity unless regulators take action to transfer those products
and the corresponding open interest to another DCM or participants move
to another product on another DCM. Given these differences, SEFs should
not be held to the same 1 year financial-resources requirement as DCMs.
The financial-resources requirement is overly burdensome and
disproportionately impacts SEFs that offer voice-based execution
methods. These SEFs must significantly increase their financial
resources to cover the compensation of employee brokers who facilitate
execution through these voice-based methods.\87\ This requirement ties
up additional capital for these SEFs, which puts them at a competitive
disadvantage.
---------------------------------------------------------------------------
\87\ It is a common practice in traditional voice brokerage firms
for the bulk of compensation of client-facing personnel to be
calculated as a percentage of transaction commissions generated and
collected by the employer. Such aggregate compensation is often one of
the largest components of operating costs at such firms.
---------------------------------------------------------------------------
Congress should reexamine this core principle and only require a
SEF to hold enough capital to conduct an orderly wind-down of its
operations. It would not take a SEF 1 year to terminate employees and
contracts and conduct an orderly wind-down of its operations. It would
not be unreasonable to expect a SEF to conduct such a wind-down in 3
months.\88\ This approach would release significant capital back to the
SEF for innovation, lower barriers to entry, reduce costs and increase
competition.
---------------------------------------------------------------------------
\88\ See, e.g., CME Comment Letter to SEF Rule, Appendix A, at 37
(Mar. 8, 2011), available at http://comments.cftc.gov/PublicComments/
ViewComment.aspx?id=31276&SearchText=CME (stating that 3 months is an
appropriate time frame for winding-down operations).
---------------------------------------------------------------------------
In the meantime, the Commission and staff should reexamine CFTC
rules and work with SEFs to reduce their financial burden. The
Commission and staff could, for example (1) flexibly interpret a SEF's
financial resources to include additional resources such as projected
revenues or projected capital contributions, (2) flexibly interpret
operating costs to mean wind-down costs or to exclude certain costs not
directly tied to core principle compliance or (3) flexibly interpret
operating costs to exclude compensation that is not payable unless and
until collected by the SEF.
B. Adverse Consequences of the CFTC's Swaps Trading Regulatory
Framework
I have reviewed some of the chief flaws in the CFTC swaps trading
rules. Let me now address some of the adverse consequences for U.S.
financial markets.
Non-U.S. person market participants' efforts to avoid the ill-
designed U.S. swaps trading rules are fragmenting global swaps markets
between U.S. persons and non-U.S. persons and driving away global
capital.\89\ This phenomenon is fostering smaller, disconnected
liquidity pools and less efficient and more volatile pricing. Market
fragmentation is exacerbating the inherent challenge of swaps trading--
maintaining adequate liquidity.
---------------------------------------------------------------------------
\89\ See ISDA Update. See also Amir Khwaja, A Review of 2014 U.S.
Swap Volumes and SEF Market Share, TABB Forum (Jan. 16, 2015),
available at http://tabbforum.com/opinions/a-review-of-2014-us-swap-
volumes-and-sef-market-share.
---------------------------------------------------------------------------
Divided markets are more brittle, posing a risk of failure in times
of economic stress or crisis. Fragmentation increases firms'
operational risks as they structure themselves to avoid U.S. rules and
now must manage multiple liquidity pools in different jurisdictions.
Fragmentation also increases trading firms' operational and structural
complexity and reduces their efficiency in the markets. In short,
market fragmentation caused by the CFTC's ill-designed trading rules--
and the application of those rules abroad--is harming liquidity and
increasing the systemic risk that the Dodd-Frank Act was predicated on
reducing.
In addition to global market fragmentation, the CFTC's unwarranted
slicing and dicing of swaps trading into a series of novel regulatory
categories, such as Required Transactions and Permitted Transactions
and block transactions ``off-SEF'' and non-blocks ``on-SEF,'' each with
their corresponding execution methods, has fragmented domestic swaps
trading into an artificial series of smaller and smaller pools of
trading liquidity, increasing market inefficiencies. So long as such
disparate segments remain, U.S. swaps markets face a CFTC-imposed
liquidity challenge compared with non-U.S. markets.
The CFTC's swaps trading regime is also threatening the survival of
many SEFs. The CFTC's prescriptive and burdensome rules have ensured
that operating a SEF is an expensive, legally intensive activity.\90\
This may drive consolidation in the industry, providing trading
counterparties with less choice of where and how to execute swaps
transactions.
---------------------------------------------------------------------------
\90\ Catherine Contiguglia, Sef Boss Spends His Days `Worrying
About Costs,' Risk.net, Sep. 24, 2014, available at http://
www.risk.net/risk-magazine/news/2371788/sef-boss-spends-his-days-
worrying-about-costs.
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Further, the swaps trading rules are hindering technological
innovation. In 1899, U.S. Patent Commissioner Charles H. Duell is said
to have pronounced that ``everything that can be invented has been
invented.'' \91\ Not to be outdone, the CFTC's SEF rules pre-suppose
that order book and RFQ methodologies are today and will always remain
the only suitable technological means for U.S. swaps execution. These
restrictive SEF rules close U.S. swaps markets to promising
technological development while the rest of the world proceeds ahead in
financial market innovation.
---------------------------------------------------------------------------
\91\ Charles Holland Duell, Wikipedia, available at http://
en.wikipedia.org/wiki/Charles_Holland_Duell. The statement has been
debunked as apocryphal.
---------------------------------------------------------------------------
The application of certain CFTC rules threatens jobs in the U.S.
financial services industry. As explained above, the CFTC's November
2013 Staff Advisory imposed swaps transaction rules on trades between
non-U.S. persons whenever anyone on U.S. soil ``arranged, negotiated,
or executed'' the trade.\92\ While the Staff Advisory has been delayed
for the fourth time, it is causing many overseas trading firms to
consider cutting off all activity with U.S.-based trade-support
personnel to avoid subjecting themselves to the CFTC's flawed swaps
trading rules.\93\ The Staff Advisory jeopardizes the role of bank
sales personnel in U.S. financial centers like Boston, Charlotte,
Chicago, New Jersey and New York. It will likely have a ripple effect
on technology staff supporting U.S. electronic trading systems, along
with the thousands of jobs tied to the vendors who provide food
services, office support, custodial services and transportation to the
U.S. financial services industry. With tens of millions of Americans
falling back these days on part-time work, the CFTC should not cause
good-paying full-time jobs to be eliminated.\94\
---------------------------------------------------------------------------
\92\ CFTC Staff Advisory No. 13-69.
\93\ CFTC Letter No. 14-140, Extension of No-Action Relief:
Transaction-Level Requirements for Non-U.S. Swap Dealers (Nov. 14,
2014), available at http://www.cftc.gov/ucm/groups/public/
@lrlettergeneral/documents/letter/14-140.pdf.
\94\ News Release, The Employment Situation--September 2014, Bureau
of Labor Statistics, at Summary Table A, Oct. 3, 2014, available at
http://www.bls.gov/news.release/archives/empsit_10032014.pdf; Steve
Moore, Under Obama: One Million More Americans Have Dropped Out Of Work
Force than Have Found a Job, Forbes, Oct. 6, 2014, available at http://
www.forbes.com/sites/stevemoore/2014/10/06/under-obama-one-million-
more-americans-have-dropped-out-of-work-force-than-have-found-a-job/.
---------------------------------------------------------------------------
The swaps rules also appear to contain an unstated bias against
human discretion in swaps execution. The bias is seen in a range of
CFTC positions, such as:
Allowing only two specific types of execution methods for
Required Transactions; \95\
---------------------------------------------------------------------------
\95\ 17 CFR 37.9(a)(2).
Requiring an RFQ System to operate in conjunction with an
Order Book; \96\
---------------------------------------------------------------------------
\96\ Id. and 17 CFR 37.9(a)(3).
Requiring an RFQ to be sent to three market participants;
\97\
---------------------------------------------------------------------------
\97\ 17 CFR 37.9(a)(3).
Placing various conditions around basis risk mitigation
services; \98\ and
---------------------------------------------------------------------------
\98\ See CFTC Letter No. 13-81, Time-Limited No-Action Relief from
Required Transaction Execution Methods for Transactions that Result
from Basis Risk Mitigation Services (Dec. 23, 2013), available at
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/
letter/13-81.pdf.
Showing aversion to Dutch Auction systems that utilize
professional discretion in setting auction prices.\99\
---------------------------------------------------------------------------
\99\ Apparently, an objection of the CFTC staff to Dutch Auction
swap execution is that brokers have discretion in finding price points
at which to commence an auction.
Yet, there is just no legal support in Title VII of Dodd-Frank for
restricting human discretion in swaps execution.
Is it not odd that, while the CFTC has been restrictive of human
interaction in swaps markets, the U.S.'s most successful financial
marketplace--the IPO market--is trumpeting the importance of ``human
touch'' in its market? \100\ They assert the human element as a key
safeguard against the type of runaway technical errors that plagued
Facebook's 2012 IPO, when more than 30,000 buy and sell orders were
either canceled or delayed.\101\ It would be a regulatory failure to
restrict human involvement and interaction in the $691 trillion swaps
markets and herd trading onto automated electronic platforms, where
software failures and technical glitches could someday cause a ``flash
crash'' unlike anything yet seen in global markets.
---------------------------------------------------------------------------
\100\ Sam Mamudi, Nasdaq Tries Human Beings to Stave Off IPO
Poaching by Bid Board, Bloomberg, Jan. 6, 2015, available at http://
www.bloomberg.com/news/2015-01-06/nasdaq-highlights-human-touch-in-ipo-
process-to-fend-off-nyse.html.
\101\ Id.
---------------------------------------------------------------------------
In a peculiar twist, the CFTC's insistence upon RFQ systems and
centralized, order-driven markets to execute swaps transactions has the
potential to open U.S. swaps markets to algorithmic and high-frequency
trading (HFT), which are not currently a factor in swaps markets. It is
unclear how those who support the CFTC's impetus for electronic central
limit order book (CLOB) execution of swaps, yet decry HFT in today's
equities and futures markets, will reconcile these views when the
enormous but human-managed swaps markets are launched into unmanned
hyperspace by HFT algorithmic trading technologies.
For these reasons and more that I have set out in my white paper, I
am of the firm view that key elements of the CFTC swaps trading rules:
Do not accord with Congressional intent;
Have not enhanced market transparency; and
Have not decreased the systemic risk that the Dodd-Frank Act
was premised on reducing.
C. A Swaps Trading Regulatory Framework Consistent with Title VII of
Dodd-Frank
I have proposed an alternative swaps trading regulatory framework
that is pro-reform and fully aligned with the express statutory
framework of Title VII of the Dodd-Frank Act. My proposed swaps
regulatory framework is built upon five key tenets:
Comprehensiveness;
Cohesiveness;
Flexibility;
Professionalism; and
Transparency.
The first tenet is to subject a comprehensive range of U.S. swaps
trading activity to CFTC oversight. My approach supports the CFTC's
broad SEF requirement for registration,\102\ but insists that the scope
of regulatory coverage be fully set forth in clear and definitive rule
text and not buried in footnotes, staff advisories or no-action
letters.
---------------------------------------------------------------------------
\102\ 17 CFR 37.3(a)(1); SEF Rule at 33481-83.
---------------------------------------------------------------------------
As of April 9, 2015, CFTC staff has had to issue 258 no-action
letters, 56 exemptive letters and 43 statements of guidance,
interpretation and advice to implement the Dodd-Frank mandates. That is
a total of 357--and counting--miscellaneous communications without
formal CFTC rulemaking. There is something clearly wrong with our swaps
regulatory framework if it requires that much staff work to put it in
place. We need a better set of rules.
The second tenet is regulatory cohesiveness. We must remove the
CFTC's artificial slicing and dicing of swaps markets. We must do away
with these odd categories of Required Transactions and Permitted
Transactions and with block transactions ``off-SEF'' and non-blocks
``on-SEF.'' Instead, all CFTC-regulated swaps trading should fall
within the same cohesive and undivided regulatory framework.
The third tenet is flexibility. The CFTC must adhere to Dodd-
Frank's express prescription for flexibility in swaps trading.\103\
That means that swaps market participants must be allowed to choose
from the broadest possible array of methods of swaps execution that
comply with the statutory SEF definition. Those include:
---------------------------------------------------------------------------
\103\ CEA section 1a(50); 7 U.S.C. 1a(50).
---------------------------------------------------------------------------
Electronic CLOBs;
Simple order books;
RFQ systems;
Electronic Dutch Auctions;
Hybrid electronic and voice execution methods;
Full voice-based execution methods; and
Work-up.
It also includes any other ``means of interstate commerce'' that
may today or someday in the future satisfy swaps customer trading and
liquidity requirements. U.S. swaps markets must be reopened to business
and technological innovation. Technology is improving American lives
today in many ways, from hailing a taxi with Uber to connecting with
business colleagues on LinkedIn. Technological innovations are also
transforming capital markets in areas such as raising money for
business start-ups through Kickstarter and consumer borrowing through
Payoff. These innovations lower barriers to entry, reduce costs and
open markets to a broader range of participants. Unfortunately, the
CFTC's swaps rules would prevent such technological innovation in the
U.S. swaps markets.
Customer choice and technological innovation, not regulators, must
determine the various means of interstate commerce utilized in the
swaps market. That is clearly what Congress intended. That is surely
the American way.
As I have recommended, the CFTC should do away with its unworkable
MAT process, which is not authorized by Dodd-Frank. Yet, eliminating
the MAT process will only work if SEFs are allowed to offer swaps
execution through ``any means of interstate commerce.'' This approach
would also give a plain reading to the requirement for impartial access
that does not confuse it with a mandate for open access. Dodd-Frank did
not call into being any particular swaps market structure, such as
existing separate dealer-to-dealer and dealer-to-customer markets or
combined all-to-all markets. Therefore, regulators must leave
participants in the marketplace to determine the optimal market
structure based on their swaps trading needs and objectives.
This approach would also better accommodate established and
beneficial swaps market practices. It would allow SEFs to implement
clear, workable error-trade policies to address the situation where an
executed swaps transaction is rejected from clearing. It would end the
void ab initio policy, which is not statutorily sound. The proposal
would further treat the SEF core principles as true principles as
Congress intended and not as rigid rule sets.
The fourth tenet of my alternative framework is to enhance
professionalism in the swaps market by setting standards of conduct for
swaps market personnel. This is consistent with the current approach of
advanced overseas regulators, such as the UK's Financial Conduct
Authority, that look to supervise professional behavior in overseas
financial markets. Rather than implementing highly prescriptive swaps
trading rules here in the U.S. that limit intermediaries' discretion,
my approach is to establish standards that would enhance the knowledge,
professionalism and ethics of personnel in the U.S. swaps markets who
exercise discretion in facilitating swaps execution.
It is remarkable that today, if you want to trade a share of
Microsoft, you go to a broker who has passed a Series 7 exam confirming
his or her product knowledge, skills and abilities in the
marketplace.\104\ If you want to trade corn futures on the CME you may
speak to an IB who has passed the Series 3 exam confirming his or her
futures-markets proficiency.\105\ Yet, brokers handling billion-dollar
CDS and interest-rate swap trades are not required to pass any exams
whatsoever.
---------------------------------------------------------------------------
\104\ See Financial Industry Regulatory Authority (FINRA), General
Securities Representative Qualification Examination (Series 7) Content
Outline (2014), available at http://www.finra.org/web/groups/industry/
@ip/@comp/@regis/documents/industry/p124292.pdf.
\105\ See National Futures Association (NFA), NFA, Examination
Subject Areas National Commodity Futures Exam, available at http://
www.nfa.futures.org/NFA-registration/study-outlines/SO-Series3.pdf.
---------------------------------------------------------------------------
In the U.S. there is currently no standardized measurement of one's
knowledge and qualification to act with discretion in the largest and,
arguably, most systemically important financial market--swaps. My
proposal would look to established precedents, such as the NFA's Series
3 exam and rules for IBs and other members, as well as FINRA's Series 7
exam and rules for broker-dealers, as guides and modify them to apply
to swaps trading and markets.
But enhancing the professionalism of swaps brokers is only worth
doing if they are allowed to exercise professional discretion in
flexible methods of swaps execution as Congress intended. It is surely
pointless and unsupportable otherwise.
The last tenet of my framework focuses on promoting swaps trading
and market liquidity as a prerequisite to increased transparency. To
date, pre-trade price transparency has been greatly emphasized to the
detriment of liquidity in the swaps trading rules. Yet, no meaningful
increase in swaps market transparency has been achieved by CFTC rules
requiring Order Books that few are using. Requiring Order Books was not
how Dodd-Frank balanced the goals of SEF trading.
The right way to promote price transparency is through a
proportioned focus on promoting swaps trading and market transparency,
as Congress intended. Instead of taking a prescriptive approach to
swaps execution that drives away participants, this framework would
allow the market to innovate and provide execution through ``any means
of interstate commerce.'' That way, participants could choose the
execution method that meets their needs based upon a swap's liquidity
characteristics, which in turn, would promote trading on SEFs and
liquidity. In other words, promoting swaps trading and market liquidity
will lead to the enhanced price transparency that Congress sought to
achieve.
Many of the adverse consequences of the CFTC's swaps trading rules
could be reversed if the rules were redesigned to be much simpler and
more effective and if they were in accord with the clear provisions of
Title VII of the Dodd-Frank Act.
A smarter and more flexible swaps regulatory approach would eschew
the artificial slicing and dicing of U.S. trading liquidity and
unwarranted restrictions on means of execution that are unsupported by
the law. Rather, it would enable the U.S. to take the global lead in
measured and smart regulation of swaps trading. It would allow American
businesses to more efficiently hedge commercial risks, promoting
economic growth. It would stimulate the American economy and job
creation.
For decades the CFTC has been a competent and effective regulator
of U.S. exchange-traded derivatives. The opportunity is at hand to
continue that excellence in regulating swaps markets. It is time to
seize that opportunity.
IV. Cross-Border Impact of Derivatives Regulation
At the 2009 Pittsburgh G20 Summit, global leaders agreed to work
together to support economic recovery through a ``Framework for Strong,
Sustainable and Balanced Growth.'' \106\ The G20 leaders agreed upon
three fundamental principles \107\ for OTC derivatives markets: (1)
moving many bilateral swaps to CCPs for clearing; (2) where
appropriate, trading all standardized OTC derivative contracts on
regulated trading platforms; and (3) reporting swap trades to trade
repositories.\108\ To achieve these common goals, the Pittsburgh
participants pledged to work together to ``implement global standards''
in financial markets, while rejecting ``protectionism.'' \109\ I am
pleased to note that Chairman Massad and CFTC staff, especially the
CFTC's Division of Clearing and Risk, have made it a priority to work
constructively and collaboratively with our international counterparts
to achieve the goals set out in the G20 commitments. Yet, many
challenges remain in coordinating global efforts to reform the
derivatives markets.
---------------------------------------------------------------------------
\106\ G20 Leaders' Statement, The Pittsburgh Summit at 2 (Sept. 24-
25, 2009) (G20 Statement), available at http://www.treasury.gov/
resource-center/international/g7-g20/Documents/
pittsburgh_summit_leaders_statement_250909.pdf.
\107\ In addition, the G20 leaders agreed on a fourth principle:
that non-centrally cleared derivatives should be subject to higher
capital requirements.
\108\ G20 Statement at 9.
\109\ Id. at 7.
---------------------------------------------------------------------------
A. Clearinghouse Recognition and Regulation
One of the most critical cross-border issues currently facing the
CFTC is U.S. clearinghouse recognition by the European Commission. The
EC has not recognized U.S. CCPs as equivalent under the European Market
Infrastructure Regulation (EMIR), as it has for CCPs in Japan, Hong
Kong, Australia and Singapore.\110\ If the EC does not recognize U.S.
CCPs as equivalent by June 15, 2015, they will not be classified as
``qualifying'' CCPs for purposes of Basel III risk-weighting for
banking institutions. This will make it cost-prohibitive for EU banks
to clear through U.S. CCPs, which will be unable to maintain direct
clearing member relationships with EU firms and will be ineligible to
clear contracts subject to the EU clearing mandate later this
year.\111\
---------------------------------------------------------------------------
\110\ Press Release, First `Equivalence' Decisions for Central
Counterparty Regulatory Regimes Adopted Today, European Commission,
Oct. 30, 2014, available at http://europa.eu/rapid/press-release_IP-14-
1228_en.htm.
\111\ Article 4(88) of the EU Capital Requirements Regulation
provides that a CCP is not qualified unless it is authorized in
accordance with Article 14 of EMIR or recognized pursuant to Article 25
of EMIR. Pursuant to EU CRD IV, trades cleared with a non-qualified CCP
are subject to significant capital charges.
---------------------------------------------------------------------------
Needless to say, this outcome will be destructive to both U.S. and
European economic interests and lead to further market fragmentation
and contraction of liquidity, market disruption and dislocation in the
global derivatives markets.
This issue remains unresolved despite the fact that the U.S. has
adopted global clearing standards. The CFTC adopted the CPMI-IOSCO
Principles for Financial Market Infrastructures (PFMIs) in December
2013.\112\ The CFTC also patterned its swaps clearing rules on its
rules for clearing futures, which have worked successfully for
decades.\113\ The CFTC's rules do not require that swaps clearing take
place in the United States, even if the swap is in U.S. dollars and
between U.S. persons. But the CFTC does require that swaps clearing
take place on a CFTC-registered and supervised clearinghouse or CCP
that meets core principles and basic standards, including the PFMIs.
The CFTC's approach is drawn from its successful record of respecting
the integrity of the parallel regulatory regimes that govern the
clearing activities of dually registered U.S.-EU CCPs.\114\
---------------------------------------------------------------------------
\112\ CFTC regulations have fully implemented the PFMIs. See
Derivatives Clearing Organizations and International Standards, 78 FR
72476 (Dec. 2, 2013).
\113\ See Derivatives Clearing Organization General Provisions and
Core Principles, 76 FR 69334 (Nov. 8, 2011); Enhanced Risk Management
Standards for Systemically Important Derivatives Clearing
Organizations, 78 FR 49663 (Aug. 15, 2013).
\114\ The CFTC has not required that dually registered U.S.-EU CCPs
apply what is referred to as the ``FCM'' or ``agency'' model of
clearing to intermediaries that are not CFTC-registered FCMs. This
enables the non-U.S. intermediaries of dual registrants to continue to
clear ``back-to-back'' transactions. Similarly, while CFTC regulations
prohibit a registered CCP from imposing a minimum capital requirement
of more than $50 million on clearing members, the CFTC does not require
that U.S.-EU dual registrants apply this standard to non-U.S. and non-
FCM clearing members.
---------------------------------------------------------------------------
Yet, this lack of coordination in swaps clearing does not exist in
a vacuum. It follows on the heels of an uncoordinated approach to the
regulation of swaps trading.
B. Swaps Trading
I believe the CFTC started the current rift in cross-Atlantic swaps
cooperation with its July 2013 ``Interpretive Guidance and Policy
Statement Regarding Compliance With Certain Swap Regulations''
(Interpretive Guidance).\115\ In essence, the Interpretive Guidance
asserted that every single swap a U.S. person enters into, no matter
where it is transacted, has a direct and significant connection with
activities in, and effect on, commerce of the United States, which
requires imposing transaction rules of the CFTC.
---------------------------------------------------------------------------
\115\ 78 FR 45292 (Jul. 26, 2013).
---------------------------------------------------------------------------
Several months later, the CFTC issued a ``Staff Advisory'' that
declared that, even if no U.S. person is a party to the trade, CFTC
trading rules apply if it is ``arranged, negotiated, or executed'' by
personnel or agents of a non-U.S. swap dealer located in the U.S.\116\
---------------------------------------------------------------------------
\116\ CFTC Staff Advisory No. 13-69 (Nov. 14, 2013), available at
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/
letter/13-69.pdf.
---------------------------------------------------------------------------
Taken together, these CFTC pronouncements say that CFTC trading
rules apply anytime and anywhere a U.S. person is a party to a swaps
trade or the trade is assisted from U.S. shores.
Making things worse, the CFTC swaps trading rules contain a host of
peculiar limitations based on practices in the U.S. futures markets
that I have describe in my January 29, 2015 white paper and are
summarized elsewhere in this Testimony. Many of these limitations have
not been adopted in the EU \117\ or anywhere else. Several of these
peculiar CFTC swaps trading rules are contrary to common practice in
global markets and are unlikely to be replicated by non-U.S.
regulators.
---------------------------------------------------------------------------
\117\ Consultations are still underway under MiFID II and MiFIR.
---------------------------------------------------------------------------
The combined effect of the CFTC's Interpretive Guidance and Staff
Advisory \118\--neither of which is a formally adopted CFTC rule--is to
dictate that non-U.S. market operators and participants must abide by
the CFTC's peculiar, one-size-fits-all swaps transaction-level rules
for trades involving U.S. persons or supported by U.S.-based personnel.
---------------------------------------------------------------------------
\118\ In addition, the Division of Market Oversight issued Guidance
on November 15, 2013, stating that it ``expects that a multilateral
swaps trading platform located outside the United States that provides
U.S. persons or persons located in the U.S. (including personnel and
agents of non-U.S. persons located in the United States) . . . with the
ability to trade or execute swaps on or pursuant to the rules of the
platform, either directly or indirectly through an intermediary, will
register as a SEF or DCM.'' Division of Market Oversight, Guidance on
Application of Certain Commission Regulations to Swap Execution
Facilities at 2 (Nov. 15, 2013), available at http://www.cftc.gov/ucm/
groups/public/@newsroom/documents/file/dmosefguidance
111513.pdf.
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The avowed purpose of the CFTC's broad assertion of jurisdiction is
to insulate the United States from systemic risk. Yet, on the
ostensible grounds of ring-fencing the U.S. economy from harm, the CFTC
purports to tell global swaps markets involving U.S. persons to adopt
particular CFTC trading mechanics that do almost nothing to reduce
counterparty risk. In the words of one former senior CFTC advisor, the
Interpretive Guidance ``yoked together rules designed to reduce risk
with rules designed to promote market transparency. Yet it provided
almost no guidance about how to think about the extraterritorial
application of market transparency rules independent of risk. As a
result, [the CFTC prescribed] how to apply U.S. rules abroad based on
considerations that are tangential to the purposes of those rules.''
\119\
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\119\ Timothy Karpoff, The Smart Way to Regulate Overseas Swaps
Trading, American Banker (Jul. 21, 2014), available at http://
www.americanbanker.com/bankthink/.
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C. Market Fragmentation
This uncoordinated approach to the regulation of swaps execution
and the CFTC's problematic swaps trading regulations have fragmented
global markets. Traditionally, users of swaps products chose to do
business with global financial institutions based on factors such as
quality of service, product expertise, financial resources and
professional relationship. Now, those criteria are secondary to the
question of the institution's regulatory profile. Non-U.S. person
market participants are avoiding financial firms bearing the scarlet
letters of ``U.S. person'' in certain swaps products to steer clear of
the CFTC's problematic regulations. Non-U.S. person market
participants' efforts to escape the CFTC's flawed swaps trading rules
are fragmenting global swaps markets between U.S. persons and non-U.S.
persons and driving away global capital.
Since the start of the CFTC's SEF regime in October 2013 and
accelerating with mandatory SEF trading in February 2014, global swaps
markets have divided into separate trading and liquidity pools between
those in which U.S. persons are able to participate and those in which
U.S. persons are shunned. Liquidity has been fractured between an on-
SEF, U.S. person market on one side and an off-SEF, non-U.S. person
market on the other.
According to a survey conducted by the International Swaps and
Derivatives Association (ISDA), the market for euro interest-rate swaps
(IRS) has effectively split.\120\ Volumes between European and U.S.
dealers have declined 77 percent since the introduction of the U.S. SEF
regime.\121\ The average cross-border volume of euro IRS transacted
between European and U.S. dealers as a percentage of total euro IRS
volume was 25 percent before the CFTC put its SEF regime in place and
has fallen to just nine percent since.\122\
---------------------------------------------------------------------------
\120\ See International Swaps and Derivatives Association,
Revisiting Cross-Border Fragmentation of Global OTC Derivatives: Mid-
year 2014 Update, ISDA Research Note (Jul. 2014) (ISDA Update),
available at http://www2.isda.org/functional-areas/research/research-
notes/. See also Phillip Stafford, US Swaps Trading Rules Have ``Split
Market,'' Financial Times (Jan. 21, 2014), available at http://
www.ft.com/intl/cms/s/0/58251f84-82b8-11e3-8119-00144feab7de.
html#axzz3CHQbMKxU. Beginning in October 2013 after the SEF rules
compliance date, European dealers began to trade exclusively with other
European counterparties in the market for euro IRS and dramatically
moved away from trading with U.S. counterparties. Since October 2013,
91 percent of euro IRS trades take place between two European
counterparties, while only nine percent occur between a U.S. and a
European dealer. By May 2014, 94 percent of euro IRS trades were
between two European counterparties, while only six percent of euro IRS
trades were between a European and U.S. counterparty. Compare these
figures to those from a month before the SEF rules' compliance date,
when 71 percent of euro IRS trades were between two European
counterparties and 29 percent between a U.S. and European dealer. This
has been a clear shift in trading behavior for European dealers. This
observation is also supported by an ISDA survey wherein 68 percent of
non-U.S. market participant respondents indicated that they have
reduced or ceased trading with U.S. persons. ISDA Update.
\121\ ISDA Update.
\122\ Id.
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Rather than controlling systemic risk, the fragmentation of global
swaps markets into regional ones is increasing risk by Balkanizing
pools of trading liquidity and market pricing.
With the CFTC's swaps trading regime dividing trading in global
swaps markets between U.S. persons and non-U.S. persons, we cannot risk
further dividing U.S. and European markets in derivatives clearing.
That would be the effect if the EC does not recognize U.S. CCPs as
equivalent under EMIR.
Now, I can fully understand if some observers of the European
resistance to CCP equivalence are reminded of the old idiom,
``turnabout is fair play.'' If the American regulators can overreach
when it comes to swaps execution, why should European regulators not
overreach on swaps clearing?
D. The Smoot-Hawley Tariff Act of 1930
I have previously likened the current circumstance to the situation
after passage by the U.S. Congress of the infamous Smoot-Hawley Tariff
Act of 1930, which steeply hiked tariff rates on over 3,300 categories
of imported agricultural and manufactured goods.\123\ Smoot-Hawley came
into effect just as the United States was descending into the Great
Depression. Promoters of the law said it was necessary to raise U.S.
agricultural prices and help American farmers.\124\ They gave little
consideration to what the international reaction would be to the higher
tariffs.\125\
---------------------------------------------------------------------------
\123\ Douglas A. Irwin, Peddling Protectionism: Smoot-Hawley and
the Great Depression at 89-91 (Princeton University Press 2011).
\124\ Id. at 18-23.
\125\ Id. at 145.
---------------------------------------------------------------------------
Smoot-Hawley did not cause America's Great Depression, but it made
it worse than it might otherwise have been by contracting both U.S.
imports and exports and inviting harsh retaliation.\126\ It surely
failed in its promised objective of increasing U.S. farm income.\127\
---------------------------------------------------------------------------
\126\ Id. at 142-143.
\127\ Id. at 218.
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Instead, through Smoot-Hawley the U.S. abdicated economic
leadership and poisoned commercial relations with its major trade
partners.\128\ Smoot-Hawley was interpreted as a declaration of trade
war at a critical time in the world economy. Smoot-Hawley made the U.S.
a special target of discriminatory trade retaliation from some of the
U.S.'s largest and most important trade partners.\129\ It led other
countries to form preferential trading blocs that discriminated against
the United States, diverting world trade and delaying economic recovery
on both sides of the Atlantic.\130\
---------------------------------------------------------------------------
\128\ Id. at 152.
\129\ Id. at 183.
\130\ Id.
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The formation of European trading blocs failed to stem Europe's
trade deterioration. Rather, this development worsened Europe's
economic decline through the 1930s, culminating in a devastating World
War and the annihilation of Europe's economy. This trade war was not
fully reversed until the General Agreement on Tariffs and Trade a
decade later.
E. Return to the Spirit of the Pittsburgh Accords
The EC and CFTC must develop a cross-border regulatory relationship
in the spirit of the Pittsburgh G20 accords. This relationship is
necessary to avoid a trade war in financial markets akin to that which
worsened the Great Depression.
A trade war over swaps market clearing and execution will be
harmful for the U.S. As the world's largest economy and largest debtor,
the U.S. must retain deep and liquid capital markets if it is to
maintain its reserve currency status and its standard of living.
Unfortunately, fragmentation of global swaps markets between U.S.
persons and non-U.S. persons means smaller and disconnected liquidity
pools and less efficient and more volatile pricing for market
participants and their end-user customers. It also means greater risk
of market failure in the event of economic crisis. By Balkanizing
global swaps liquidity, the CFTC's Interpretive Guidance is actually
increasing the systemic risk that it was predicated on reducing. Like
Smoot-Hawley, the CFTC's Interpretive Guidance is ill-suited to its
ostensible purpose of systemic risk reduction. It is, however, wreaking
havoc and forcing U.S. financial institutions to retreat from what were
once global markets. We simply cannot allow uncoordinated regulatory
reforms to permanently divide global swaps markets between U.S. and
non-U.S. persons.
Similarly, a trade war in swaps markets will be a disaster for
Europe. The EU has a serious growth problem. Except for Japan, the EU
has had the weakest economic growth in the industrialized world.\131\
In the words of Francois Heisboug, ``The world is advancing, but not
Europe.'' \132\ European Central Bank President Mario Draghi has
highlighted that EU Governments need to implement structural reforms to
increase sustainable growth and encourage investment in the euro
zone.\133\ Mr. Draghi's warning may be of little help if the debate
over clearing equivalence remains unresolved, hampering business access
to liquid markets for hedging of investment risk.
---------------------------------------------------------------------------
\131\ Francois Heisbourg, La Fin du Reve Europeen (the End of the
European Dream) (Editions Stock 2013).
\132\ Id.
\133\ Todd Buell and Paul Hannon, Eurozone Growth Drivers Were
Broad Based, Data Show, Wall Street Journal (Mar. 6, 2015), available
at http://www.wsj.com/articles/german-industrial-production-increased-
in-january-1425631587?KEYWORDS=european+economic+growth.
---------------------------------------------------------------------------
Undeniably, the EU is in desperate need of investment in economic
development and job creation. European investment capital comes
overwhelmingly from banks. European banks are significant participants
in the U.S. derivatives markets, and the EU banks cannot afford to
retreat from those markets.
Moreover, the process of bank deleveraging and overstretching of
national governments mean that Europe must look to a broader array of
financing sources available in modern global financial systems,
including private lending, securitized credit and private equity. To
avail itself of these options, the EU must assure U.S. capital access
to European risk-hedging markets. According to CFTC data, trading
volume on European futures exchanges relies to a considerable extent on
direct access from the U.S. EU markets cannot afford to jeopardize this
U.S. trading volume. Denying equivalence to U.S. CCPs will not cure
Europe's stagnant economic growth--it will worsen it.
We must not let the current cross-border impasse over swaps markets
persist and thwart European growth and, in turn, lead Europeans to
conclude that the EU is not part of the solution but part of the
problem.
Flourishing capital markets are the answer to U.S. and European
21st century economic woes, not trade wars and protectionism. The
solution to sluggish growth in the developed economies is safe, sound
and vibrant global markets for investment and risk management. We must
maintain liquid and broad global derivatives markets. To do so, we must
reach an accord on how to regulate derivatives execution and clearing
in a harmonious manner across jurisdictions.
The CFTC is continuing its dialogue with the Europeans to
facilitate their recognition of our clearinghouses as equivalent. Work
continues on both sides to establish a sound and practical basis for
regulatory and supervisory cooperation. As both sides work through
differences to find common--and solid--ground, it remains critically
important to provide certainty to CCPs and market participants to
prevent any potential disruption to their businesses.
But we can go further. The CFTC must replace its cross-border
Interpretive Guidance with a formal rulemaking that recognizes
outcomes-based substituted compliance for competent non-U.S. regulatory
regimes. I support the withdrawal of the CFTC staff's November 2013
Advisory that fails not only the letter and spirit of the ``Path
Forward,'' but also contradicts the conceptual underpinnings of the
CFTC's Interpretive Guidance.
V. CFTC Resources and Budget
I want to thank Congress for the increase to the CFTC's budget for
FY 2015. In fact, as Chairman Aderholt noted at the CFTC FY 2016 Budget
Hearing in February of this year, the CFTC's spending has increased 123
percent since the Financial Crisis of 2008.\134\ This significant
increase is all the more appreciated given the nation's substantial
debt. I realize the challenges Congress faces in allocating scare
resources among agencies seeking increased funding to support their
missions. I also realize that the CFTC must make a compelling case, and
efficiently utilize existing resources, in order to justify further
increases.
---------------------------------------------------------------------------
\134\ Opening Statement of Chairman Robert Aderholt, House
Committee on Appropriations, Subcommittee on Agriculture, Rural
Development, Food and Drug Administration, and Related Agencies, Fiscal
Year 2016 Budget Hearing--Commodity Futures Trading Commission, Feb.
11, 2015, available at http://docs.house.gov/meetings/AP/AP01/20150211/
102910/HHRG-114-AP01-20150211-SD001.pdf.
---------------------------------------------------------------------------
In this regard, the CFTC could be doing more. For example, managing
the CFTC's flawed swaps trading regulatory framework is expensive and
time-consuming. Fitting the square peg of the CFTC's swaps trading
rules into the round hole of the established global swaps markets
requires the Commission and staff to devote enormous resources to
continuously explain, clarify, adjust, exempt and manipulate rules to
allow rough swaps market operability. The Commission and staff must
constantly add to the plethora of no-action letters, guidance, staff
advisories and other written communications that go out to the market
and participants. During the course of implementing the Dodd-Frank Act,
the CFTC staff has issued 357 such communications.\135\ The CFTC's
current swaps trading regulatory framework requires enormous
bureaucratic ``make work'' to assure industry compliance. Yet, it is
mostly unnecessary and unsupported by Title VII of the Dodd-Frank Act.
It wastes taxpayer dollars at a time when the CFTC is seeking
additional resources from Congress.
---------------------------------------------------------------------------
\135\ As of April 9, 2015, the CFTC staff has issued 258 no-action
letters, 56 exemptive letters and 43 staff interpretive letters,
guidance, advisories and other written communications.
---------------------------------------------------------------------------
Similarly, the CFTC's proposed position limits rules are overly
burdensome and will require substantial agency resources to implement
and sustain. They do nothing to leverage the decades of experience and
large existing staffing capabilities of the major U.S. DCMs. Instead,
the CFTC's proposed position limits rules would partially duplicate--at
U.S. taxpayer expense--the management of position limits already being
done by DCMs at industry expense.
The CFTC should work to reduce these and other examples of
inefficiencies before asking for substantial budget increases. I will
work to make sure that the CFTC is using its resources wisely. However,
let me be clear. These comments are not meant to criticize the CFTC
staff. The CFTC has a dedicated, professional staff who have been
working hard to implement the Dodd-Frank Act and carry out the agency's
existing responsibilities. The CFTC is fortunate to have such a staff
to fulfill the agency's mission in service to the American public.
Conclusion
The CFTC has accomplished much since the passage of the Dodd-Frank
Act, but many challenges remain. The CFTC must do more to reduce the
regulatory burdens on end-users. The CFTC must make sure that our rules
do not treat end-users as though they were the cause of the financial
crisis. The CFTC must revisit its swaps trading rules and fully align
them with the clear provisions of Title VII of the Dodd-Frank Act. Not
doing so will continue to drive away market participants, harming swaps
market liquidity and increasing market fragility. Finally, the CFTC and
foreign regulators must redouble their efforts to cooperate and
harmonize their regulations to preserve the global market for swaps
trading. Without such efforts, market fragmentation will continue and
systemic risk will increase, hurting global markets and growth.
Thank you for the opportunity to testify. I would be happy to
answer any questions you may have.
The Chairman. Commissioner Wetjen.
STATEMENT OF HON. MARK P. WETJEN, COMMISSIONER,
COMMODITY FUTURES TRADING COMMISSION,
WASHINGTON, D.C.
Mr. Wetjen. Good morning, Chairman Scott, Ranking Member
Scott, Chairman Conaway, and Members of the Subcommittee. Thank
you for inviting me to testify before you today, and allowing
me to share some of my thoughts on the reauthorization of the
Commodity Futures Trading Commission. It is a pleasure to be
here.
I would like to acknowledge my colleagues and friends
sitting beside me; Commissioner Bowen and Commissioner
Giancarlo. Both have spent much of their careers working in the
financial markets in some capacity, and so have brought
significant expertise and professionalism to the Commission,
which benefits not only the Commission's work but the public as
well. It is an honor to serve with them.
I also want to acknowledge Chairman Massad for his
continued pursuit of an agenda dedicated to further
implementation of, and refinements to, Dodd-Frank. He has led
the Commission in an admirable way, and has achieved consensus
through his engagement of the Commission's policymaking and
enforcement missions. I also appreciate this Subcommittee's
constructive and collaborative relationship with the
Commission.
The swaps and futures markets in the U.S. look considerably
different today than they did in 2011, when I joined the
Commission. Today, there are more than 100 swap dealers
provisionally registered with the CFTC, clearing mandates in
place for liquid swaps, and trading mandates requiring liquid
swaps to be executed on registered exchanges, or SEFs. There
also are new reporting obligations for market participants.
Additionally, registered clearinghouses must meet heightened
risk management requirements, and customer funds held by
clearing members enjoy greater protections. The sum of these
component rules and requirements is a safer and more
transparent market structure for derivatives in the U.S. But
there remains more work to be done, including three key
rulemakings to implement Dodd-Frank; the rulemaking on margin
requirements for uncleared swaps, the rulemaking on capital
requirements related to uncleared swaps, and the rulemaking on
Federal position limits.
My written testimony goes into detail about a variety of
other initiatives the Commission should undertake to continue
and improve its implementation efforts. It also identifies
developing trends in the derivatives markets that this
Committee should monitor in its oversight capacity. I will
briefly summarize some of the key points.
Regarding cross-border initiatives, the Commission should
clarify how it views the use of U.S. personnel by registered
dealers otherwise located outside the U.S., and should use its
authority to create a foreign SEF regime. These steps would
address challenges created by the Commission's first mover
impact as it has implemented reforms, especially the swap
trading mandate. The Commission also should take steps to
promote the trading of swaps on SEFs. These steps should
include revising the conditions for eligibility under the floor
trader exemption, clarifying that anonymous trading protocols
on SEFs must remain anonymous post-execution, clarifying the
application of the embargo rule as it relates to work-up
trading sessions on SEF, and revising the process for imposing
a trading mandate for swaps. Importantly, the Commission also
must promptly approve SEF requests to offer appropriate
execution methods different from those expressly permitted in
the SEF rule. Regarding FCM risk management, the Commission
should clarify how FCMs may screen block trades that are
executed on or pursuant to the rules of SEFs.
All of these steps the Commission could undertake with
existing authority. If accomplished, these steps would lead to
an even safer and simplified market structure. The Congress
could assist the Commission in two important ways through the
reauthorization process. First, although outside the specific
jurisdiction of this Subcommittee, the Congress should consider
amendments to the Bankruptcy Code to allow the protection of
individually segregated margin accounts of customers. This
would enhance both customer protections and choice that would
benefit end-users. Second, the Congress should revise the
indemnification provision related to the use of data kept at
swap data repositories. The current law has imputed data
sharing and harmonization efforts at both the domestic and
international levels. Finally, there are several developing
trends this Subcommittee should monitor because they could
provoke future policymaking responses. In no particular order,
they are, regulatory market fragmentation, public distributed
ledger technologies, FCM concentration, clearinghouse risk
controls, automated trading systems, and cybersecurity. I am
happy to elaborate further on these topics.
Thank you again for inviting me, and I look forward to
questions.
[The prepared statement of Mr. Wetjen follows:]
Prepared Statement of Hon. Mark P. Wetjen, Commissioner, Commodity
Futures Trading Commission, Washington, D.C.
Good morning, Chairman Scott, Ranking Member Scott, and Members of
the Subcommittee. I would like to thank you for inviting me to appear
before the Subcommittee this morning and allowing me to share some of
my thoughts on the reauthorization of the U.S. Commodity Futures
Trading Commission (CFTC). It is a pleasure to be here today.
Reauthorization provides Congress an opportunity to reflect on the
work of the Commission and determine legislative solutions to any
identified inadequacies. I appreciate the Subcommittee's efforts to
approach reauthorization thoughtfully by listening to all stakeholders,
such as in the Subcommittee's hearing with end-users on March 24 and
with market participants on March 25, as well as in today's hearing.
Since I joined the Commission in 2011, the agency has largely
completed its rulemakings under Title VII of the Dodd-Frank Wall Street
Reform and Consumer Protection Act (Dodd-Frank), which includes
registering swap dealers and major swap participants, implementing the
Commission's clearing and trading mandates for swaps, and setting up a
regulatory-reporting regime for swaps. We now have more than 100 swap
dealers provisionally registered with the CFTC, clearing mandates in
place for liquid swaps and trading mandates requiring liquid swaps to
be executed on designated contract markets (DCMs) or one of the more
than 20 newly provisionally registered swap execution facilities
(SEFs), as well as new reporting obligations for market participants.
Additionally, the agency has strengthened the risk-management practices
of registered clearinghouses, enhanced protections of customer funds
held by futures commission merchants (FCMs), and issued a concept
release addressing risk-management enhancements for automated trading
systems and the firms that deploy them. Compliance with most of these
rules has begun in full.
Since the beginning of 2014, as the Commission has continued its
efforts to implement the new swaps market structure under Dodd-Frank
and harmonize those efforts internationally, it also began to focus on
revisiting policies that had an unintended impact on the end-user
community of derivatives-market participants. The Commission recognizes
the importance of limiting costs to these end-users.
I commend Chairman Massad for his continued pursuit of this agenda.
Under Chairman Massad's leadership, the Commission considered
amendments to the so-called residual interest rule, which was adopted
unanimously by the Commission, and is currently considering amendments
to the 1.35 recordkeeping rule, the treatment of forwards with embedded
volumetric optionality, and the treatment of trade options as defined
under the Commodity Exchange Act (CEA).
The Commission also has enjoyed an increase in resources needed to
accomplish its mission, for which the agency and its staff are
grateful. This year the Commission requested $322 million to pursue its
mission activities, an increase of $72 million over its current
operating budget. These additional funds would allow the agency to
improve its examinations of clearinghouses, FCMs, and swap dealers;
deploy additional technology to perform surveillance of increasingly
automated markets as well as rationalize data; and enforce the
Commission's rules. Given the increase in scope of its responsibilities
and the consequent risks of inadequate oversight of the complex and
global derivatives markets, the Commission can, and would continue to,
appropriately deploy future, additional funds and deliver a good return
on the taxpayer investment.
I have organized my testimony today with the goal of offering a
constructive viewpoint on where the Commission and the derivatives
marketplace stand generally, and with respect to implementation of
Dodd-Frank more specifically. Toward that end, my testimony will
address multiple topic areas, including (1) key rules the Commission
should promulgate to continue implementation of Dodd-Frank; (2) the
cross-border implications of the Commission's rules (identifying
several discreet issues in particular); (3) swap-trade execution; (4)
clearing and FCM risk management; and (5) swap reporting and data. In
each of these topical areas my testimony identifies whether
Congressional action is needed to address insufficiencies in authority
or clarity concerning Congressional intent, or whether Commission
action is recommended (based on existing, adequate authority from
Congress). Finally, this testimony identifies developing trends in the
derivatives markets that the Committee should be aware of and monitor
while serving in its role as an authorizing Committee of the CFTC.
1. Dodd-Frank Rulemakings Related to Uncleared Swaps and Federal
Position Limits
There are three key rulemakings required under Dodd-Frank that the
Commission should complete and finalize: the rulemaking on margin
requirements for uncleared swaps; the rulemaking on capital
requirements related to uncleared swaps; and the rulemaking on Federal
position limits.
Rulemaking on Margin for Uncleared Swaps. Perhaps the most
important remaining rulemaking is the Commission's margin rule. The new
market infrastructure for swaps agreed to by the G20, and required
under Dodd-Frank, mandates clearing for liquid swaps, and appropriate
margin requirements for those swaps that are not cleared. Measured in
notional volumes, the market for cleared swaps steadily has increased
since 2008, but the uncleared swap market remains substantial and in
need of appropriate risk-management safeguards. Margin is an essential
tool to mitigate the default risk associated with uncleared swaps as
well as the consequent systemic risk that may follow the default of a
large market participant.
In September, the Commission re-proposed its rule on margin for
uncleared swaps, working in close cooperation with relevant domestic
and international regulators. Importantly, and consistent with
Congressional intent, the proposal exempts commercial end-users from
the margin requirements that apply to swap dealers and certain
financial entities. The Commission should finalize the margin rule as
quickly as possible to provide certainty on the requirements for one of
the last component parts of the post-reform, swaps-market structure. In
finalizing this rule, the Commission must continue to coordinate with
regulators both in the United States and abroad. The importance of
global harmonization cannot be overstated given the risk of regulatory
arbitrage if material differences in margin requirements exist among
major financial markets.
Rulemaking on Capital Requirements Related to Uncleared Swaps. The
Commission should proceed soon with its rulemaking on capital
requirements related to uncleared swaps. When the Commission first
proposed capital requirements for certain swap dealers and major swap
participants in 2011, it aligned the comment periods for the proposed
capital and margin rules so that commenters would ``have the
opportunity to review the proposed capital and margin rules together
before the expiration of the comment periods for either proposed
rule.'' This was done because to the extent that uncleared swaps are
not fully margined, additional capital may be appropriate to address
the resulting increased risk in the swaps marketplace. The Commission
should continue to be mindful of this interaction in finalizing the
capital rule and should ensure that it does not create improper
incentives that may increase costs for end-users.
Rulemaking on Federal Position Limits. Following the vacating by a
Federal district court of the original position-limits rule in 2012, a
rule was re-proposed on December 12, 2013. The comment period to that
proposal has been re-opened several times, and as of today, the CFTC
has received over 500 comments. Mindful of the potential impact this
rule could have on the public, last year the CFTC held a public
roundtable and an Agricultural Advisory Committee meeting that
addressed position limits, and in February the CFTC's Energy and
Environmental Markets Advisory Committee held a public meeting to hear
from commercial end-users and other participants in the energy markets
on the subject.
As reflected in Dodd-Frank, Congress intended for the CFTC to apply
Federal position limits on DCMs and SEFs. I note that Congress gave the
agency broad authority to craft a position-limits rule that protects
against excessive speculation without curtailing legitimate hedging
activities, including certain types of anticipatory hedging. In
finalizing a rule, the CFTC should consider the effect on commercial
end-users, farmers, ranchers, and other participants who use our
markets to hedge risk, and ensure that we provide the appropriate
flexibility for granting bona fide hedge exemptions.
2. Cross-Border Implications of CFTC Rules
As mentioned, one of the most important tasks before the Commission
is to continue assessing the cross-border impact of Title VII and
consider ways to appropriately harmonize its implementation efforts
with those of non-U.S. regulators. Along these lines, the following
issue areas are particularly important for the Commission to be engaged
in over the coming weeks and months.
Equivalency Decision for U.S. Clearinghouses by the European Union.
The CFTC continues to negotiate with the European Commission and
European Securities and Markets Authority on whether our clearinghouse
regulatory framework should be deemed equivalent to the European
Union's clearinghouse regulations. The European Union has extended the
deadline for the determination to June 2015. Without an agreement,
higher capital standards would apply to European banks that clear their
trades through registered clearinghouses in the United States, which
could disrupt the ability of European banks to use our markets. The
CFTC continues to consult with European regulators to work through the
remaining issues, and I commend Chairman Massad and Commission staff
for their efforts. Considerable progress has been made and an
equivalency decision should be made soon by the European Commission.
Staff Advisory on U.S. Personnel. On November 14, 2013, CFTC staff
issued an advisory that would apply the Commission's transaction-level
requirements under Dodd-Frank, such as mandatory SEF trading, to swaps
between a non-U.S. swap dealer and its non-U.S. client where the non-
U.S. swap dealer regularly uses personnel located in the United States
to arrange, negotiate, or execute such swaps. The Commission had
previously determined in its cross-border guidance that swaps between
two non-U.S. persons that are not guaranteed by U.S. persons lack a
sufficient nexus with U.S. commerce for the Commission's transaction-
level requirements to apply. Shortly after the staff issued the
advisory, the Commission requested comment from the public on its
subject matter and the staff provided no-action relief delaying its
applicability.
Now that the comment period has been closed for some time, the
Commission should take action to clarify the matters discussed in the
staff advisory. Commission action in this regard should be accompanied
by an appropriate implementation period to permit the marketplace to
come into compliance without undue cost or burden. The current no-
action relief expires in September of this year, so the Commission must
act promptly or otherwise provide adequate additional time for
compliance upon formulating its policy.
QMTF and Foreign SEF Regime. In collaboration with the Commission's
European colleagues, last year the Commission provided relief from
registration for qualified swaps-trading venues in Europe (QMTFs). This
relief applied to QMTFs that have sufficient pre- and post-trade price
transparency requirements, and provide non-discriminatory access to
market participants. QMTFs also have to meet certain regulatory
requirements in their home jurisdictions. So far, no foreign trading
venues have used the QMTF relief. The Commission should continue to
work with the Financial Conduct Authority in the United Kingdom and
other global regulators to resolve any issues relating to the QMTF
regime.
The Commission also should invoke its statutory authority and
promulgate rules creating a permanent regime for non-U.S. swap-trading
venues, under which entities from a variety of jurisdictions could
request exemption. The Commission, however, also must carefully
consider the impact of such action on its own SEF framework and
standards in order to protect the swaps marketplace and preserve the
competitive standing of SEFs. Both efforts would help address some of
the regulatory fragmentation (discussed below) the swaps market has
experienced since the Commission's SEF framework and trading mandate
went into effect.
3. Swap-Trade Execution
In 2012, the Commission completed rules providing for the
registration of SEFs, which are regulated trading platforms designed to
provide pre-trade transparency, reduce risk, and improve pricing for
the buy-side, commercial end-users, and other participants that use
these markets to manage risk. On February 15, 2014, the Commission
implemented the first trading mandate for cleared interest rate and
credit default swaps in the U.S. derivatives market. As of the most
recent data, over $7.7 trillion notional of interest rate and credit
swaps were traded in 1 month on SEF platforms under the CFTC's
oversight.
The requirement that certain swaps trade on SEFs or DCMs was a
momentous change for a marketplace that previously traded largely on an
over-the-counter basis. A great many users of swaps were required to
connect to execution venues and execute their swaps pursuant to certain
trading protocols for the first time. Additionally, there was much
uncertainty regarding the applicability of the execution requirement to
swaps that were executed as part of a package with other swaps,
futures, or securities (i.e., ``package trades'').
Complicating matters further, the United States was the first
country in the world to impose a trading mandate for swaps. While U.S.
persons have been trading the most liquid swaps--particularly those
denominated in U.S. dollars--in a more highly regulated trading
environment (i.e., on provisionally registered SEFs), the rest of the
globe continues to trade swaps bilaterally, or on trading venues that
are subject to lesser regulatory requirements than SEFs. The G20
committed to reforms that would require swaps to trade on regulated
venues where appropriate, so it is expected that eventually there will
be comparable trading venues in other jurisdictions. No other country,
however, has achieved that objective as of now (Japan expects to impose
a swaps trading mandate by the fall of 2015, but the European Union is
not expected to impose one before 2017).
This is an important context to the analysis of the Commission's
SEF and trading-mandate rules, and largely explains why non-U.S.
entities have demonstrated a preference for avoiding execution on SEFs.
Because SEFs are regulated trading environments and serve as self-
regulatory organizations (SROs) for their platforms, SEF participants
incur costs and face compliance burdens not found in other
jurisdictions. Unless commercially or legally compelled to do so,
market participants largely have chosen to avoid subjecting themselves
to these higher costs and increased compliance risks associated with
SEFs.
Policymakers therefore should be careful not to draw the wrong
conclusions from the fact that many non-U.S. persons have avoided
trading on SEFs. Indeed, while subject to core principles and
Commission rules, required to function as SROs, and required to provide
specific trading protocols for their participants, SEFs nonetheless are
designed to be, and are--relatively speaking--flexible trading
platforms as compared to DCMs. For instance, SEFs can offer requests
for quote (RFQs) and conduct work-up sessions, and can conduct RFQs and
work-ups using voice methods. Independent brokers, moreover, can
continue brokering trades for mandated swaps outside of the SEF
environment so long as the trade is ``crossed'' against a SEF order
book.
Notwithstanding this fact, there are a number of steps the
Commission should take to further realize Congressional mandates to
promote trading of swaps on SEFs as well as promote pre-trade price
transparency, both of which appear in the text of Dodd-Frank. These
steps are described below under the categories of (i) initiatives that
would further promote the trading of swaps on SEFs, and (ii)
initiatives that would provide needed clarity to the SEF market
structure.
i. Initiatives That Would Promote the Trading of Swaps on SEFs
The following policies should increase trading volumes on SEFs.
Floor Trader Designation for Market Makers. When the Commission
finalized its swap-dealer-registration rule, it provided that those
trading entities that are registered as ``floor traders'' and meet a
number of specified conditions under the rule do not have to register
as swap dealers. This exemption was designed to promote market-making
activities by non-traditional liquidity providers for the purpose of
promoting liquidity formation on SEFs, and recognized that swap-dealer
registration was not necessary or appropriate when the trading activity
of the floor trader was anonymous and cleared at a clearinghouse (thus
avoiding a traditional dealer-customer relationship).
The conditions for the floor-trader exemption need to be revised to
make compliance practicable while ensuring that floor traders do not
pose an increased risk to the marketplace. This would encourage more
liquidity provision by non-dealer market makers and even more
automation in execution. There are important policy debates associated
with increasingly automated execution, as mentioned below in the
developing trends discussion of this testimony. Separate risk-
management requirements for intermediaries and registered
clearinghouses currently in place, as well as other future initiatives
to appropriately register non-dealer liquidity providers, are designed
to address concerns raised by this automation trend.
Name Give-Up. Due to post-trade affirmation services or the SEF's
rules, there are instances where counterparty identities are revealed
after trades are executed on SEFs through an anonymous order book
trading protocol. The Commission should require that trades that start
anonymously on an order book must remain anonymous post-trade. This
will promote a more competitive, transparent, and liquid swaps market.
On April 2, 1015, Commissioner Bowen hosted a meeting of the Market
Risk Advisory Committee where this issue was discussed, and the
consensus of the participants was that the Commission should take
action to end this practice through Commission guidance or rulemaking.
Embargo Rule--Work Ups. The embargo rule in part 43 of the
Commission's real-time public reporting rules may impair a SEF's
ability to generate liquidity during a work-up session. Immediately
after an order or RFQ is executed, a SEF can conduct a work-up session,
whereby a SEF's participants buy or sell additional quantities of the
executed swap at the same price. These sessions can start and end
within seconds or minutes, and can be a significant source of swaps-
trading volume on SEFs.
The embargo rule prohibits the disclosure of swap transaction and
pricing data to a SEF's market participants prior to the transmission
of the data by the SEF to a swap data repository (SDR). Before the data
is sent to the SDR, it needs to be enriched and converted. The embargo
rule introduces latency into the work-up process by making the SEF wait
until each order that results during a work-up is transmitted to the
SDR before another work-up order can take place. SEFs conducting work-
ups have expressed concerns about liquidity generation with the
application of the embargo rule to work-ups. In addition, the time
delay can frustrate the ability of market participants to trade at the
price agreed to through the work-up session. Providing relief from the
embargo rule for work-up sessions would promote more liquidity on SEFs,
something the Commission could do under existing authority.
ii. Initiatives That Would Provide Clarity Around the SEF Market
Structure
The following actions would address uncertainties caused by
Commission rules concerning the current SEF market structure, and could
minimize legal and compliance concerns that frustrate participation on
SEFs.
MAT Determinations. The Commission should replace the current
``made available to trade'' (MAT) process with a Commission-initiated
process that identifies the swap instruments subject to the mandate.
Under the existing process, a single SEF's commercial interests in
mandating (or not mandating) a swap dictates whether the Commission
will review a proposed mandate. This is not the best approach to make
policy decisions for the entire market. A Commission-initiated
determination would be more orderly and would eliminate many questions
around the scope of a mandate--including its applications to package
trades (see below)--by including a traditional comment period process.
No additional authority is needed by the Commission to pursue this
policy change.
Package Trades. Commission staff provided relief from the trading
requirement for package trades on May 1, 2014, and subsequently held a
public roundtable to identify practical and jurisdictional concerns
that affect their trading on SEFs. Having heard from the public on the
issue, the staff set forth a phased compliance approach that has since
brought package trades involving all MAT legs, and MAT legs with non-
MAT cleared legs, onto SEFs with minimal disruption to the marketplace.
On November 10, 2014, staff granted further relief for SEFs for package
trades with futures legs until November 2015, and for more complex
package trades (e.g., transactions that include MAT legs with uncleared
swaps, a non-swap instrument, or security-based swap legs) until
February 2016, to be executed by any means of execution.
The Commission should consider whether to formalize making some of
this temporary relief permanent in order to provide more certainty and
flexibility for these transactions. In the meantime, the Commission
will continue to examine how the market has reacted to the expiration
of previous package-trade relief.
Block Trades. The Commission's requirement that a block trade
``occurs away'' from the SEF has created additional complexity for
trading large transactions, and executing block trades away from the
SEF has presented difficulties for SEFs and FCMs to conduct the
required pre-execution, credit-check screenings. The Commission should
similarly consider whether to make permanent the existing no-action
relief that allows executing block trades on or pursuant to a SEF's
rules, which expires at the end of this year, or clarify other ways for
market participants to execute block trades.
Error Trades. Some swap trades are rejected by a clearinghouse
because of operational or clerical errors made by market participants
or SEFs. While these operational and clerical errors otherwise would be
easily corrected, due to certain Commission rules the trades are
rejected from clearing. Relatedly, because trades are required to be
submitted for clearing immediately after execution, counterparties may
not have an opportunity to attempt to correct an error until after the
transaction has cleared. Re-submitting these same trades again
correctly could conflict with the CFTC's rules against pre-arranged
trading. The Commission has been granting and extending no-action
relief since 2013 to address these issues.
SEFs should be permitted to determine whether there are actual
errors, and to correct such errors, or to execute an offsetting or pre-
arranged swap that reflects the correct parties and terms. The policy
goals of submitting trades immediately for clearing are obviously
important, but in some instances they should be balanced against the
goals of fixing errors and allowing counterparties who want to maintain
the swap to do so. Although the Commission has been responsive by
granting no-action relief, in order to provide certainty to the market
and participants, the Commission should consider revising our rules to
find a more lasting solution.
Financial Resources. SEF Core Principle 13 requires a SEF to have
financial resources in an amount that exceeds the total amount that
would enable the SEF to cover the operating costs of the SEF for a 1
year period, as calculated on a rolling basis. As we have become more
familiar with the role of SEFs, it has become clearer that unlike other
registered entities, SEFs do not hold or carry the risks of positions
and trades executed on it, and do not own the products traded on them
(i.e., swaps are fungible and can be traded on other SEFs). As such, a
SEF does not need as much time or capital to wind-down as a DCM or
clearinghouse. In addition, this core principle disproportionately
affects SEFs that offer voice-based execution methods as compared to
purely electronic SEFs.
In light of these facts, Congress could consider reducing the 1
year period to provide more flexibility to SEFs. In the meantime, the
Commission should consider whether there are ways to interpret this
core principle and revise its regulations to provide a more reasonable
and execution-method-neutral way for SEFs to comply. One such way to do
so would be to re-consider commenters' requests to interpret operating
costs to mean the costs of an orderly wind-down.
4. Clearing and FCM Risk Management
A hallmark of Dodd-Frank is the clearing mandate for liquid swaps.
A cleared marketplace relies on clearinghouses as well as FCMs to
manage risks associated with positions taken by participants. To
improve this market structure further and minimize risks to customers
in particular, the following steps should be considered.
Individual Segregation. Customers and end-users have repeatedly
approached the Commission seeking greater protection for their funds in
the event their FCM becomes insolvent. These concerns have been
amplified by the failures of MF Global and Peregrine, and by the market
impact of the Swiss central bank's decision to abolish its 3 year old
policy of capping the Swiss franc against the euro. The Commission has
spent considerable resources enhancing protections for customer funds,
but there is more that could be done.
Currently, section 766(h) of the U.S. Bankruptcy Code continues to
subject customers to mutualized risk by requiring that customer
property be distributed ``ratably to customers on the basis and to the
extent of such customers' allowed net equity claims.'' With respect to
cleared swaps, this requirement limits the Commission's flexibility in
designing a model for the protection of customer funds that allows for
individual segregation. This means that even if a customer's funds are
held in a completely separate account from the funds of other
customers, if the customer's FCM becomes insolvent and there is a
shortfall in the FCM's customer omnibus account that customer only will
get back his or her pro rata share.
For customers who believe they can better protect their funds in
the OTC marketplace, this potential result is unsatisfactory. It would
aid the Commission's work if Congress were to amend the Bankruptcy Code
to permit greater flexibility with respect to the protection of
customer funds.
Futures Commission Merchant Risk Management. Regulation 1.73(a)(2)
provides that an FCM must screen trades against its risk-based limits.
The method and timing of the FCM's screening obligation, however, is
dependent upon the nature of the trade, recognizing that not all types
of screens are possible on certain types of transaction. As discussed
above, there exists in the marketplace some uncertainty with respect to
how [rule] 1.73 applies to block trades. The Commission should address
this uncertainty and clarify how the FCMs can comply with rule 1.73
with respect to block trades.
5. Swap Reporting and Data
The following steps should be considered to improve the
Commission's swap-reporting regime.
Rulemaking on Reporting of Cleared Swaps. Dodd-Frank added to the
CEA section 2(a)(13)(G), which requires all swaps--whether cleared or
uncleared--to be reported to SDRs. Notwithstanding the harmonization
effort between the CFTC and the SDRs to make swap data more consistent,
and therefore more usable for regulatory purposes, there remain
challenges to the usability of the cleared-swap data being reported.
For example, reporting of cleared swaps is complicated by the so-called
alpha swap being reported to one SDR, and the beta and gamma swaps
being reported to another SDR. Alpha swaps remain open in SDR data and
appear to be bilateral, but are in fact subject to the clearing
requirement.
The result is that swaps that appear to be subject to the clearing
requirement are appearing in the SDR as bilateral, uncleared ``open
swaps'', when in fact they have been accepted for clearing by a
clearinghouse. This outcome impedes the Commission's ability to quickly
and accurately review compliance with the clearing and trade-execution
requirements, assess the size and scope of a given product's market,
and assess the impact of uncleared swaps trades on the risk profile of
clearing members and their customers. Staff is preparing a
recommendation to the Commission on how to address this matter, and the
Commission should act on that recommendation as soon as practicable.
Indemnification Provision related to Swap Data Repositories. As
indicated, Dodd-Frank required that all swaps be reported to SDRs.
Separately, CEA section 21 requires SDRs to make data available to
certain domestic and foreign regulators so long as they have agreed in
writing to abide by specified confidentiality requirements, and to
indemnify the SDR and the Commission for any expenses arising from
litigation relating to the delivered data or information. In 2012, the
Commission issued guidance that clarified that the confidentiality and
indemnification provisions do not apply to a registered SDR if it also
is registered (or otherwise authorized) in a foreign jurisdiction, and
the data sought to be accessed by the foreign regulator had been
reported to the registered SDR pursuant to the foreign jurisdiction's
rules. Notwithstanding this helpful interpretation, issues remain.
First, other U.S. regulators may need access to this information to
fulfill their responsibilities and mandates, but they would be
prohibited from obtaining the information from an SDR without executing
an indemnification agreement. Second, these requirements continue to
cause concern among foreign regulators, some of which have expressed
unwillingness to register or recognize an SDR unless they have access
to necessary information. The CFTC continues to work toward ensuring
that both domestic and international regulators have access to swap
data to support their regulatory mandates. But it would be useful to
the Commission's regulatory mission if Congress were to revise the CEA
to remove the indemnification requirement from these information
sharing provisions.
6. Developing Trends in the Global Derivatives Markets
Finally, the Committee should be aware of the following
developments, as they could re-shape the derivatives markets and
potentially provoke future policy responses from the Congress and the
Commission.
Liquidity Fragmentation in the Global Swaps Markets. As indicated
in the discussion above on SEFs, today, some swap-trading decisions are
being made to comply with or avoid rules and mandates imposed by law,
and are no longer driven solely by the liquidity profile of, or
expertise in, a given marketplace. Consequently, separate pools of
liquidity have formed in distinct parts of the world largely based upon
the legal status of counterparties. To be sure, differences in the
timing and content of global reforms are part of the reason, as
mentioned.
Avoiding fragmentation is desirable because (i) consolidated
liquidity pools translate to reduced costs for end-users through
tighter bid-ask spreads and improvements to other market-quality
factors; (ii) centralized liquidity not only increases transparency for
the broadest cross-section of price-takers, but reduces informational
and trading advantages that accrue only to those able to navigate the
complexities of a fragmented market structure; and (iii) from a
systemic-risk standpoint, fragmentation can lead to increased
operational risks as entities react to and structure around the rules.
The steps identified in the cross-border section of this testimony
could make significant strides towards limiting market fragmentation.
Apart from those refinements to existing Commission policy, a
revamp of the Commission's overall cross-border guidance for swaps is
not necessary at this time. The better policymaking course would
include waiting until more of the other G20 nations with significant
swap markets--namely, the European Union, Japan, Canada and Australia--
implement their clearing and trading mandates pursuant to their
respective reforms, and then analyze how those reforms compare as well
as their market impacts. Only then will U.S. policymakers be able to
make informed and thoughtful decisions about additional steps they
should take.
Disruptive Technologies. Some relatively recent technological
advancements have the potential to further reduce risk in our markets
if those technologies become more widely embraced. Bitcoin-like
protocols or distributed public ledger technologies could provide and
enhance various settlement and other trustee-like services provided by
registered entities in the derivatives markets, where monies and
collateral are frequently transferred and settled throughout a trading
day. These technologies work to provide a record of transactions and
changes of ownership, and can be used to validate any type of
transaction--including the more familiar concept of exchanging cash or
currencies, as well as other types of assets or collateral, such as
stocks, bonds, and securities. With these technologies, this can be
done without the use of banks or other intermediaries.
Whereas now settlement may take days or occur intra-day depending
on the market, this technology potentially could be used to facilitate
settlement close to, or in, real-time. Reducing the time for transfers
and the need to use an intermediary in the settlement process could
further reduce risk to end-users and other market participants. This
technology, moreover, has the potential to be used to display
transaction information in close to real-time, and to maintain records
of those transactions.
These are just a few of the obvious use cases for this technology,
which, if deployed in Commission-regulated markets, would present new
policy questions for the agency and this Committee. These questions
include, among others, how new technologies will challenge or fit into
current regulatory frameworks, potential regulatory barriers for new
technologies, the impact on incumbents, and whether their use
necessitates additional customer protections. Both the Commission and
this Committee should continue to think about these questions and
challenges. The Subcommittee also might consider directing the
Commission to undertake a study to examine how these technologies could
assist with compliance or otherwise reduce risk in the markets it
oversees.
FCM Concentration. Policymakers should continue monitoring the
number of FCMs actively involved in the derivatives markets as time
continues. The number of registered FCMs has decreased since the
financial crisis, which may make it more difficult for customers to
manage their risk by limiting their ability to access the markets, or
by making it more difficult for them to allocate funds among multiple
FCMs to minimize concentration risk.
The overall framework of regulatory requirements that registered
FCMs must comply with is substantially different today than it was
before the crisis. FCMs are now subject to an enhanced customer-
protection framework enforced by the Commission, with the result that
the risks posed to customers funds stewarded by FCMs have been
significantly reduced. This is a positive development.
During this same timeframe, the prudential regulators have enhanced
their capital requirements for global financial institutions, resulting
in more capital being held by FCMs that are affiliated with a bank
holding company. While the Commission's and Prudential Regulators'
measures are intended to safeguard the markets in times of stress, the
consequences resulting from the costs associated with this framework
remain to be seen. For instance, clearinghouses and FCMs have begun
more serious discussions about facilitating more self-clearing
arrangements for customers, a development that could raise a host of
policy issues and considerations. Meanwhile, there are more reports in
the media of additional fees being imposed on customers by FCMs
resulting from the new capital-requirements framework.
This Committee should monitor these developments and could play a
role in ensuring that market regulators such as the CFTC on the one
hand, and prudential supervisors on the other--which separately enforce
different types of regulatory regimes with different policy
objectives--do not pursue goals that are at cross purposes with each
other. The G20, and subsequently the U.S. Congress and regulatory
community, agreed to reforms that (i) promote the clearing of
derivatives, as well as (ii) raise capital standards for global banks.
Policymakers should take care to avoid unnecessarily thwarting the
former in pursuit of the latter. It also is worth pointing out,
however, that if market regulators and prudential supervisors pursue
conflicting agendas as it relates to clearing, it could further
incentivize the deployment of novel legal and technological solutions
to compliance.
Central Counterparty Risk. Clearinghouses play an increasingly
important role in the wake of implementation of G20 financial reforms
related to the clearing of derivatives contracts. Consequently, the
CFTC has been hard at work putting in place a framework for effective
oversight and regulation of clearinghouses. Nonetheless, it is
appropriate that at this stage of the overall financial-reform effort,
regulators and the Congress consider what, if any, additional measures
should be taken.
Additional authority from Congress is not needed for the Commission
to responsibly undertake this process of review. The areas related to
clearinghouse risk management worth analyzing include: enhancing
transparency with respect to clearinghouse stress tests, and reviewing
how much of a clearinghouse's own capital--and under what
circumstances--should become part of their plans for determining who
pays in the case of a major clearing member default. Market regulators
such as the CFTC also should assess clearinghouses' recovery and wind-
down plans, and, to the extent a settlement or custodian bank failure
impacts the ability of a clearing member (or group of clearing members)
to timely meet its payment obligations to a clearinghouse, the ability
of a clearinghouse to timely meet its payment obligations to its
clearing members.
Cybersecurity. DCMs, SEFs, SDRs, and clearinghouses are required by
the CEA and Commission regulations to establish and maintain ``system
safeguards,'' which include, among other things, a program to identify
and minimize sources of operational risk, emergency procedures, backup
facilities, a business continuity and disaster recovery (BCDR) plan,
and to conduct periodic BCDR plan testing. These entities are also
required to promptly notify Commission staff of certain cyber security
incidents or targeted threats. Commission staff conducts systems
safeguards testing that examines whether these standards are being
adhered to; however, staff does not conduct independent testing. Other
registered entities are also required to have BCDR plans and
periodically test them.
Commission staff recently conducted a public roundtable on
cybersecurity and system safeguards testing in March where we heard
from registered entities, market participants, and other government
agencies that have developed best practices. End-users and participants
rely on our markets to hedge their risks, and any disruption by way of
a cyberattack could have an adverse effect on those users, such as the
theft of personal information or a market disruption or outage.
The Commission is considering potential enhancements to our systems
safeguards rules and testing to further strengthen the security and
resilience of our markets to cyberattacks. As part of this effort the
Commission should evaluate what types of system safeguards or testing
are appropriate for other registered entities. In addition, the
Commission can consider changes to the current rules, such as making
the notifications to the Commission of cyberattacks confidential, in
order to foster transparent and prompt disclosure to the Commission.
Finally, the Commission should assess whether entities that provide
services to our registered entities, such as the National Futures
Association, or third-party vendors like Markit, should be subject to
systems safeguards rules or testing.
In addition to making changes to our rules, in order to develop and
test more effective cybersecurity and systems safeguards, it is
critical to have the participation of all interested parties--financial
regulators, the private sector, and the intelligence/law enforcement
community. We should be considering innovative ways to foster this
testing and participation, such as the voluntary CBEST program
conducted by the Bank of England which brings regulators and the
intelligence/law enforcement community together to assess cybersecurity
risks to the financial system.
Automated Trading. Automated trading systems are becoming more
omnipresent in the derivatives markets, and are often used by both
traditional and non-traditional liquidity-providing firms. Automated
trading can sometimes be seen in a negative light, but there are
academic studies that support the views that such trading can be
detrimental to a market, or benefit liquidity, or both. For example, a
recent report on the rapid Swiss franc currency swings highlighted how
automated trading might have contributed to sharp price movements, but
also enabled the market to stabilize faster than otherwise expected. As
the trend towards automated trading continues, and especially if the
Commission encourages it by adopting policies that facilitate the use
of automated systems in swap execution, the Commission must be vigilant
in ensuring those systems have adequate risk controls, and operate in
an appropriate regulatory framework to enable the Commission to achieve
its overall mission.
On September 12, 2013, the Commission published a Concept Release
on Risk Controls and Systems Safeguards for Automated Trading
Environments. The Commission is considering the next steps for
regulatory action in this area with respect to pre-trade risk controls,
post-trade measures, and other protections to reduce the risks arising
from a malfunctioning automated trading system, and to promote the
safety and transparency of automated-trading environments. To pursue
these measures, the Commission sought comment on the role of a
registration requirement for firms that deploy automated trading
systems. Recently, the U.S. Securities and Exchange Commission took a
similar approach and proposed a rule that requires such firms operating
in the equities markets to become members of the Financial Industry
Regulatory Authority.
Thank you again for inviting me today. I would be happy to answer
any questions from the panel.
The Chairman. Thank you, Commissioners. And I would like to
remind the Members I would like to hold as closely as possible
to the 5 minute rule, and then hopefully we will have a second
round of questions.
I would like to start with a question about the swap dealer
de minimis levels that I am sure you are familiar with, and we
have heard numerous witnesses explain the uncertainty that they
face with the current rule that automatically lowers the swap
dealer de minimis level. Regardless of the results of the
pending study on what the level should be, recently the
Commission voted to undo a similar automatic change in the
residual interest deadline. I would like to ask each of you, do
you think it would be appropriate to also undo the automatic
change in the swap dealer de minimis level and simply set it at
$8 billion, unless the Commission votes to change that? It is
for all of you.
Mr. Wetjen. Are we going in alphabetical order?
The Chairman. We will start with Commissioner Bowen.
Ms. Bowen. Yes. I think it is important that we make sure
that our rules are based upon good data, and at this stage, I
have no basis upon which I would suggest that we change a rule
that is already in effect. So at this stage, I would not think
that would be wise for us to do so.
Mr. Giancarlo. Chairman, under the prior Chairman of the
CFTC, two rules were adopted. You referred to both of them;
residual interest and the swap dealer de minimis. Both of those
called for an automatic change in the standard in the year
2017, and both of those rules called for a study to be done,
and in both cases they prescribed that whatever the outcome of
the study, the rule would, nevertheless, change.
I disagree with that just as a matter of good regulatory
practice. If we are going to go and spend the taxpayers' money
to do a study, then we ought to take account of what the study
says before we change our rule. That was the basis for which
we, in September, changed the rule with regard to residual
interest. What we said was we will read that study, and then if
residual interest needs to--if there needs to be a change, we
will make the change. At the same time, I also said we should
approach it in the same way with regard to the de minimis
levels for swap dealers. Right now, $8 billion and more is the
qualification by which an entity is treated as a swap dealer.
In 2017, that will automatically lower to a $3 billion
threshold, regardless of what the study, that we are spending
taxpayer money to do, says should be the right level. So I feel
that we should not make an automatic change; we should read the
study, and then if it is appropriate to change the de minimis
level, we should do that.
The Chairman. Yes.
Mr. Wetjen. Mr. Chairman, I echo the comments made by my
fellow Commissioners. I think the importance here is that
whatever decision is made about what types of entities should
be registered as dealers, there should be a data-based reason
for it.
I actually think the way the rule is drafted now reflects
that approach, but I am open to changing that approach as well.
If a vote has to take place after a data analysis is done, I am
perfectly comfortable with that.
As Commission Giancarlo alluded to, we just made a similar
revision--well, as you alluded to, we just made a similar
revision in the residual interest context, so I am open to it
in the swap dealer de minimis context as well.
The Chairman. Well, thank you.
Last fall, there was an article on Risk.net regarding the
use of special calls by the CFTC staff. The article noted that
many farms were small, legitimate hedgers are facing increased
scrutiny under the large trader reporting rule. This rule
significantly lowered the amount of exposure and swaps
contracts that would trigger a reporting requirement in some
cases to as little as \1/4\ of the equivalent exposure in the
comparable futures contract.
Commission Giancarlo, can you explain the process for
deciding when special calls are issued, and what the internal
process for overseeing them is, and have they ever been issued
in error?
Mr. Giancarlo. Thank you, Mr. Chairman. The special call
process is a process used at the CFTC as part of its oversight
authority, and part of its long-standing practice at the
Commission. Special calls have a legitimate role in our work. I
have become aware over the last few months of a large number of
industry participants raising concerns about an expansion in
the use of special calls, a fairly dramatic expansion, over the
last several years. I am also aware that these special call
letters contain in them some fairly serious statements about
legal liability and responsiveness from which our market
participants perceive to be fairly threatening.
It has also come to my attention that some time in the
fall, several hundred special call letters were issued that had
to be called back in the first quarter of this year, that they
were issued in error. I am quite concerned that we have the
right processes and procedures around our special call process,
that there is appropriate oversight within the agency, and
there is reporting up through the Commission as to how special
calls are used. They do have a legitimate role, but we need to
make sure that we as a Commission operate them, because it goes
to our credibility as a Commission that we operate this process
through proper procedures.
The Chairman. All right, thank you. My time has expired.
Mr. Scott.
Mr. David Scott of Georgia. Thank you, Mr. Chairman.
Let me start off by asking each of you, do you believe that
we in the Congress are appropriating sufficient funds for you
all to do the job that we are mandating you to do?
Ms. Bowen. As I mention in my statement, it is critically
important that we receive additional funds. Our role has
expanded tremendously, and yet we have fewer employees today
than we did before Dodd-Frank.
The markets that we are overseeing are quite complex, and
the products that are there are really quite complex. So in
order for us to really do our jobs as effective regulators, we
really need to be able to have the resources to actually hire
additional staff to make sure that our technology, frankly, is
up-to-date. The market, as you know, moves at an extremely fast
pace, and that is not likely to change.
Mr. David Scott of Georgia. All right.
Ms. Bowen. Likewise, as I mentioned, with cybersecurity
being a growing threat, we need to make sure we have the
resources to have protections in place.
Mr. David Scott of Georgia. Thank you.
Mr. Giancarlo?
Mr. Giancarlo. Thank you, Ranking Member. As a longstanding
consistent supporter of the Dodd-Frank reforms, I believe we
absolutely must have the resources to do a job that has been
greatly expanded. However, I am also sensitive to the fact that
our budget has increased 123 percent since 2008. I support the
current funding levels, to the question of going above those
levels really turns on whether, as you put it, the job we need
to do. And I have some questions as to whether in some cases we
are doing the job we need to do, or we are doing other jobs. I
have, in my white paper, outlined ways in which our swaps
transaction reforms are overly complex, do not accord with the
Dodd-Frank reforms. I am also concerned that our position
limits proposal creates an enormous amount of make-work for the
Commission that could be done in other ways at less taxpayer
expense.
So finding the right level of funding really is the key
question.
Mr. David Scott of Georgia. And, Mr. Wetjen?
Mr. Wetjen. Ranking Member, I do think we could use
additional resources. The responsibilities of the agency have
grown in three different respects. The size of the market we
oversee is larger than it was before, the number of registered
entities that we regulate has increased, and the amount of risk
that registered entities have to manage has also meaningfully
increased over the years. To reflect all of those key points,
the resources of the agency have to come in line with that as
well.
This isn't a scientific process. I don't think there is any
special number; but, as I just explained, as the
responsibilities have grown, the resources of the agency have
to grow as well.
One last point on the number of registered entities. We
have literally tens of thousands of registered entities. We
have some help from the NFA in overseeing those entities. The
most important entities are clearinghouses, in my judgment, to
make sure that those are properly managed, given the amount of
risk being managed by those entities at the moment, and we are
just not doing a good enough job, I don't believe, in examining
them. There are several very important and large clearinghouses
that we should be looking at and examining on an annual basis,
and given the team that we have today, we are not able to do
that.
Mr. David Scott of Georgia. All right. Well, thank you very
much. It has been very helpful.
Let me go back to you, Ms. Bowen, and you mentioned two
important areas that concerned me; cybersecurity as well as the
penalty enforcement level of wrongdoers. Could you elaborate
for a minute on that? How do we get our hands around getting
stronger enforcement penalties applicable for those within the
financial service industry that do wrong and for those bad
actors out there? What would be your proposal and how far could
you go in terms of brining criminal actions where people could,
if they do wrong, could serve time in jail because, unless we
get to that and be able to nip it in the bud, being strong and
give examples, we have MF Global, we have so many examples, how
would you guide us in that direction?
Ms. Bowen. Thank you for that question. First, we should
have much higher penalties. Frankly, they are just way too low.
And we have heard people refer to that as it is just the cost
of doing business. So we are not conveying the right message to
deter people.
The other thing that I would suggest is that, because the
market that we oversee is so complex of so many bad actors, we
need more people. We are the cop on the beat, so we can't
afford not to have the sufficient staffing there in terms of
our enforcement division. They have done a really good job. We
have gotten some fairly large civil penalties over the last few
years, and in some respects that signals the commitment and the
dedication of our enforcement staff, but we need more of them
to do the right thing and to make sure that our markets are
safe. And, frankly, in the 10 months that I have been there, I
have been, frankly, surprised at the number of Ponzi schemes
and the attempts to take advantage of retirees, and----
Mr. David Scott of Georgia. Yes.
Ms. Bowen.--we need to make sure that the most vulnerable
are really protected.
Mr. Davis Scott of Georgia. Thank you very much.
I yield back, Mr. Chairman.
The Chairman. Chairman Conaway, you have 5 minutes, or as
much time as you would like.
Mr. Conaway. I will endeavor to stay under the 5 minute
rule, thank you.
Couple of years ago, we had European Commissioner, guy
named Patrick Pearson, who was in front of us who was warning
us about: if we didn't have regulatory harmonization, that
firms would conduct and clear their trades and ward-off
regulatory jurisdictions, which would regionalize markets and
concentrate risks in different segments of the world. Two years
hence, are we seeing Mr. Pearson's predictions come true, and
then if so, what are the consequences? So why don't we start at
the other end, Mark, and come this way this time.
Mr. Wetjen. Thank you, Mr. Chairman. I indicated in my
written testimony, Mr. Chairman, that we have seen some
regulatory fragmentation since the CFTC has implemented its
rules. I believe it is largely the result of this first mover
impact I mentioned. There are some changes and revisions that
we should make, as I have outlined, and there is considerable
agreement among the Commissioners about some initiatives that
we can and should take to simplify or refine or improve our
rules, but I do think by and large, what we have seen has been
a result of this first mover impact of the CFTC. And part of
the reason I say that is our cross-border guidance, it was a
risk-based policymaking. So we looked at risk and how it might
be transferred back to the United States, but importantly, it
relies very heavily on this notion of substituted compliance,
and in order for it to work, in order to avoid what we have
seen happen already, every jurisdiction needs to be open to and
embrace a substituted compliance framework.
We actually have at the CFTC a pretty good record on this.
We have found substituted compliance for six major non-U.S.
jurisdictions where we have swap dealers registered, so in
essence, we have said you must register because of the amount
of U.S. business you are doing, but if you comply with your
home rules, you are going to be compliant with ours. And that
is just one example. There are many other examples of
substituted compliance that we have already found as an agency.
Going forward, we have to continue to do that, including on the
trade execution front. I mentioned in my remarks how we need to
put in place a foreign SEF regime. We already have a foreign
board of trade regime. And those types of regimes are critical,
again, to avoiding what we have seen. I wish we didn't have the
situation that we are facing now, but again, it is largely due
to the fact that we have largely completed our implementation
effort today, and the other major swap jurisdictions have not.
Mr. Giancarlo. Thank you for the question, Chairman
Conaway.
Patrick Pearson's prediction has absolutely come true, and
I must say he wasn't the only one to make that prediction 2
years ago. We are definitely seeing the conduct and clearing of
trades being siloed into regional marketplaces, and
unfortunately, we are seeing trading in a whole range of
products flee U.S. shores. We have seen interest rates swaps
outside of the dollar pairs move outside of the U.S. shores, we
have seen it in certain sections of the credit default swaps
market, and in other financial markets as well. This is not
unprecedented, just a historical example that multitrillion
dollar Euro-dollar market that takes place in London and in
Asia should be a market that should be an onshore market, but
Treasury regulations put in place in the 1970s drove that
marketplace offshore, and when those regulations were lifted in
the 1980s, those markets did not come back.
We have built a way--as I have said in my white paper--a
way more over-engineered and overly complex swaps trading
regime that is driving trading offshore. Interestingly, the
Singapore authorities and the Hong Kong authorities have not
put anything similar in place. They are sitting there hoping
those markets will move in their direction, and they will
benefit from it, and it will not only--we will lose that access
to those markets, or at least direct access, all the jobs that
will go with them as well. So I am very concerned about what
Patrick Pearson talked about, and I sadly have to say, it is
coming true.
Mr. Conaway. Right. Go ahead, Ms. Bowen.
Ms. Bowen. I think it is critically important for us to
harmonize as best we can, and I agree with Commission Wetjen
that part of it is a question of timing, and the fact that we
were the first movers. But let's look at this in the context of
a global market, which is the market we are regulating. We are
trying to protect investors and to make sure that the risk that
may occur outside of our borders doesn't flow back. And that
means that we have to make sure that our standards are
sufficient to protect our investors. At the same time, as you
know, I support the Chairman's efforts. I think he is making
some great progress with substitute compliance and equivalency,
and we are moving in the right direction. But I would not
suggest that we slow down our efforts by any stretch of the
imagination.
Mr. Conaway. I yield back.
The Chairman. Thank you. Mr. Aguilar.
Mr. Aguilar. Thank you, Mr. Chairman.
I had a question regarding SEFs. Commissioner Wetjen, you
mentioned in your testimony some of the ideas that we could
implement, and that the success of the SEFs is determined on
the volume at these facilities. Can you expand on that, and I
would love to hear what the other Commissioners feel we can do,
specifically ideas to encourage increased volume?
Mr. Wetjen. Thank you, Congressman. There are two
requirements of SEFs laid out in Dodd-Frank. The first is to
promote trading on SEFs, and then the other is to promote pre-
trade price transparency. So there is a dual mandate, as it
were. And the SEF platform--rather, the SEF rule was designed
to try and meet those two objectives. But at the heart of this
is a Congressional intent, I believe, to make these platforms
flexible. And to put that in a context, if Congress had wanted
us to make them less flexible than they are, they could have
said that all swaps must be traded on a futures exchange, and
that is not what they did. So I agree with the other
Commissioners that we do have a separate task here with SEFs.
They are designed to be more flexible than other exchanges.
A couple of things would be helpful in terms of promoting
trading, but also would have the effect of promoting pre-trade
transparency, is bring additional liquidity providers onto the
SEFs, and based on a couple of policies in place today, some of
those liquidity providers are unwilling to trade on SEFs. So we
should not have the same kinds of regulatory obligations for a
trading firm that does not have customers, for example, and
that uses automated trading systems to trade. We shouldn't have
the same obligations for them as we do a swap dealer. That was
the purpose behind the floor trader exemption. The conditions
in place to take advantage of that exemption are too onerous,
so they need to be revised.
That is really one of the key things we have to do. I also
mentioned doing away with the name give-up of counterparties to
trades when they are trading in a central limit order book. It
sounds like a bunch of gobbledygook, but a central limit order
book is supposed to be an all-to-all anonymous trading
environment. And the fact that some platforms are revealing the
identities of some of the participants post-trade, again,
discourages some market participants from wanting to trade
there.
So again, it speaks to the willingness of people to come
onboard these platforms and trade, and we need to make an
adjustment there as well if we want to bring additional
liquidity providers.
Mr. Giancarlo. Thank you your question, Congressman. In
2014, in fact, for the last 5 years in a row, the United
States' initial public offering market has led the world in
IPOs. In fact, companies from all around the world have flocked
to conduct their initial public offering on the U.S. Stock
Exchange. In fact, the largest IPO in history took place last
September when Alibaba listed its shares. Alibaba, a Chinese
company, listed its shares on the New York Stock Exchange. Now,
they did that despite the fact that the Hong Kong Exchange
wooed them enormously to get them to list their offering there.
The reason they listed in the United States is because we have
the best rules for listing of initial offerings. Not the most
lenient rules, not the most harsh rules, but the best rules.
That should be our objective with regard to swaps trading as
well. We should have the best regulatory regime in the world
with the best protections, with the most clarity and, as
Commissioner Wetjen said, the most flexibility. The same
flexibility that Congress provided for in Title VII.
I believe if we could get our SEF rules right, we could
lead the world in swaps trading, and that will be good for the
United States of America.
In my written testimony, I have put forward several
proposals where Congress can help in the area of our core
principles. The core principles that were in Title VII were
unfortunately lifted directly from the DCM, or Designated
Contract Market, specifications for core principles. With some
slight changes, we could get our core principles to work much
better than they do. Changes in Core Principle 4 to margin of
trading in underlying markets, Core Principle 6 of the SEF
control of position limits, Core Principle 8, emergency
authority for liquidation, and Core Principle 13 for financial
resources. I don't want to take more time; I direct you to my
written testimony for an explanation of those. Thank you very
much.
Mr. Aguilar. Thank you.
Ms. Bowen. I am proud to be a sponsor of the newly formed
Market Risk Advisory Committee. And, frankly, one of our
meetings we had a couple of weeks ago, market structure and
SEFs was one of the primary topics of that day. We have input
from the market, we have input from academics, we have input
from other stakeholders, and that is the kind of feedback that
we need to make sure that we can make the proper decisions. And
we are looking at things such as whether no-name give-up is a
practice. We are looking at things as to whether we should
separate the SRO function from SEFs. And so we are moving in
the right direction, and it is something I can tell you that my
committee that I sponsor will be looking at a lot more closely.
Mr. Aguilar. Thank you, Commissioner.
Thank you, Mr. Chairman.
The Chairman. Thank you. Congressman LaMalfa.
Mr. LaMalfa. Thank you, Mr. Chairman. Welcome,
Commissioners. Thank you for being here today as we sort
through this ongoing subject.
Commissioners, in reference to position limits, as was
touched on earlier, an important quote by former Commissioner
Dunn, he said, ``Position limits are, in my opinion, a sideshow
that has unnecessarily diverted human and fiscal resources away
from actions to prevent another financial crisis.'' To be
clear, no one has proven that the looming specter of excessive
speculation in the futures market re-regulated even exist, let
alone played any role whatsoever in the financial crisis of
2008. Even so, Congress has tasked CFTC with preventing
excessive speculation by imposing position limits. This is the
law. So do any of you on this panel share Commissioner Dunn's
view, and if not, how can we evaluate the effectiveness of any
position limits that would be implemented by CFTC? Do you share
any of those views?
Mr. Wetjen. Congressman, thank you for the question. I
agree with Commissioner Dunn that it is the law that we impose
Federal position limits. I think the best legal and statutory
analysis of Dodd-Frank leads one to that result.
Mr. LaMalfa. He said a whole lot of stuff in the previous
part of the quote that is pretty important too though, even if
they are not----
Mr. Wetjen. Well, okay, if I----
Mr. LaMalfa. If nothing has been proven that, again, the
specter of excessive speculation even exists, let alone played
any role in the crisis of 2008.
Mr. Wetjen. Congressman, here is what I would say about
that. When we proposed the position limits rule in the last
instance, we had a presentation made by the Office of the Chief
Economist, and I don't remember her precise words but basically
what she represented at the open meeting was that there are an
equal number of studies that show that there is a role for
speculation in terms of pricing in the market, and then there
is an equal number of other studies that come to a different
result. So stating that more simply, the studies are a little
inconclusive at the moment, but nevertheless, again, the best
statutory construction leads me to believe that we have a
mandate as an agency to impose the position limits. That is not
to say that we have to impose inflexible position limits that
just aren't workable. Congress gave us a number of different
ways to make sure we have appropriate bona fide hedging
exemptions eligible for the marketplace, for example. So that
is my position. We are legally required to do it, but we need
to impose a sensible and flexible position limits regime.
Mr. LaMalfa. Flexibility is key. We don't want to inhibit
liquidity in the markets.
Commissioner Bowen, I wanted to touch on the data that is
currently being used to design these limits. How current is
that data, and would input from the industry be helpful in
keeping that current or make it more up-to-date? How current is
what you are using----
Ms. Bowen. Right.
Mr. LaMalfa.--in this plan?
Ms. Bowen. The staff has been working quite hard to make
sure that the data that we receive is accurate and that it is
useful. We have the ability to get market surveillance on a
daily basis, and that is critically important to our ability to
make sure that our markets are safe. We have made some great
progress in terms of making sure that the data that we receive
is relevant.
Mr. LaMalfa. How about current though? That was my key
point in the question. How current is that data?
Ms. Bowen. Well, every day we get data. We get reports
every day. And so the data is, frankly, quite current.
Mr. LaMalfa. Now, does industry have a role in helping you
to not only properly vet data but helping you to shape and use
that data as well?
Ms. Bowen. Yes. It will allow us to look at trends that may
be happening in the market. One of the ways and one of the
reasons we have position limits, frankly, is to make sure that
there is no undue concentration by one market participant or
any one particular product. So it is critically important for
us to have that information to protect against excessive
speculation.
Mr. LaMalfa. Thank you. Commissioner Giancarlo, you
mentioned that it is important to have timely data. What if it
is out-of-date, how harmful do you think this is in the
process? I can think out-of-date data being used in other
important aspects like, whether it is military or space travel,
things like that, I mean it could be very important in this
area. What is the effect, do you think?
Mr. Giancarlo. Thank you, Congressman. Three weeks ago we
held a meeting of our Energy Environmental Markets Advisory
Committee at the CFTC, and our keynote speaker was Adam
Sieminski, the Administrator of the U.S. Energy Information
Administration, a Federal Government agency. He, on behalf of
the Federal Government, studies movements in energy prices, and
he said he sees absolutely no evidence of excessive speculation
in the recent fall in energy prices, and yet, the CFTC is using
more than 20 year old data for its estimates of deliverable
supply for liquid natural gas.
Mr. LaMalfa. I need to yield my time, sir. I would like to
follow up with you on that. Twenty year old data, you say?
Mr. Giancarlo. Twenty year old data.
Mr. LaMalfa. Thank you. We will come back to you.
The Chairman. Mrs. Kirkpatrick.
Mrs. Kirkpatrick. Thank you, Mr. Chairman, Mr. Ranking
Member. And, Commissioners, thank you very much for being here
today.
I really appreciate your comments on enforcement because
rules and regulations really don't work unless there is
adequate enforcement. And I will be honest with you, I opposed
Dodd-Frank for that very reason because I didn't think we were
adequately enforcing the rules and regulations we had in place
at the time.
There is a rule 1.35 that requires records of
communications be adequately kept, excuse me. In last year's
bill, we removed that recordkeeping requirement. We know there
has been a recent complaint alleging manipulation of the wheat
market by a commercial end-user. In enforcement, we are always
trying to balance the requirements and the extra burden on the
end-user, and then also the evidence needs to be preserved for
prosecution. My question is, as a former prosecutor, do we need
to revisit Section 353, and if that section goes into law,
would it be more difficult for enforcement of these types of
cases? So that is for the whole panel, I would like to know
each one of your thoughts on that.
Mr. Wetjen. Congresswoman, I appreciate the question.
Mrs. Kirkpatrick. Your microphone sounds like my voice.
Mr. Wetjen. So you referred to the section of the bill
which would change rule 1.35 under our rules as it----
Mrs. Kirkpatrick. Correct.
Mr. Wetjen.--exists today, and we proposed a revision to
rule 1.35 last fall, and so we are in the process of
deliberating internally about how to finalize that rulemaking.
So there are some limits on what I can say, but here is how I
am looking at this issue. There are two key points for me. The
first is, if you are an entity that has not triggered
registration because you are not engaged in the sort of
activities that would require that, or if you have consciously
chosen to change your activities in a way so that you don't
have to register with the CFTC, and you are an end-user, that
is meaningful to me. The second thing that I am looking at very
carefully is, regardless of how we finalize this rule, it
should not be done in a way that unnecessarily or
unintentionally impedes access by an end-user to a particular
marketplace. And so those are the two things that are animating
my thinking as I am engaged in these deliberations.
I think it is really, really important to point out,
Congresswoman, that rule 1.35 is only one recordkeeping
obligation under CFTC rules. We have multiple recordkeeping
obligations under our rules. If you are a member of a futures
exchange or a SEF, you have recordkeeping obligations. And
there are others as well. So, frankly, there has been perhaps
more attention paid to rule 1.35 than is merited in a lot of
respects. I understand the concerns that people have in
complying with it, but it is very, very important for us to
understand that, regardless of the revision of rule 1.35, there
are other recordkeeping obligations that enable the enforcement
division of our agency to perform its mission.
Mrs. Kirkpatrick. Other Commissioners?
Mr. Giancarlo. I will be brief, Congresswoman. Thank you
for the question. I don't think I could express it better than
Commissioner Wetjen just did. There are a lot of balancing
factors that go into this, and I agree with all of those
factors. I would just also add, as a general goal, the new
regulatory framework we have put together with its
shortcomings, which I have mentioned, is nevertheless one we
want to work. We don't want to discourage membership in swap
execution facilities or on registered exchanges. And the impact
of rule 1.35 has been for a number of participants to say,
``Well, then I just won't get involved as a direct member, I
will work through an intermediary.'' What we want to do is
bring more of them on to the platforms, not off.
And the final thing I will say is we have seen a diminution
in the number of futures commission merchants of dramatic
extent over the last several years. We are down to less than
what we had less than 10 years ago. And this is another rule
that FCMs are concerned about in terms of adding to their
costs, adding to their burdens, and not adding to their ability
to survive in the marketplace. So those are two more factors to
add into the balancing here.
Mrs. Kirkpatrick. Ms. Bowen?
Ms. Bowen. Yes, one of the reasons we have devoted so much
time to this rule is because we are trying to seek the right
balance. You are right, we need to make sure that enforcement
has the capability to look back, and that is critically
important to us. At the same time, we want to make sure that we
don't have unintended consequences of making the rules so
onerous that people either flee, or that we have shrinkage in
our markets. We are doing a fairly good job in terms of making
the correct balance. I think we will be out, hopefully quite
soon, on a decision on that.
Mrs. Kirkpatrick. Thank you.
My time has expired. Thank you, Mr. Chairman, for your
indulgence. I yield back.
The Chairman. Mr. Davis.
Mr. Davis. Thank you, Chairman Scott, and thank you to each
of the witnesses for being here today.
Commissioner Giancarlo, how is the swaps market different
than the futures market, and how should those differences be
taken into consideration when drafting rules and regulations
for the swaps market?
Mr. Giancarlo. Thank you for the question. The best way I
can describe it is the swaps market is as different from the
futures market as the bond market is as different from the
stock market. The liquidity characteristics, the way in which
instruments trade are very, very different. If a share of
Microsoft trades an enormous continuous volume from the moment
the Stock Exchange opens in the morning to the moment it
closes, millions, if not tens of millions of trades per minute.
The bond market, on the other hand, trades with much more
episodic trading. Ford Motor Company's Series G 2028 Q5 bond
may trade once a month, and I just made that up, I don't even
know if there is such a bond, but it may trade once a month. It
trades by appointment. Similarly, the swaps market, for the
most part, what you get out of the very center of it, trades by
appointment. And, therefore, trying to use futures instruments
trade just like the Stock Market trade, highly liquid, constant
liquidity. Trying to use futures models to trade swaps products
just won't work. And one of the biggest shortcomings in our
swaps execution transaction protocol is that we assume futures
models, continuous order book electronic models, would work in
swaps, and they are just not working in swaps.
Mr. Davis. Well, in your testimony you suggested ways that
we here in Congress could help improve the SEF regime. Can you
elaborate on those points, and which of these issues may keep
you up at night?
Mr. Giancarlo. Two very different questions. So in terms of
where help can be, it would be in the core principles that I
outlined directly in my testimony.
But I will tell you what keeps me up at night. What keeps
me up at night is that, in our rule-writing, we are writing
rules to prevent the last crisis, and we are creating the
opportunity for a very different crisis. The last crisis was
one of counterparty credit risk, and we are doing everything to
strengthen bank balance sheets, and to cause more capital to be
put aside. But the next crisis, as they always are, will be a
very different crisis, and I worry the next crisis will be a
crisis of market liquidity; that there just won't be
availability of the trading instruments that institutions will
need to survive a crisis in the marketplace. And if you look at
the same rules we are doing now, whether they be the Volcker
Rule, the National Capital Rule, supplemental leverage ratios,
position limits, proposals for transaction taxes, swap trading
rules, all of these things are making liquidity, that means the
ability to fund the other side of a trade much, much harder.
And as we move things into central counterparty clears, into
clearinghouses, I am worried in the event of another crisis
those clearinghouses won't be able to sell instruments in order
to gain the liquidity they need. So I worry, what keeps me up
at night is that we are preparing for the last crisis, and
doing things that are actually going to perhaps, if not cause,
exacerbate the next crisis; a crisis of liquidity.
Mr. Davis. Thank you very much for your response.
Commissioners Bowen and Wetjen, have you reviewed the
Commissioner's white paper, and if so, do you believe that any
of the other recommendations are worth considering?
Mr. Wetjen. Congressman, I have reviewed the white paper
and, as always, a very thoughtful piece of work by Commissioner
Giancarlo, who has been such a great addition to the
Commission.
The Commissioner is right that swaps do trade differently,
but SEFs are different platforms than futures exchanges. There
is tremendous flexibility in a SEF. It is not as flexible as a
completely unregulated trading venue, which is what we saw
before Dodd-Frank was passed, but there is enormous
flexibility. Let me give you an example. Under the SEF rule,
brokers can broker a trade just as they did back in 2008, so
long as it is then sent to the SEF platform, just to see if
there is a better price. And there are certain other limits,
but the point is that by and large, that mode of execution
permitted under the SEF today is very, very similar to how it
has been done for a long, long time.
The Commissioner is right, we have requirements that there
be the offering of an order book, but there is no mandate that
anyone trade on the order book. The rule does not say you must
trade on the order book. It does not. And order books don't
work when there are instruments that don't have a lot of
liquidity, as suggested. It also requires an RFQ that says that
you have to send the request for a quote out to a minimum of
three people. We fussed around on the right number of people
that the quote--or request, rather, should be sent to. We
settled on three. There is no particular magic in that number
either, but the point is that, yes, if you are a SEF, you have
to offer an order book, but no one has to trade there. In fact,
we have seen SEFs that have order books with very limited
trading in the order book. We say yes, you have to offer an
RFQ, but importantly, we allow, or the SEF rule allows,
brokerage of trades so long as they are crossed.
So that offers a number of different ways for execution,
flexible ways for execution, particularly in the case of a
cross, and even an RFQ to some degree.
The other thing that I--as I mentioned in my testimony, the
preamble of our rule says we need to remain open to, and will
consider, other modes of execution. And one of the things we at
the agency need to do a better job on is analyzing those other
methods of execution expeditiously, getting answers back to the
SEFs, giving them some sense of whether they can be allowed or
not. And in the analysis about whether they should be allowed,
again has to reflect these two mandates under the statute;
promoting trading on SEFs, but also promoting pre-trade price
transparency.
Mr. Davis. Thank you. My time has expired.
The Chairman. All right. Mr. Emmer.
Mr. Emmer. Thank you, Mr. Chairman, and the Commissioners
for being here.
Commissioner Giancarlo, we are concerned about the impact
of CFTC Advisory 13-69 on cross-border swap activities. It is
our understanding that this advisory triggers CFTC swap rules
to be applied to transactions between two non-U.S. entities
simply because a person located in the U.S. was used to
arrange, negotiate, or execute the transaction.
Can you clarify for the Committee what it means to arrange,
negotiate, or execute a transaction, and how such activities
can import risk back to the United States?
Mr. Giancarlo. Thank you for that question. I think a lot
of the industry is trying to understand what those three words
mean, and what impact they have on their business operations.
But the context for this is that these swap execution rules,
which I have criticized in my white paper, are meant to apply
under an interpretive guidance that was issued by the
Commission without cost-benefit analysis in the summer of 2013,
are meant to apply to transactions between, effectively, non-
U.S. persons. The staff guidance that you reference says that
they also apply even if the transaction is between non-U.S.
persons, all transaction rules apply if, as you say, a person
in the U.S. arranged, negotiated, or executed the transaction.
Now, I will tell you that staff advisory has now been
delayed four times, so it is not in effect, which the fact that
it needs to be delayed four times tells you a little something
about perhaps the efficacy of that staff advisory. But what to
many people, myself included, it appears to say that if a
transaction is taking place outside of the United States,
entirely between non-U.S. persons, if somebody in the U.S.
helped in that trade, and I will give you an example, let's say
you have a Swiss pension fund looking to buy a credit default
protection against the failure of a U.S. company, say, Ford
Motor Company, but they are trading with a German bank, it is
entirely two European persons, if one of those banks calls a
sales associate in New York who may be the bank specialist in
Ford Motor Company credit, just to say how is Ford looking
these days, what are the ratings on Ford's bonds, are we
comfortable advising this client in Switzerland to buy this
bond from us in Germany, suddenly now this trade, at least
under the advisory, is a U.S. trade and has to be done pursuant
to all of our trade execution rules. What that really means is
nobody is going to turn to that specialist in New York or
Boston or Chicago or Charlotte anymore, and that person has to
worry about whether they are going to have a job next year.
Mr. Emmer. Commissioner Bowen, does the location of the
individual negotiating a trade have a direct and significant
impact on U.S. commerce if the trade occurs between foreign
counterparties in a foreign jurisdiction? Is that a reasonable
approach to cross-border regulation, do you think?
Ms. Bowen. It is one approach, but I think----
Mr. Emmer. No, I was asking if it is a reasonable approach.
Ms. Bowen. I think it is an approach, but I would suggest
that we should follow where the risks actually lie. And so
whether the person is located in New York versus London, in
some respects, may not be indicative as to where the real risk
is. And so we have global markets, the concept of a U.S.
person, frankly, may be irrelevant because transactions will be
taking place in cyberspace. So from my perspective, one of the
reasons we have opened this up to comment is to look at all the
different scenarios. And so that is one approach, but there are
other approaches.
Mr. Emmer. Thank you.
Commissioner Giancarlo, in the short time I have left,
there is concern about the CFTC's position limits rule and the
new requirement that all bona fide hedge exemptions be
evaluated by the Commission rather than by the exchange, as has
typically happened with non-enumerated contracts. Inserting the
Commission formally into this process of granting exemptions
seems like a substantial commitment of new resources. Do you
know how much new data the Commission will have to evaluate for
this process, and how many man hours this will require of the
Commission staff?
Mr. Giancarlo. Thank you for the question. It is one of my
concerns, and as we have talked about earlier about funding of
the agency, this is an area where the agency is taking on
things that could be well done by others. It has been tradition
in the futures industry for the exchanges to operate a system
of position accountability. Under our CFTC current proposal,
they would not be involved in the process; everything would be
done at the CFTC level through a series of hard limits on
positions, not only in the spot month but in the outer month.
The CFTC has also narrowed the bona fide hedge exemptions
from a much more--a longer list that was present before to a
much narrower list with no unenumerated hedges. Specifically,
the CFTC is not going to recognize storage transactions as bona
fide hedges, merchandising and anticipatory hedges, cross-
commodity hedges, and cross versus net hedging. These are all
tools that have been used for a long, long time in the futures
market, but under the CFTC's current proposal would not be bona
fide hedges. That is not in the interest of many end-users of
futures and swaps markets in the marketplace.
Mr. Emmer. Thank you. My time has expired.
The Chairman. The former Chairman of the full Committee,
Mr. Lucas.
Mr. Lucas. Thank you, Mr. Chairman. And I appreciate this
hearing subject matter and our Commissioners being here today.
It is very important.
Commissioner Bowen, I understand that you also have shared
your concerns about regulatory clarity and how important that
is. Let's visit for a moment in regard to cross-border
guidance. As you know, the Commission staff issued a series of
no-action letters, suspending the impact of an unexpected staff
advisory letter which significantly modified the meaning of a
footnote which was buried on the bottom of page 60 of that
cross-border guidance. Let me think about this a minute. A
series of no-action letters designed to suspend an unexpected
staff advisory letter, which pertained to a footnote which was
on the bottom of page 60 of an 80 page guidance. In a recent
speech, you outlined three ways in which regulators can be
unclear, and it seems that this particular example might hit
the trifecta. After all, there was no notice of the proposed
interpretation, the requirements of the interpretation have
continually been delayed, and the significant change hinges
entirely on a staff interpretation of a Commission guidance
document. That is really pretty amazing actually.
Are you concerned, Commissioner, about how the Commission's
cross-border guidance has been implemented?
Ms. Bowen. That footnote has gotten a lot of attention,
that is for sure, but let me say this. Where possible,
obviously, in rulemaking, what the benefit of a notice and
comment period is the way to really regulate, but at the same
time we have tools that we can use as well. Guidance and
interpretations are one of them. And, frankly, when we issue
those, they are typically in response to a market participant
seeking relief, or asking the question does this apply to me or
not. And so it is a tool to allow us to be a lot more flexible,
to respond much more quickly. So the process itself, I support
that we use all the tools that we can be effective and to be
responsive.
Mr. Lucas. But you can understand----
Ms. Bowen. I can't comment on that particular footnote, I
wasn't there at the time.
Mr. Lucas. But you can understand the general principle of
a series of no-action letters sent out to suspend the impact of
an----
Ms. Bowen. Yes.
Mr. Lucas.--unexpected staff advisory letter which
pertained to the meaning of a footnote on page 60 of the 80
page document. You can understand why that might be a little
confusing to both those of us looking over your shoulder and
those trying to understand what you are doing. So I guess my
question becomes this, and I will address this first to you and
then the other Commissioners, what are we doing to try to not
continue in this pattern of doing things this way? How do we
get away from this system and what are we doing? I will start
with you, Commissioner Bowen----
Ms. Bowen. Okay.
Mr. Lucas.--and then, of course, your colleagues if they
would care to comment.
Ms. Bowen. Sure. As I said before, in the best of all
worlds, my preference, obviously, is to do rulemaking through
comment and notice. That is our preference. At the same time, I
would not want to take away the tool of having staff issue
guidance or interpretive releases because they are responsive
to questions that are being asked by the industry. So I would
not take those tools away. I think they are extremely
important. I think they can be used really effectively.
I understand your frustration in terms of that footnote
being buried. We have heard a lot about that footnote.
Mr. Lucas. Because it almost implies that the process with
which--that set off this chain reaction, there is something
wrong with that or we wouldn't have had to have had this
layering effect.
Gentlemen, any comments?
Mr. Giancarlo. Congressman, you have put your finger on it.
The problem with the abuse of the no-action letter process is
it erodes the public's confidence in the agency's undertaking
of its responsibilities, and second, it stymies our ability as
an agency to inculcate a compliance culture in the companies
that we oversee. It really hurts our own reputation and it
makes it harder for us to do our job in terms of the companies
we regulate.
Mr. Lucas. Commissioner?
Mr. Wetjen. Congressman Lucas, it is a great question. I
think one of the ways to avoid the need for unnecessary or
plentiful no-action letters is to be sure there is maximum
consensus in the policymaking in the first instance. That tends
to be a good barometer and a good way of predicting what kinds
of challenges, unexpected or otherwise, you might face or
market participants might face. And usually, that means that if
there is full consensus, it usually means that there has been a
nice fulsome taking into account of the comment file. So that
is one way to do it. But if I could just add one other thing,
Congressman. We need to look at this in its proper context. We
at the CFTC, we are given an enormous task to do. We had to
pass more than 50+ rules to implement Title VII, so it is
inevitable that in a process like that there are going to be
unexpected compliance challenges. And we have been as
responsible as we could be in responding to those, and this no-
action relief is an important tool to use in that regard.
Mr. Lucas. If the Chairman will indulge me for just a
moment. I wholeheartedly agree, Commissioner. The magnitude and
the scope of what was dumped in the lap of the Commission was
far beyond what it should have been, set up in a fashion that
was far more complicated, far more convoluted, and the process
with which some of your predecessors interpreted it only made
it more complicated, from my perspective. But that said, we
cannot allow this way of doing business to become the new norm.
We cannot allow this to be the standard way that we do things
at the Commission. The confusion that it will bring amongst the
participants, the confusion it brings in the market is just
unacceptable. So that is my simple point to you; this cannot
become the new norm, and I worry that that is where we are
headed.
With that, I yield back, Mr. Chairman.
The Chairman. Thank you, Mr. Lucas.
We are going to get our second round of questions now. I am
going to let Mr. Scott go ahead of me.
Mr. David Scott of Georgia. Thank you.
I would like to get into the cross-border issues here
because I have a concern that we need to be very careful as we
deal with our foreign markets, our foreign competitors, that we
not put our financial system, our financial industry, as both
our market participants and our end-users, in a non-competitive
position. Issues like, for example, the push-out rule, which,
to me, to push-out commodity swaps, for example, from the same
bank in which you are doing the interest rate swaps, clearly
puts our end-users as well as our banking system at a
disadvantage. And my whole point that I want to ask on that is
what are these other foreign markets doing? Are they doing the
same thing? The other point I want to ask is how do you all
measure, and in collaboration with the Securities Exchange
Commission, what accounts for a robust regime that has the same
measure and depth of regulation that we have when we go in, and
we are going to allow that to happen? So on position limits, on
the clearinghouse risk, on these issues, I know, Mr. Wetjen,
you have put a lot of time into cross-border, if you could give
us a little clarity on that. And you as well, and, Ms. Bowen,
if you would like to comment on that, particularly on the push-
out rule, I would be appreciative. Yes.
Mr. Wetjen. Ranking Member Scott, thank you for the
question. You had asked what other markets are doing on the
cross-border front, which I understood to mean where are they
with respect to the reform effort. Back in 2009, the G20
convened in Pittsburgh and agreed to a series of reforms as it
relates to derivatives. And there were several key points:
increased transparency through reporting, clearing of liquid
swaps, and then, where appropriate, trading of swaps on
regulated venues. So all the G20 nations agreed to that.
They are in different states of the implementation stage as
you look around the globe. Europe has done a great deal. They
are beginning to impose clearing mandates. I don't think we are
likely to see a trading mandate any time soon. Japan has a
clearing mandate in place. They are expected to have a trading
mandate in place later this year. So there is significant
progress in those two jurisdictions, but as we have discussed
earlier, we still--there is still a lag time between when our
rules went into effect and when theirs are going into effect.
Mr. David Scott of Georgia. Yes.
Mr. Wetjen. And to be fair, there are some differences as
well. So those are all going to have to be managed. That is why
I say in my testimony that the appropriate thing to do is be
sure that during this stage, as the rest of the G20 nations
complete their process, we make sure our institutions in the
U.S. are competitive, and back to the guidance, we took care to
try and be sure that that is the case. And then once the rest
of the nations have completed their task, we can look again and
see how everything compares, how the global marketplace fabric
is fitting together, and decide whether additional policy
makings might----
Mr. David Scott of Georgia. So----
Mr. Wetjen.--take place.
Mr. David Scott of Georgia. So do any of you see where we
are putting our American end-users, our American financial
institutions in any phase of all of the issues of cross-border
in a disadvantaged position with what is going on now? Is there
any area we need to really worry about where we are putting our
financial institutions or end-users, these folks operate all
around the world and I want to see if we are putting them at
any risk. Mr. Giancarlo, you mentioned a little bit about that
when you talked about the energy, the manufacturers, the
farmers. I am very concerned about that. There are a lot of
farmers in Georgia, and manufacturers like Coca-Cola. I mean we
don't want to put them at----
Mr. Giancarlo. Can I take a moment and walk you through? It
is a somewhat complex issue but it does answer your specific
question.
So clearly, one of the premises of Dodd-Frank was that we
would find a way to ring-fence the American markets from
imported risk from abroad. But one of our rules might have the
effect of actually retaining risk within that ring-fence
environment, and disable end-users, farmers, manufacturers'
ability to hedge risk outside of the United States.
Mr. David Scott of Georgia. Yes.
Mr. Giancarlo. And that is in the matter of internal risk
transfer. The charging of an initial margin when an
intermediary between an end-user and an overseas marketplace
for a swap that may reduce the risk, when that intermediary,
whether it is a bank or other financial house, has to charge
initial margin on their own transaction between their U.S.
affiliate and their overseas company. Now, I will give you an
example that will clarify this. Let's say that John Deere, a
tractor manufacturer that employs a lot of workers to build
tractors, also has a plant in, let's say, Japan where they make
steering wheels, for example, and they borrow in the Japanese
currency to build and operate that plant, and yet their cost of
borrowing is in U.S. dollars----
Mr. David Scott of Georgia. Yes.
Mr. Giancarlo.--they have risk of the Japanese interest
rate changing, and that is real risk in this market. They may
seek to hedge that risk in the Japanese marketplace and use a
Japanese financial house, but if that Japanese financial house
has to charge internal margin, the cost has now just gone up to
John Deere, who may have a factory in Ohio, for example.
Mr. David Scott of Georgia. Yes.
Mr. Giancarlo. And what that means is they won't hedge that
Japanese Yen interest rate risk in Japan, they will hedge it in
the United States. That is risk that we are warehousing here
and not taking abroad.
So when we talk about ring-fencing our markets from risk,
as Commissioner Bowen rightly puts it, these are global
marketplaces.
Mr. David Scott of Georgia. Yes.
Mr. Giancarlo. If you ring-fence from outside risk, you are
also keeping internal risk in our own marketplace, and that is
something we have to take account of.
Mr. David Scott of Georgia. Okay. Very well stated. Thank
you, sir.
The Chairman. Mr. LaMalfa.
Mr. LaMalfa. Thank you, Mr. Chairman. I appreciate you
allowing me to go ahead here again with the other Subcommittees
pending right now too.
Following back with Mr. Giancarlo, you were speaking
earlier about timeliness and up-to-date data, and you were
talking about in energy, negative effects, 20 year old data,
was this affecting swaps or swap dealers, please elaborate.
Mr. Giancarlo. Thank you for the question. So one of the
parts of our position limits rules is that the CFTC will
determine what the appropriate limits are based upon what is
called deliverable supply estimates; what is the available
supply of an instrument by which one may hedge in. It is very
important to have up-to-date data. My understanding is the data
we are using for position limits in gold and silver is 30 years
old. It goes back to the 1980s. The data we are using for
liquid natural gas is based on 1990s data.
Now, everyone knows that we have had a complete revolution
in the production of natural gas in the United States in the
last 6 or 7 years.
Mr. LaMalfa. There have been some changes, yes. We have----
Mr. Giancarlo. There have been dramatic changes, and yet we
are still using 20 year old data to determine deliverable
supply.
Mr. LaMalfa. Why is it? Why are we stuck in that?
Mr. Giancarlo. I don't know the answer.
Mr. LaMalfa. How do we fix it?
Mr. Giancarlo. Well, certainly, I and the Commission are
calling for the use of contemporary data to set these
deliverable supply estimates. I don't know how, in a modern
economy, as a world-class regulator that we strive to be, that
we could be using out-of-date data to set deliverable supply
estimates.
Mr. LaMalfa. We look forward to working with you on how to
accomplish that.
Mr. Giancarlo. I would be delighted to keep you apprised of
how that comes along.
Mr. LaMalfa. Thank you.
In my remaining time, Commissioner Bowen, switching gears
here a little bit. The proposed bona fide hedge rules ignore
existing commercial market practices of allowing a market
participant to obtain a hedge exemption in the spot month for
unfixed price purchases and sales on fixed contracts or
legitimate hedging tool for sellers, yet these will no longer
be allowed under the rules. Why is the Commission seeking to
take away this longstanding legitimate hedging tool from
farmers? Does this change your longstanding exemptions meet
your definition of regulatory clarity that was discussed
earlier? So again, why is the Commission looking to take away
this longstanding hedging tool from farmers?
Ms. Bowen. Right. As you know, that is a subject that we
have looked at, or continue to look at, but as you know, it is
important that farmers can use hedging to hedge against
legitimate commercial risk. That is critically important. And
so we don't intend to put obstacles in their way to prevent
effective market risk-taking activity. That is really not the
point. I don't believe that we are managing the process and
receiving comments that would suggest that we would create new
obstacles. That is not what we are doing. We are trying to be
practical----
Mr. LaMalfa. The proposed--again, the proposed rule----
Ms. Bowen. It is a proposed rule, yes.
Mr. LaMalfa. Yes. Well, then the proposed rule hanging out
there is----
Ms. Bowen. Yes.
Mr. LaMalfa.--a concern for people that it would be
implemented and taking away that----
Ms. Bowen. Yes.
Mr. LaMalfa.--existing ability to use these practices. So
what is--I mean how do we----
Ms. Bowen. Yes, I mean----
Mr. LaMalfa.--this proposed rule on the backburner then?
Ms. Bowen. No, what we have done with the proposed rule is
we have opened it up for comments, we are reviewing the
comments that we receive from the industry, and we are making
sure that----
Mr. LaMalfa. How are the comments looking? Pardon my
interruption, but how are the comments----
Ms. Bowen. They are fairly comprehensive.
Mr. LaMalfa.--looking?
Ms. Bowen. We have received hundreds of comments from many
end-users.
Mr. LaMalfa. And are the percentages running heavily one
way or the other on the----
Ms. Bowen. I can't comment on that specifically, but I am
happy to meet with you later on that.
Mr. LaMalfa. All right, please if you could submit a
statement to my office or my staff on that, on how that looks,
because I would imagine it would be pretty overwhelming, given
the feedback we are getting so far on this, that they are not
at all in favor of the proposed rule and that it should likely
be scrapped, or some other angle taken on that.
The follow-up question on that, does this change to the
longstanding exemptions meet your definition of regulatory
clarity that was discussed earlier on? Regulatory clarity, does
this meet that goal? Do we need that?
Ms. Bowen. Well, again, the point in having and receiving
comments from the industry is to make sure we take into account
all viewpoints, and the way to----
Mr. LaMalfa. Well, one of the things you defined earlier is
looking for regulatory clarity.
Ms. Bowen. Correct.
Mr. LaMalfa. Does the industry feel like it has enough
clarity already, or is this something that is entirely being--
--
Ms. Bowen. I think the industry----
Mr. LaMalfa.--brought up----
Ms. Bowen.--is seeking more clarity, sir. I really do. I
think the industry would like for us to give them more clarity,
and that is our job as regulators.
Mr. LaMalfa. But I run into that again and again when
people have longstanding practices they are pretty comfortable
with----
Ms. Bowen. Yes.
Mr. LaMalfa.--and Federal Government comes up with
additional clarity, it actually harms those folks who--we are
talking farming and ranching practices in regards to water,
environment, whatever. Clarity has generally closed doors to
them, and that is what I am hearing here, so please be apprised
of how people are feeling about when clarity gives them less
options. Okay, and we look forward to previous information on
how those comments are going. If you could submit----
Ms. Bowen. Yes.
Mr. LaMalfa.--submit that to my office----
Ms. Bowen. Happy to, sir.
Mr. LaMalfa.--the Committee, with the Chairman's
permission. Thank you.
The Chairman. Mrs. Kirkpatrick.
Mrs. Kirkpatrick. Commissioner Giancarlo, I really
appreciate your comment that we may be too focused on the past
financial crisis and not enough on the future, which you
identify as a crisis in market liquidity. And, Mr. Chairman,
and Ranking Member Scott, I hope you would consider maybe
having a hearing of this Committee specifically on that issue.
But, Commissioner, very briefly, could you just give us a
framework for what you see as that crisis, where that happens
and maybe just a framework of how we could put into place some
safeguards to maybe prevent that?
Mr. Giancarlo. Yes, it is very hard to have a crystal ball
as to what----
Mrs. Kirkpatrick. I appreciate that, but it is something--
--
Mr. Giancarlo. Yes, of course.
Mrs. Kirkpatrick.--we should talk about.
Mr. Giancarlo. What I start from is I look at the measures
that we are putting in place now, and there is sort of a net
impact of these measures. So many of the measures, they are all
banking-driven measures. They are all measures to strengthen
the balance sheets of institutions. And in strengthening
balance sheets, which is a worthy goal, there is no question
about it, what that does is those institutions are not putting
that capital to work, it is sitting on their balance sheet. So
that capital is not in the marketplace to make markets, to
transact at markets, it is not available to end-users and other
market participants to put that capital to work. So let's look
at some of the rules we have put in place. The Volcker Rule,
the Basel Capital Requirements, the supplementary leverage
ratios, these are all capital-constraining provisions. And then
add on top of it our own proposed position limits rule which,
in certain parts of the marketplace, will perhaps take out
participants who would normally be there providing liquidity.
And then there is talk about different swaps trading, or
trading taxes or transaction taxes, whatever the merits of that
proposal would have another liquidity-reducing impact on the
marketplace. And then there is an additional margin on
uncleared swaps. So all of these initiatives all have important
purposes and constituents and momentum behind them, but every
one of them has a liquidity reduction impact to it. And I don't
know what provisions are going into place that have liquidity-
enhancing elements to it. So I do worry that the net impact of
important rulemaking though will be to take liquidity out of
the market. When a crisis comes, that is when everyone pulls
back, and I am worried that, in the face of all these
requirements, the warehouse capital on bank balance sheets,
they will pull back in the event of crisis.
And the last point on this: I was in the markets in 2008
during the financial crisis. It was not a crisis of liquidity.
Even the swaps market was liquid throughout the financial
crisis. Banks were in the market buying and selling, making
liquid markets for market participants. I wonder if in the next
crisis they will remain in that same posture or whether they
will pull back from the marketplace.
Mrs. Kirkpatrick. I really appreciate that. That was
exactly my concern at the time, that we would overreact in a
way that would hurt us in the future.
And any other Commissioners want to address that?
Mr. Wetjen. Congresswoman, it is a great question, and
something I have given some thought to as well. As Commissioner
Giancarlo says, a large result because of prudential
requirements on traditional banking institutions we have seen
some of the retreat from liquidity provision by the same
institutions, whether that is in the previous markets or other
markets as well, including the bond markets. So to me, one of
the solutions has to be how do we open up these marketplaces to
additional different types of non-traditional liquidity
providers. As Chris Giancarlo and I have discussed, there are
risks that come along with that as well because, in a lot of
cases, these non-traditional firms have practices or execution
strategies, or what have you, that they are electronic,
automated, and so consequently carry with them different types
of risks that also have to be managed. We do have a series of
risk controls in place for our exchanges and for our
intermediaries to try and address that. We are looking at other
measures that we might impose on these types of firms so risk
controls are applied to the trading firms themselves. But to
me, that is something, as policymakers, we need to be open to
because there seems to be a lot of consensus behind some of
these additional prudential requirements on traditional banks
who are important liquidity providers. So part of the solution,
it just seems as a matter of logic, has to be, okay, well, how
do we bring in other liquidity providers, non-bank liquidity
providers, and what kind of risks do they pose that are
different from the traditional ones, and how do we manage those
risks.
Mrs. Kirkpatrick. Well, thank you. My time has expired, but
I do hope this is something the Committee will look at.
Thank you, and I yield back.
The Chairman. Yes, ma'am, and I'd like to point out on that
same issue, Chairman Conaway and Ranking Member Peterson have
both sent a letter to the Prudential Regulators expressing some
of the same concerns, and that that is something that the
leadership of the Committee, both Democratic and Republican,
have, and we will be spending a lot of time on that particular
issue and making sure that we get it right.
Commissioner Bowen, this is pretty much for you, but I will
ask the others to follow up as well. It relates to the
Financial Times article on Sunday that indicated that according
to data from the CFTC, the number of registered futures
commission merchants is down significantly to 71 at the end of
February, which is down from 91 a year earlier, and 189 in
2005. It is my understanding that you are the sponsor of the
Market Risk Advisory----
Ms. Bowen. Yes.
The Chairman.--Committee, and my concern is that the
drastic reduction in the number of clearing members could lead
to additional systemic risk, and I would just like for you to
speak to that issue if you would.
Ms. Bowen. Yes. Thank you for that question. And that is an
issue that we are looking at. We are concerned whenever there
is concentration that reduces the number of platforms and
places where end-users can go, so that is something we will
definitely take a look at. I will say though I do think the
current interest rate environment probably contributes somewhat
to the reduction, but we will take a look at other sources as
well. But on your question about concentration of risk as well,
our committee is looking at clearinghouses, and its impact and
its default management regimes, again, as a way to address any
concerns as to whether we are creating more risk. And so I look
forward to looking at both of those issues more in-depth.
The Chairman. Yes. Would each of you speak to that as well,
the loss of members?
Mr. Wetjen. Chairman, that is an issue that I mentioned in
my written testimony: the concerns around FCM concentration.
Commissioner Bowen is right; a lot of the reason why we have
seen some institutions getting out of the clearing brokerage
business is because of the low interest rate environment. There
are limits on what kinds of investments can be made with
customer monies that are taken in by the members, and so again,
with the low interest rate environment, you just aren't getting
the same kinds of returns as you used to see before. And so
that explains to some degree what we have seen in terms of the
retreat by some of these FCMs.
The other reason is, as we discussed before, some of the
additional prudential requirements on these same institutions
have made the business more difficult. So we have to be mindful
of that. As you alluded to, if we have too few a number
clearing members and FCMs, it is going to lead to problems with
respect to accessibility in the marketplace, particularly by
the end-user community.
Mr. Giancarlo. Two points. Briefly, Mr. Chairman, of that
number of 74, so FCMs is probably closer to 50 that are
actually serving farmers, ranchers, and manufacturers. We are
also seeing a concentration of futures commission merchants
with major dealer banks, and less and less smaller FCMs which
are the traditional service providers to smaller end-users. So
this is a real concern.
My fellow Commissioner is absolutely right that the low
interest rate environment hurts their business model, but we
need to be very careful with the regulations that we are piling
on them that those--the cost of complying with regulations is
also not difficult for them.
And I just want to add one other thing. Commissioner Bowen
held an excellent meeting of her sponsored committee, the
Market Risk Advisory Committee, a few weeks ago, in which we
heard from some of these non-traditional liquidity providers
that Commissioner Wetjen mentioned, and that is a real
opportunity. These advisory committees operated at the CFTC are
one of the unique aspects of our agency, and they provide very
valuable input to a lot of the questions that we have been
discussing today. Thank you.
The Chairman. Thank you. Mr. Davis.
Mr. Davis. Thank you, Mr. Chairman. Thanks for allowing us
a second round of questions. Sometimes the 5 minute limit is
not as accommodating as the five-times limit that you guys deal
with.
Commissioner Giancarlo, the Commission recently offered no-
action relief for Southwest Airlines from its hedges in
illiquid markets, and some have questioned the Commission's
rationale for not broadening that relief to any similarly
situated market participant, in effect, requiring a hedger to
come to the CFTC and plead the same case over and over again.
Would you support offering broad relief to any market
participant who is similarly situated in illiquid swaps
markets?
Mr. Giancarlo. Yes, I would. I found that matter to be
quite interesting because it actually illustrates the point I
made earlier in response to your question about how the swaps
market is different than the futures market. As I mentioned,
liquidity in the swaps market is very different. There are a
number of very important market participants, such as Southwest
Airlines, that are engaged in transactions that just can't
settle in a day, 2 days, 3 days, and it may take longer, and
our rules need to be much more open to that. It should not be
an exception to our rule that there are transactions like that.
Our rule framework should accommodate transactions like that.
And market participants shouldn't have to come cap in hand to
the CFTC with a question that says, ``Mother, may I,'' to
engage in a transaction that is just part of their everyday
business of serving their customers. Our rule framework should
allow for that because that is the nature of the swaps market.
It is very different than futures; it is the nature of the
swaps market.
Mr. Davis. Thank you. Commissioner Bowen, do you agree?
Ms. Bowen. I think this is one instance, in fact, where the
response to a request for relief in no-action, which is why it
is critically important that we don't do away with those tools.
To the extent that there may be other participants that are in
the same situation, they should come forward and seek relief.
Mr. Davis. So on an individualized basis?
Ms. Bowen. I think that case is, frankly, quite unique. I
think part of it had to do with whether or not the disclosure
of their hedging strategies, whether that itself would change
the pricing for them.
Mr. Davis. Okay.
Ms. Bowen. But it was quite unique.
Mr. Davis. No other airlines have come and said we want to
see this happen?
Ms. Bowen. Not that I am aware of.
Mr. Davis. Okay. Commissioner Wetjen?
Mr. Wetjen. I do think that you are referring to the relief
on the real-time reporting obligation, and there was relief
given to Southwest Air. I think we should try and deal with
issues like that on more of a broad basis than an
individualized basis, and if there is, in fact, an unintended
effect on liquidity based on reporting, it does stand to reason
that it could be impactful for other market participants as
well. So it does make you wonder, well, does something need to
be addressed in the timing of the reporting of those
particularly long-dated swaps. So it is something we should
revisit.
Mr. Davis. Great.
Mr. Wetjen. And incidentally, Congressman, I expect we will
probably get requests, and you might have that on your mind
when you asked that question, but I wouldn't be surprised if we
get requests from others.
Mr. Davis. Absolutely. Thank you. Thank you for your
response.
Commissioner Giancarlo, Ranking Member Scott asked a
question on requiring margin, and I would like to ask a follow-
up to that. And on internal risk management swaps, does
requiring the margin on internal risk transfer trades improve
the systemic safety of our markets?
Mr. Giancarlo. I know that has been argued, but I don't
honestly appreciate how it does. So the answer is I don't see
how that does improve systemic safety. I think, in fact, if
anything, it probably adds to systemic risk because it causes
risk to be kept within the United States as opposed to allowing
hedgers to hedge risk in markets outside the United States
where they might find greater liquidity. So in the example I
gave of John Deere, if they have to pay more because their
agent they are using in that instance to hedge outside the
United States has to charge internal margin because of CFTC
rules, then that added cost will just have that domestic end-
user, John Deere in my example, say, ``You know what, it is too
expensive to hedge outside, we will hedge inside.'' So the risk
is remaining here, not being exported outward.
Mr. Davis. Thank you. My time has expired.
The Chairman. Mr. Emmer.
Mr. Emmer. Thank you, Chairman Scott.
Commissioner Wetjen, although the reporting rules were the
first set of rules to be finalized, much has been made of the
Commission's difficulty consolidating and analyzing trade data.
Last summer, the Commission solicited comment on potential
improvements to the reporting rules. Can we assume that many of
the comments identified, both problems and suggested solutions,
and what does the Commission plan to do with the information
received through this process, and when will a plan be
implemented?
Mr. Wetjen. Thank you, Congressman. There is going to be
action, there should be action, and the first matter we are
going to address is what to do about trades that begin
bilaterally, but then become cleared, and what are the
different reporting obligations for the bilateral parties in
the first instance, and then for the clearinghouse once it
becomes cleared. So there has been some work on that. There has
been confusion under the existing rules because a lot of times
it appears from the data that the original swap that ultimately
was cleared is still outstanding, and once it is cleared it
becomes novated and so that is no longer the case. So that has
the effect of bringing inaccuracies to the data set, so we need
to address that.
Mr. Emmer. Can you answer my question though about when
will a plan be implemented?
Mr. Wetjen. Well, that is just one particular rule that
will come from the solicitation of comments. When that happens,
the rulemaking identified, when that happens I am not sure. I
have been briefed by the staff at the agency about it, but we
have not seen an actual recommendation. We have seen nothing in
writing. My understanding is that we should see something
relatively soon but I can't say for sure.
Mr. Emmer. Relatively soon. Is that like this month or next
month, or----
Mr. Wetjen. I don't have the answer to that.
Mr. Emmer. All right, thank you.
Commissioner Giancarlo, in your opinion, does the CFTC
currently have the necessary technology to monitor the massive
amounts of new swaps data that flow into the Commission on a
daily basis, and what is the ultimate goal of the Commission
with respect to collecting this type of date?
Mr. Giancarlo. The situation we find ourselves in something
that, out in Silicon Valley and other places where they use
enormous amounts of data, firms like Google and Facebook and
others, they call that big data: the emerging science of how to
analyze enormous amounts of data. Well, as a government agency,
we find ourselves with a big data problem as well, but without
all of those terrific tools and talents and training that they
have out in Silicon Valley.
It is something we are going to have to move much further
in. Dodd-Frank has charged us with enormous responsibility in
terms of gathering data, analyzing data. It is something that
should be broadly supported as a mission. As someone who was in
the markets during the financial crisis, it was clear that
there was not accurate data of which institution had exposure
to which institution, and it is part of the reason why the TARP
Program was as broad as it was, simply because the lack of real
ability to discern the absolute exposures of one institution to
another. We do have to master the big data problem, but that is
a very, very difficult thing to do. Some of the brightest minds
in the world are moving into this new emerging science and we
need to catch up with it.
Mr. Emmer. All right. Commissioner Bowen, that was the
extent of my questions, but I saw you start to lean forward so
I wondered if you had a comment on that same question.
Ms. Bowen. No, I was just going to echo the need for us to
have the capability to be relevant and up-to-date with the
market. And yet again, another reason why we could really use
additional funding.
Mr. Emmer. Thank you. I yield back.
The Chairman. Thank you.
And before we adjourn, I understand that Congressman Scott
may have an additional question, and I would like to recognize
him for that, and as the Ranking Member, allow him to make any
closing remarks that he may have.
Mr. David Scott of Georgia. Thank you, Mr. Chairman. I
thought it would be good for us to ask this question because we
are going to have to put together a new bill for
reauthorization of CFTC. We had a previous bill, H.R. 4413. So
give us your thoughts on how you feel any suggestions,
recommendations, if you have read over any of this, that you
would instruct us as a Committee that we can improve upon this
work. Any thoughts?
Ms. Bowen. I am happy to say that for many of the things
that are in the bill, we as a Commission have already begun to
address those. I think to the extent that we really need
flexibility as regulators, it is really our job to be able to
be responsive to the market, and sometimes it could be
complicated to have things codified that may not give us that
flexibility. So I would urge that you give us as much
flexibility as possible.
Mr. David Scott of Georgia. All right.
Ms. Bowen. As I said in my opening statement, if you could
find a way to impose additional user fees or ways for us to
fund ourselves----
Mr. David Scott of Georgia. Yes.
Ms. Bowen.--that would be greatly appreciated.
Mr. David Scott of Georgia. Good. All right, thank you.
Yes, Mr. Giancarlo?
Mr. Giancarlo. If I could, Ranking Member, I would like to
just suggest five areas where the reauthorization bill could
benefit the industry generally, and the CFTC's work
specifically.
We took action with regard to special entity utilities, the
small, taxpayer-owned utilities, but supporting that in a
reauthorization bill would underline the work we have done at
the Commission level.
Second, I have mentioned improvement in the core principle
for swap execution facilities.
Mr. David Scott of Georgia. You said special----
Mr. Giancarlo. Entity utilities.
Mr. David Scott of Georgia. Entity utilities.
Mr. Giancarlo. Yes, these are the small, taxpayer-owned
electric utilities and others.
Mr. David Scott of Georgia. Okay.
Mr. Giancarlo. The core principles for swap execution
facilities, which I mentioned, I believe the Congress got most
of Title VII quite right at the beginning, but the core
principles were lifted out of the core principles for futures
exchanges----
Mr. David Scott of Georgia. Yes.
Mr. Giancarlo.--and there is some work that needs to be
done there in a few instances, which I have laid out in my
written testimony.
Mr. David Scott of Georgia. Yes.
Mr. Giancarlo. The swap dealer de minimis, as I said
before, I really feel that that level should not be lowered
unless we read, interpret and make a decision based upon the
study that we have already authorized to do----
Mr. David Scott of Georgia. Yes.
Mr. Giancarlo.--and Congressional support for that would be
very helpful.
There is a provision in Dodd-Frank with regard to
indemnifying overseas regulators if they seek information from
our swap data repositories. That has been an irritant between
regulatory relations between ourselves and our European
counterparts for years now, and I know there has been talk
about removing that indemnification language, and I would
highly encourage the Committee to put that in the
reauthorization language. It would help us do our mission at
the CFTC.
Mr. David Scott of Georgia. But to your knowledge, is there
any opposition to removing that? It makes sense. Is there
anybody against that that you know about?
Mr. Giancarlo. I haven't heard of any.
Mr. David Scott of Georgia. Okay.
Mr. Giancarlo. I am not aware of any. I will check with my
staff, and if there is, I will make you aware.
Mr. David Scott of Georgia. Okay.
Mr. Giancarlo. And then finally, the initial margin charged
on those internal risk transfers that I discussed a few moments
ago----
Mr. David Scott of Georgia. Yes.
Mr. Giancarlo.--with the number, that would be an area
where, if we seek to really think about systemic risk, that is
one area where actually the effect of it is to warehouse risk
in the United States, not export it. So I would ask that you
think about that as well.
Mr. David Scott of Georgia. Okay. Mr. Wetjen?
Mr. Wetjen. I agree with Commission Giancarlo. I think the
indemnification provision under Dodd-Frank should be
eliminated. It has created too many difficulties and it just
needs to be changed. I would echo what Commissioner Bowen said
about whatever the Congress does, it is important that it
leaves with the agency sufficient flexibility to adjust to the
changing circumstances. And so any authorities, we need to bear
that in mind and----
Mr. David Scott of Georgia. All right.
Mr. Wetjen.--and that would be helpful and allow us to
continue executing our mission.
Mr. David Scott of Georgia. Thank you. We added
indemnification eliminated, flexibility, funding, special
entity utilities.
Now, last question I want to ask. I want to go back to you,
Ms. Bowen. We have this serious threat now of cybersecurity,
and I know you have sunk your teeth into this. How serious a
threat is it, and is the threat greater, for example,
particularly our critical clearinghouses and exchanges and the
third parties that they have to--how far does the threat go and
what are we doing? It is a big territory out here we have to
cover because there are so many players; the clearinghouses,
exchanges, the companies. How serious is this threat?
Ms. Bowen. I think it is a serious threat, and we can try
to put the best practices and protocols in place, and have
different levels of protection, if you will, so that those that
are most at risk or have the most risky products would have to
have measures in place that are specific to them and additional
ones. The weakest link is what makes us vulnerable. So the
extent that our markets are so interconnected, and to the
extent that our participants rely on third party vendors, there
are different ways that someone could, in fact, wreak havoc to
our system. It is critically important that we allow our
participants to have really robust systems in place, and that
we have the ability as a Commission----
Mr. David Scott of Georgia. Let me just ask----
Ms. Bowen.--to make sure they are doing that.
Mr. David Scott of Georgia.--the Chairman is going to
pull--specifically, how do you judge the protections against
for cybersecurity with the exchanges and the clearinghouses? I
think those are very critical. Are there any variations there
with clearinghouses or the exchanges?
Ms. Bowen. Yes, the types of protections that you want to
have in place should be equally as robust.
Mr. David Scott of Georgia. I know, but are there any alarm
bells that have been----
Ms. Bowen. That have happened so far?
Mr. David Scott of Georgia. Yes. To your knowledge.
Ms. Bowen. Not yet.
Mr. David Scott of Georgia. All right. Let me just end by
saying thank you, Mr. Chairman. It has been another very good
hearing, and it is a joy working with you. And thank you,
Commissioners. I appreciate your testimony.
The Chairman. I too would like to thank you all for being
here and taking the time to advise us, and for the work that
you do. And as I have said, I look forward to a bill that
balances that access and integrity, and moving that piece of
legislation hopefully sooner rather than later. So we will be
working hand in hand with you to get that language correct.
And with that, under the rules of the Committee, the record
of today's hearing will remain open for 10 calendar days to
receive additional material and supplementary written responses
from the witnesses to any questions posed by a Member.
The Subcommittee on Commodity Exchanges, Energy, and Credit
hearing is now adjourned.
[Whereupon, at 12:00 p.m., the Subcommittee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Questions
Response from Hon. Sharon Y. Bowen, Commissioner, Commodity Futures
Trading Commission
Question Submitted by Hon. Randy Neugebauer, a Representative in
Congress from Texas
Question. The CFTC issued proposed rules, which define bona fide
hedging and include a finite list of transactions that would be
considered bona fide hedges under the proposed rule. At a meeting of
the Energy and Environmental Markets Advisory Committee last month,
members of the committee representing the end-user community provided
examples of typical transactions used by their companies to hedge risk
in the ordinary course of business that would not be given bona fide
hedge treatment under the proposed rule. As currently proposed, the
rule would severely restrain hedging in energy markets and result in
risk premiums being added to energy prices and causing consumers to pay
higher prices. No explanation was provided at the EEMAC meeting for
disallowing the transactions to be treated as bona fide hedges.
Commissioners, has any reasonable explanation been identified to
date for not including historically accepted transactions as bona fide
hedges under the proposed rule? What are your plans to follow up and
ensure that the hedging needs of end-users are not severely constrained
and that the final rule addresses speculative activity, as intended,
and not the legitimate hedging activities of end-users?
Answer. Thank you for the question. As you know, the Commission is
currently considering comments received on its proposed position limits
rule following the closure of the most recent comment period. The
Commission has received many comments from commercial end-users with
suggestions for how the rule could be improved, including comments
addressing what types of transactions are covered under the definition
of bona fide hedging. I look forward to carefully reviewing those
comments. Allowing end-users to utilize the markets to hedge is at the
very heart of our futures markets and the Commission needs to preserve
their ability to do that. As the Commission moves forward in its
consideration of this matter, I will carefully consider how the rule
can better facilitate commercial hedging while still guarding against
excessive speculation and market concentration.
Response from Hon. J. Christopher Giancarlo, Commissioner, Commodity
Futures Trading Commission
Question Submitted by Hon. Randy Neugebauer, a Representative in
Congress from Texas
Question. The CFTC issued proposed rules, which define bona fide
hedging and include a finite list of transactions that would be
considered bona fide hedges under the proposed rule. At a meeting of
the Energy and Environmental Markets Advisory Committee last month,
members of the committee representing the end-user community provided
examples of typical transactions used by their companies to hedge risk
in the ordinary course of business that would not be given bona fide
hedge treatment under the proposed rule. As currently proposed, the
rule would severely restrain hedging in energy markets and result in
risk premiums being added to energy prices and causing consumers to pay
higher prices. No explanation was provided at the EEMAC meeting for
disallowing the transactions to be treated as bona fide hedges.
Commissioners, has any reasonable explanation been identified to
date for not including historically accepted transactions as bona fide
hedges under the proposed rule? What are your plans to follow up and
ensure that the hedging needs of end-users are not severely constrained
and that the final rule addresses speculative activity, as intended,
and not the legitimate hedging activities of end-users?
Answer. Chairman Scott and Ranking Member Scott,
I appreciated the opportunity to testify before the Subcommittee on
Commodity Exchanges, Energy, and Credit on April 14, 2015. I was
pleased to share my views on important issues facing the Subcommittee
as it prepares to reauthorize the Commodity Futures Trading Commission
(``CFTC''). Below, I respond to the supplemental questions for the
record from Rep. Neugebauer.
With respect to the first part of Rep. Neugebauer's question,
whether ``any reasonable explanation [has] been identified to date for
not including historically accepted transactions as bona fide hedges
under the proposed rule[,]'' unfortunately, the short answer to this
question is ``NO.'' No reasonable explanation has been identified.
As you know, Congress instructed the CFTC to implement a bona fide
hedging exemption so that hedging positions do not count towards
position limits.\1\ I have repeatedly raised the concern that ``the
effect of the CFTC's [proposed] bona fide hedging framework is to
impose a Federal regulatory edict in place of business judgment in the
course of risk hedging activity by America's commercial enterprises.''
\2\
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\1\ See 7 U.S.C. 6a(c); J. Christopher Giancarlo, Keynote Address
of Commissioner J. Christopher Giancarlo: End Users Were Not Source of
the Financial Crisis: Stop Treating Them Like They Were, (Jan. 26,
2015) (``Keynote''), available at http://www.cftc.gov/PressRoom/
SpeechesTestimony/opagiancarlos-3.
\2\ Keynote.
---------------------------------------------------------------------------
To explore these concerns, I directed the CFTC's Energy and
Environmental Markets Advisory Committee (``EEMAC''), which I sponsor,
to focus on the CFTC's position limits proposal.\3\ The EEMAC devoted
an entire panel at its public hearing on February 26, 2015 to examining
the bona fide hedging portions of the proposal. Market participants
described several ``bread-and-butter'' hedging transactions used in the
energy industry, such as hedging costs for storing and/or transporting
energy commodities as diverse as electricity, natural gas, oil, and
other distillates.\4\ Although bona fide hedging status is--and has
historically been--available for all of the trades involved in these
transactions, the CFTC has proposed to do away with that status and
count these obviously risk reducing trades as speculative activity.\5\
When asked to explain the denial of bona fide hedging treatment for
commonly used hedging transactions, the CFTC staff was not able to
articulate a satisfying explanation.\6\ The staff suggested that an
exemption of this kind could be abused and used for speculative
purposes,\7\ but EEMAC members conclusively rebutted those concerns.\8\
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\3\ Position Limits for Derivatives, 78 Fed. Reg. 75680 (Dec. 12,
2013) (``Proposal'').
\4\ EEMAC Meeting Transcript, 163-79 (Feb. 26, 2015) (``EEMAC
Tr.'').
\5\ Id. at 168-79; 174-79.
\6\ Id.
\7\ Id.
\8\ Id.
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The full answer to Rep. Neugebauer's first question, then, is: No,
the CFTC has not put forward any reasonable explanation for not
including historically accepted transactions as bona fide hedges under
the proposed rule. Secondly, Rep. Neugebauer asked ``[w]hat are your
plans to follow up and ensure that the hedging needs of end-users are
not severely constrained and that the final rule addresses speculative
activity, as intended, and not the legitimate hedging activities of
end-users?'' The first prong of my plan was, as described above, to ask
that the EEMAC examine the issue of bona fide hedging in detail. After
analyzing the evidence adduced at the February 26, 2015 EEMAC meeting
and the subsequently filed comment letters, I have determined that the
CFTC must substantially adjust its approach to bona fide hedging before
I can support a final position limits rule.
As I described in my full written testimony and summarize below,
the evidence presented at the EEMAC meeting and the subsequent comment
letters filed with the CFTC make clear that the CFTC's proposed bona
fide hedging definition is deeply flawed. It is important to remember
that Congress intended that position limits target those who engage in
``excessive speculation,'' while leaving hedgers to their task of
reducing risk in their businesses. The CFTC's proposal unduly focuses
on ``limiting the activity of commercials in hedging in the markets,''
which in turn increases the risk of pricing commodities, the cost of
which ``is ultimately borne by consumers.'' \9\
---------------------------------------------------------------------------
\9\ Id. at 157-58, 183.
---------------------------------------------------------------------------
The clearest and potentially most harmful limitation on the
marketplace is the CFTC's proposal to limit the entire universe of
transactions that can receive bona fide hedging treatment to a limited
number of ``enumerated'' hedges. If a transaction does not fall into
one of these categories, it is not entitled to the bona fide hedging
exemption to position limits, even if the particular position is risk
reducing and is a common, ``bread and butter'' transaction widely used
in the market.\10\ To make matters worse, the CFTC has proposed to
repeal its current system in which market participants can submit
proposed risk reducing transactions that the CFTC in turn reviews on a
timely basis to determine whether such trades can be considered bona
fide hedging transactions.\11\ The repeal of this process will stifle
flexibility and enhancements in risk management, thereby raising prices
and hindering overall energy markets. I cannot accept these proposed
changes, which will have the effect of stifling the innovation and
dynamism that are at the heart of U.S. energy and commodity markets.
---------------------------------------------------------------------------
\10\ Id. at 160-61.
\11\ Id. at 177-78.
---------------------------------------------------------------------------
Let me briefly summarize a few elements of the CFTC's significant
reduction of the bona fide hedging exemption:
1. Storage Transactions
In a reversal from its 2011 proposal, the CFTC no longer recognizes
as bona fide, transactions used to hedge risk from storage,
transmission or generation of commodities. The EEMAC learned that these
transactions form the ``bread and butter'' of energy industry efforts
to hedge risks--and thereby pass along the best possible prices to
consumers.\12\ Although the CFTC once recognized the legitimacy of this
sort of hedge, the new proposal denies bona fide hedge treatment,
apparently because of the fear of abuse in the agricultural sector
where a storage bin could be used for multiple commodities \13\--
soybeans and corn, for example. Yet, the proposed rule does not explain
why this transaction is unavailable in the energy space, where storage,
transmission and generation are obviously not fungible in the same
way.\14\ I recently toured the Valero refinery in Houston. I did not
need to have a degree in chemical engineering to understand that
liquefied natural gas or generated electricity cannot be stored in a
gasoline tank farm. The CFTC rules need to recognize that as well.
---------------------------------------------------------------------------
\12\ Id. at 170-76.
\13\ Id. at 174-75.
\14\ E.g., id. at 178-79.
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2. Merchandising and Anticipatory Hedging
EEMAC members expressed considerable frustration that the CFTC's
proposal does not recognize the importance of merchandising and its
role in connecting the two ends of the value chain: production and
consumption.\15\ Moreover, merchandising promotes market convergence,
an important component of price discovery and market health.\16\ EEMAC
members explained that unfixed price contracts are frequently used in
merchandising transactions and argued forcefully that the CFTC should
re-evaluate its approach to basis contracts.
---------------------------------------------------------------------------
\15\ E.g., id. at 161-62, 190-91, 209.
\16\ E.g., id. at 191.
---------------------------------------------------------------------------
3. Cross-Commodity Hedges
EEMAC members also raised significant concerns with the CFTC's
application of the hedge exemption to cross-commodity hedges. Cross-
commodity hedging, such as hedging jet fuel with ultra-low sulfur
diesel futures contracts, is currently permitted in the spot month and
is critical to the price-discovery process, but would not be permitted
under the position-limits proposal.\17\ Similarly, EEMAC members stated
that the proposed quantitative restriction on cross-commodity hedges
was deeply problematic.\18\ This proposed quantitative restriction
would kill long-used, tried-and-true cross-commodity hedges, including
hedging electricity with natural gas and fuel oil with crude oil.\19\
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\17\ E.g., id. at 115-16.
\18\ E.g., id. at 191, 200-03; see also Proposal, 78 FR at 75717-18
(describing quantitative factor and suggesting it should preclude
electricity-natural gas cross commodity hedging).
\19\ EEMAC Tr. at 200-203.
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4. Gross versus Net Hedging
Finally, EEMAC members raised concerns regarding the CFTC's
proposed approach of permitting hedging only on an enterprise-wide
level. The EEMAC heard evidence that this approach substitutes
regulatory edict for the common-sense business judgments that underlie
existing risk-management procedures and hedging programs.\20\ The risk-
management systems and procedures on which so many hedgers depend were
built in reliance on long-standing CFTC interpretations, which this
proposal changes suddenly and with questionable justification.\21\ In
some cases, the CFTC's proposed approach is in tension with other state
or Federal regulatory requirements with regard to hedging or
reliability.\22\
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\20\ E.g., id. at 158-60, 186-87, 216-18.
\21\ See id.
\22\ Id. at 216-18.
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I am very concerned that the effect of the CFTC's proposed
exclusion of these common exemptions and its narrowed list of remaining
exemptions is to impose a Federal regulatory edict in place of business
judgment in the course of risk-hedging activity by America's commercial
enterprises. The CFTC is primarily a markets regulator, not a
prudential regulator. It has neither the authority nor the technical
expertise to substitute its regulatory dictates for the commercial
judgment of America's business owners and hedgers when it comes to
basic risk management. Instead, the CFTC must allow for greater
flexibility and encourage commercial enterprises to adapt to
developments and advances in hedging practices, not impede their
efforts to do so.
In short, I share Rep. Neugebauer's concerns. In my view, the
Commission and the staff have to think carefully about many aspects of
the proposed bona fide hedge exemption. The CFTC needs to take special
care that in chasing excessive speculation, it does not needlessly add
unnecessary burdens on hedgers, end-users and consumers--the very
participants that Congress intended to protect against excessive
speculation.
I pledge to work closely with my fellow Commissioners, the CFTC
staff, and Members of Congress, particularly on this Committee, to
ensure that the CFTC's position limits rule preserves the ability of
America's commercial enterprises to prudently manage their risks
without needless constraint or added cost.
Hon. J. Christopher Giancarlo, Commissioner, U.S. Commodity Futures
Trading Commission
Response from Hon. Mark P. Wetjen, Commissioner, Commodity Futures
Trading Commission
Question Submitted by Hon. Randy Neugebauer, a Representative in
Congress from Texas
Question. The CFTC issued proposed rules, which define bona fide
hedging and include a finite list of transactions that would be
considered bona fide hedges under the proposed rule. At a meeting of
the Energy and Environmental Markets Advisory Committee last month,
members of the committee representing the end-user community provided
examples of typical transactions used by their companies to hedge risk
in the ordinary course of business that would not be given bona fide
hedge treatment under the proposed rule. As currently proposed, the
rule would severely restrain hedging in energy markets and result in
risk premiums being added to energy prices and causing consumers to pay
higher prices. No explanation was provided at the EEMAC meeting for
disallowing the transactions to be treated as bona fide hedges.
Commissioners, has any reasonable explanation been identified to
date for not including historically accepted transactions as bona fide
hedges under the proposed rule? What are your plans to follow up and
ensure that the hedging needs of end-users are not severely constrained
and that the final rule addresses speculative activity, as intended,
and not the legitimate hedging activities of end-users?
Answer. For decades prior to the Dodd-Frank Act, the Commodity
Exchange Act did not provide a definition for bona fide hedge
positions. Instead, the Commission created a definition of and process
for granting hedge exemptions in rule 1.3(z) of the Commission's
regulations. Under the Dodd-Frank Act, Congress directed the Commission
to define what constitutes a bona fide hedge or position, subject to
certain enumerated criteria. The Commission's proposed rule provided
that bona fide hedge positions do not count towards speculative
position limits and provided a list of enumerated bona fide hedging
positions. The Commission also provided a process to seek relief from
the Commission for risk-reducing practices a person commonly uses in
the market that are not included in the enumerated list.
The proposed rule also explicitly requested comment in a number of
areas. For instance, comments were requested on industry practices
involving the hedging of risks of cash market activities in a physical
commodity that were not enumerated in the list of bona fide hedge
positions; on all aspects of transactions or positions proposed that
were not included in the enumerated list; and on the appropriate
measures to consider an anticipated merchandising transaction as a bona
fide hedging position. In addition, the Commission asked for comment on
whether it should adopt an administrative procedure that would allow
the Commission to more easily add additional enumerated bona fide
hedges.
Recognizing the importance of getting the bona fide hedging
definition right, last year as acting Chairman, I directed the CFTC
staff to hold a public roundtable in order to provide another
opportunity for the Commission to hear from commercial end-users on how
they use derivatives to hedge their risks. The roundtable was helpful
and informative, and separately generated more than 50 comment letters
addressing bona fide hedging and other important aspects of the CFTC's
proposed position limits rule. The Commission has now received hundreds
of comments on the subject of Federal position limits and bona fide
hedge positions, including comments in response to the requests in the
proposal and from the recent meeting of the Energy and Environmental
Markets Advisory Committee. The Commission and its staff are still
considering the comments we have received, including those from the
commercial end-users, farmers, ranchers, and other participants who use
our markets to hedge risk. In finalizing a rule for bona fide hedge
positions and exemptions, we should ensure that we provide the
appropriate flexibility, including the flexibility to hedge legitimate
anticipated business needs. We should also ensure that there is an
efficient process for granting additional bona fide hedge exemptions
where appropriate going forward.
I look forward to continuing to work with Chairman Massad, my
fellow Commissioners, and staff on this issue.
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