[House Hearing, 119 Congress]
[From the U.S. Government Publishing Office]
THE CFTC AT 50: EXAMINING THE PAST AND
FUTURE OF COMMODITY MARKETS
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HEARING
BEFORE THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED NINETEENTH CONGRESS
FIRST SESSION
__________
MARCH 25, 2025
__________
Serial No. 119-3
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]
Printed for the use of the Committee on Agriculture
agriculture.house.gov
__________
U.S. GOVERNMENT PUBLISHING OFFICE
60-761 PDF WASHINGTON : 2025
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COMMITTEE ON AGRICULTURE
GLENN THOMPSON, Pennsylvania, Chairman
FRANK D. LUCAS, Oklahoma ANGIE CRAIG, Minnesota, Ranking
AUSTIN SCOTT, Georgia, Vice Minority Member
Chairman DAVID SCOTT, Georgia
ERIC A. ``RICK'' CRAWFORD, Arkansas JIM COSTA, California
SCOTT DesJARLAIS, Tennessee JAMES P. McGOVERN, Massachusetts
DOUG LaMALFA, California ALMA S. ADAMS, North Carolina
DAVID ROUZER, North Carolina JAHANA HAYES, Connecticut
TRENT KELLY, Mississippi SHONTEL M. BROWN, Ohio, Vice
DON BACON, Nebraska Ranking Minority Member
MIKE BOST, Illinois SHARICE DAVIDS, Kansas
DUSTY JOHNSON, South Dakota ANDREA SALINAS, Oregon
JAMES R. BAIRD, Indiana DONALD G. DAVIS, North Carolina
TRACEY MANN, Kansas JILL N. TOKUDA, Hawaii
RANDY FEENSTRA, Iowa NIKKI BUDZINSKI, Illinois
MARY E. MILLER, Illinois ERIC SORENSEN, Illinois
BARRY MOORE, Alabama GABE VASQUEZ, New Mexico
KAT CAMMACK, Florida JONATHAN L. JACKSON, Illinois
BRAD FINSTAD, Minnesota SHRI THANEDAR, Michigan
JOHN W. ROSE, Tennessee ADAM GRAY, California
RONNY JACKSON, Texas KRISTEN McDONALD RIVET, Michigan
MONICA De La CRUZ, Texas SHOMARI FIGURES, Alabama
ZACHARY NUNN, Iowa EUGENE SIMON VINDMAN, Virginia
DERRICK VAN ORDEN, Wisconsin JOSH RILEY, New York
DAN NEWHOUSE, Washington JOHN W. MANNION, New York
TONY WIED, Wisconsin APRIL McCLAIN DELANEY, Maryland
ROBERT P. BRESNAHAN, Jr., CHELLIE PINGREE, Maine
Pennsylvania SALUD O. CARBAJAL, California
MARK B. MESSMER, Indiana
MARK HARRIS, North Carolina
DAVID J. TAYLOR, Ohio
______
Parish Braden, Staff Director
Brian Sowyrda, Minority Staff Director
(ii)
C O N T E N T S
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Page
Craig, Hon. Angie a Representative in Congress from Minnesota,
opening statement.............................................. 3
Prepared statement........................................... 4
Thompson, Hon. Glenn, a Representative in Congress from
Pennsylvania, opening statement................................ 1
Prepared statement........................................... 2
Witnesses
Carey, Charles ``Charlie'' P., Chairman, Commodity Markets
Council, Chicago, IL........................................... 6
Prepared statement........................................... 7
Sandor, Ph.D., Dr. sc. h. c., Richard L., Chairman and Chief
Executive Officer, Environmental Financial Products, LLC; Aaron
Director Lecturer in Law & Economics, University of Chicago Law
School, Sarasota, FL........................................... 10
Prepared statement........................................... 11
Schryver, Jr., David ``Dave'' G., President and Chief Executive
Officer, American Public Gas Association, Washington, D.C...... 13
Prepared statement........................................... 15
Dow, J.D., De'Ana H., Partner and General Counsel, Capitol
Counsel LLC, Gaithersburg, MD.................................. 16
Prepared statement........................................... 18
Sexton III, J.D., Thomas W., President and Chief Executive
Officer, National Futures Association, Wilmette, IL............ 21
Prepared statement........................................... 22
Giancarlo, Hon. J. Christopher, former Chairman, Commodity
Futures Trading Commission, Haworth, NJ........................ 28
Prepared statement........................................... 30
Submitted article............................................ 77
Submitted report............................................. 79
THE CFTC AT 50: EXAMINING THE PAST AND FUTURE OF COMMODITY MARKETS
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TUESDAY, MARCH 25, 2025
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 10:01 a.m., in Room
1300 of the Longworth House Office Building, Hon. Glenn
Thompson [Chairman of the Committee] presiding.
Members present: Thompson, Lucas, Austin Scott of Georgia,
LaMalfa, Rouzer, Kelly, Bacon, Johnson, Baird, Mann, Feenstra,
Moore, Cammack, Rose, De La Cruz, Nunn, Wied, Messmer, Harris,
Taylor, Craig, David Scott of Georgia, Costa, McGovern, Adams,
Hayes, Brown, Davids of Kansas, Salinas, Davis of North
Carolina, Budzinski, Jackson of Illinois, Thanedar, McDonald
Rivet, Figures, Vindman, Riley, Mannion, and Carbajal.
Staff present: Paul Balzano, Parish Braden, Wick Dudley,
Timothy Fitzgerald, Luke Franklin, John Hendrix, Kyle Upton,
John Konya, Britton Burdick, Kate Fink, Joshua Lobert, Clark
Ogilvie, Ashley Smith, and Jackson Blodgett.
OPENING STATEMENT OF HON. GLENN THOMPSON, A REPRESENTATIVE IN
CONGRESS FROM PENNSYLVANIA
The Chairman. The Committee will come to order. Welcome,
and thank you all for joining today's hearing entitled, The
CFTC at 50: Examining the Past and Future of Commodity Markets.
After brief opening remarks, Members will receive testimony
from our witnesses today, and then the hearing will be open to
questions. So I will take the liberty of providing an opening
statement.
Good morning once again, and welcome to the House Committee
on Agriculture.
Fifty years ago, the Commodity Futures Trading Commission
opened its doors and began operation as the world's first
independent regulatory agency specifically focused on
derivatives. From its early days of safeguarding agriculture
futures markets to today's global swaps markets, the Commission
plays a critical role in adapting to an increasingly
interconnected and dynamic world economy.
Over the decades, well-regulated derivative markets have
been an anchor of stability during periods of tremendous change
from financial crisis and global supply chain disruptions to
technological advancements in market globalization. Today's
hearing is to examine the full arc of the Commission's 50 year
history and to assess its long-term success in meeting the
purposes of the Commodity Exchange Act (Pub. L. 74-675), which
it is chartered to implement.
In a little over 100 words, section 3 of the Act lays out
an ambitious agenda to protect market participants and to
ensure resilient, fair, and dynamic American markets. The first
sentence reads, ``It is the purpose of this Act to serve the
public interest . . . through a system of effective self-
regulation . . . under the oversight of the Commission.'' In
this sentence, Congress established the principle that industry
participants are partners in regulation. As partners, they have
both rights and duties under the Act. This is an extraordinary
feature of our regulatory system. By holding regulated parties
accountable to outcomes and not just compliance checklists,
Congress sought to expand the responsibility for promoting
market integrity.
The purpose continues, laying out the principles of market
integrity and customer protection that are the bedrock of the
Commission's work and essential to a healthy, functioning
marketplace. Section 3 closes with the final purpose of the
Commodity Exchange Act, quote, ``to promote responsible
innovation and fair competition,'' end quotes. This too is a
remarkable charge.
Unique among Federal financial laws, Congress has
unambiguously set out the expectation that new ideas, new
products, and new services should be welcome across derivatives
markets. It articulates the principle that the Commodity
Exchange Act is not intended to be static or to govern static
markets. As we examine the Commission's success over the past
50 years, we should start our inquiry here with the purpose of
the Commodity Exchange Act and consider whether the Commission
is fulfilling that statutory mandate.
Joining us are six expert witnesses whose careers span the
history of the Commission. They were there for the most pivotal
moments in the Commission's history, and their work shaped the
markets that exist today. We are honored to have them with us
today to share their insights into the work of the Commission
and its impact on global derivatives markets.
[The prepared statement of Mr. Thompson follows:]
Prepared Statement of Hon. Glenn Thompson, a Representative in Congress
from Pennsylvania
Good morning and welcome to the House Committee on Agriculture.
Fifty years ago, the Commodity Futures Trading Commission opened
its doors and began operation as the world's first independent
regulatory agency specifically focused on derivatives.
From its early days of safeguarding agricultural futures markets to
today's global swaps markets, the Commission plays a critical role in
adapting to an increasingly interconnected and dynamic world economy.
Over the decades, well-regulated derivatives markets have been an
anchor of stability during periods of tremendous change, from financial
crises and global supply chain disruptions to technological
advancements and market globalization.
Today's hearing is to examine the full arc of the Commission's
fifty-year history and to assess its long-term success in meeting the
purposes of the Commodity Exchange Act which it is chartered to
implement.
In a little over a hundred words, Section Three of the Act lays out
an ambitious agenda to protect market participants and ensure
resilient, fair, and dynamic American markets.
The first sentence reads ``It is the purpose of this Act to serve
the public inter-
est . . . through a system of effective self-regulation . . . under the
oversight of the Commission.'' In this sentence, Congress established
the principle that industry participants are partners in regulation. As
partners, they have both rights and duties under the Act.
This is an extraordinary feature of our regulatory system. By
holding regulated parties accountable to outcomes and not just
compliance checklists, Congress sought to expand the responsibility for
promoting market integrity.
The purpose continues, laying out the principles of market
integrity and customer protection that are the bedrock of the
Commission's work and essential to a healthy functioning marketplace.
Section 3 closes with the final purpose of the Commodity Exchange
Act: ``to promote responsible innovation and fair competition . . .''
This too, is a remarkable charge. Unique among Federal financial laws,
Congress has unambiguously set out the expectation that new ideas, new
products, and new services should be welcomed across derivatives
markets. It articulates the principle that the Commodity Exchange Act
is not intended to be static or to govern static markets.
As we examine the Commission's success over the past 50 years, we
should start our inquiry here, with the purpose of the Commodity
Exchange Act, and consider whether the Commission is fulfilling that
statutory mandate.
Joining us are six expert witnesses whose careers span the history
of the Commission. They were there for the most pivotal moments in the
Commission's history and their work shaped the markets that exist
today. We are honored to have them with us today to share their
insights into the work of the Commission and its impact on global
derivatives markets.
The Chairman. With that, I would now like to welcome the
distinguished Ranking Member, the gentlewoman from Minnesota,
Ms. Craig, for any opening remarks that she would give.
OPENING STATEMENT OF HON. ANGIE CRAIG, A REPRESENTATIVE IN
CONGRESS FROM MINNESOTA
Ms. Craig. Well, thank you, Chairman Thompson, for holding
this incredibly important hearing, not only to look back at the
successful 50 year history of the CFTC, but also to look
forward and see what is potentially ahead for the agency for
the next 50 years.
This Committee, more than most, has historically worked on
a bipartisan basis when it comes to these issues, including
those that impact farmers and ranchers across this country.
That bipartisanship has also traditionally extended to the
Committee's work and oversight of derivatives markets and the
CFTC. Whether it was the 2008 CFTC reauthorization or the
crafting of the derivatives title of the Dodd-Frank Act,
history has shown that this Committee achieves great
legislative outcomes when Republicans and Democrats work
together. And I believe there is potential for more bipartisan
success in this area in this Congress.
We all know that a well-regulated financial system keeps
our country strong and prosperous while protecting Americans
and their livelihoods. For 50 years, the CFTC has been the cop
on the beat in overseeing U.S. derivative markets and making
sure they work, not just for Wall Street, not just for the
exchanges and clearinghouses themselves, but for main street
Americans whose livelihoods are impacted by these markets every
single day.
But to have effective oversight over these markets and
protect the customers who use them takes resources. Last July
at a Subcommittee hearing on reauthorizing the CFTC, we heard
from commercial end-users of these markets about the agency's
stagnant funding and how the agency needs sufficient resources;
otherwise, its ability to ensure the integrity of the more
traditional commodity markets for risk management purposes
would be diminished. If the users of these markets get it, we
should too.
Even in the FIT21 (H.R. 4763, Financial Innovation and
Technology for the 21st Century Act, 118th Congress) bill
passed last year, the House recognized that the CFTC would need
additional resources to implement the bill's new requirements
and provisions. I believe the funding provided by that bill was
a good first step, but if we are going to hand the agency new
responsibilities, we need to find a more permanent solution to
the agency's funding needs.
So I look forward to working with my friends across the
aisle to develop a meaningful, durable plan that provides the
CFTC with the resources that will allow it to bring a strong
history of regulatory achievements to new markets, including
digital assets like crypto.
I want to thank our witnesses for coming in today and for
your testimony. All of you have been either working for or with
us and the CFTC, for years, and I appreciate the perspectives
you bring to the table. But I particularly want to thank Mr.
Schryver for your participation. Your members need these
markets to hedge their risks and obtain price discovery. While
we can acknowledge the need and role speculators can play in
these markets, the truth is, these markets are for your members
and all other commercial end-users. If these markets ever stop
providing utility to the end-users, then they will have truly
become the gambling halls they so often are accused of being.
Again, Mr. Chairman, thank you for holding this hearing,
and with that, I yield back.
[The prepared statement of Ms. Craig follows:]
Prepared Statement of Hon. Angie Craig, a Representative in Congress
from Minnesota
Thank you, Chairman Thompson for holding this very important
hearing not only to look back at the successful 50 year history of the
CFTC, but also to look forward and see what's potentially ahead for the
agency for the next 50 years.
This Committee--more than most--has historically worked on a
bipartisan basis when it comes the issues that impact farmers and
ranchers across the country. That bipartisanship has also traditionally
extended to the Committee's work and oversight of derivatives markets
and the CFTC.
Whether it was the 2008 CFTC Reauthorization or the crafting of the
derivatives title of the Dodd-Frank Act, history has shown that this
Committee achieves great legislative outcomes when Republicans and
Democrats work together, and I believe there is potential for more
bipartisan success in this area in this Congress.
We all know that a well-regulated financial system keeps our
country strong and prosperous while protecting Americans and their
livelihoods. For 50 years, the CFTC has been the cop on the beat in
overseeing U.S. derivative markets and making sure they work, not just
for Wall Street, not just for the exchanges and clearinghouses
themselves, but for main street Americans whose livelihoods are
impacted by these markets every day.
But to have effective oversight over these markets and protect the
customers who use them takes resources. Last July, at a Subcommittee
hearing on reauthorizing the CFTC, we heard from commercial end-users
of these markets about the agency's ``stagnant funding'' and how the
agency needs sufficient resources otherwise its ability to ensure the
integrity of the more traditional commodity markets for risk management
purposes will be diminished. If the users of these markets get it, we
should too.
Even in the FIT21 bill passed last year, the House recognized that
the CFTC would need additional resources to implement the bill's new
requirements and provisions. I believe the funding provided by that
bill was a good first step, but if we are going to hand the agency new
responsibilities, we need to find a more permanent solution to the
agency's funding needs. So, I look forward to working with my friends
across the aisle to develop a meaningful, durable plan that provides
the CFTC with the resources that will allow it to bring its strong
history of regulatory achievement to new markets, including digital
assets like crypto.
I want to thank our witnesses coming in today and for your
testimony. All of you have been either working for or with the CFTC for
many years, and I appreciate the perspectives you bring to the table.
But I particularly want to thank Mr. Schryver for your participation.
Your members need these markets to hedge their risks and obtain price
discovery.
While we can acknowledge the need and role speculators can play in
these markets, the truth is that these markets are for your members and
all other commercial end-users. If these markets ever stop providing
utility to these end-users, then they will have truly become the
gambling halls they are often accused of being.
Again, Mr. Chairman, thank you for holding this hearing, and with
that, I yield back.
The Chairman. I thank the gentlelady.
The chair would request that other Members submit their
opening statements for the record so the witnesses may begin
their testimony and to ensure there is ample time for
questions.
Our witnesses today--and it is an esteemed panel that we
have before us--our first witness today is Charlie Carey, a
lifelong trader, the former Chairman of the Chicago Board of
Trade, and the current Chairman of the Commodity Markets
Council, but perhaps most importantly, Mr. Carey is a member of
the Futures Industry Association's Hall of Fame, recognizing
his many contributions to the futures industry.
Our second witness today is Dr. Richard Sandor, Chairman
and CEO of the Environmental Financial Products, LLC. In
addition to that role, he is also the Aaron Director Lecturer
in Law and Economics at the University of Chicago Law School.
Dr. Sandor is widely recognized as the father of financial
futures and has also been recognized by his peers as a member
of the FIA Hall of Fame for his pioneering work in futures
markets.
Our next witness after that is Dave Schryver, who is the
President and Chief Executive Officer of the American Public
Gas Association. Mr. Schryver's diverse membership represents
some of the most important users of derivatives markets, the
companies that heat our homes and power our economy.
Following that, our next witness will be De'Ana Dow, a
Partner and General Counsel with Capitol Council LLC. Mrs. Dow
has been a trusted counselor to a Commissioner and two Chairmen
at the Commission during a pivotal time. She also served in
executive roles across the industry. She too is a member of the
FIA Hall of Fame.
Our fifth witness today is Thomas Sexton, the President and
Chief Executive Officer of the National Futures Association.
Mr. Sexton has spent over 30 years at NFA, helping to shape
regulatory practices across the industry.
And our sixth and final witness is Christopher Giancarlo.
Mr. Giancarlo is no stranger to this Committee. As the former
Chairman of the Commodity Futures Trading Commission, he has
been an esteemed and passionate voice about the importance of
derivative markets, and we are honored for him to round out our
panel today.
So thank you all for joining us today, and we are now going
to proceed to your testimony. You will each have 5 minutes. The
timer in front of you will count down to zero, at which point
your time has expired. Mr. Carey, please proceed whenever you
are ready.
STATEMENT OF CHARLES ``CHARLIE'' P. CAREY, CHAIRMAN, COMMODITY
MARKETS COUNCIL, CHICAGO, IL
Mr. Carey. Chairman Thompson, Ranking Member Craig, and
Members of the Committee, thank you for inviting me here today
to testify on the history of our markets and our regulatory
structure in the United States.
Is that not working?
The Chairman. Go ahead and pull that microphone just a
little closer. That is all.
Mr. Carey. Okay. A little closer? Okay.
The Chairman. Yes, please.
Mr. Carey. Okay. Thank you. As you said, I am Charlie
Carey. I have been a trader, and I joined the Chicago Board of
Trade in 1978. I am honored to appear here today on behalf of
the Commodity Markets Council.
The Commodity Markets Council, originally the National
Grain Trade Council, was founded over 90 years ago. We are the
trade association that brings agriculture and energy commercial
end-users together with commodity exchanges and clearinghouses.
In my written testimony, I cover some of my personal history,
but today, I want to focus on the function of the derivative
markets and the importance of the CFTC.
Derivatives markets provide for price discovery and risk
management, vitally important functions to our economy, part of
the economic engine, especially today. Given the geopolitical
and economic uncertainty of recent years, risk in price,
weather, interest rate fluctuations, foreign currency, as well
as geopolitics, are examples of exposures that are managed on
U.S. exchanges.
The CFTC has direct oversight of exchanges, clearinghouses,
intermediaries in U.S. markets. U.S. markets are the deepest,
most liquid, efficient derivatives markets in the world. Clear,
transparent, tough, and flexible regulation is a contributor to
the success and of the trust in our markets. Our agricultural
futures contracts serve as global benchmarks for the underlying
commodities, meaning businesses around the world use our
futures to hedge their risk. That is something Congress and
regulators must always be mindful of as global liquidity can
move offshore, and it will always be to our advantage for
global benchmarks to be subject to U.S. oversight and priced in
U.S. dollars.
In 2008 defaults in unregulated off-exchange markets caused
the global financial crisis, whereas the CFTC regulated markets
did not have these problems, and they continue to perform well,
even during this period of historic market stress. The system
of exchanges, clearinghouses, and intermediaries were
resilient, leading Congress to use CFTC regulation as a
framework for previously unregulated swaps markets.
When the CFTC was created, futures markets were primarily
made up of agricultural-based contracts, but Congress and
regulators saw a need for a framework that could handle the
market's desire for new innovative products. The CFTC has a
history of vetting new innovative products, including weather
futures, interest rates, event contracts, and digital assets.
In the face of global competition in the late 1990s, Congress
passed the Commodity Futures Modernization Act of 2000 (Pub.
Law. 106-554, Appendix E), which transformed a prescriptive
regime into a principles-based model. These core principles
allowed the market participants flexibility on how to meet the
requirements, which in turn spurred American innovation. The
principles-based regime also allowed exchanges to self-certify
products, something that has led to continued innovation.
CMC end-user members are agriculture and energy
merchandisers who serve as buyers and risk managers on the raw
commodity side, as well as sellers and risk managers to the
businesses which will ultimately purchase the commodity. End-
users depend on risk management markets to allow farmers to
lock in prices for their crops and attain critical financing.
This allows the farmer to pass that price risk on to the end-
user so they can focus on making next year's planting
decisions.
While most Americans do not see this critical marketplace
and the type of shock absorber it provides for prices, our
markets do allow farmers as well as businesses, both small and
large, to manage and mitigate that risk. From the price of
gasoline we put in our car to the milk we buy at the grocery
store to the electricity or natural gas that powers our homes,
derivatives markets provide price discovery and risk management
to the industry that supplies these goods to us. The end-user,
without these vital tools, would be exposed to upside price
pressure in buying the raw commodity and the producer would
face downside pressure in the event that they had to sell.
In conclusion, I would say the flexible regulatory regime
for derivatives serves as a forward-looking model that has
served our markets well. The CFTC is somewhat unique in
structure because of this flexibility, but this flexibility
benefits our users, and it markets America's global position.
It is important that the markets our farmers use are subject to
rules you as a Committee oversee, and the CFTC knows these
markets best. It is critical we keep these markets in the U.S.
subject to U.S. rules. As we look to the future, I am confident
we will continue to enjoy deep, liquid, and strong derivatives
markets so long as we are allowed to innovate and our
regulation remains right sized. Thank you.
[The prepared statement of Mr. Carey follows:]
Prepared Statement of Charles ``Charlie'' P. Carey, Chairman, Commodity
Markets Council, Chicago, IL
Introduction
Chairman Thompson, Ranking Member Craig, and Members of the
Committee, thank you for inviting me here today to testify on the
history of our markets and our regulatory structure in the United
States.
My name is Charlie Carey, I am from Chicago, IL, and I have been a
trader and market observer most of my life. I was honored to serve as
the Chairman of the Chicago Board of Trade in the mid 2000s until we
merged with the CME Group in 2007. I joined the exchange in 1976, my
grandfather served as Chairman in the 1930s as did my uncle in the mid
1960s. I guess you could say it runs in my blood. I am honored to
appear before the Committee today on behalf of an organization I Chair,
the Commodity Markets Council (CMC).
CMC was founded over 90 years ago and was originally called the
National Grain Trade Council. Today, CMC is the leading Washington
D.C.-based trade association that brings agriculture and energy traders
together with commodity exchanges, and its members including commercial
end-users that utilize futures and swaps markets for agriculture,
energy, metal, and soft commodities as well as designated contract
markets (DCMs), futures commission merchants (FCMs), and swap execution
facilities (SEFs). While its membership has expanded over the years,
its mission has remained the same: CMC advocates for an open,
competitive marketplace by combining the expertise, knowledge, and
resources of our members to develop and support market-based policy.
For decades, we have supported both the principled regulation of and
responsible innovation in derivatives markets, which ultimately serve
as the most robust and resilient risk management markets in the world.
History of Regulation
The CFTC first opened its doors in 1975, which is the same year I
started trading corn. It is hard to believe that was 50 years ago. So,
the CFTC, along with my trading career, are turning 50. The CFTC was
preceded by the Commodity Exchange Administration, which was created in
the mid 1930s to oversee the agricultural futures markets and was part
of the Department of Agriculture. The Commodity Exchange Administration
was preceded by the Grain Futures Commission authorized in the 1920s by
Congress. As far back as the 1880s, Congress considered various pieces
of legislation to regulate, ban, or tax futures trading.
All regulatory authority, prior to the creation of the CFTC, was
limited to futures on contracts listed, or ``enumerated'' in the law.
The statutory update in the mid 1970s gave this new agency jurisdiction
over all futures transactions. As the markets evolved to include
futures on non-agricultural commodities, broader policing of these new
markets began.
Purpose and Function of Derivatives Markets
Derivatives markets are where businesses go to manage risk.
Managing this risk has always been a vitally important aspect of the
commodities world, especially today given the geopolitical and economic
uncertainty the world has experienced in recent years. I serve on the
board of the CME Group, a Chicago-based futures exchange that continues
to break annual volume records almost every year, given the increase in
demand for risk mitigation. Price risk, risks of weather, interest rate
fluctuation, foreign currency risk, as well as geopolitical risks are
examples of exposures that are managed on U.S. exchanges.
Exchanges have a required robust self-regulatory function, and the
CFTC has direct oversight of that function as well as the exchanges,
clearinghouses, and intermediaries in U.S. markets. Our markets are the
deepest, most liquid, efficient derivatives markets in the world.
Clear, transparent, tough, and flexible regulation is a contributor to
the success of our markets.
U.S. derivatives markets are where the world comes for price
discovery and risk management. As examples, our agriculture futures
contracts on corn, soybeans, and wheat serve as global benchmarks for
the underlying commodities, meaning businesses around the world use our
U.S. futures to hedge their risk. That is a distinction we in the U.S.
are proud of, but it is also something Congress and regulators must
always be mindful of, as global liquidity is portable and can move to
other jurisdictions, and it will always be to our advantage for global
benchmarks to be subject to U.S. oversight and priced in U.S. dollars.
Make no mistake, derivatives markets face global competition, and I
believe it is important to the American risk manager, which includes
our U.S. farmers, for these global benchmarks to remain anchored in the
United States. Right-sized regulation and a regulator who understands
the markets are key elements of our competitive position. Since 1975,
the CFTC, under the oversight of this Committee and the Senate
Agriculture Committee, has served a leadership role in ensuring our
markets have the right amount of regulation. They've been tough on
wrongdoers and pragmatic on problem solving and fostering innovation.
While our markets have been resilient over the years, they have
been tested. As I reflect on 50 years of observing our derivatives
markets, I think of the times in that history where market functions
have been stressed. During 9/11 our markets were closed as industry
worked with our regulators and the White House to get the markets back
up and functioning. As historically horrific as that time was, the
partnership between the government and the industry was excellent and
ultimately led to the reopening of these critically important markets
in only a few days.
During the financial crisis in 2008, confidence in the condition of
swaps market counterparties was low. Futures markets and their
clearinghouses served as safe havens for parties seeking risk
management and price discovery. Our markets performed well during that
stressful time in our nation's history. The system of exchanges,
clearinghouses, and intermediaries was resilient, leading Congress to
pass the Dodd-Frank Act, requiring more transaction be put through this
model to reduce systemic risk.
Right-Sized Regulation
In the face of global competition in the late 1990s, Congress had
the vision to pass the Commodity Futures Modernization Act of 2000
(CFMA), which transformed a prescriptive, rule-based regime into a more
modern and flexible core principles model. Simply put, these core
principles allowed the regulated market flexibility in how they met the
required standards, which in turn spurred American innovation. The
CFTC's principles-based regime has, as part of its mission, a mandate
to promote responsible innovation and competition in the marketplace. A
principles-based model is especially effective in the regulation of new
asset classes because it allows the regulator to set out the desired
regulatory outcomes but permits market participants to decide the
products and contract structures they need to manage their risk.
The CFMA also permitted exchanges to self-certify new rules and new
contracts, which led to new ideas going to market much faster than in
the past, allowing exchanges to innovate and compete globally when new
risk management was necessary. This regime remains in place today and
has served the U.S. industry well.
Markets have benefited from the CFTC's approach to regulation and
its long history of taking on the oversight of new and innovative
products. It would be hard to imagine back when CFTC-regulated
exchanges listed only agricultural commodity-based products that these
same exchanges would be listing contracts based on foreign currency,
interest rates, the S&P 500, volatility indexes, and more. The CFTC has
a history of vetting and approving new types of exchanges to trade new,
innovative products, including climate, interest rate, event contracts,
and digital assets.
Role of the End-User
Our CMC end-user members are merchandizers, who serve as buyers and
risk managers on the raw commodity side, as well as sellers and risk
managers to the ultimate businesses which will process or manufacture
the commodity into a finished product to be sold to consumers. These
consumers are the American public that shops at the grocery store and
pays an electric or gas bill. Our members buy grain from farmers at a
flat price, giving the farmer price certainty for their crop, which is
critical for crop financing.
Derivatives markets offer the tools necessary for our members to
offer that flat price to farmers by locking in prices in the future.
This function is not just important to direct users of the markets, but
the broader economy. While most Americans do not tangibly see this
critical marketplace and the shock absorber it provides, it is
nonetheless critical to our businesses and citizens.
From the price of gasoline we put in our car, to the milk we buy at
the grocery store to the electricity or natural gas that powers our
homes, derivatives markets provide price discovery and risk management
to the industry that supplies these goods to us. We may not always like
the ultimate price of the goods we buy, but our markets allow
businesses both small and large to manage volatility, which can be
unpredictable and disruptive if not properly managed. Most of us do not
know how the internet works, but we would be lost without it. The same
analogy holds true for the reliability and price of finished goods and
the role of risk management markets.
The end-user, without these vital tools, would be exposed to upside
price pressure in buying the raw commodity and downside price pressure
in selling the raw commodity to a processor or manufacturer. Without
liquid and reliable markets, the end-user merchandizer would lack
protection from unknown risks, aside from bidding a below-cash-market-
price to the farmer and a higher-than-cash-market price to the
processor.
Liquidity provision is often described as speculation and is also a
key contributor to the success of our markets. When the end-user goes
to the market to hedge a position, there needs to be someone there to
fill that order. Liquidity providers do just that. When I started,
those liquidity providers were standing in the trading pits next to the
end-user hedgers. Now, these markets are overwhelmingly electronic and
many of the liquidity providers are algorithmic. These firms are highly
competitive and sophisticated. Fills today are faster and cheaper per
contract than at any other time in the history of our markets. The role
of the speculator is a necessary part of a healthy derivatives
ecosystem.
Conclusion
The flexible regulatory regime for derivatives we have in the U.S.
serves as a forward-looking model that has served our markets well. The
CFTC is somewhat unique in structure because of this flexibility. In my
view, the agency has embraced the model for the benefit of our industry
and, most importantly, our global position. Innovation has been
observed over the years in these markets.
It is important that the markets our farmers use are subject to
rules you as a Committee oversee. It is critical we keep these markets
in the U.S. subject to U.S. rules. The CFTC knows these markets best.
As we look to the next 50 years, I am confident in a couple of things:
First, I will likely not be around to observe all of them. And second,
we will continue to enjoy deep, liquid, and strong derivatives markets
as long as we are allowed to innovate, and our regulation remains
specialized, focused, and right-sized.
Thank you for the opportunity to share my thoughts today on behalf
of the Commodity Markets Council. I am happy to answer any questions.
The Chairman. Mr. Carey, thank you so much.
Dr. Sandor, please begin when you are ready.
STATEMENT OF RICHARD L. SANDOR, Ph.D., Dr. sc. h. c., CHAIRMAN
AND CHIEF EXECUTIVE OFFICER,
ENVIRONMENTAL FINANCIAL PRODUCTS, LLC; AARON
DIRECTOR LECTURER IN LAW & ECONOMICS, UNIVERSITY OF CHICAGO LAW
SCHOOL, SARASOTA, FL
Dr. Sandor. Chairman Thompson, Ranking Member Craig,
Members of the Committee, my name is Richard Sandor. I am an
economist who invents markets. I get it wrong a lot, and once
in a while I get it right. I joined the Board of Trade in 1972
as Vice President and Chief Economist. In that role, I had the
honor of working on the legislation that created this
Commission, as well as writing the first interest rate futures
contract. In 1973 there were worldwide crop failures, and food
prices hit record levels. We had an Arab oil embargo, anchovies
stopped running off the coast of Peru, and the world exploded.
There was a demand for regulation, and there was concerns that
this inflation was caused by speculation, which led the
Congress to convene and to create this Act.
The Board of Trade at that time, Henry Hall Wilson, its
President, who was in the Johnson and Kennedy White House, was
the President of the exchange and legal counsel was Phil
Johnson. I had the privilege of working with Phil and John
Rainbolt, who was the chief of staff of this Committee, to
ensure that new products, and particularly interest rate
futures, were enabled by the Act.
The second big challenge was to ensure exclusive
jurisdiction, and we worked with Mike McLeod, who was chief of
staff for Herman Talmadge, to create exclusive jurisdiction so
that interest rates would not be fragmented by five or six
different regulatory agencies, banking, securities, et cetera.
The first contract that was introduced was Ginnie Mae
mortgage-backed securities. The markets, I believe, drove down
the cost of housing by $6,000-$10,000 per homeowner,
significantly by allowing hedging and transparency. That was
followed by the long-term Treasury bond after the Treasury
lifted the ceiling on long bonds from 4\1/4\ and started
issuing bonds on a regular basis in 2007. And that was followed
by the 10 year Treasury futures. And the 10 year futures again
were initiated because of the Treasury's continuous round of 10
year securities.
The last product that I worked on was options, which in
1982 were really battled, and there was a lot of hostility
because they had been banned in the 1920s, and people said that
they would distort the markets. Quite to the contrary, they
worked flawlessly. And ultimately, farmers could use puts as
opposed to futures, or grain merchandisers could use them. So
that was a very important regulation.
If we take a look at the issuance last year--and I don't
have to remind this body that we issued $5 trillion of
securities, the interest cost is now the single biggest factor,
and I would say on a back-of-the-envelope basis, that the
introduction of interest rate futures and its widespread use
probably saved $5-$10 billion in interest expense at a minimum,
and that doesn't include Mr. Carey's remarks about serving as a
benchmark, the 10 year, internationally for all sovereign debt
in the world.
This agency gave me my life and my living, and I really
want to thank you all. You have been creative. You have been
ahead of the mark. This was in agriculture, and interest rates
are up to 50 percent. In addition to that, interest rate risk
management is in every MBA program in the world, so you
fostered educational achievement and provided soundness.
I think the best is yet to come. There are thousands of
products that we have not even thought of, and you can do it by
continuing to see this Committee works. Thank you all very
much.
[The prepared statement of Dr. Sandor follows:]
Prepared Statement of Richard L. Sandor, Ph.D., Dr. sc. h. c., Chairman
and Chief Executive Officer, Environmental Financial Products, LLC;
Aaron Director Lecturer in Law & Economics, University of Chicago Law
School, Sarasota, FL
Chairman Thompson, Ranking Member Craig, Members of the Committee,
thank you for the opportunity to testify today. I joined the Chicago
Board of Trade (CBOT) in 1972 as Vice President of Economic Research
and Planning. As the exchange's chief economist, my primary
responsibility was to revise existing futures contracts and develop new
ones in response to evolving economic conditions. I had the opportunity
to help design several features of the legislation that established the
Commodity Futures Trading Commission (CFTC) and concurrently played a
role in the creation of the world's first interest rate futures
contract. I subsequently had the privilege of being the principal
architect for U.S. Treasury futures and options. I appear today to
share my experience with this Committee and to congratulate the CFTC,
and this Committee, for an extraordinary 50 years.
Economic Challenges and Market Response
In 1973, the economic landscape shifted dramatically in the United
States and globally. Grain prices surged due to a confluence of
factors, including reduced U.S. crop yields from delayed spring
planting and early frosts, crop failures in China and Russia, and a
diminished anchovy harvest off the coast of Peru, affecting global
animal feed supplies. Inflationary pressures were further exacerbated
by the Arab oil embargo and the United States' departure from the gold
standard, leading to unprecedented increases in food prices and
interest rates. During this volatile period, the CBOT faced scrutiny.
Rising food costs fueled calls for increased regulation and
restrictions on speculation. The exchange's vital role in hedging and
price discovery was often overlooked. As an aside and contrary to
public perception, speculators were largely short during the price
surge, which helped moderate the increases, while exporters were the
primary longs. Recognizing the inevitability of new regulations, CBOT
leadership took a proactive approach. Rather than opposing legislative
action outright, we worked to shape regulations that would preserve
market functionality while addressing public concerns. This period
provided an opportunity for me to bring to life a financial innovation-
mortgage interest rate futures that had been the focus of my academic
research for 4 years. It was one of the key reasons I joined the
exchange.
Leadership and Legislative Engagement
As the world's oldest and largest futures exchange, the CBOT
spearheaded discussions on regulatory changes, setting the standard for
other exchanges. CBOT President Henry Hall Wilson, supported by
Chairman Fred Uhlmann and board member Les Rosenthal, played a crucial
role in these negotiations. Wilson, a former Congressman and Kennedy
Administration official, brought invaluable legislative experience to
the process. Legal counsel Phil Johnson of Kirkland & Ellis also played
a pivotal role as a trusted advisor and drafter of prototype
legislative language. I worked closely with Mr. Johnson and the House
Agriculture Committee staff, led by John Rainbolt, to draft legislative
language that would facilitate the introduction of financial futures.
As interest rates rose and market volatility increased, the necessity
of hedging mechanisms became evident. A key legislative challenge was
redefining what constituted a futures contract. This Committee and the
staff accomplished that goal. However, redefining eligible contracts
was not enough. Establishing exclusive jurisdiction for the newly
created CFTC was essential to enable financial futures, particularly
contracts based on interest rates and equities. Initially absent from
the House version of the legislation, exclusive jurisdiction was
championed by Senate Agriculture Committee Chairman Herman Talmadge and
his chief of staff, Mike McLeod. They recognized that fragmented
oversight across multiple agencies--the Federal Home Loan Bank Board,
Federal Deposit Insurance Corporation, Federal Savings and Loan
Insurance Corporation, Federal Reserve, and Securities and Exchange
Commission--would be unworkable. Exclusive jurisdiction was crucial,
reinforcing the principle that one cannot serve two masters.
Implementation and Market Impact
The creation of the CFTC in 1975 marked a turning point for
financial innovation. Interest rate and equity futures became feasible.
The first contract approved under the new legislation was the
Government National Mortgage Association (GNMA) mortgage interest rate
futures contract, launched on October 20, 1975. It was an unequivocal
success.
Benefits of the GNMA Mortgage Interest Rate Futures Contract
This contract provided essential benefits, including hedging
against interest rate risk, improved price transparency in the spot
market, and enhanced price discovery for future interest rates. The
designation request was strongly supported by GNMA, the Federal Home
Loan Mortgage Corporation (FHLMC), and other housing market
stakeholders. The contract design embodied a technical concept know as
Cheapest to Deliver (CTD) which became the standard for all subsequent
futures on treasury securities. As interest rates surged from 8% to
16%, a futures market facilitated hedging thereby providing substantial
economic advantages to depositary institutions and contributing to
financial stability. The reduction in the bid/ask spread and some
extrapolation of rate protection costs suggests a saving of $6,000 to
$10,000 on a $260,000 home. This is a conjecture based on the facts at
that time.
Expansion of Financial Futures: 30 Year Treasury Bond Futures
The success of GNMA futures paved the way for further innovations,
including the introduction of 30 year Treasury bond futures in 1977.
Before 1971, the U.S. Treasury had capped long-term bond yields at
4.25%. After lifting this ceiling, the Treasury began issuing long-term
securities with varying maturities, culminating in the regular issuance
of 30 year Treasury bonds in 1977, which provided sufficient supply for
a viable futures market. It was a simple objective with technical
complexities. We modified the cheapest to deliver architecture in the
GNMA futures, creating a nominal 20 year bond term with an 8% coupon.
This contract was launched on August 22, 1977.
Economic Benefits of the 30 Year Treasury Bond Futures Contract
At the time of its launch, the bid/offer spread in the spot market
for 30 year Treasury Bonds was \1/8\ to \1/4\ point for the current
coupon (significantly larger on bonds issued in prior years) while the
futures market adopted a trading increment of \1/32\. This shift in
cash market convention helped reduce the spread from approximately \6/
32\ to \1/32\. In 2024, the U.S. issued $300 billion in 30 year
Treasury bonds. It is easy to infer from the reduction in the bid/offer
spreads combined with hedging benefits that the futures market drove
borrowing costs down significantly.
The Futures Market in 10 Year Treasury Notes
The 10 year Treasury note futures contract, launched on May 3,
1982, continued the innovation by the exchanges and the regulator.
Regular Treasury auctions underscored the need for a futures contract
tailored to this segment of the yield curve. This contract became the
benchmark for U.S. interest rates, influencing mortgages, corporate
bonds, and sovereign debt markets worldwide.
Economic Benefit of the 10 Year Treasury Note Futures
At the time of launch, the bid/offer spread for the 10 year
Treasury note was \4/32\, which narrowed to \1/32\ with the contract's
launch. This \3/32\ reduction equated to one basis point. In 2024 the
U.S. Treasury sold about $500 billion of 10 year notes. That lowered
interest costs by $1.875 billion. Once again, it is easy to infer from
the reduction in the bid/offer spread combined with the hedging
benefits that the futures market reduced borrowing costs significantly.
Reduction in Interest Costs with the 2024 issuance to 30 Year Bonds and
10 Year Notes
The combined issuance to the 30 year Bond and 10 year Note totaled
$800 billion. A back of the envelope analysis suggests that the
benefits of transparency, hedging and price discovery is about $3.75
billion. Adding in all notes and bonds issued in 2024 suggests reduced
interest rate costs of $5 billion and possibly up to $10 billion in
2024. These are conjectures that are grounded in real world experience.
These numbers suggest that further research would be of significant
interest to economists and policy makers. These numbers don't include
the benefits of options on futures.
The First Options on Futures: 30 Year Bond Futures
The introduction of options on 30 year Treasury bond futures on
October 1, 1982, despite initial skepticism, further enhanced interest
rate risk management. The ability to create floors and caps on interest
rates was economically justified in the submission to the CFTC. It was
the same requirement for economic purpose as the GNMAs, 30 year bond
and 10 years Treasury Note. While it is challenging to quantify the
exact economic value of these options, their impact on price discovery
and risk management was undoubtedly significant. The success of these
options led to their adoption in grain markets, providing farmers with
tools to set price floors while retaining upside potential.
Human Capital
In 1975, when the CFTC emerged as an independent regulatory agency
I was encouraged by Donald Jacobs, Dean of the Kellogg School of
Management, Northwestern University to teach the first course ever at a
business school on futures and options. It became a regular part of
their curriculum. Interest rate risk management is now a standard
component of MBA education in the U.S. Our markets are the envy of the
world partly due to human capital and our role as financial innovators.
No doubt this Committee and the CFTC share the credit.
Conclusion
The creation of the CFTC and its regulatory framework laid the
foundation for a dynamic futures industry. These markets have delivered
immense value to borrowers, including the U.S. Treasury,
municipalities, corporations, and households, by providing tools for
managing interest rate risk and promoting financial stability. I
suggest that these three Treasury products alone have delivered a
minimum economic benefit of $5 to $10 billion annually in interest rate
savings by the U.S. Government while enhancing market efficiency and
financial stability. We are the benchmark for sovereign and corporate
debt worldwide.
While past innovations have provided significant benefits, I firmly
believe the best is yet to come. With a strong regulatory framework and
the continuing ingenuity of the exchanges, futures markets will remain
indispensable tools for risk management and economic growth in the
United States. Thank you, and I welcome any questions you may have.
The Chairman. Dr. Sandor, thank you so much, much
appreciated.
Mr. Schryver, please begin when you are ready.
STATEMENT OF DAVID ``DAVE'' G. SCHRYVER, Jr., PRESIDENT AND
CHIEF EXECUTIVE OFFICER, AMERICAN PUBLIC GAS ASSOCIATION,
WASHINGTON, D.C.
Mr. Schryver. Thank you. Chairman Thompson, Ranking Member
Craig, and Members of the Committee, thank you for the
opportunity to testify before you today. I also want to thank
the Committee for holding this hearing, recognizing the 50th
anniversary of the creation of the CFTC.
My name is Dave Schryver, and I am the President and CEO of
the American Public Gas Association, or APGA. The APGA
represents approximately 1,000 communities across the United
States in 38 states that own and operate their retail gas
distribution entities. APGA's members include not-for-profit
gas distribution systems owned by cities and other local
government entities, all directly accountable to the customers
they serve.
Public gas systems focus on safely providing efficient,
reliable, and affordable energy to their customers in the
communities they serve. Today, I want to highlight three key
points: First, how community-owned gas systems engage in the
derivatives market; second, the CFTC's role in protecting APGA
members and others from market manipulation and other market
abuses; and finally, the importance of market transparency to
ensure fair energy pricing.
Community-owned gas utilities use derivatives as a risk
management tool. By engaging in over-the-counter swaps in
futures contracts, our members can lock in prices. This helps
minimize the impacts of sudden price spikes due to extreme
weather or other market disruptions on their customers. Without
these hedging tools, price volatility would have a greater
impact upon consumers, leading to unpredictable energy costs.
Also, when industrial consumers of public gas systems face
higher energy costs, their production costs rise, leading to
higher prices for consumers in the form of more expensive
goods. By contrast, under strong CFTC oversight, markets
function properly and prices remain more stable, reflecting
real supply-and-demand conditions.
The CFTC's oversight ensures our members and others have
fair access to these markets. This allows them to plan
responsibly and help to keep natural gas affordable for the
communities they serve. The CFTC's oversight is critical in
preventing market abuses that can distort natural gas prices.
APGA continues to be a strong supporter of market transparency,
limiting excessive speculation, and providing the CFTC with the
resources it needs to protect consumers.
We have seen the harm caused by instances where large
financial entities manipulate prices and ultimately increase
costs for end-users. Strong CFTC oversight through position
limits, trade monitoring, and adequate enforcement is essential
to keeping markets fair and preventing price swings that hurt
American families.
Transparency is vital to ensuring fair energy prices. The
CFTC has made great strides in improving reporting and
oversight, primarily through their operation as a principles-
based regulator. A transparent market reduces the risk of
manipulation, fosters confidence, and benefits not just public
gas utilities, but the broader economy.
Natural gas is essential to our economy, and millions
depend on it daily. It is critical that the price those
consumers are paying for natural gas comes about not only
through the application of fair and orderly markets, but also
through appropriate market mechanisms that establish a fair and
transparent marketplace. The CFTC plays a critical role in
ensuring the integrity of the derivatives market.
As Congress considers the future of financial market
oversight, we urge continued support for the CFTC's principle-
based mission and its authority to regulate the evolving
derivatives landscape. Derivatives markets are a risk
management tool that APGA members utilize to help provide
affordable energy to their customers and communities. A strong,
well-resourced CFTC is vital for public utilities to continue
to utilize these markets.
Thank you again, and I look forward to your questions.
[The prepared statement of Mr. Schryver follows:]
Prepared Statement of David ``Dave'' G. Schryver, Jr., President and
Chief Executive Officer, American Public Gas Association, Washington,
D.C.
Chairman Thompson, Ranking Member Craig, Members of the Committee,
my name is Dave Schryver, the President and CEO of the American Public
Gas Association (APGA). Thank you for the opportunity to testify before
the Committee.
I am honored to appear today on behalf of the approximately 1,000
communities across the United States that own and operate their retail
gas distribution entities. APGA's members include not-for-profit gas
distribution systems owned by municipalities and other local government
entities, all directly accountable to the citizens they serve. Public
gas systems focus on safely providing efficient, reliable, and
affordable energy to their customers and support their communities by
delivering fuel to be used for cooking, clothes drying, and space and
water heating, as well as for various commercial and industrial
applications, including electricity generation.
APGA's number one priority is the safe and reliable delivery of
affordable natural gas. If we are to fully utilize efficient,
domestically produced natural gas at long-term affordable prices,
natural gas production and transportation must occur at levels that
sufficiently meet demand. However, equally critical is to ensure public
confidence in the pricing of natural gas. This requires a level of
transparency in natural gas markets, which assures consumers that
market prices are a result of fundamental supply and demand forces and
not the result of manipulation or other abusive market conduct.
Community-Owned Gas Utilities' Engagement in the Derivatives Market
Community-owned natural gas utilities utilize the derivatives
market as a risk management tool to protect consumers from volatile
energy prices. As not-for-profit entities, these utilities do not
engage in speculative trading but instead use derivatives to hedge
against unpredictable fluctuations in the natural gas market. The
Commodity Futures Trading Commission's (CFTC) role in regulating these
markets is critical in ensuring APGA members' equitable engagement.
As previously mentioned, the primary goal of public utilities is to
provide stable and affordable gas prices for their customers. To
achieve this, they enter into over-the-counter (OTC) swaps and futures
contracts to lock in prices for future purchases. This helps them to
minimize the impacts on consumers from sudden price spikes caused by
unforeseen market disruptions such as severe weather events.
Without access to these hedging mechanisms, community-owned gas
systems would have fewer options available to them to help minimize the
impacts of costs associated with market volatility on their customers,
leading to unpredictable and potentially unaffordable energy costs. The
ability to manage risk through derivatives is a critical component of
public gas systems' financial strategy and long-term planning.
Community-Owned Gas Utilities' Reliance on the CFTC to Protect Against
Market Manipulation
The CFTC serves as the primary regulatory body overseeing
derivatives markets, ensuring that these markets operate fairly and
free from manipulation. Community-owned utilities rely on the
Commission's oversight and principle-based regulation to prevent market
abuses that could distort natural gas prices and harm consumers.
History has shown that unregulated or under-regulated markets can be
subject to manipulation by large financial entities. Market
manipulation can have severe consequences, artificially inflating
prices and ultimately increasing costs for end-users, including
residential and industrial customers of public gas utilities.
By enforcing position limits, monitoring large trades, and
investigating potential abuses, the CFTC helps to ensure that natural
gas prices are a reflection of true supply and demand realities rather
than speculative excesses. This role is vital in maintaining confidence
in the market and ensuring that community-owned utilities can continue
to use derivatives to help protect consumers from price volatility.
When financial entities engage in market manipulation or other
market abuses, the consequences are felt most acutely by everyday
consumers. Price spikes resulting from speculative trading force
utilities to pass these artificially high prices onto consumers,
leading to higher energy bills. Also, when industrial customers of
public gas systems face higher energy rates, their production costs
rise, leading to higher prices for consumers in the form of more
expensive goods. By contrast, under strong CFTC oversight, markets
function properly and prices remain more stable, reflecting real supply
and demand conditions. The CFTC's ability to detect and deter such
market distortions is critical to maintaining fairness and
affordability in energy pricing.
The Importance of Enhancing Market Transparency
Transparency in the derivatives market is fundamental to
maintaining fair pricing and ensuring that public utilities and
consumers are not subjected to hidden risks. The CFTC's efforts to
increase market transparency are critical in preventing manipulation
and protecting consumers.
The implementation of the CFTC's Large Trader Reporting System and
other transparency measures has provided regulators with better insight
into market dynamics. Ensuring that all significant market participants
are subject to robust reporting and oversight is essential to
preventing another crisis driven by undisclosed, high-risk trading
activities.
APGA member systems support continued improvements in data
collection and reporting that allow regulators to detect irregular
trading patterns before they become systemic threats. In recent years,
the CFTC has made strides in expanding its reporting capabilities.
Transparency benefits not just public utilities but also other end-
users, energy producers, and the broader economy by fostering a more
stable pricing environment.
Conclusion
Natural gas is a lifeblood of our economy and millions of consumers
depend on natural gas every day to meet their daily needs. It is
critical that the price those consumers are paying for natural gas
comes about through the operation of fair and orderly markets and
through appropriate market mechanisms that establish a fair and
transparent marketplace. The CFTC plays an indispensable role in
ensuring the integrity of the derivatives market, ensuring that
community-owned gas utilities--and others--can continue to help protect
consumers from significant price volatility. By preventing market
manipulation and enhancing market transparency through principle-based
regulation, the Commission is uniquely situated to create a fair and
efficient market that benefits all stakeholders.
As Congress considers the future of financial market oversight, we
urge continued support for the CFTC's mission and its authority to
regulate the derivatives landscape. Maintaining a strong, well-
resourced regulator is essential to ensuring that public gas utilities
can continue to provide affordable and reliable energy to the
communities they serve.
Thank you for the opportunity to testify today. I look forward to
answering any questions the Committee may have.
The Chairman. Mr. Schryver, thank you so much for your
testimony.
Ms. Dow, please proceed when you are ready.
STATEMENT OF De'Ana H. DOW, J.D., PARTNER AND GENERAL COUNSEL,
CAPITOL COUNSEL LLC, GAITHERSBURG, MD
Ms. Dow. Thank you. Good morning, Chairman Thompson,
Ranking Member Craig, and esteemed Members of the Committee.
Thank you for the opportunity to testify today. My name is
De'Ana Dow, and I am a Partner and General Counsel at Capitol
Council LLC, where I specialize in advising clients on a wide
range of regulatory and legislative matters related to futures
and derivatives markets. I began my legal career at the CFTC in
1980 in the Division of Trading and Markets. I later served as
counsel to Commissioner Barbara Holum, Chairman Bill Rainer,
and Chairman Jim Newsome, who is here today. After 22 years at
the CFTC, I continued my regulatory work at FINRA and then
served in senior regulatory roles at the New York Mercantile
Exchange and CME Group before moving to a multi-client
platform.
I have been asked to speak today about the Commodity
Futures Modernization Act, a law that brought the most
substantial revisions to the Commodity Exchange Act since the
creation of the CFTC and fundamentally restructured the
regulation of exchange-traded derivatives. The CFMA, among
other things, addressed legal certainty and ensured the
enforceability of over-the-counter swaps, adopted core
principles-based regulation, transforming the CFTC's role in
overseeing futures markets, lifted the ban on single stock
futures and narrow-based stock indices, established direct
regulation of derivatives clearinghouses, and added new
product-based exclusions and exemptions, our focus today on the
CFMA amendments to the CEA that introduced principles-based
regulation and changed the trajectory of the futures and
derivatives industry.
Signed into law in December 2000, the CFMA substituted
flexible core principles for the prescriptive regulations under
the prior law. This flexible principles-based approach promoted
innovation and competition and the growth of more deep and
liquid markets for hedging and price basing by commercial end-
users. The implementing regulations set forth acceptable
practices for compliance with the core principles; a
certification process for new rules, rule amendments, and new
product listings; and shortened time frames for the rule review
process. It is important to note here that these compressed
time frames and certification processes in no way diminished
the effective regulation of these markets.
As a result of the CFMA, U.S. futures markets experienced
exponential growth, successfully competing with derivatives
markets globally on and off exchange. The benefits of the
growth of exchange-traded futures are clear. More regulated and
transparent trading in these economically important markets
ensured market integrity and customer protection. Moreover,
deep and liquid markets provide an accurate price discovery
function and risk-shifting mechanism for commercial hedgers.
The CFMA also fostered innovation and expanded the use of
electronic trading platforms in a space dominated by trading
floors, hand signals, handwritten order tickets and trading
cards with timestamps.
A key goal of the CFMA was to ensure proper regulation and
oversight of futures markets without stifling innovation or
market growth. By right-sizing regulation of these markets, the
CFMA ensured the innovation and competitiveness of U.S. futures
exchanges.
It is important to note that futures markets have performed
well in the midst of crises triggered by geopolitical events,
terrorist attacks, a pandemic, and other severe shocks to the
financial system. In implementing the CFMA, the CFTC created a
robust regulatory program that effectively oversees the futures
markets, protects customers, ensures market integrity, and
enforces anti-fraud and anti-manipulation requirements.
For 50 years, the CFTC has effectively regulated futures
markets, keeping pace with change and adapting regulations to
fit the ever-evolving markets. In those 50 years, the CFTC and
its regulated markets have remained resilient and strong, even
in the face of events that threaten the markets. While the CFMA
helped foster innovation and growth in the exchange-traded and
OTC markets, it is essential to continue adapting regulations
to ensure both market efficiency and financial stability.
With the interconnectedness of markets, both domestic and
global, it is also important to guard against systemic risk.
The CFTC has the unique expertise to oversee futures markets,
trading and clearing, and to enforce anti-fraud and anti-
manipulation in those markets.
Thank you. I am happy to answer any questions.
[The prepared statement of Ms. Dow follows:]
Prepared Statement of De'Ana H. Dow, J.D., Partner and General Counsel,
Capitol Counsel LLC, Gaithersburg, MD
Good morning, Chairman Thompson, Ranking Member Craig, and esteemed
Members of the Committee. Thank you for the opportunity to testify
today. My name is De'Ana Dow, and I am a Partner and General Counsel at
Capitol Counsel LLC, where I specialize in advising clients on a wide
range of regulatory and legislative matters related to futures and
derivatives markets. I began my legal career at the Commodity Futures
Trading Commission (CFTC) in 1980, in the Division of Trading and
Markets. I later served as counsel to Commissioner Barbara Holum,
Chairman Bill Rainer and Chairman Jim Newsome. After 22 years at the
CFTC, I continued my regulatory work at FINRA, then called NASDR,
providing regulatory services to security futures and carbon markets,
and then served in senior legal roles at the New York Mercantile
Exchange and CME Group, before moving to a multi-client platform.
Background
I have been asked to speak today about the Commodity Futures
Modernization Act (CFMA), a law that brought the most substantial
revisions to the Commodity Exchange Act (CEA or Act) since the creation
of the CFTC and fundamentally restructured the regulation of exchange-
traded derivatives. The CFMA, among other things, addressed legal
certainty and ensured the enforceability of over-the-counter swaps,
adopted core principles-based regulation transforming the CFTC's role
in overseeing futures markets, lifted the ban on single-stock futures
and narrow-based stock indices, established direct regulation of
derivatives clearing houses, and added new products-based exclusions
and exemptions.
For purposes of this hearing, I will focus on the CFMA amendments
to the CEA that introduced principles-based regulation and changed the
trajectory of the futures and derivatives industry. Specifically, I
will focus on the core principles of regulatory framework, addressing
why it was adopted, how it works, the significant impact of less
prescriptive regulation on promoting innovation and competition, and
the growth of more deep and liquid markets for hedging and price-
basing.
First, to give credit where credit is due, then-Chairman Bill
Rainer had a vision for a strong regulatory regime that allowed
exchange-traded markets to compete, innovate, and grow. He appointed
Paul Architzel to work with an internal CFTC task force to draft a new
regulatory framework that ultimately became the CFMA. Signed into law
in December 2000, the CFMA revamped the regulation of designated
contract markets by substituting an approach based on flexible core
principles for the prescriptive regulations under the prior law. The
regulations adopted under the CFMA set forth acceptable practices for
compliance with the core principles, a certification process for new
rules, rule amendments, and new product listings, and shortened
timeframes for the rule review process. These were all components of a
new approach to regulating exchange-traded derivatives designed to
foster the growth of deep and liquid markets that are critical for
commercial hedging.
This substantial rewrite of the CEA addressing exchange-traded
derivatives, in part, responded to significant challenges associated
with the ability of regulated markets to compete with the growing over-
the-counter (OTC) swaps markets. Interest rates, foreign currencies,
other financial futures contracts, and energy and agricultural swaps
contracts were trading OTC without regulation, while on-exchange
trading of the same instruments was subject to heavy-handed regulation
that impeded the ability of regulated markets to compete, innovate, and
grow. As a result of the CFMA, U.S. futures markets experienced
exponential growth, successfully competing with derivatives markets
globally, on- and off-exchange. A report authored by CFTC economists in
2008 stated that futures and options open interest quintupled between
2000 and 2008.\1\ Similarly, a Bank for International Settlements
report released in May 2012, found that from 2000 until the end of
2008, the volume of derivatives contracts traded on-exchange globally
grew by 475%.\2\
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\1\ ``Fundamentals, Trader Activity and Derivative Pricing'' by
Bahattin Buyuksahin, Michael S. Haigh, Jeffrey H. Harris, James A.
Overdahl and Michael Robe (December 4, 2008).
\2\ Bank of International Settlements, ``Statistical release: OTC
derivatives statistics at end-December 2011'' (May 2012).
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The benefits of the growth of exchange-traded futures are clear.
More regulated and transparent trading in these economically important
markets ensured market integrity and customer protection. In addition,
deep and liquid markets ensure an accurate price discovery function for
commercial hedgers. Moreover, the CFMA fostered innovation and expanded
the use of electronic trading platforms in a space dominated by trading
floors, hand signals, handwritten order tickets, and trading cards with
timestamps. A key goal of the CFMA was to ensure proper regulation and
oversight of financial markets without stifling innovation or market
growth. By right-sizing regulation of these markets, the CFMA ensured
the U.S. financial markets' competitiveness in global markets and
innovation.
The CFMA--A New Regulatory Framework
The CFMA included criteria for designation as a contract market and
requirements to maintain that designation. In order to list futures
contracts for trading, a market must apply to the Commission to become
a Designated Contract Market (DCM). A market applying for designation
as a contract market must meet specified criteria, including having the
capacity to prevent market manipulation, provide public access to its
rules, regulations and contract specifications, and establish and
enforce rules that: (1) promote fair and equitable trading; (2) govern
market operations; (3) ensure financial integrity of transactions on
the board of trade; (4) implement disciplinary procedures; and (5)
enable the market to obtain any information necessary to perform these
duties.
To maintain designation, a contract market must adhere to 18 core
principles, such as: (1) enforcing compliance with its rules; (2)
listing contracts not readily susceptible to manipulation; (3)
monitoring trading to prevent abuses; (4) providing for the financial
integrity of transactions and protecting customer funds; (5) protecting
participants from abusive practices; (6) establishing proper fitness
standards for directors and those with trading privileges, among other
requirements.
Implementing regulations carefully incorporated the flexible core-
principles approach contemplated by Congress. Express language included
in the CFMA provides, as follows:
``Reasonable Discretion of Contract Markets.--Unless
otherwise determined by the Commission by rule or regulation, a
board of trade . . . shall have reasonable discretion in
establishing the manner in which the board of trade complies
with the core principles described in this subsection.''
(Section 5(d)(1)(B))
In effect, although the CFTC is authorized to issue interpretations
of the core principles, the Act expressly provides that the CFTC's
interpretations are not the exclusive means of complying with the core
principles. This express language effectively removed the Commission's
longstanding prescriptive approach to rulemaking and opened the door
for exchanges to adopt rules, policies, and procedures appropriate for
the markets.
In implementing the statutory provisions, the Commission adopted
Part 38 of its regulations, which set forth 18 core principles
applicable to designated contract markets. It also adopted Appendix B
to Part 38--``Guidance on, and Acceptable Practices in, Compliance with
Core Principles''. These were not prescriptive rules, but guidance on
how a DCM could comply with the core principles. The Commission built
in timeframes for the designation of new exchanges and the review of
new rules and rule amendments, and included a self-certification
process for rules that did not need prior approval. These timeframes
and permission-less rule certifications dramatically reduced the time
to market for new exchanges and new products, and the timeframe for
implementation of new and amended rules.
It is important to note here that these compressed timelines and
certification processes in no way diminished the effectiveness of the
regulatory regime over these markets. In the CFTC's 50 year history, no
futures exchange or clearing house has failed due to market forces in a
way that left customers and intermediaries with losses. Moreover, the
markets have performed well in the midst of market events and crises
triggered by geopolitical events, terrorist attacks, a pandemic, and
other severe shocks to the financial system.
Also noteworthy, the principles-based regulation resulted in
greater market liquidity. Deep and liquid markets are essential for
commercial end-users seeking to manage the risk of changes in commodity
prices and determine the best price for a commodity. The interplay of
buyers and sellers in an open and competitive market quickly
establishes what a commodity is worth at any given moment. Hedging and
price basing are the overarching purposes of futures markets, and the
more liquid they are, the more effective.
Here is a high-level overview of how the self-certification process
works for new product listings. Under CFTC regulation 40.2, listing new
products for trading by certification permits listing without prior
approval if it complies with certain conditions, including a
certification that the product listed complies with the CEA and
Commission regulations. The submission must include an explanation and
analysis of the product and its compliance with core principles and the
Commission's regulations thereunder. The submission must be received by
the Commission by the open of business on the business day preceding
the product's listing. Relative to this process, the Commission may
request additional information from the registered entity that
demonstrates that the contract meets the requirements of the CEA, or
the Commission's regulations. Part (40.2(b)). In addition, the
Commission may stay the listing of a contract during the pendency of
Commission proceedings for filing a false certification or during the
pendency of the proceeding to alter or amend the contract terms or
conditions under Section 8a(7) of the Act. (Part 40.2(c)).
With respect to rule certifications, regulation 40.6 requires,
among other things, that the submission include a certification that
the rule complies with the Act and Commission regulations, and an
explanation and analysis of the operation, purpose and effect of the
proposed rule or amendment and its compliance with applicable
provisions of the Act and regulations. The Commission must receive the
submission no later than the open of business on the business day 10
business days prior to the registered entity's implementation of the
rule amendment. The Commission has a 10 day window to review the new
rule or rule amendment before it is deemed certified and can be made
effective unless the Commission notifies the registered entity during
the 10 day review period that it intends to issue a stay of the
certification. The grounds for a Commission stay of a rule
certification are: (1) the rule or rule amendment presents novel or
complex issues that require additional time to analyze; and (2) the
rule or rule amendment was accompanied by an inadequate explanation and
is potentially inconsistent with the Act or Commission regulations. The
Commission would then have an additional 90 days from the date of the
notification to conduct the review. (Part 40.6(c)).
Registered entities can continue to seek prior review and approval
of new products and rules by voluntarily submitting them to the
Commission. The timeframe for review and approval of new products,
rules, and rule amendments is 45 days. The Commission is required to
approve the new product unless its terms and conditions violate the Act
or Commission regulations. Likewise, the Commission must approve the
new rule or rule amendment unless it is inconsistent with the Act.
The flexible core principles regime, a cornerstone of the CFMA,
coupled with the reasonable timelines for Commission action on pending
products and rules have worked extremely well for the industry and the
Commission. This explanation of the self-certification process and
review process is intended to give you a picture of a robust regulatory
program that effectively oversees the futures markets, protects
customers, ensures market integrity, and enforces anti-fraud and anti-
manipulation requirements. It should be noted that there is frequent
open and constructive dialogue between the regulators and registered
entities seeking to list new products and implement new or amended
rules. This regulatory framework is tried and proven and should be
preserved.
In addition to streamlining the regulatory process and ushering in
a flexible, core principles-based approach to regulation, the CFMA
revamped the regulations with a focus on the commodity being traded.
For the first time, the Commission would differentiate between classes
of commodities, abandoning the historical approach of regulating all
commodities the same. Under the CFMA, three different classes of
commodities emerged: agricultural commodities, energy and precious
metals commodities, and financial commodities. The core principles for
each class flowed from addressing the regulatory requirements needed
based on the type of commodity traded. In addition, physical delivery
contracts would be treated differently from cash-settled contracts.
This approach has worked well to ensure appropriate commodities-focused
regulation.
The CFMA also established a regulatory framework for clearing
organizations, giving the CFTC clear jurisdiction over Derivatives
Clearing Organizations (DCOs), which previously had been regulated only
through the clearing house's relationship with the futures exchange to
which it was attached. The law required futures contracts and options
on futures contracts to be cleared by a DCO and required the DCO to be
registered with the Commission. To become and remain a DCO, an entity
must demonstrate compliance with specified core principles designed to
ensure the financial integrity of the DCO. There currently are 19
registered DCOs.
Conclusion
For 50 years, the CFTC has effectively regulated futures markets,
keeping pace with change and adapting regulations to fit the ever-
evolving markets. In those 50 years, the CFTC and its regulated markets
have remained resilient and strong even in the face of events that
threatened the markets. While the CFMA helped foster innovation and
growth in the exchange-traded and OTC markets, it is essential to
continue adapting regulations to ensure both market efficiency and
financial stability. With the interconnectedness of markets, both
domestic and global, it is also important to guard against systemic
risk. The CFTC has the unique expertise to oversee futures markets
trading and clearing and to enforce anti-fraud and anti-manipulation in
those markets.
The Chairman. Mrs. Dow, thank you so much, much
appreciated.
And now, Mr. Sexton, please begin when you are ready.
STATEMENT OF THOMAS W. SEXTON III, J.D., PRESIDENT AND CHIEF
EXECUTIVE OFFICER, NATIONAL FUTURES
ASSOCIATION, WILMETTE, IL
Mr. Sexton. Thank you. Chairman Thompson, Ranking Member
Craig, and Members of the Committee, thank you for the
opportunity to testify on the important topic of the CFTC's
past and future at 50 years.
NFA is the industry-wide independent self-regulatory
organization for the derivatives industry and is a registered
futures association, referred to as an RFA, pursuant to section
17 of the Commodity Exchange Act. NFA is solely a regulatory
body. We do not operate a market, and we are not an industry
trade association.
Over 50 years ago, Congress passed legislation, the
Commodity Futures Trading Commission Act of 1974 (Pub. L. 93-
463), which amended the Commodity Exchange Act to establish the
regulatory framework for the derivatives industry. This
framework remains in place today and has adapted to changing
and innovative products and markets, which have experienced
extraordinary growth over the years.
Of significant import, this legislation established the
CFTC and authorized RFAs to augment the CFTC's oversight. NFA
is the sole RFA. In creating this structure, Congress did not
place the important roles played by the CFTC and independent
SROs at odds with each other, but rather sought to weave them
into an integrated regulatory fabric. The CFTC's original
mandate was limited to oversight of the commodity futures
markets, and its responsibilities have grown significantly over
the years. As the CFTC's responsibilities grew Congress and the
CFTC entrusted NFA with additional oversight responsibilities
as well.
The CFTC's responsibilities are enormous, and its core
principles regulatory approach has allowed it to adopt
practical and sound regulations that safeguard the integrity of
the markets and allow for growth and innovation. Over the
years, the CFTC's Chairmen, including the two with us today,
former Chairman Giancarlo and Newsome, and its Commissioners
have been outstanding leaders, and the CFTC has a professional,
talented, and expert staff to advance its mission. NFA and the
derivatives industry, including farmers, ranchers, and
producers, are extremely well served by having the CFTC, an
agency which is laser focused on supporting, strengthening, and
safeguarding the derivatives markets.
NFA began operations on October 1, 1982. We partnered with
the CFTC and have a clearly defined mission, safeguard the
integrity of the derivatives markets, protect investors, and
ensure that NFA members meet their regulatory responsibilities.
We perform seven primary functions, registration, rulemaking,
monitoring members, rule enforcement, market regulation,
investor protection and education, and dispute resolution.
NFA's performance of these functions allows the CFTC to
allocate its resources effectively and efficiently.
NFA is subject to broad CFTC oversight. The CFTC closely
reviews and monitors NFA's activities to ensure that we fulfill
our regulatory responsibilities. The results of our partnership
with the CFTC can be demonstrated in at least two ways. First,
our work with them to detect and combat fraud. My written
testimony highlights how NFA has worked with the CFTC over the
years to address significant customer protection abuses
associated with south Florida boiler rooms that sold out-of-
the-money options, retail forex, and the misappropriation of
customer segregated funds. Second, we have partnered with the
CFTC to develop sound and innovative regulatory programs,
including to oversee swap dealers post-Dodd-Frank and our
member firms engaged in spot digital asset commodity
activities.
The CFTC's success over the past 50 years is due to its
ability to identify new risks, adopt new approaches, and allow
for innovation. The CFTC's success in the future will
necessitate the same adeptness. In recognition of the CFTC's
important mission, proven track record of success, and
potential expansion of responsibility to oversee spot digital
asset commodities, NFA believes Congress should once again
consider reauthorizing the CFTC. I would also like to reaffirm
NFA's willingness to assist the CFTC in regulating the spot
digital asset commodity market if Congress moves forward with
legislation in this area.
Fifty years after the Commodity Futures Trading Commission
Act of 1974, we can certainly say that self-regulation,
combined with the CFTC's regulatory oversight, has been a
successful and effective framework for the derivatives
industry. This framework has withstood the test of time, and we
anticipate, as markets continue to innovate and the CFTC and
NFA's responsibilities potentially grow, this regulatory
partnership will continue to flourish.
In conclusion, I am honored to appear before you today to
commemorate this very important milestone, the CFTC's 50th
anniversary. The CFTC and NFA have been strong and effective
regulatory partners, and I look forward to our future together.
I am happy to take any questions.
[The prepared statement of Mr. Sexton follows:]
Prepared Statement of Thomas W. Sexton III, J.D., President and Chief
Executive Officer, National Futures Association, Wilmette, IL
Chairman Thompson, Ranking Member Craig, and Members of the
Committee, thank you for the opportunity to testify at this hearing on
the important topic of the Commodity Futures Trading Commission's (CFTC
or Commission) past and future at 50 years. My name is Thomas W.
Sexton, and I am the President and CEO of National Futures Association
(NFA). NFA is the industry-wide independent self-regulatory
organization (SRO) for the derivatives industry and is a registered
futures association (RFA) pursuant to Section 17 of the Commodity
Exchange Act (CEA). NFA is solely a regulatory body. We do not operate
a market, and we are not an industry trade association. NFA is funded
by the derivatives industry.
Our principal objective is to partner with and help the CFTC
regulate the derivatives markets and, in doing so, we are committed to
protecting customers and counterparties. The CFTC's original mandate
was limited to oversight of the commodity futures markets, but its
responsibilities have grown significantly over time. In response to
fraud in the sale of foreign currencies (forex) to retail customers,
Congress in 2008 clarified the CFTC's anti-fraud jurisdiction in this
area and expanded its authority to adopt rules for these transactions.
In 2010, Congress passed the Dodd-Frank Act (DFA) that gave the CFTC
oversight of the previously unregulated swaps market. In doing so,
Congress and the CFTC entrusted NFA with additional oversight
responsibilities for these markets' participants.
Our global membership includes CFTC registered futures commission
merchants (FCMs), swap dealers (SDs), commodity pool operators (CPOs),
commodity trading advisors (CTAs), introducing brokers (IBs), retail
foreign exchange dealers (RFEDs) and associated persons of these
entities. We currently have approximately 2,850 NFA Member firms and
38,000 individual Associate Members. The CFTC requires these registered
firms to be NFA Members. Without mandatory membership, those firms
least likely to comply with NFA's rules would elect not to join NFA or
would relinquish their NFA membership if they did not want to follow a
rule or were being disciplined for failing to follow NFA's rules.
Over fifty years ago, in October 1974, Congress amended the CEA by
passing the Commodity Futures Trading Commission Act of 1974 (1974
Act), which President Ford signed into law. The 1974 Act is remarkable
legislation that established the regulatory framework for the
derivatives industry that remains in place to this day. This structure
has adapted to changing and innovative products and markets, which have
experienced extraordinary growth over the years.
Of significant import, the 1974 Act established the CFTC, which
began operations on April 21, 1975. Further, the 1974 Act contained the
enabling authority to create RFAs,\1\ allowing for the opportunity to
establish a private independent SRO. Over the next several years,
industry leaders began working closely with Congressional leaders, CFTC
officials, and futures firms and exchanges to construct an organization
that would strengthen the reputation of the markets by establishing and
enforcing high standards of business conduct. The CFTC granted NFA's
RFA registration in September 1981 and we officially began operations
on October 1, 1982, with a clearly defined mission: safeguard the
integrity of the derivatives markets, protect investors and ensure that
NFA Members meet their regulatory responsibilities.
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\1\ Title III of the 1974 Act added Section 17 to the CEA and
provides for the registration and CFTC oversight of self-regulatory
associations of futures professionals.
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The CFTC at 50 Years
Before turning to my substantive remarks relating to the
criticality of self-regulation within the derivatives markets'
regulatory structure, I want to recognize the CFTC's commitment and
significant efforts in promoting the integrity, resilience, and
vibrancy of the U.S. derivatives markets through sound regulation. The
CFTC's responsibilities are enormous, and its core principles
regulatory approach has allowed it to adopt practical and sound
regulations that safeguard the integrity of markets and allow for
innovation. Over the years, the CFTC's Chairm[e]n and Commissioners
have demonstrated outstanding leadership. I want to thank Acting
Chairman Pham for her leadership and support of NFA and self-
regulation. Further, we look forward to working with President Trump's
nominee for CFTC Chairman, Brian Quintenz, once he is confirmed by the
U.S. Senate. During his prior tenure as a CFTC Commissioner, Mr.
Quintenz was always willing to thoughtfully engage with us to resolve
the industry's regulatory issues.
NFA recognizes the derivatives markets offer vital hedging and risk
management benefits to farmers, ranchers, producers and other market
participants. Over the years, the CFTC has assembled a professional,
talented and expert staff to advance its mission. These individuals are
dedicated to public service and committed to ensuring the derivatives
markets are effectively overseen. Each day, their hard work contributes
to effectuating the CEA's key purposes to deter and prevent price
manipulation or any other disruptions to market integrity; ensure the
financial integrity of transactions and avoid systemic risk; protect
all market participants from fraudulent or other abusive sales
practices and the misuse of customer assets; and promote responsible
innovation and fair competition.
NFA and the derivatives industry are extremely well-served by the
CFTC, a Federal regulatory agency laser focused on supporting,
strengthening and safeguarding the derivatives markets. In our view,
Congressional guidance and support, CFTC leadership and its exceptional
employees have led to its tremendous success over the past fifty years.
NFA's Critical Role
As noted above, the 1974 Act did not just envision the
establishment of a Federal regulatory agency, the CFTC, to regulate the
derivatives markets. To augment the CFTC's oversight, Congress also
enabled the creation of an RFA (i.e., a private independent SRO). NFA
is the sole RFA for the derivatives industry. Within this framework,
the CFTC and NFA partner to effectively oversee the derivatives
industry. Self-regulation is the first line of defense in this
framework to ensure that markets and market professionals operate in a
professional and ethical manner. To that end, NFA plays a critical role
in regulating the derivatives markets, subject to broad CFTC
oversight.\2\
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\2\ Exchanges, clearinghouses and swap execution facilities also
have self-regulatory responsibilities, which the CFTC oversees. The
CFTC's statutory mission requires, in part, that it provide oversight
of ``a system of effective self-regulation of trading facilities,
clearing systems, market participants, and market professionals.'' 7
U.S.C. 5(b).
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NFA's Primary Functions
As the industry SRO for the derivatives market, our principal
objective is to help the CFTC. In doing so, we perform seven primary
functions--registration, rulemaking, monitoring Members, enforcement
and disciplinary process, market regulation, investor protection and
education, and dispute resolution. NFA's performance of these functions
allows the CFTC to allocate its resources effectively and efficiently.
Registration. The CEA requires certain firms and individuals that
conduct business in the derivatives industry to register with the CFTC.
The CFTC delegated its registration function to NFA over 40 years ago.
On behalf of the CFTC, NFA registers firms and market professionals
after a thorough investigation of their background to determine if they
meet specified fitness standards.
Rulemaking. The essence of self-regulation involves identifying
industry best practices in certain areas and then mandating those
practices for the entire industry. In developing these best practices,
we involve market professionals who bring insight and perspective to
examine regulatory issues and develop effective solutions. After
identifying an issue or a problem that may require rulemaking, we work
with our Member Advisory Committees, industry trade associations and
the CFTC to develop proposed rules, and then present them to NFA's
Board of Directors. All rule changes approved by the Board are subject
to CFTC review and/or approval. In times of market crisis, NFA's
ability to respond quickly is key to restoring and maintaining market
participants' confidence. Prior to implementing a new or amended rule,
NFA develops and delivers education to Members to help them understand
their regulatory requirements.
Monitoring Members. NFA's largest departments are devoted to
monitoring Members for compliance with NFA rules and investigating
possible violations. Our key monitoring efforts include among other
things: risk-based examinations; analysis of Member financial and
operational data; the investigation of customer/counterparty
complaints; the review of retail foreign exchange trade data; and the
review of swap valuation dispute and key market and credit risk data.
Enforcement and Disciplinary Process. Adopting stringent rules and
monitoring for compliance with those rules does little good if those
rules are not vigorously enforced. To enforce its rules, when
appropriate, NFA takes disciplinary actions against its Members.\3\
NFA's disciplinary panels may impose penalties against Members that
include expulsion or suspension from NFA membership, fines, or any
other appropriate penalties or remedial actions. All NFA disciplinary
decisions are subject to CFTC review, either at the request of the
disciplined Member or Commission staff.
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\3\ Historically, NFA's enforcement efforts have focused on serious
types of misconduct including Ponzi schemes, improper loans and
advances from commodity pools, misleading and high-pressure sales
practices, electronic trading platform abuses, abusive trading
practices and anti-money laundering deficiencies, to name a few.
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NFA works very closely with the CFTC's enforcement division to
address emergency situations and to not duplicate enforcement actions,
unless necessary, so that we can properly allocate our regulatory
resources. Importantly, we also work cooperatively with law enforcement
agencies when we observe or suspect criminal activity. Over the years,
NFA and the CFTC have brought many cases that have rapidly shut down
Ponzi and fraud schemes with the individuals involved subsequently
prosecuted.
Market Regulation. NFA's Market Regulation Department performs
trade practice and market surveillance services on behalf of eleven
swap execution facilities and two futures exchanges. Each trading venue
may enter into a regulatory services agreement with NFA to perform
specific outsourced compliance functions for which they remain
ultimately responsible under the CEA.
Investor Protection and Education. Protecting investors has been
part of the CFTC's and NFA's mandate since inception. NFA offers a
variety of resources to help investors learn how the derivatives
markets work and about the firms and individuals offering investment
opportunities in the derivatives markets. We want investors to make
informed decisions and avoid dealings with bad actors. Importantly, NFA
offers a website tool, BASIC, that investors, the public and NFA
Members can use to research the background of industry
professionals.\4\
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\4\ BASIC contains information relating to firms' and individuals'
CFTC registration and NFA membership, regulatory actions, FCM financial
information and dispute resolution information.
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Dispute Resolution. Finally, NFA offers an affordable and efficient
arbitration program to help customers resolve futures-related and
forex-related disputes with Members. In general, NFA's dispute
resolution program is less expensive, faster, and less formal than
civil litigation or other dispute resolution forums.
Over the years, the Commission has also delegated and assigned
important regulatory responsibilities to NFA that were previously
performed by the Commission. In addition to the registration function
noted above, the Commission has also delegated to NFA the review of
CPO/CTA disclosures documents, commodity pool financial statements,
commodity pool exemption notices, IB financial statements and swap
valuation disputes.
The CFTC's Broad Oversight of NFA
Broad government oversight is vital to effective self-regulation,
and this oversight should cover all aspects of the SRO's regulatory
activity. While we may partner with the CFTC to regulate our Members,
the CFTC also closely reviews and monitors NFA's activities to ensure
that we fulfill our regulatory responsibilities. The 1974 Act
recognized the importance of Commission oversight and provided it with
broad oversight powers, which include the ability to review NFA's
disciplinary actions, review and/or approve NFA's rules, abrogate NFA's
rules or require NFA to change or supplement its rules.\5\ The CFTC's
oversight of NFA's activities includes both formal actions, required by
the statute or regulations, and informal actions, which have evolved
over time.
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\5\ See 7 U.S.C. 21(h), (j)-(l).
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At the formal level, NFA's most significant actions are all subject
to the CFTC's direct review and/or approval. The CFTC performs frequent
rule enforcement reviews of NFA's work in our core areas to ensure that
we meet our regulatory obligations. Informally, NFA is in regular
contact with the CFTC to discuss ongoing investigations, registration
matters, examinations, rulemaking issues, or any of the myriad issues
that arise. We also have regular coordination meetings with the CFTC's
Chairman and Commissioners and its CFTC's Operating Divisions (e.g.,
Division of Enforcement, Market Participants Division, Division of
Market Oversight, Office of International Affairs and Office of
Legislative Affairs) to ensure that they are aware of our activities.
The Effective Results of Our CFTC Partnership
The results of our partnership with the CFTC can be demonstrated in
at least two ways--our work with them to detect and combat fraud and to
develop sound regulatory oversight programs.
Detecting and Combating Fraud
Detecting and combating fraud is central to NFA's and the CFTC's
mission. Our collective efforts working with the CFTC, the industry's
other SROs,\6\ and industry participants have yielded significant
results--customer complaints and single-event customer arbitrations
filed at NFA, as well as CFTC reparation cases, remain near all-time
lows. The following are just a few examples of how we worked with the
CFTC to eradicate wrongdoers and protect retail customers.
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\6\ See Fn. 2.
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The 1990s--Options Sales Practices. In the 1990s, NFA and the CFTC
dealt with ``boiler rooms'' in South Florida and California that
utilized misleading, high-pressure sales practices to pitch retail
customers to trade exchange-traded options. NFA and/or the CFTC would
take an enforcement action and shut down one of these firms, only to
see a related firm open shortly thereafter under a new name with many
of the same brokers. To address this situation, NFA enhanced its sales
practice and supervision rules, which were approved by the CFTC, to
make it difficult for these firms to continue their fraudulent
operations.\7\ Due to NFA's and the CFTC's efforts, the large-scale
boiler rooms that preyed on retail customers are a thing of the past.
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\7\ Specifically, NFA placed restrictions on Members' use of radio
and television advertisements and banned practices that presented a
distorted and misleading view of the likelihood of customers earning
dramatic profits or those that constituted high-pressure sales.
Importantly, if a Member firm had brokers who were previously
associated with a firm that had been shut down for sales practice
fraud, we imposed enhanced requirements upon it relating to higher
capital, tape recording of sales solicitations, and the pre-approval by
NFA of its promotional material.
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The Early 2000s--Retail Spot Forex. In the late 1990s and early
2000s, an unregulated over-the-counter forex market aimed at retail
customers grew rapidly. Many customers were victimized when firms
either absconded with their funds or falsely promised them high
profits. In the early 2000s, Congress passed legislation providing that
off-exchange retail forex transactions were only permitted if the
counterparty to the retail customer was a regulated entity (e.g., an
FCM). As a result, many entities that had no intention of engaging in
the usual FCM on-exchange trading activities became registered FCMs
solely to act as counterparties to retail forex transactions. These
FCMs performed several functions that traditionally had been performed,
in part, by separate entities--they solicited customers, accepted
customer funds, operated an electronic trading platform via an internet
interface, and acted as counterparty (i.e., took the other side of the
trade) to retail customers. At one point, there were over forty of
these firms and fraud and mismanagement were rampant. Even though these
firms made up less than 1% of NFA's total Members, they accounted for
20% of our arbitration cases and over 50% of NFA's emergency actions.
Although Congress gave the CFTC anti-fraud authority over these
FCMs' retail forex activities and the CFTC took several fraud-related
enforcement actions in this area, the CFTC lacked authority to regulate
these firms' retail forex activities. Equally significant, the CFTC's
anti-fraud enforcement efforts were frustrated with respect to these
retail forex transactions after Federal Appeals Courts found that these
transactions were not futures contracts but ``rolling spot
transactions'' that fell outside of the CFTC's jurisdiction.\8\
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\8\ The CFTC brought enforcement actions against several of these
firms and lost these actions after Federal courts found that these
transactions were not contracts of sale of a commodity for future
delivery. The courts recognized the leveraged and 2 day ``rolling''
nature of these transactions but held they were spot contracts after
deciding that the retail customers had no guaranteed right of offset
and there was allegedly no standardization to the transactions' sizes.
Consistent with the CFTC's position, NFA took the position that these
transactions were futures contracts.
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Therefore, the CFTC was unable to stop this fraud. Since these
firms were NFA FCM Members, however, NFA was able to step in and fill
this regulatory gap until Congress acted in 2008 to clarify the CFTC's
anti-fraud jurisdiction and expressly grant the CFTC the necessary
authority. To regulate Members' spot retail forex activities, NFA
adopted--with CFTC approval--an anti-fraud provision and rules to
establish enhanced capital requirements and business conduct rules for
forex dealers. These efforts began to weed out the bad actors and today
these firms account for very few of NFA's disciplinary and customer
arbitration cases.
The Early 2010s--Customer Segregated Funds Misappropriation. In
late 2011 and early 2012, personnel from two FCMs engaged in misconduct
that resulted in customer funds losses. Due to the shortfall in
customer segregated funds at these two firms, NFA and CME worked with
the CFTC to adopt a daily customer funds verification process to more
effectively monitor each FCM's compliance with its obligation to keep
customer funds safe. For more than 10 years, NFA and CME have confirmed
daily all balances in customer segregated, secured and cleared swap
bank accounts directly with the depositories holding those funds. FCMs
file daily reports with NFA and CME reflecting the amounts owed to
their customers and this process is designed to ensure that the
accounts' balances are sufficient to cover the amount owed to
customers. With the CFTC's approval, NFA and CME implemented this
process in early 2013.
Developing Sound Regulatory Oversight Programs
The 1974 Act envisioned an integrated regulatory framework in which
an independent SRO and the CFTC work together to develop sound
oversight programs. As the CFTC's jurisdiction grew over the years to
include new markets, NFA drew upon the industry's and our Members'
expertise and worked with the CFTC to develop practical and effective
regulatory programs for these markets. The following are a few
examples.
Post Dodd-Frank--Swaps. In 2010, the DFA mandated the registration
of SDs. This led to a significant change to NFA's self-regulatory role
when the CFTC, in early 2013, required these firms to register and
become NFA Members. NFA currently has over 100 SD Members, the vast
majority of which are either large U.S. banks or financial
institutions, foreign banks, or affiliates of one of these entities.
Prior to Dodd-Frank's passage, NFA had little, if any, experience
with swaps. Therefore, NFA worked closely with the CFTC and SDs to
develop an oversight program, which evolved over time. The program
initially focused on reviewing each SD Member's policies and procedures
relating to key CFTC rulemakings and subsequently implementing an
examination program to test SDs' compliance with NFA's rules, which
incorporated the CFTC's core requirements for SDs.
Our oversight program's scope grew further in 2016 when the CFTC
gave NFA the responsibility to review and approve covered SDs' use of
initial margin (IM) models and we subsequently developed an oversight
program to assess SDs' ongoing use of an approved IM model. Finally, in
2021, NFA assumed responsibility for overseeing covered SDs' compliance
with NFA's and the CFTC's SD capital rules and the CFTC gave NFA
responsibility to review and approve SD market and credit risk models
used for calculating capital. NFA's fully mature SD oversight program
is over 10 years old and our work with the CFTC in this area allowed
the U.S. to lead efforts globally in swaps regulation.
The Early 2020s--Digital Assets. NFA's primary responsibility is to
regulate our Members' derivatives activities and, in limited instances,
their spot market activities (e.g., retail forex and digital asset
commodities) when they may pose a risk to retail customers. Over 5
years ago, NFA became concerned, in part, that investors did not fully
understand the nature of digital assets and the substantial risk of
loss that may arise from trading these products. Given these concerns,
in 2018, we required that Members engaging in these activities provide
customers with enhanced disclosures and investor advisories.\9\
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\9\ Members are required to provide customers with an NFA Investor
Advisory: Futures on Virtual Currencies Including Bitcoin and a CFTC
Customer Advisory: Understand the Risk of Virtual Currency Trading.
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More recently, to proactively ensure that we have jurisdiction to
discipline a Member and, in part, to regulate our Members' activities
in this area, NFA adopted NFA Compliance Rule 2-51.\10\ This rule
imposes anti-fraud, just and equitable principles of trade, and
supervision requirements on NFA Members and Associates engaged in spot
digital asset commodity activities. This rule is critical to our
oversight of Members engaging in spot digital asset commodity
activities since our longstanding rules cover primarily our Members'
derivatives and retail forex activities.
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\10\ NFA Compliance Rule 2-51 covers those digital assets that are
commodities (e.g., Bitcoin and Ether). These two digital asset
commodities have related futures contracts listed for trading on CFTC
regulated exchanges. If Congress, Federal regulators or the courts
identify other digital assets as commodities in the future, NFA will
amend this Rule to cover them.
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The CFTC Beyond 50
NFA has always recognized the importance of Congress reauthorizing
the CFTC and ensuring that it continues to have the necessary tools to
properly regulate the derivatives industry. In the past, Congress has
used momentous changes to the CFTC's responsibilities to reauthorize
it.\11\ In light of the CFTC's potential new responsibilities in the
digital asset commodity area, NFA strongly encourages Congress to
consider whether now may be an appropriate time to reauthorize the
CFTC. If reauthorization moves forward, then NFA firmly believes that
customer protection issues should again be front and center. The 2019
reauthorization bill voted out of this Committee included a key
customer protection provision that amends the CEA to clarify the
Commission's authority to adopt rules that provide customers with
priority in the event of an FCM bankruptcy. NFA fully supports this
provision, and we believe there is broad-based industry support for
this approach. We hope any future CFTC reauthorization legislation
includes this key statutory change.
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\11\ For example, the Commodity Futures Modernization Act of 2000
and Food, Conservation, and Energy Act of 2008 each made momentous
changes to the CFTC's regulatory oversight and/or jurisdiction and
reauthorized the CFTC.
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At this time, I would also like to reaffirm NFA's willingness to
assist the CFTC to the extent requested in regulating the spot digital
asset commodity market if Congress moves forward with legislation in
this area. The House of Representatives May 2024 bipartisan Financial
Innovation and Technology for the 21st Century Act (FIT Act) included a
significant role for an RFA in regulating the digital asset commodity
market. NFA fully supports providing a role for an RFA to partner with
the Commission in developing an appropriate oversight regime for this
market and is fully capable of performing the responsibilities of an
RFA as outlined in the FIT Act. The fact is, our Member firms have been
engaging in spot digital asset commodity activities for over 5 years
and, as explained above, we have already taken steps to regulate these
Members' activities to ensure that appropriate customer protections are
in place.
The 1974 Act's regulatory framework for the derivatives industry
respects the roles played by Federal Government agencies and an
independent, industry-wide SRO.\12\ Congress did not place these roles
at odds with each other but rather sought to weave them into an
integrated regulatory fabric.\13\ The 1974 Act's framework has stood
the test of time--adapting to changing and innovative market structures
and products. More than fifty years after the 1974 Act, we can
certainly say that self-regulation combined with the CFTC's regulatory
oversight has been a successful and effective regulatory framework for
the derivatives industry.
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\12\ The advantages and requirements for effective self-regulation
are further detailed in an IOSCO report published in 2000 entitled
``Model for Effective Regulation''.
\13\ See former CFTC Chairman Heath P. Tarbert, Self-Regulation in
the Derivatives Markets: Stability Through Collaboration, 41 Nw. J.
Int'l L. & Bus. 175 (2021).
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In conclusion, thank you again for the opportunity to appear before
you today to commemorate this very important milestone--the CFTC's 50th
Anniversary. The CFTC has been NFA's strong and effective regulatory
partner since we opened our doors in 1982, and we look forward to our
future together.
The Chairman. Mr. Sexton, thank you so much for your
testimony.
And Mr. Giancarlo, please begin when you are ready.
STATEMENT OF HON. J. CHRISTOPHER GIANCARLO, FORMER CHAIRMAN,
COMMODITY FUTURES TRADING COMMISSION, HAWORTH, NJ
Mr. Giancarlo. Thank you, Chairman, and Ranking Member
Craig, and other distinguished Members of this Committee, many
of whom I have had the pleasure of working with over the years.
It is indeed right for us to acknowledge the CFTC's
remarkable record of success and the enormous economic value it
provides for American consumers. When I am asked to explain the
purpose of the CFTC, I use a comparison to the better-known
Securities and Exchange Commission. I explain that the SEC
oversees markets for capital formation, that is, markets where
those with a business idea find those with capital to fund
their growth and success. Well, that is not what the CFTC does.
What the CFTC does is oversees markets for risk transfer,
and that is markets with those with business risk, risk to
farmers of falling prices for their crop production, risk to
American manufacturers for rising energy prices, and risk to
home builders of fluctuating interest rates can offset some or
all of that risk with those who are better able to bear it.
CFTC markets for risk transfer are very different than SEC
markets for capital formation, and because they are so
different, they require specialized regulatory skills. And
fortunately, the CFTC and its terrific staff have those skills
in spades.
During almost 5 years on the Commission, I traveled the
country and visited ag producers in over two dozen states, from
Montana and Texas, Arkansas, Louisiana, and Iowa to Minnesota
and Missouri, New York, Mississippi, and Oklahoma, and I walked
in wheat fields and harvested soybeans. I tramped through rice
farms and beneath pecan groves, and I milked dairy cows in
Minnesota and toured feedlots, and I visited grain elevators
and viewed cotton gins. And many of my fellow Commissioners
continue to do the same. What other Federal financial regulator
can say that they do that? And throughout these visits, I was
moved not only by the grace and dignity of hardworking
Americans, but by the importance to their lives of these risk-
hedging markets under CFTC's supervision.
Now, it is true that most Americans are not farmers.
Compared to having their 401(k)'s invested in the stock market,
many Americans do not directly participate in markets under
CFTC's supervision. And yet, thanks to these well-regulated
markets, all American consumers enjoy relatively stable prices
in all their financial activity, from auto loans to household
purchases to the price and availability of heating to the
energy used in the factories where they work, to the interest
rates that borrowers pay on home mortgages, and even the
returns workers earn on their retirement savings in those
401(k)'s.
One area where these markets are essential to American
prosperity is in managing risk associated with the U.S. dollar.
In fact, when the CFTC was reformulated out of the Department
of Agriculture 50 years ago, it was quite specifically to
safeguard a breakthrough in financial innovation that Dr.
Sandor and others worked on, and that was financial futures
because these new instruments enabled the global economy to
manage the risk of variable interest and exchange rates and
assured that the U.S. dollar remain the world's reserve
currency.
The United States is the only major economy to have a
regulatory agency specifically dedicated to derivative market
regulation, and it is worth asking whether having such a
dedicated regulator is the reason why U.S. commodity derivative
markets are bigger and perhaps more important than most of our
economic competitors. Or is the fact that these American
markets are so big that they require a dedicated regulator in
its own right? Perhaps both of those reasons are true, and it
is clear that the CFTC provides a great American advantage in
terms of economic cooperation.
We have heard from Mr. Carey that the CFTC's clear,
transparent, tough, but flexible rules support U.S. ag
production, and from Dr. Sandor, that the CFTC's regulated
markets are indispensable tools for economic growth, driving
down the cost of home ownership. And Mr. Schryver explained
that the CFTC's rules protect U.S. consumers from abuse. And
Ms. Dow described the uniqueness of the CFTC's principles-based
self-certification framework. And my dear friend Tom Sexton
talked about the critical role of CFTC's self-regulation.
Well, I just want to add one more remarkable aspect, and it
is something that the Ranking Member alluded to. It said that
organizations reflect the tone from the top. Certainly, the
CFTC's reduced partisanship mirrors the general cordiality and
frequent bipartisanship of this Committee and its Senate
counterpart, and that characteristic, in turn, reflects the
courtesies and values of America's homeland.
As a former Chairman, I readily admit my affection for this
remarkable agency. For 5 decades, the CFTC has enhanced the
American way of life, stabilized the everyday cost of living,
and the CFTC has done so without undue rancor and partisanship,
with a budget and a staff that is a pittance against those of
its Federal regulatory peers. The CFTC is pound for pound the
best value in Washington, especially for American farmers,
producers, and end-users.
So, Mr. Chairman, 50 years after its creation, I am
delighted to join this Committee and say, happy birthday, CFTC.
Thank you.
[The prepared statement of Mr. Giancarlo follows:]
Prepared Statement of Hon. J. Christopher Giancarlo,\1\ Former
Chairman, Commodity Futures Trading Commission, Haworth, NJ
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\1\ These remarks are given in Memory of the late Michael D. Gill,
Former CFTC Chief Operating Officer and Chief of Staff.
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Introduction
Thank you Chairman Thompson, Ranking Member Craig, Members of the
Committee, and other distinguished colleagues for holding this hearing
to mark the 50th anniversary of the founding of the Commodity Futures
Trading Commission (``CFTC''). It is indeed right to take the time to
acknowledge the CFTC's remarkable record of success and the economic
value it provides for the U.S. economy and American taxpayers.
When I am asked to explain the purpose of the CFTC, I use a
comparison to the better-known Securities and Exchange Commission. I
explain that the SEC oversees markets for capital formation. That is,
markets where those with business ideas find those with capital to fund
their growth and success. That is not what the CFTC does. Rather, the
CFTC oversees markets for risk transfer. That is, markets where those
with business risk--risk to farmers of falling prices for crop
production, risk to American manufacturers of rising energy prices and
risk to home builders of fluctuating interest rates--can offset some or
all of that risk with those better able to bear it. CFTC markets for
risk transfer are very different than SEC markets for capital formation
and require specialized regulatory skills and understanding.
Fortunately, the CFTC has that capability in spades.
Derivatives Moderate the Costs of Everyday Life
But let's start close to home and look at how CFTC regulation
affects real American families. During almost 5 years on the
Commission, I traveled the country and visited agriculture producers in
over two dozen states from Montana, Texas, Arkansas, Louisiana and Iowa
to Minnesota, Missouri, New York, Georgia, Mississippi and Oklahoma. I
walked in wheat fields and harvested soybeans, tramped through rice
farms and beneath pecan groves, milked dairy cows and toured feedlots,
visited grain elevators and viewed cotton gins. I met with American
energy producers, going 900 underground in a Kentucky coal mine, 90
in the air in an Arkansas crop duster and climbed 99 up a North Dakota
oil rig.
And many of my fellow CFTC Commissioners continue to do the same.
What other Federal regulatory agency does that?
Throughout, I was moved not only by the grace and dignity of hard
working Americans, but by the importance to their lives of risk hedging
markets under CFTC supervision.
It is true that most Americans are not farmers and, compared to
having their 401(k)s invested in the stock market, many Americans do
not directly participate in markets overseen by the CFTC. Yet, thanks
to these well-regulated markets all American consumers enjoy relatively
stable prices in the supermarket and in all manner of consumer finance
from auto loans to household purchases, to the price and availability
of heating in American homes, the energy used in factories, the
interest rates borrowers pay on home mortgages, and the returns workers
earn on their retirement savings.
To emphasize the importance of robust and well-regulated derivative
markets, let me share one of my most interesting experiences as CFTC
Chairman.
In the Spring of 2018, the Vatican published a bollettino, or
bulletin, titled `` `Oeconomicae et pecuniariae quaestiones'.
Considerations for an ethical discernment regarding some aspects of the
present economic-financial system'' which laid out certain ethical
principles to govern economic and financial systems. While many of the
points made in the document were quite interesting, the bulletin
fundamentally mischaracterized the nature of derivatives as largely
speculative products tantamount to gambling. As the Chairman of the
CFTC and a practicing Roman Catholic I felt compelled to respond. The
CFTC's Chief Economist Bruce Tuckman and I issued a response to the
Holy See to set the record straight and explain that derivatives were
not ``ticking time bomb[s] ready sooner or later to explode.'' \2\
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\2\ `Oeconomicae et pecuniariae quaestiones'. Considerations for an
ethical discernment regarding some aspects of the present economic-
financial system of the Congregation for the Doctrine of the Faith and
the Dicastery for Promoting Integral Human Development, May 17, 2018,
available at https://press.vatican.va/content/salastampa/en/bollettino/
pubblico/2018/05/17/18051
7a.html.
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We explained that derivatives have been used for thousands of years
to manage commercial and market risk.\3\ Yet, today in many of the
world's poorest societies the lack of functioning risk transfer markets
means that the boom and bust cycle of subsistence is a source of
poverty, crime and hunger. We explained that each planting season,
farmers across the globe face a myriad of uncertainties from
unfavorable weather patterns, equipment costs, farmhand availability,
market prices, and others. Where available, derivatives serve as an
essential tool to mitigate and constrain these risks in a number of
ways. First, they provide reliable and fair pricing benchmarks that
promote market efficiencies overall. Second, derivatives reduce price
volatility in a resource-constrained world by removing the economic
incentive to hoard physical supplies. Farmers can quantify and transfer
the risks they want to avoid at a reasonable price to persons willing
and able to hold that risk. Such risk protection reduces earnings
volatility and thus price volatility, benefiting all parties, including
consumers who may never get involved in derivatives markets in the
first place. Finally by entering into futures contracts to sell farm
production at a predetermined price, the farmer can secure revenue
regardless of market fluctuations that may appear down the line. This
provides the farmer with financial predictability and stability,
enabling better planning and investment in the business.
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\3\ Robert J. Shiller, Finance and the Good Society (Princeton
University Press 2012) p. 76, citing Aristotle's description of the
successful use of options on olive pressing by the Greek philosopher
Thales in 600BCE.
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Mr. Tuckman and I explained that it was the absence, not the
presence, of functioning derivatives markets that harmed some of the
world's poorest and most vulnerable populations. I am pleased to say
that the CFTC's presentation better educated the Vatican and tempered
its under-appreciation of the role of derivatives in alleviating global
hunger and malnourishment. I was subsequently invited to the Vatican to
meet senior officials and discuss finance and derivatives. It was
perhaps another first for the CFTC.
Derivatives Support American Consumers
Beyond agriculture, derivatives enhance other aspects of modern
life. They are used by both big and small enterprises, such as
commercial manufacturers, power utilities, retirement funds, banks and
investment firms. More than 90% percent of Fortune 500 companies use
derivatives to control costs and other risks in their worldwide
business operations. Energy companies, for instance, use futures
contracts to hedge against gas and electric price volatility, ensuring
stable energy costs for consumers. Similarly, financial institutions
use interest rate swaps to manage the costs associated with mortgage
lending to make home ownership more affordable. And through the use of
innovative new products like event contracts, consumers and businesses
may utilize derivatives markets to hedge risks of national and global
events. Overall, derivatives serve the needs of society to control
commercial and other risk, essential to economic growth and job
creation.
Derivatives generally fall into two broad categories: exchange-
traded and over-the-counter (OTC). Both categories are primarily
regulated in the United States by the CFTC. They are some of the
world's fastest growing and technologically innovative markets of any
kind. U.S. markets have extraordinary depth and breadth, allowing
participants to execute transactions without distorting market prices.
Liquidity ensures that market participants can easily enter and exit
positions, which is essential for the effective mitigation of risk.
These markets are also made up of an extraordinarily diverse cast of
participants, who each provide essential functions to effectively
facilitate efficient price discovery and risk transfer.
One area where these markets are essential to American prosperity
is in the managing of risk associated with the U.S. dollar and here,
the CFTC plays a crucial role. In fact, when the CFTC was reformulated
out of the Department of Agriculture fifty years ago into an
independent body it was quite specifically to safeguard a breakthrough
in financial innovation: financial futures. These new instruments
enabled the global economy to hedge the risk of moving interest and
exchange rates ensuring the U.S. Dollar's primacy as the world's
reserve currency.\4\ Under the CFTC's able leadership, U.S. derivatives
markets offer participants a range of instruments to hedge risk
associated with the dollar, enabling businesses and governments
worldwide to safely hold Dollars, the world's essential reserve
currency.
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\4\ Leo Melamed, ``Man of the Futures: The Story of Leo Melamed &
the Birth of Modern Finance'' (Harriman House 2021).
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The World's Best Derivatives Regulator
American derivatives markets are also some of the world's best
regulated. The CFTC is globally recognized as the world's preeminent
derivatives regulator with some of the most knowledgeable, skilled and
committed professional staff of any market regulator in the world. The
CFTC's unparallel global reputation for expertise and effectiveness,
attracts both domestic and international participants to have
confidence in American trading markets. This confidence fosters market
growth, as participants trust that the regulatory environment in which
they operate is one based on openness, innovation, the rule of law, and
integrity.
And how good is CFTC regulation? First off, many of the world's
market regulators send their derivatives specialists to be trained by
the CFTC. As a result, many senior overseas [derivatives] regulators
are alumni of the CFTC's esteemed summer training program. Second, CFTC
segregation requirements for customer funds, protect market
participants from misappropriation. In fact, the only American piece of
Sam Bankman-Fried's FTX crypto empire that didn't fail its customers
was the trading platform under CFTC supervision, a testament to the
strength of the CFTC's regulatory framework. Thirdly, CFTC-regulated
clearinghouses are among the most robust and resilient in the world.
The CFTC has been a global leader in clearinghouse supervision for
decades before the 2008 financial crisis and since. Even in the face of
extreme volatility, CFTC-regulated derivatives clearing firms
successfully handle and manage risk, enabling valuable price risk
transfer to support and stabilize the broader financial market. Under
the CFTC's watch not a single CFTC-regulated clearinghouse has ever
defaulted or even come close to using its mutualized default resources
to cover market losses, not even during the 2008 financial crisis.
The United States is the only major country in the Organization for
Economic Co-operation and Development to have a regulatory agency
specifically dedicated to derivatives market regulation. It is worth
asking whether having such a skilled and dedicated commodity
derivatives regulator is the reason why U.S. commodity futures markets
are bigger and more globally important than many global competitors.
Or, is the fact that American futures markets are more critical than
many overseas competitors the reason why they require a highly skilled
and dedicated regulator? Perhaps the relationship is symbiotic. The
expansive and dynamic nature of the U.S.'s derivatives markets requires
a regulator capable of mastering complex market structures and
responding to rapid innovation. The CFTC has evolved to meet these
demands by developing a regulatory framework uniquely suited to
ensuring market integrity without stifling competition. Clearly, the
CFTC provides an American advantage in global economic competition.
The Uniqueness of the CFTC
Considering the CFTC's prowess in overseeing and fostering markets
compared to overseas peers, it is worth reflecting on exactly what sets
the CFTC apart from other Federal Government regulators. Three
characteristics among others stand out: (1) the CFTC's principles-based
regulatory approach; (2) the agency's embrace of innovation; and (3)
the Commission's tradition of comity.
How a government agency regulates is just as important as what it
regulates. The two most common methods of regulation are principles-
based and rules-based regulation. The CFTC has a long-history as a
principles-based regulator utilizing regulatory principles to achieve
its objectives. Under this approach, the CFTC develops broadly-stated
principles under which its registrants operate in the marketplace.
Principles-based regulation accomplishes the same goals as rules-based
regulation, but offers regulated entities greater flexibility and
innovation in achieving regulatory objectives. When needed, however,
the CFTC blends rules-based regulation into its regime, allowing for an
overall regulatory system that is broadly principles-based while also
offering clarifying rules when it would be helpful. This principles-
based approach is significantly more encouraging to innovation and
market evolution than the strict rule sets utilized by other financial
and Prudential Regulators.
As this Committee knows, the CFTC has been at the forefront of U.S.
financial market innovation since the agency's inception. During the
past decades, the CFTC has deftly overseen more new financial product
innovation than almost any other market regulator.\5\ The CFTC promotes
market and product innovation in a number of ways. First, through its
self-certification process, whereby derivatives exchanges introduce new
products without formal CFTC approval by certifying that the new
products comply with the Commodity Exchange Act and the CFTC's
regulations. This approach has enabled the rapid introduction of novel
and innovative financial instruments, such as derivatives based on
cryptocurrencies.
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\5\ See generally, Written Testimony of Chairman J. Christopher
Giancarlo before the Senate Banking Committee, Washington, D.C.,
(February 6, 2018) at: https://www.banking.senate.gov/imo/media/doc/
Giancarlo%20Testimony%202-6-18b.pdf.
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As this Committee knows, the CFTC engaged early with digital
assets, finding in 2015 that Bitcoin was properly defined as a
commodity under its authority. Two years later, the CFTC greenlighted
the self-certification of BTC futures initiating the world's first
significant, fully regulated market for digital assets. Since then,
other commodity-based, digital asset products including ETH futures and
very recently SOL futures have come under CFTC oversight. Today,
derivatives on digital asset commodities (the largest digital asset
category by volume) trade in orderly and transparent markets under
close CFTC supervision, fostering Dollar-based pricing, with healthy
liquidity and high levels of open interest despite volatile current
economic conditions.\6\
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\6\ CME Bitcoin Liquidity Report, September 2, 2022, at: https://
www.cmegroup.com/ftp/bitcoinfutures/
Bitcoin_Futures_Liquidity_Report.pdf.
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Markets for digital commodities futures like BTC, ETH and SOL
provide the CFTC with regulatory visibility supporting robust
enforcement that is second to no other market regulator in prosecuting
perpetrators of digital asset fraud, abuse and market manipulation.
Yet, perhaps most importantly, the CFTC's early and unhesitant
engagement with digital assets (compared to other U.S. market
regulators) has reduced regulatory risk and uncertainty for responsible
financial market innovation and paved the way for an important new
ecosystem of retail and institutional digital asset investment
generating economic activity here in the United States. It is a perfect
example of how the CFTC facilitates market-driven innovation while
maintaining effective oversight of regulatory compliance and market
integrity.
Another way in which the CFTC encourages innovation is through the
agency's Office of Technology Innovation. Established in 2017 as
LabCFTC, the Office of Technology Innovation serves as the CFTC's
innovation hub by providing a venue for CFTC operating divisions,
market participants, startups, and technology firms to engage
collaboratively on cutting-edge developments in blockchain, artificial
intelligence, decentralized (DeFi) finance, and other transformative
technologies with the potential to innovate derivatives markets. This
collaboration ensures that the CFTC's regulatory approach can develop
alongside private-sector market innovations. I understand that this
Committee is considering establishing LabCFTC in an amendment to the
Commodity Exchange Act. I fully endorse that legislative action.
The final key and highly unique characteristic of the CFTC is the
relative lack of partisanship among the Commissioners. It is no secret
that political partisanship is common to our social and governmental
institutions. But one place where there is a relative lack of
partisanship is among the five Commissioners leading the CFTC. Of
course, such comity is relative and political differences inevitably
play a role in each Commissioner's approach to regulation. Yet, the
CFTC has a long history of encouraging bipartisan cooperation and
collaboration among its Commissioners.
It is said that organizations reflect the ``tone from the top''.
Certainly, the CFTC's reduced partisanship mirrors the general
cordiality and frequent bipartisanship of this Committee and its Senate
counterpart compared to other Congressional committees of jurisdiction.
That characteristic, in turn, reflects the courtesies and values of the
citizens of America's heartland. Maintaining this attitude is critical
for the success of the CFTC in accomplishing its mission--only through
continued bipartisanship and cooperation can the CFTC truly achieve its
mission of fostering open, competitive, and financially sound markets.
Looking to the next 50 years
As the 119th Congress contemplates an appropriate legal and
regulatory framework for digital assets it is not surprising that
attention is directed to the CFTC. This Committee will address the
important public interest in closing a gap in CFTC oversight. As you
know, spot markets facilitate immediate physical delivery of tradable
goods in contrast to markets for futures, forwards and options
deliverable in the future. In spot markets, the CFTC has only limited
authority over trading of digital asset commodities. As a result, there
are no platform registration, operator supervision or standard investor
protection measures in crypto spot markets that are common in U.S.
derivatives markets to police against fraud, manipulation and abuse.
Clearly, there are elements of the digital commodity cash markets
suitable for direct CFTC oversight that are distinguishable from
traditional cash commodity markets. I fully support extending the
CFTC's oversight to specifically (and [solely]) cover spot digital
commodity markets.
The world is once again experiencing a fundamental new innovation
in finance. Thoughtful, clear-eyed and unbiased American leadership is
needed. American consumers and financial innovators alike deserve the
benefit of the CFTC's decade of market supervision, expert analysis and
product engagement in digital commodity markets. It is time to close
the regulatory gap over spot digital commodities with the oversight of
the world's most experienced and farsighted crypto regulator. I urge
this Committee to draw upon the CFTC's expertise and competence to meet
the challenge of digital asset innovation and face the digital future
of finance it portends.
Conclusion
I have enjoyed a 4 decade career in law and finance largely in the
private-sector. My work in trading markets from New York to London to
Singapore and Tokyo and my government service provide me with both an
inside and outside perspective on the effectiveness of many government
institutions.
Yet, as a former CFTC Chairman and proud American, I readily admit
my bias and affection for this remarkable agency and its skilled
professionals. Today we mark the 50th anniversary of the CFTC, a
commemoration well recorded. For 5 decades, the CFTC has enhanced
American markets, providing competitive pricing for the everyday cost
of living. Through its well-crafted and principles approach to
regulation, it has fostered effective risk hedging for American farmers
and producers, while guarding the strength of the U.S. Dollar. As a
Federal institution it has leaned into innovation both in new products
and market structure, often leading the way among Washington's alphabet
soup of financial regulators. And, the CFTC often manages to do so
without undue rancor and partisanship. With a budget and staff that is
a pittance against those of its Federal regulatory peers, the CFTC is
pound-for-pound the best value in Washington--especially for American
farmers, producers and everyday consumers.
Mr. Chairman, fifty years after its creation, I am proud and
delighted to join this Committee in saying:
``Happy Birthday, CFTC! Long may you run!''
The Chairman. Mr. Giancarlo, thank you much for your
testimony, and a fitting end to that testimony as well, based
on our celebration of 50 years. I just thank you, to all
members of our panel, for your presentation. I couldn't imagine
a more experienced panel than I have before us today with the
topic at hand.
At this time, Members will be recognized for questions in
order of seniority, alternating between Majority and Minority
Members and the order of arrival for those who joined us after
the hearing convened. You will be recognized for 5 minutes each
in order to allow us to get to as many questions as possible. I
now recognize myself for 5 minutes.
Ms. Dow, as you know, the purpose statement that I quoted
in my opening statement was added to the law during the
enactment of the Commodity Futures Modernization Act. It is not
a stretch to say that the reforms made by that law built the
modern Commission. As you review the Commission's
implementation of the CFMA, have the principle-based
regulations worked as intended, and has it been able to both
promote responsible innovation and fair competition while
protecting consumers and market integrity?
Ms. Dow. Thank you for that question, Mr. Chairman. I
absolutely believe that the CFMA core principles-based
regulation has worked as intended and potentially even better
than intended. It has really given the industry and the
exchanges the opportunity to respond to changes in the markets,
demands from their customers. It has allowed them to really
take the responsibility for ensuring that the rules that they
put in place are in compliance. So they certify that these
rules are in compliance with the CEA, and they are responsible
for providing the analysis and all of the things that would
give the CFTC the information they need to allow them to
certify and put these rules into place without permission.
And this has really allowed the time frames for these
different new products, new rules to go into effect, which is
really important for getting to market in a timely way, which
is important to business. So while there have been concerns
about the permission list-based rules, it has proven to work
well, and we have had no issues or concerns. The Commission has
the authority to stay potential rules if they think that there
is something lacking, is not in compliance, or the explanation
is not good enough, so they still have the opportunity to stay
when you have this principles-based certification of rules. So
yes, it has worked extremely well. It has allowed the markets
to grow and to innovate and continues to work well and should
remain in place.
The Chairman. And thank you for that. Mr. Giancarlo, both
you and Mr. Carey noted in your testimony that the risk
transfer markets regulated by CFTC require, quote,
``specialized regulatory skills and understanding,'' end quote.
As this Committee thinks about how best to fulfill the purpose
of the Commodity Exchange Act, what are those specific skills
and understandings needed to be effective in these markets that
other financial regulators might not have?
Mr. Giancarlo. The ability to oversee dynamics in complex
wheat markets, of which there are many different varieties, and
they all have different market participants and different
dynamics and different seasonality, the ability to understand
difference in different trading markets for petroleum products,
certainly in interest rates and dollar-based instruments
require specialized knowledge, specialized skills that take
decades, in some cases, to develop.
I think what we need to start thinking about doing as we go
into the 21st century is enhancing those human skills with some
of the big data analytics tools that companies like Amazon and
Facebook use so that those human talents, which really are
trained nowhere else but at the CFTC in many of our markets,
can actually do their work, but powered with some of the latest
data analytics. I think the CFTC has the human talent, and I
think with the support of this Committee, we can give them the
data analysis tools to really move this forward into the next
century.
The Chairman. Well, thank you.
Dr. Sandor, in your testimony you estimated that three
Treasury futures products have saved the United States
Government between $5-$10 billion each year. Even for
Washington, that is a lot of money each year. How do these
products only help the U.S. Government save on interest costs?
Dr. Sandor. These markets are transparent, so they provide
the least-cost bond prices, essentially the lowest interest
rates, and also hedging and the ability to sell its debt. And
for dealers in U.S. Government securities, they can bid for
those bonds at a higher price and a lower interest rate because
they can hedge the risks. The liquidity in the futures market
is so broad that it can absorb that amount of hedging, thereby
reducing interest costs for the U.S. Government.
The Chairman. Well, thank you, Dr. Sandor.
I am now pleased to recognize the Ranking Member from
Minnesota for 5 minutes of questioning.
Ms. Craig. Thank you, Mr. Chairman.
This question is to Mr. Sexton. I appreciate your testimony
explaining the steps that NFA has taken on its own to help
investors better understand the nature of digital assets and
the substantial risk of loss that can arise from trading these
products. And I also appreciate NFA's efforts to regulate your
members' activities in this area through compliance rule 2-51.
Do you have any estimate or guess as to how much of the total
amount of digital asset spot market trading is being conducted
by or through your members and hence has these extra
protections?
And then, second question, does NFA often hear customer
complaints from those who are trading in these spot markets
with entities who are not NFA members? And if so, what do you
tell them?
Mr. Sexton. Thank you very much for the question. Let me
start off by saying that with regard to compliance rule 2-51,
we adopted that, Congresswoman, because our traditional rules
were aimed towards futures contracts, and therefore, if we had
a member firm that was engaging in spot digital asset
commodities and engaging in fraudulent activities, then we
could not bring a disciplinary case against them because we
didn't have them under our jurisdiction. So it was a very
important rule for us in that sense.
We have approximately over 100 members or so that are
engaging in spot digital asset activities, and they self-report
to us those activities, primarily in their commodity pools,
which can invest in futures, securities, anything, including
digital assets. We have not received any customer complaints
significant with regard to our members' activities in this
area. I think part of what we were trying to accomplish too is
establish supervision requirements for them, which is key to
our regulatory oversight. So with regard to our members, we
have not taken any cases under 2-51. And, as I said, very
limited customer complaints have been received with regard to
our members.
If we receive customer complaints not involving our
members, we typically will refer those to the CFTC. We act very
closely with the CFTC in their enforcement area. Obviously, if
they are not a member of ours, the CFTC would have jurisdiction
and be able to bring an enforcement action.
Ms. Craig. Thank you so much.
I want to turn to Mr. Schryver. In your testimony, you cite
the importance of the CFTC in investigating potential abuses,
fraud, and manipulation in the markets. For Fiscal Year 2023,
the CFTC reported it brought 96 enforcement actions, and almost
half of them were involving conduct related to digital
commodities. For Fiscal Year 2024, the agency brought 58
enforcement actions, again, many of them in the digital asset
space. As traditional users of derivatives markets, do your
members have any concern whether the agency is focused enough
on surveilling and policing the markets you use compared to
trading in these newer products?
Mr. Schryver. Thank you for the question. Our members need
to have confidence in these markets to engage in the markets.
They do have confidence in the markets. When we see instances
where natural gas prices have escalated, a lot of volatility
such as Storm Uri, we have raised concerns, and you always
learn from these incidents. In the case of Winter Storm Uri,
steps have been taken to mitigate those impacts in the future,
which we support. But otherwise, no, our members have
confidence in the markets and the integrity of the markets.
These markets, as I mentioned, are critical to our members
because 95 percent of our members are captive to one pipeline.
They can't physically hedge. They don't have access to storage,
so using derivatives tools to hedge in these markets really
helps protect our consumers.
Ms. Craig. Thank you so much, Mr. Schryver.
At this point, I just want to say, Dr. Sandor, I was born
in 1972, and in my last 30 seconds, I just think I should give
you the opportunity to say anything else you want to say. So,
Dr. Sandor, what do you want to tell us today?
Dr. Sandor. I want to echo Chairman Giancarlo's remarks.
Being 800 years old and having been in this town since 1966
after completing my Ph.D. at the University of Minnesota I
might say, I think pound for pound this agency is incredible.
If you take a look at cost-benefit ratios, which economists
like to think of two or three, I think the agency runs on under
$4-$500 million, Chris. If you take $5 or $10 billion just from
the interest rate sector, you are talking about a cost-benefit
ratio of 20:1. I mean, that is unbelievable in the commercial
world, let alone in governmental affairs. People would be very
happy. So I want to join Chris and say happy birthday to this
Commission and to all of you that have enabled this.
Ms. Craig. Well, Go Gophers. And with that, Mr. Chairman, I
yield back.
The Chairman. Very good. I now recognize the gentleman from
Oklahoma, Mr. Lucas, for 5 minutes.
Mr. Lucas. Thank you, Mr. Chairman. And I would note in
1972 I was driving a Ferguson tractor pulling a hay rake, so we
all had a glorious time in those days. Thank you, Mr. Chairman,
and thank you to all of our witnesses for testifying.
Of course, today's hearing focused on the 50th anniversary
of the creation of the Commodity Futures Trading Commission.
This anniversary gives us an opportunity to review the
operations and activities of the Commission and examine the
pressing issues end-user consumers are facing in their
interactions with the markets today.
Derivative markets are essential risk management tools for
farmers, ranchers, and all producers. The ability to transfer
risk, manage price volatility, and reasonably predict cost
allow businesses to free up capital to invest in the economy,
pass savings to consumers. That way, Americans pay less at the
grocery store and at the gas pump. Congress must protect the
markets' integrity and function so our producers can continue
to affordably supply that food, fuel, fiber, energy that the
world runs on.
The previous Administration posed significant challenges
and uncertainty to the derivatives markets, as the Prudential
Regulators look to dramatically increase capital requirements
for many derivative transactions. I am hopeful that the Basel
endgame re-proposal by President Trump's nominees will not
present such a threat.
Mr. Carey, in my role as a former Member of the Dodd-Frank
Conference Committee--maybe survivor is the way to describe
that--I remember well the broad bipartisan agreement to leave
end-users exempt from the regulatory burdens of the Dodd-Frank
Act. Some of the rules and proposals that came out of the last
Administration, especially the Basel III endgame proposal, were
particularly burdensome and disproportionately harmed end-
users. How should incoming Chairman Quintenz work with
Secretary Vilsack and the Prudential Regulators to ensure that
derivatives markets are affordable and accessible?
Mr. Carey. Well, I think one of the reasons that we are
here talking about the CFTC and their role as a regulator, I
think that one of the biggest strengths that they have had in
their entire existence is their ability to conduct a dialogue
where everybody's concerns are addressed and using judgment and
the ability to determine where or where not certain rules
should be applied because you want safety and soundness in the
system. You want enough capital to basically protect the
customers, but you don't want to make it prohibitive to the
point where they can't do business on these exchanges, and it
is better for them to go unhedged rather than hedged.
Mr. Lucas. Dr. Sandor, you suggest both in your testimony
and in your response to questions that the introduction of
futures and options of Treasury bonds and notes have led to
billions of dollars in interest savings for the U.S.
Government. We are now at a time where, compared to 20, 25
years ago, we are rolling over eight times as much debt as we
did. We have half the primary market makers that we had 20+
years ago. Could you expand on your testimony about how CFTC
and SEC can partner to alleviate stresses on the Treasury
market, particularly in light of the clearing rule that the
industry is gearing up for? If we can't move our paper, we are
in a world of hurt.
Dr. Sandor. Yes, I can't speak to the CFTC's role. My
understanding is that the interest rate market is a very small
part of the SEC, so I am not sure--they handled equities, not
fixed income, and government securities are totally exempt, so
I don't know of any competence in that area.
I do share your concerns. If my recollection is right, and
I think, given my experience, I think we had a total
outstanding supply in 1977 of long-term bonds of $18 billion.
In U.S. history, that was the total outstanding issue. When you
think of $36 trillion of debt out there, it is dwarfed. I think
that we have to encourage more primary dealers and make the
rules and accession in there because it is that competitive
process at auctions that really keeps prices up of bonds, and
thereby interest rate lowers, so a dramatic expansion.
I think we really need to have clearing consolidated of
government securities. I think we celebrate things which should
not necessarily--it took 3 or 4 years to get T+1 through. That
shouldn't be that way. I think the blockchain, other
technologies, trusted partners, the use of technology, which is
being routinely used in AI today and industry needs to be used
in the regulatory process, and that would be my fundamental
concern. There should be enough competence there that ranks it
with Google or Amazon in clearing and in other functions.
Mr. Lucas. Thank you, Doctor.
I yield back, Mr. Chairman.
The Chairman. I thank the gentleman. I now recognize the
gentleman from Georgia for 5 minutes of questions.
Mr. David Scott of Georgia. Thank you. Thank you very much.
All of us understand from what we went through with the Dodd-
Frank era, bad actors, poor transparency in the derivatives
market, that is what contributed to the 2008 financial crisis,
and it was one of the worst crises we had. And thank God, thank
goodness we had the CFTC there to respond to it.
And so, Mr. Schryver, you first. In your testimony, you
discussed the importance of derivatives market transparency as
fundamental to maintaining fair pricing for consumers. Can you
very briefly describe the impact that transparency requirements
have in protecting consumers from risk, including for those who
receive services by the 86 municipal gas utilities in my
district in the great State of Georgia.
Mr. Schryver. I appreciate the question. If you look at the
universe of public gas systems, I know Georgia takes their
football seriously. We are an SEC-intensive association.
Mr. David Scott of Georgia. We do.
Mr. Schryver. The bulk of our membership is in the SEC
football states, including the 86 in Georgia, and a lot of
these are very-small- and medium-sized communities. So they
are, as I mentioned, not for profit. Their consumers rely on
them getting natural gas to them.
APGA was a strong supporter of the Dodd-Frank reforms in
terms of increasing market transparency, giving our members
confidence that the prices reflected in the marketplace were
accurate and accurately reflected supply and demand. We realize
there is a role for speculation in terms of providing
liquidity, but, as you mentioned, transparency is critical, and
our members have a lot more confidence in the marketplace as a
result of the action the Committee and Congress took through
Dodd-Frank to enhance market transparency.
Mr. David Scott of Georgia. Yes, very good. Now, Ms. De'Ana
Dow, welcome home. For 22 years you have served with the CFTC,
and for 22 years I have served here in Congress. And for those
22 years, the constant battle has been getting enough money to
the CFTC. Why is that? And what more should we be doing to get
the money to the CFTC to do their job? And I see Chairman
Austin Scott here. We went to battle for the CFTC. You all
remember. The European Union, as you recall, wanted to come
over and take away the regulatory authority of our markets and
financial system, but we stood up to them and said pleasantly
or rather strongly, heck no.
And let me just ask you. What more should we be doing in
Congress here to impress the importance of the CFTC from your
22 years' experience that we can finally get folks to get the
CFTC more funding?
Ms. Dow. Thank you for that question. I wish I knew the
answer to how to address this issue that has been going on
since when I was at the Commission starting back in 1980
through 2002.
Mr. David Scott of Georgia. That is right.
Ms. Dow. So the important thing to note and remember is the
markets have evolved. Back when the CFTC was first created,
they weren't as large as they are now. The markets have
evolved. The CFTC now has authority over the swaps market. It
now has expanded into other types of markets, events contracts
for retail.
Mr. David Scott of Georgia. Yes.
Ms. Dow. It is also looking to take on responsibility in
the digital asset space. All of these additions to the CFTC's
jurisdiction and authority demand that their budget be
increased.
Mr. David Scott of Georgia. Right.
Ms. Dow. And while maybe it is a lack of education or
understanding, but certainly, it is important for the Congress
to realize and recognize that the jurisdiction of the CFTC has
expanded significantly, and the current budget is not
sufficient to cover all of the responsibilities that it
currently has.
Mr. David Scott of Georgia. Well stated, and I hope all our
ears were open to hear that. We are determined on both sides of
the aisle to make sure that we get the CFTC more funding. Thank
you very much.
Mr. Austin Scott of Georgia [presiding.] Thank you, Mr.
Chairman, and I recognize myself for 5 minutes.
Commissioner Giancarlo, you mentioned one thing that we
don't talk about enough in Congress. You mentioned the U.S.
Dollar as the world reserve currency. I do believe the CFTC has
played a vital role in keeping the dollar as the world
currency, and your testimony would allude to that as well.
Would you speak briefly, 30 seconds, 60 seconds, of what the
consequences of the U.S. dollar not being the world currency
would be for the United States citizens?
Mr. Giancarlo. To my mind, it is not a coincidence that the
founding of the CFTC coincides with the dollar going off the
gold standard in the mid-1970s. When that happened, the world
nations that held dollars suddenly had enormous risk of
interest rate movements, of foreign exchange changes with the
dollar no longer anchored to gold. It was the creation of
financial futures by Dr. Sandor and others that allowed these
markets to actually support the dollar in its truly fiat state
because now the world can hedge their risk of holding dollars,
the interest rate, the risk, the foreign exchange risk in
holding dollars.
I will argue to you that the CFTC is really the agency that
safeguards the dollar and its ability to be held by global
nations around the world, and their holding of it is what makes
it the world's reserve currency allows us to fund that enormous
debt that Dr. Sandor spoke about. So I think the CFTC plays
this sleeper role. When I say pound for pound, Dr. Sandor, it
might even be better than 20:1 because if this agency is the
agency that stands between the dollar service as a reserve
currency and ending that service, I think it is a vital agency.
You might remember that old story about the boy with his finger
and the dike. We may be the boy or the child with the finger in
the dike that is supporting the dollar is the world's reserve
currency.
Mr. Austin Scott of Georgia. Chairman----
Dr. Sandor. Can I just poke my head quickly.
Mr. Austin Scott of Georgia. Yes, briefly, please.
Dr. Sandor. Chris, I think that is exactly right, and the
Members of this Committee might witness a significant increase
in interest rates if we lose our role as a reserve currency,
driving up automobile costs, housing costs, food costs, and
every other manner of consumer expenditures.
Mr. Austin Scott of Georgia. Thank you. And coming back to
you, Chairman, as Congress contemplates legislation related to
digital assets, there is discussion about CFTC, SEC. Would you
explain to us why you think the CFTC's framework is the best
with regard to the digital currencies to regulate them?
Mr. Giancarlo. Well, let's even start with the CFTC has
been looking at digital assets going back to at least 2014 when
I first started with the Commission. And under my predecessor,
Chairman Massad, we declared in 2015 Bitcoin to be the world's
first digital commodity under CFTC jurisdiction. And over the
last few years, while our sister agency, the SEC, has really
been quite frankly resistant to engaging with digital assets,
the CFTC has upped its game considerably. It has over a decade
of studying the most important digital assets, which are the
digital commodities like Bitcoin and Ethereum. So its inherent
knowledge base is better than any other agency in Washington
pretty much, unarguably. Then its framework, which Ms. Dow
spoke about, its self-certification process, its principles-
based regulation is ideally suited for these new instruments
that are evolving so rapidly.
And I want to say one other thing. It is now almost 7 years
since the CFTC first greenlighted Bitcoin futures. That was a
controversial step at the time, but here we are 7 years later,
and that market is deep, it is liquid, and it is transparent,
and it is very well regulated by the CFTC, relatively free of
fraud and manipulation compared to spot markets. And that is
why I think the CFTC is the ideal regulator to take what it has
learned from futures markets and go into digital spot markets
for digital commodities.
Mr. Austin Scott of Georgia. In my last 50 seconds, we know
about the FTX failure, obviously shocked the system, but the
DCM and the DCO, those people did not lose money. Can you
explain how, as a market regulator, the CFTC protected?
Mr. Giancarlo. So there are only two places of the entire
global FTX empire that didn't fail, the piece under Japanese
supervision, and the piece under CFTC supervision. And the
reason why the users of those systems under CFTC and the
Japanese got every dollar back is because both regulators
required segregation of the customer funds. They couldn't be
used by Sam Bankman-Fried as a piggy bank for his other
activities. They had to be held separate and apart and held
pledged to those users, so that is why they got their money
back.
Mr. Austin Scott of Georgia. Thank you, Mr. Chairman.
My time has expired, but the segregation of the funds is an
important aspect that I don't think we talk about much either.
Ms. Adams, you are recognized for 5 minutes.
Ms. Adams. Thank you, Mr. Chairman, and thank you, Ranking
Member, both of you, for hosting this hearing in honor of the
50th anniversary of the Commodity Futures Trading Commission:
1972 was a great year. My second child, my daughter, was born,
so I still celebrate that.
But let me just say, the CFTC's mission statement is to
promote the integrity, the vibrancy, and the resilience of the
United States' various financial markets through proper and
dependable regulation, and in the next 50 years of the CFTC's
work, I hope that this will remain the goal and the plan of the
Commission to ensure that consumers, including those involved
in agriculture commodities, are all aware of necessary
information and are protected.
So Mr. Schryver, from your testimony, it appears that your
members are supportive of speculative position limits in these
derivative markets. And, as you know, there are some parts of
the market that have not been supportive of position limits,
and the agency took a very long time to implement new position
limit requirements included in the Dodd-Frank Act. So can you
please tell us why your members believe in position limits and
the role you believe they play in establishing fairness and
confidence in these markets for commercial end-users?
Mr. Schryver. Thank you for the question. Our members are
market takers, not market makers, and the concern of our
membership, as I mentioned, a lot of small-, medium-sized
public gas systems, is that there is integrity in the market,
and position limits help ensure that no one party has a
substantial share of the market to allow excessive speculation
to change the price beyond normal market factors. So APGA has
been a strong supporter of position limits. We believe they are
an important tool for the CFTC.
Ms. Adams. Okay. Thank you. So from your testimony, I am
also interested in your emphasis on the importance of CFTC's
role of promoting market transparency and setting the standard
around the world for financial markets. And this is
particularly relevant in terms of its potential impact on
everyday consumers, especially regarding rising energy bills
and goods. So could you further discuss how the CFTC can help
prevent market manipulation or practices that could negatively
affect consumers?
Mr. Schryver. Thank you for the question. Market
transparency is critical to our members to ensure that they
have confidence in the markets. They see what is happening.
They can make decisions based on that full level of
transparency. And as I mentioned previously, a lot of the
reforms that came about through Dodd-Frank significantly
increased transparency to a level that gave our members greater
confidence in the marketplace.
Ms. Adams. Thank you, sir.
Mr. Carey, you noted that a key function of the derivatives
market is to help businesses manage volatility in our country's
financial markets. So what advice would you give Congress and
the CFTC to help strengthen derivatives markets' ability to
withstand volatility and uncertainty? And additionally, how can
Congress ensure the effectiveness of commodity markets and
derivatives products as tools for risk management and price
discovery?
Mr. Carey. Well, actually, the point I was trying to make
was that the markets themselves and the liquidity in the
markets themselves help reduce the amount of volatility, but
there is volatility, there is price risk, but it allows users
to transfer that risk to somebody who is willing to accept it.
So I think that the CFTC has proven itself as the regulator of
choice because these markets work, and you have seen them
protect the customers and protect the integrity of the
marketplace by what they do and how they constantly evolve to
the needs of the marketplace. So I think that the CFTC, with
the expertise within the organization, is one of the places
Congress should look to make sure that our markets remain the
economic engine in this country that they are.
Ms. Adams. Okay. Thank you, sir. And thank you all for your
testimony and your responses. And, Mr. Chairman, I yield back.
The Chairman [presiding.] Ms. Adams, thank you so much.
I now recognize the favorite son of South Dakota, Dusty
Johnson, for 5 minutes.
Mr. Johnson. Chairman Giancarlo, we will go with you. Good
to have you back here. Of course, you knew a lot about swaps
before you became a Commissioner or Chairman. Dodd-Frank
obviously gave the Commission tremendous new authorities and
responsibilities over the swaps market, new transparency, new
Fed regulation. There were some at the time, I am sure, that
wondered whether or not the Commission was up to it or whether
that regulation was even appropriate. Give us a sense of why
that was important and why the CFTC was the right home for it.
Mr. Giancarlo. I was probably unique at the time in
actually being a wholehearted supporter of Title VII of Dodd-
Frank, the provisions that awarded the CFTC oversight for most
but not all of the U.S. swaps market. I saw really three key
components of that, regulated swaps clearing, swaps reporting,
and swaps execution. And I was a supporter of all three for a
really particular reasons. I had spent 40 years in the private-
sector and 15 years as the head of one of the largest swaps
trading platforms, not a trading firm. We didn't trade. We
operated the platform on which these trades took place. And I
recognize--in fact, we had tried, in 2005 and 2006 to launch a
derivatives clearing platform. We believe that clearing is not
a panacea for risk, but it professionalizes risk management. It
professionalizes and mutualizes the risks of a failure. And so
when Dodd-Frank took that up as a requirement for many, but not
all, swaps, I was supportive of that.
Similarly, swaps reporting made complete sense, even though
I think the approach is a 20th century, not a 21st century
approach of reporting to a repository. But the reason we had a
crisis in 2008 was not because we felt that swaps would fail.
It is because we believed they would work. And we only
understood the gross total amount of swaps. We perceived at the
time there was $400 billion swaps written against the failure
Lehman Brothers. We now know, because of work done by the
former CFTC Chief Economist Bruce Tuckman, that the net
exposure was less than $9 billion. In September of 2008 if we
knew that a failure of Lehman Brothers would have triggered
less than $9 billion, we wouldn't have had a financial crisis
because we could have let Lehman fail. We could have let it be
sold. We could have let it be bought. It was the fog of war,
the inability to understand the true exposure. So I am a big
supporter of that.
But the blockchain is the true answer to that, not these
swap data repositories. By the time the data is reported, it is
too late. Regulators need to be able to see true exposures in
real time, and the blockchain will be able to do that.
And finally, in terms of swaps execution, I truly believe
that Congress got that provision right in the Dodd-Frank Act by
allowing swaps trading platforms to use any means of interstate
commerce because the episodic nature of liquidity in the swaps
market is very different than the continuous nature of
liquidity that exists in the futures market.
Mr. Johnson. And again, the regulation of the transparency
isn't a panacea, as you said.
Mr. Giancarlo. Not at all.
Mr. Johnson. Clearly, this is a better way to have the
markets run overall?
Mr. Giancarlo. Right. And this is where the CFTC does well.
Mr. Johnson. Yes.
Mr. Giancarlo. CFTC takes a lot of partisanship, a lot of
emotion out of managing markets. When it comes to swaps and
futures clearing, in 50 years, no clearinghouses ever failed
under CFTC supervision. During the 2008 financial crisis----
Mr. Johnson. Pretty remarkable when you think about it.
Mr. Giancarlo. Truly remarkable.
Mr. Johnson. Yes.
Mr. Giancarlo. Our markets are some of the biggest and the
most sophisticated in the world. It is really got--I mean,
again, we talk about pound for pound, whatever way you want to
measure it, the CFTC's record is really quite extraordinary.
Mr. Johnson. So in your written testimony, one of the
headings is the next 50 years. And then I got excited when you
started to talk digital assets because I thought, oh, we are
going to get into something real here. You didn't address the
market structures bill that passed out of Committee on a
strongly bipartisan basis, and I don't want to put you on the
spot. It wasn't like you were an author of it or anything. But
any observations for us as we get ready to relaunch that effort
here in Committee?
Mr. Giancarlo. Yes, so the United States needs a regulator
for spot markets for crypto, I truly believe.
Mr. Johnson. Yes.
Mr. Giancarlo. And when I look around the landscape, there
is really only one that is ready to take up that baton today,
and that is the CFTC. It has been engaged continuously under
both Republican Chairs and Democratic leadership for the past
dozen years in this marketplace. Its record in terms of Bitcoin
futures, Ethereum futures, and now, just recently launched
Solana futures. It is superb. The information is transparent.
It is available. The markets operate in an orderly fashion.
I mean, I don't want to throw shade at a sister regulator,
but its failure to engage----
Mr. Johnson. Oh, please do. We are fine with that here.
Mr. Giancarlo. Its failure to engage is quite notable
against an agency like this that has engaged and done so quite
successfully and proven that regulators can engage with this
new innovation.
And I will say one other thing. Crypto is a lot more than
about just is the number going up. This is a new architecture
of finance that is going to change everything we know about how
you record who owns what and who is transferring what to whom.
The United States must be a leader in this, and this is the
agency that has already served as a leader for the last dozen
years.
Mr. Johnson. Very well said. I yield back.
The Chairman. The gentleman yields back.
I now recognize the gentlelady from Oregon, Ms. Salinas,
for 5 minutes.
Ms. Salinas. Thank you, Mr. Chairman and Ranking Member
Craig, and thank you to our witnesses today for being here.
Since joining this Committee, I have taken particular
interest in the CFTC's regulatory responsibilities over event
contracts, especially those related to electoral and political
outcomes. The rise of platforms like Kalshi has turned election
event contracts into a major market. In fact, during the 2024
election, Kalshi alone saw around $400 million wagered on
election outcomes, and that is only a small portion of the
broader market that easily reaches into the billions.
But it is not just elections. As you all know, political
outcomes of all kinds are wagered. For example, right now on
Polymarket, an alternative to Kalshi, individuals can currently
acquire event contracts on things like how many gold cards
might President Trump sell in 2025, whether President Trump
will end the war between Ukraine and Russia in his first 90
days, and this market alone has about $36 million in volume.
These markets exist alongside those for pop culture and sports
outcomes.
So, Mr. Giancarlo, as a former CFTC Chairman who
subsequently joined Polymarket as chair of its advisory board,
I suspect you have strong perspectives on these event
contracts. And to that end, I just have a couple of questions
for you. As it currently stands, an event contract on whether
President Trump will end the war between Ukraine and Russia is
treated exactly the same as a contract on whether the
Trailblazers will win their next game. Knock on wood. These
contracts can be on literally anything, and they are treated
the same by the platforms. How, from a Kalshi or Polymarket
user's perspective is an event contract on the conclusion of a
war different from betting on the outcome of, say, a basketball
game?
Mr. Giancarlo. So the questions on these event contract
markets are driven by the market participants. That is one of
the things that is quite unique about them. In the case of both
platforms, they are quite international. And in many ways, we
here in the United States have let the cat out of the bag in
terms of the desire for people to wager on events with sports
gambling. When I grew up, sports gambling was not allowed. Now,
you cannot watch a sports event without the advertisers
flooding the zone, and that is just not by accident. That is a
policy choice we have made at every level of society over the
last dozen years or so.
And if that is the case, then how much of it is a stretch
to think that people that are going to take a side in who is
going to win the Super Bowl might want to take a side in who is
going to win an election. And in fact, what we found in 2024, a
year in which something like 70 percent of the world's
democracies voted, it was the events contracts like Kalshi and
Polymarket that were far more accurate in predicting the
outcome of those elections, whether it was the French election,
the British election, the Indian election, the Japanese
election, than were any of the polling sources.
So we have two elements going on. I think that there is a
societal change with this great acceptance of betting on the
outcome of popular events, celebrated events, but we also have
the fact that they are actually becoming better measurements of
society's feelings at a time. They don't predict the outcome,
but they tell you 3 weeks out where society is, and they seem
to be far more accurate than polling is.
And, our elections do have consequences, not only United
States, around the world. They affect the outcome of trade
policy, of immigration, lots of things. People do have a stake
in the outcome, and if they can hedge that stake in these
markets, perhaps the time has come for us to really take them
up and properly regulate them. The same way that we didn't run
away from Bitcoin, we engaged it and built a regulatory
framework around it, I think the time has come for us to build
a regulatory framework around it so we can protect those who
are vulnerable. We can make sure that these platforms have good
policies and procedures and protect customers in the way that
we have done a great job with in other areas of modern life.
Ms. Salinas. Thank you. And just a quick follow-up with my
last minute left. So what is your analysis of kind of the
incentive structures that are created by allowing event
contracts on such high-stake electoral and global affairs,
especially, as you just said, I am curious to know, are they
predicting, or are they driving the outcomes?
Mr. Giancarlo. That is a hard one to measure. I don't know
if I have an answer to that. I think the same could be said
about polls. Do they drive the outcome, or are they steered to
get the outcome they want? All I can point to is looking
backwards at 2024 where it did seem that the events contract
markets were more accurate of what actually happened than were
the polling in many cases.
Ms. Salinas. Thank you. I yield back.
The Chairman. The gentlelady yields back.
I now recognize the gentleman from Ohio, Mr. Taylor, for 5
minutes of questions.
Mr. Taylor. Thank you, Chairman Thompson and Ranking Member
Craig, for holding this hearing today, and thank you to the
especially esteemed group of witnesses we have today for your
insight and testimony.
Mr. Sexton, not to pile on here, but you have considerable
experience with the CFTC and the markets it oversees, and you
have also talked about the role digital assets have played in
your career and your work to ensure there are adequate consumer
protections in place. Cryptocurrency has taken off over the
last few years. As of January, there are over 20,000 different
cryptocurrencies worldwide, and the global cryptocurrency
industry is valued around $3 trillion. How do you see the
cryptocurrencies impacting agriculture and our farmers in the
future, and are there ways for our farmers to use
cryptocurrencies or blockchain to their advantage?
Mr. Sexton. Congressman, I have to confess, I am no expert
in the blockchain, but I certainly believe, as former Chairman
Giancarlo has indicated, that there is great use for the
blockchain in the future for recording transactions, and I know
that there is also experimentation with tokenizing commodities
in order to record them, but also to transfer them. So a little
bit, maybe not completely responsive, but I think that there is
great opportunity there for farmers and ranchers and others.
Mr. Taylor. Okay. Do you see cryptocurrencies in general
being able to really promote economic growth in more rural
areas, or do you think it is predominantly going to remain in
urban areas?
Mr. Sexton. No, I think that as cryptocurrencies continue
to grow, particularly the technology, it will promote growth
across not only urban areas, but rural areas and elsewhere.
Mr. Taylor. Okay. Thank you. Ohio, my home state, is one of
the largest natural gas-producing states in the country. Mr.
Schryver, in your testimony, you mentioned that community-owned
natural gas companies can utilize futures markets to ensure
consumers have stable energy prices. People in my district work
hard to make a living, and being hit unexpectedly with a
massive energy bill could be devastating. Can you speak more
about how the futures markets under CFTC help stabilize energy
prices for utility companies and consumers?
Mr. Schryver. Yes, thank you for the question. As a fellow
Buckeye, I appreciate the question, and we do have several
members in Ohio. Our members' goal as not-for-profit utilities
is to make sure natural gas is affordable, and utilizing the
futures markets allows them to take positions that protect
their consumers from volatile price swings and keep the price
in an affordable range, which is critical, especially for the
low-, middle-income consumers they serve.
Mr. Taylor. Thank you. In your opinion, how would making
the U.S. more energy-independent and dominant help stabilize
energy prices for folks in southern Ohio?
Mr. Sexton. Very much so. The more natural gas that is
available--and, as you said, Ohio is a significant natural gas
producer, the more we have natural gas available, the more our
members have access to the commodity. We support increasing
production. Some areas of the country, New England, where
pipeline infrastructure is constrained and it is harder to get
natural gas to those areas, but certainly increasing the
availability of natural gas through production, through
increased pipeline construction benefits consumers. As I
mentioned, our members are captive for the most part. Ninety-
five percent of our members are captive to one pipeline. So
increasing infrastructure, increasing production is going to
benefit consumers.
Mr. Taylor. Thank you, sir.
Mr. Chairman, I yield back.
The Chairman. I thank the gentleman. He yields back. I now
recognize the gentlelady from Illinois, Ms. Budzinski, for 5
minutes of questioning.
Ms. Budzinski. Thank you, Mr. Chairman, and thank you,
Ranking Member Craig, for convening today's hearing on the
CFTC. And to all the witnesses, thank you so much for coming
today to share your perspective on the history and the future
of the CFTC.
I want to use my time today to talk about agricultural
commodity futures, but before I begin, I would be remiss if I
didn't mention the work that this Committee did on FIT21 last
Congress. I was proud to support a bill that properly funded
and authorized CFTC to regulate digital assets, and I am very
grateful to the Chairman for including amendments that I had
proposed to enhance consumer protections. I want to thank both
the Chairmen, Chairman Thompson and Subcommittee Chairman
Johnson, for their leadership on that issue.
Regarding ag futures, the work at the CFTC is so important,
and it provides certainty and risk management tools for farmers
across my district and the country. And there is so much to
learn. The University of Illinois, I am proud to represent in
my district, is home to the Office for Futures and Options
Research. Their team is doing cutting-edge research on
agricultural commodity futures and prices, and commodity
researchers at the University have published over 470 scholarly
articles in leading ag economics journals. Despite this
incredible research and the incredible work that the CFTC does,
much of the public is still not aware of CFTC or its function.
So my question, Mr. Carey, in your testimony, you touched
on the purpose and function of the derivatives market. Can you
explain how agricultural commodity futures are important risk
management tools in and of themselves, but also in supporting
other risk management tools like crop insurance?
Mr. Carey. Well, yes, they are all integrated. The Chicago
Board of Trade itself was founded because farmers couldn't get
a price for their wheat, so they dumped all their wheat in the
Chicago River back in the 1840s. So the Chicago Board of Trade
was founded to create rules, and those rules created a
framework where you could have elevators and storage and they
could get a fair price for their grain and ship it out East.
Nowadays, the markets are more sophisticated, but the
markets still work. You have global competition. You have
Brazil growing bigger and bigger, and they do denominate their
crops in U.S. dollars, so they are quite pleased about the
strength of our dollar.
But I think that the CFTC, along with the exchange,
provides the kind of products that are integrated with the
insurance, and it allows the farmer to make a decision. Right
now, it looks like acres are moving to corn from beans, and
that will all be reflected in November soybeans; in December,
corn. So I think that is pretty much the fact that we have open
and transparent markets is the way we service them.
Ms. Budzinski. Okay. Thank you. Yes, commodity futures are
so important to our consumers, farmers, and more. Congress
needs to uplift the work, I believe, of the CFTC, including by
reauthorizing it for the first time in more than 15 years.
Mr. Carey, again, your testimony states, ``It will always
be to our advantage for global benchmarks to be subject to U.S.
oversight and priced in U.S. dollars.'' Can you speak in more
detail about the potential consequences to our U.S. farmers if
key agricultural benchmarks are set outside the U.S. and in a
currency other than the U.S. dollar?
Mr. Carey. Well, yes, we touched on it. I think Chairman
Giancarlo talked about the value of having the dollar as the
reserve, and it is a powerful tool in a lot of ways, not just
to a farmer. But the farmer's price in dollars and regulated in
the United States with rules that come from either this
Committee or the CFTC itself or the exchanges working together
allows them the greatest chance basically for transparency. If
you move these markets to China or to Europe or Brazil, they
would be treated very differently, and we would be second
citizens, second of the group, while the growth in the
underlying production in Brazil has far outpaced us. But what
we are seeing is the global benchmarks remain here because of
our rule of law, because the way we treat customer money,
because of the way that our openness, transparency, and
regulation treats the end-users, the producers, and the
customers.
Ms. Budzinski. Okay. Thank you very much. I yield back.
The Chairman. I thank the gentlelady and now recognize the
gentleman from Indiana, Mr. Baird, for 5 minutes of
questioning.
Mr. Baird. Thank you, Mr. Chairman, and thank all the
witnesses for being here. I appreciate all the knowledge you
share with this Committee.
Anyway, Ms. Dow, your testimony notes that the CFMA
revamped how commodities are addressed, and based on three
classes, agriculture commodities, energy and precious metals,
and financial commodities. So could you talk about how the
approach led to more effective market oversight by the
Commission and therefore benefited our markets and our end-
users?
Ms. Dow. Thank you for your question. That in fact was the
first time that the Commission ever differentiated between the
classes of commodities. And, as you mentioned, there were
agricultural, energy, precious metals, and financials. So what
happened was the core principles flowed from the nature of
those commodities. So, for example, energy and agricultural,
they were subject to position limits with certain exemptions
for hedging. The financial commodities were not because there
is no finite supply, which in physical commodities raises
concerns about deliverable supplies and market manipulation
concerns. So with that recognition of the differences in the
commodities, the rules were able to be adapted to those
particular classes of commodities and were reasonable in terms
of what was needed in that particular space. And this approach
has worked well, and it ensures appropriate commodities-focused
regulation at this time, and it has continued to work well.
Mr. Baird. Thank you. And continuing on, I have another
question for you. You mentioned in the interconnectedness of
our markets in your testimony, and so during your tenure at the
Commission, and the Commission recognized the global nature of
markets in its overview and began to focus internationally, so
the CFTC began collaborating with foreign financial regulatory
authorities and chaired the working group of the International
Organization of Securities Commissions to draft principles of
cooperation in the early 1990s. So would you please talk about
the Commission and how it became the exemplar for financial
regulators around the world?
Ms. Dow. So I think the Commission was first in terms of
recognizing regulatory regimes around the world that had
comparable levels of regulation, which opened the markets up
for our customers and for foreign customers to have access to
our markets. And that comparability determination and allowing
for home rule, home-based oversight of these different types of
markets really gave the CFTC a lot of visibility globally. So
this happened, I believe it was in the 1990s.
And then, following the 2008 financial crisis, the CFTC,
their implementation of rules under Dodd-Frank, increasing
transparency and reducing systemic risk, that kind of set a
standard for global markets as well. They play a leading role
in IOSCO. They collaborate with international regulators to
align global standards for derivatives futures markets. They
work with the Financial Stability Board, other global entities
to harmonize regulations. And it has been a model for
regulatory frameworks. The CFTC has been a model for regulatory
frameworks around the world. And I believe the U.S. remains the
only regulator with exclusive jurisdiction over futures trading
in markets.
Mr. Baird. Thank you. So one more question. Mr. Giancarlo,
the CFTC is solely focused on derivatives markets, and this is
different from other financial regulators abroad. So how has
this contributed to the Commission's success, and therefore, to
the success of our markets here in the U.S.?
Mr. Giancarlo. I think it is an interesting question. Not
only does the United States have a regulator solely devoted to
derivatives, it also has some of the world's largest and most
sophisticated and most important derivative markets in the
world. So it is almost a chicken-and-egg question. Is it the
fact that we have this singular regulator that we have managed
to grow the world's perhaps most important futures markets, or
is the fact that we do have the world's most important futures
markets that requires a specialized regulator? I think it is a
little bit of both.
Mr. Baird. So thank you very much, and I appreciate those
answers. And I have 15 seconds left, and I yield back, Mr.
Chairman.
The Chairman. The gentlemen is very generous yielding back
his last 15 seconds. Thank you, Mr. Baird.
I am now pleased to recognize the gentleman from the
Commonwealth of Virginia, Mr. Vindman, for 5 minutes.
Mr. Vindman. Thank you, Mr. Chairman. Thank you to all the
witnesses today.
Mr. Carey, in your opinion, what has been the impact of the
current Administration's tariffs, which have particularly
impacted key inputs that drive American agricultural industry
on commodities markets in your organization's stakeholders?
Mr. Carey. Well, I think that there was originally tariffs
reciprocated by the Chinese, which really changed the amount of
agricultural goods we sold in China from the U.S. They have
sought supplies elsewhere. I think the uncertainty today
hopefully will be resolved in the near future and that whatever
the tariffs end up being announced, that they don't do any harm
to the agricultural community or the farm community.
Mr. Vindman. So as a follow-on, if these tariffs stay in
place, what are the long-term impacts?
Mr. Carey. Well, I think that if there is a place that they
can--and commodity prices, like the futures markets and the
businesses we are in, are extremely competitive, and so it is
just the theory of economic man. They are going to go to the
cheapest place they can source these things, all things being
equal.
Mr. Vindman. Thank you. Mr. Sexton, Mr. Schryver, same
question. How do you anticipate these tariffs will affect your
stakeholders and prices for everyday consumers?
Mr. Sexton. Congressman, we are a regulator, and as far as
the tariffs and markets, our biggest concern with regard to our
member firms and customers is volatility that is created in
making sure that customers remain protected in this
environment. So I don't have an opinion as to the economics of
the tariffs, but as a regulator, we certainly have a concern
and are carefully watching our member firms with regard to the
risks that are presented, particularly given the volatility of
the markets.
Mr. Schryver. And as an organization representing end-
users, public gas systems, not-for-profit gas systems, we don't
have a position either, but our members would be concerned
about how tariffs might potentially impact the cost of steel,
which in turn impacts the cost of pipelines.
Mr. Vindman. Yes, so I hear a lot of concern, and I am also
concerned for the 3,000 small farmers that are in my district
and the other farmers in the Commonwealth, which I represent as
their sole Representative on the Agriculture Committee.
So, Mr. Giancarlo, I agree with your enthusiastic support
for the CFTC and its mission, and I also hope it continues to
do its work in stabilizing prices and markets for my
constituents. Like many of my colleagues, I was deeply
concerned by the current Administration's choice to fire two
members of the FTC, another independent agency. So in that
vein, what do you think we can do as Members of the 119th
Congress to protect the independence of the CFTC from outside
political influence?
Mr. Giancarlo. I think it is critically important that this
Committee continue to provide the support that it has provided
for the CFTC for its 50 years. And I think Member Scott put it
very well earlier when he talked about the importance of
adequately funding the agency, both for its existing duties,
but also if this Committee sees to give the CFTC greater
jurisdiction over spot digital commodities, which was in the
FIT for the 21st Century Act, I think funding that new
responsibility is critically important as well. I think an
agency that is adequately funded for its mission can carry on
as it is meant to do. And I think the issue of political
interference, in my experience, is an equal opportunity
employer.
I served under both a Democratic and Republican
Administration, under both President Obama and first President
Trump, and their efforts each time by different White Houses to
call some shots, and the agency successfully continued to do
its mission in a bipartisan manner. And I think adequate
funding is part of that as well.
Mr. Vindman. So I think an important point there is
recognizing that the Commissioners and members of these
independent committees are not serving as Republicans or
Democrats, but they are serving in a professional capacity on
behalf of the American people. That is where the oath is.
Mr. Giancarlo. That has always been the case at the CFTC.
Mr. Vindman. Thank you. And so with only 20 seconds left, I
am just going to shout out to my army buddy friend that came in
with his family, and then I yield back, Mr. Chairman.
The Chairman. I thank the gentleman.
I now recognize the gentleman from California, the rice
farmer, the Governor of Jefferson, Mr. LaMalfa, for 5 minutes.
Mr. LaMalfa. I can claim the first title but maybe not
necessarily the second one. Thank you, Mr. Chairman.
There we go. Is that better? All right. Thank you. Thank
you, Mr. Chairman. I appreciate those fine titles there. Thanks
to the panelists here. Sorry, this life of multiple committees,
I wasn't able to be here for a lot of it here, but I do have a
couple questions we had prepared.
Mr. Giancarlo, proposed reforms for us to consider in the
crypto spot market where fraud can certainly run rampant, we
are positioned to provide some commonsense regulation in that
arena. Could you speak to other reforms you have to see from
our efforts in Congress and the Administration that you haven't
got to touch on so far in this discussion today?
Mr. Giancarlo. Well, I do want to, if I may, speak to the
issue of fraud in crypto markets. There is no question that
fraud in spot markets is an issue, and I think it is a reason
why we need proper regulation. But, we at the CFTC, along with
50 state governments, have been trying to root out fraud in
some of the world's oldest markets like gold markets for dozens
if not hundreds of years, and the fraud still takes place.
Unfortunately, the job of regulators is one of cops and
robbers, and we do our best as cops when the robbers figure out
something new and they get a step ahead, and our job is to stay
a step behind, not two steps behind.
And so the notion that there is any magic bullet to fraud
in any financial market is, sadly, just not true. As long as
there are human beings with proclivities toward fraud and
abuse, there will always be a need for regulation, and that is
just the case. And so sometimes people will point to crypto and
say, well, there is so much fraud. Well, there is so much fraud
in some of the old--every crime show I see on TV, the bad guys
always have suitcases full of cash. And so that is always the
case, and that is why good cops on the beat will always be
necessary and adequate funding.
I do think, as I said earlier, however, that crypto is
really going to turn out to be a new architecture of the
ownership and the transfer of things of value. In the same way
that digital photography has changed everything we know about
photography in terms of usability of those photographs, in the
same way, digital architecture has changed everything we know
about our money, about our banking relationships, about our
ability to hedge our risk. It is all going to move to these new
blockchain systems.
And it is critically important that the United States have
a champion in this. And there is only one agency that has
demonstrated its ability to be that champion for a dozen years
now, and that is the CFTC. It is ready for this new challenge,
and with the support of this Committee, I think it is going to
get it right.
Mr. LaMalfa. Thank you. Very good, complete answer. Thank
you for that. Indeed, as long as people are people, we are
always going to have to keep an eye on them, and only one step
behind is--and that is reality, just not two. I like that.
Thank you.
Mr. Schryver, obviously, our natural gas is incredibly
important to our electrical grid and our energy needs in this
country, and with the miracle of hydraulic fracturing has made
it so much more available the last 20 years that we are really
fortunate. So, Mr. Schryver, as you represent America's public-
owned distribution companies for natural gas, many are
regulated by the CFTC. So how do these regulations help protect
these important derivatives markets?
Mr. Schryver. Thank you for the question. It is critical
that our members have confidence in these markets. They utilize
these markets to protect their consumers from price volatility.
By taking positions in the futures markets, they can protect
consumers from swings in natural gas prices, especially during
the winter heating season.
As I mentioned previously, a lot of the changes in terms of
transparency that came about through Dodd-Frank were very
beneficial to our members. We strongly supported them, and we
believe the CFTC has done a very good job in ensuring the
integrity of the markets.
Mr. LaMalfa. Excellent. Mr. Chairman, I am going to leave
it there. Thanks so much, so I will yield back a little extra
time for a change. I appreciate it. Thank you, panelists.
The Chairman. The gentleman yields back.
I am now pleased to recognize the gentlelady from
Connecticut, Mrs. Hayes, for 5 minutes.
Mrs. Hayes. Thank you, and thank you to all our witnesses
for joining us today.
The CFTC is unique in its position as a regulator. Unlike
the Securities and Exchange Commission whose mission is to
protect investors and facilitate capital formation, the CFTC
serves, I would describe it, as sort of a referee to reduce
risks and unfair competition. The CFTC maintains orderly
markets for physical commodities like agricultural and energy
products, as well as interest rates, foreign exchange rates,
and digital assets. According to the U.S. Energy Information
Administration, roughly 41 percent of Connecticut households
use home heating oil, and 37 percent use natural gas.
Connecticut has one of the most expensive energy rates in the
country, and on average, residents pay $76 per month for
heating oil and $39 a month for natural gas.
Mr. Schryver, in your testimony, you discussed how risk-
hedging mechanisms provided by the CFTC help to protect
consumers from price volatility. In your view, how would
customers be impacted if community-owned gas utilities could
not access these risk management tools, and would customers of
privately-owned utilities be similarly impacted?
Mr. Schryver. I think they both would be impacted.
Consumers would be subject to much more price volatility, and
as we saw in Storm Uri, they would be hit by potentially
backbreaking energy bills. We believe the derivatives tools
that the marketplace makes available and the CFTC regulates are
critical to protecting consumers from price volatility.
Mrs. Hayes. I think that is especially important,
especially in communities where there are not many options. So
whoever the provider is or whatever the services that are
available, consumers just have to accept that. So if there is
no oversight, management, input, regulation over those
industries, it is the consumer who ultimately bears the brunt
of it and just has to pay those services because in a state
like Connecticut, heating oil is not something you can just opt
out of.
Mr. Schryver. That is correct. In cold-weather states,
consumers are even more vulnerable. Our members are not-for-
profits, so when prices get high, they call the mayor, and the
mayor calls the gas system manager, and that is not a call he
wants to get. So we are really focused on providing affordable
and efficient natural gas, and these hedging tools are an
important part of that.
Mrs. Hayes. And when they can't get an answer from their
mayor or their governor, they call me.
The CFTC operates with about 700 employees and has been
chronically under-funded even as the market overseas have
expanded. To put it in context, since the enactment of the
Dodd-Frank Act in 2010, funding for the CFTC has roughly
doubled, while the value of derivative markets overseen by the
CFTC has increased more than 16 times. Despite this, we have
seen layoffs at the agency as part of broader layoffs
instituted by the Trump Administration, and additionally, there
have been ongoing efforts to lobby Elon Musk to merge the CFTC
and SEC and drastically reduce the regulatory power of the
Federal Government.
Back to you, Mr. Schryver. What would the impact of a
diminished CFTC be on market stability? And would reducing
resources to the agency be harmful again for energy consumers?
Mr. Schryver. APGA supports a well-resourced CFTC. We want
a strong cop on the beat. Having a strong cop on the beat is
important for our members to give them confidence in the
marketplace, ensure there is transparency, protected from
market abuses, market manipulation. We believe the CFTC is
uniquely positioned to regulate these important markets and
support them keeping that role.
Mrs. Hayes. Thank you. And I think we would all agree this
is an area of common ground that if we can weed out waste, if
we can weed out fraud, abuse and deliver more to the American
consumer or the American people, I think it is all in our best
interest. But--yes?
Dr. Sandor. May I?
Mrs. Hayes. You may.
Mr. Giancarlo. You mentioned talk about a merger. Back in
2017, the U.S. Treasury Department did an analysis, a written
analysis, which it published as to what would be the savings
between a merger between the CFTC and the SEC. And the amount
of savings they estimated was a staggering $9 million. Even
with inflation, if that is $12 or $13 million today, I am not
sure that savings would be worth what would be sacrificed in
losing the independent, skilled oversight that the CFTC brings
to these markets.\1\
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\1\ Editor's note: The report referred to, A Financial System That
Creates Economic Opportunities--Capital Markets, is located on p. 79.
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Mrs. Hayes. Thank you. That is really important information
to consider because, to your point, I don't think that the
savings would be worth the sacrifice, but it is definitely
something that we should all pursue as these conversations are
evolving. Thank you, and I yield back.
The Chairman. The gentlelady squeezes in the yield back.
I am now pleased to recognize the gentleman from the big
1st from Kansas, Mr. Mann, for 5 minutes.
Mr. Mann. Thank you, Mr. Chairman, and thank you all for
being here today. As mentioned, I represent the big 1st
District of Kansas, which is 60 primarily rural counties in the
western, central, and some in the eastern part of my state. I
appreciate this hearing. I appreciate the CFTC and how
safeguarding markets for the good of the country over the last
50 years.
I think we have to acknowledge that all market
participants, including our ag producers in Kansas and around
the country benefit from these important risk management tools
and have to have these tools as agriculture and the markets
continue to become more complex and to be able to hedge risk in
agriculture, which is already a risky business. It is just
incredibly important.
First question for you, Mr. Sexton. Can you tell us more
about your enforcement and disciplinary process such as the
types and the number of cases that you bring in a year?
Mr. Sexton. I certainly can and thank you for the question.
Our philosophy is to work with our member firms in order for
them to understand the industry's rules and understand NFA's
rules in the context of examinations that we perform when we
find issues with the examinations.
Enforcement is something that we will use, certainly, in
those cases where we have repeat offenders in material areas or
right out of the box we have significant issues that we need to
deal with a member firm. Congressman, we bring approximately 15
enforcement actions each year, and that has been fairly
consistent during the last few years. And when we bring those
actions, certainly, if there is significant customer abuse, we
are looking to suspend or expel those members from NFA
membership, and therefore, they can no longer engage in
derivatives activity with the public. And in other cases, we
will typically assess some type of fine against the firm in the
context of our enforcement actions.
Mr. Mann. And then, how do you work with the CFTC in
sharing that enforcement burden, and how does that coordination
work?
Mr. Sexton. Great question. We work very closely with the
CFTC with regard to our enforcement work. We have quarterly
meetings with the CFTC's Division of Enforcement, with their
director and others, and we essentially go through what is on
our investigative log, what is on their investigative log, and
attempt to determine who is best suited to bring a particular
case. So we don't often duplicate resources. Of course,
Congressman, as you can understand, in serious fraud matters it
is probably necessary for us to duplicate, but we really try to
eliminate that. And oftentimes, the SROs play a key role in
that.
Mr. Mann. Great. Thank you. That is very helpful.
Mr. Giancarlo. Congressman, if I may just add?
Mr. Mann. Sure.
Mr. Giancarlo. As a former Chairman who worked very closely
with NFA, when you think about the role of NFA and you think
about the role of the CFTC, you also think about the NFA is
funded by the industry. CFTC is funded by the taxpayers.
Mr. Mann. Yes.
Mr. Giancarlo. It is very much in the American people's
interest to see self-regulators like the NFA take on a lot of
the burden, and we took that very seriously during our time
working together, horses for courses, but in many cases, NFA is
closer to the action. They are closer to the members. They have
a good beat on what is going on, who the bad actors are. They
do an excellent job, and the American taxpayer benefits from
that.
Mr. Mann. Great, great. Thank you. Next question is for
you, Dr. Sandor. Your testimony briefly discussed the
importance of exclusive jurisdiction. What did you mean that
one cannot serve two masters in this context, and why does this
matter to markets?
Dr. Sandor. If we take multiple regulations, it imposes
costs on the people being regulated, and they may have, in
fact, contradictory purposes. One might be to promote leverage,
and the other might be to diminish leverage, so you could see
that these two forces could actually counteract each other. And
so, in my opinion, and looking at the investment banking world,
and looking even at the legal profession, we have seen
specialization and focus have enormous benefits. People who
sold stocks couldn't sell government bonds, and Salomon
Brothers was born because it specialized. The same thing with
high-yield bonds and the same thing with commodities. So in the
finance world, I think specialization and single purpose really
enriches the efficiency of markets, thereby benefiting the
American consumer.
Mr. Mann. Great. And thank you. Mr. Chairman, I yield back.
The Chairman. The gentleman yields back.
I am now pleased to recognize the gentleman from Alabama,
Mr. Figures, for 5 minutes.
Mr. Figures. Thank you, Mr. Chairman. There we go, freshman
mistake.
I want to welcome all of you. The good thing about seeing
me is it means that you are close to the end here. But thank
you for hosting this hearing, Mr. Chairman, and to our Ranking
Member as well. I always begin these things by thanking my
staff, as well as you guys' staff, to the extent that they help
prepare you guys for being here. I want to extend my thanks to
them.
And I guess I will take this question kind of down the
road, but Ms. Dow, I know in your testimony you explained that
CFMA can help ensure appropriate market oversight without
stifling innovation, and I want to talk about that a little bit
and why this Commission is more well suited for those
innovative technologies, if we can just kind of go down the
line--we'll, start with you, and then just kind of go down the
line with others about that issue.
Ms. Dow. Thank you. Thank you for that question,
Congressman. What was important in adopting the core principles
flexible approach to regulation was it built in a mechanism for
reasonable discretion on the exchanges' part, which meant that
the CFTC, their interpretation wasn't the only way to comply.
And this actually worked well because it was the onus on the
exchanges to explain why their particular product or rule met
the requirements of the Act, and that took some thought, took
some creativity, took the opportunity for them to sell what it
was that they wanted to do and define why it fitted within the
CFTC's rules and regulations.
That really relieved a lot of the burden of the
prescriptive rules that the exchanges had been subject to
previously. Those rules took a lot of time to get products to
market. There were multiple layers of review. There was a lot
of back-and-forth, a lot of requests to amend things because of
the prescriptive rules that they had to comply with. So this
really opened up the door and opportunity for exchanges to meet
the requirements in a number of a variety of ways that
ultimately allowed the markets to grow, allowed them to
innovate, and allowed them to be more competitive and available
to the markets that the end-users who needed to use those
markets for hedging and price basing.
Mr. Figures. And I will open it up to any other panelists
that would like to address that.
Mr. Carey. I just had one quick point, when you went to the
CFMA, it allowed for greater competition and greater
innovation, as you mentioned. And the fact of the matter is we
could bring products to the market much faster with the
cooperation of the CFTC, which we were at a critical time in
history when we were facing threats from exchanges overseas and
other people were trying to list our products, so the fact that
this Act was put forward, I think it was 2000 was the
Modernization Act; and it really gave greater flexibility and
better alternatives to the end-users and to the exchanges that
provided it.
Mr. Figures. Got it. Thank you. No, I am sorry. Go ahead.
Dr. Sandor. Yes, from the point of view from an inventor's
point of view, I think it is really important that you can
repeatedly fail, and it doesn't mean that it is more than a
clinical trial. So you have had lots of products available for
trading that haven't worked and a bunch that have worked, and
that comes from a continuing process of trying, clinically
failing, trying, clinically failing, and then hitting up.
The last point I want to make is back in 1972 at that
particular point, it was 99 percent products that make up today
a very small fraction of the business. You didn't really have
financials. You had no energy contracts. You had none of those.
And this industry's growth rate has been comparable to the
growth rates in the technology world, 15, 20 percent a year for
the last 50 years, and I think it is because of the richness of
new products.
Mr. Figures. Mr. Chairman, I yield back.
Mr. Mann [presiding.] The gentleman yields.
The chair now recognizes the gentleman from Iowa, Mr.
Feenstra, for 5 minutes.
Mr. Feenstra. Thank you, acting chair Mann, and thank you
for holding this hearing. I want to thank our witnesses. I
really enjoyed reading your information and all that was said.
Derivative markets obviously are the backbone of our
financial system. The American farmers and ranchers use
derivative markets as a vital way to avoid risk or to manage
risk, and they do that in their inputs and outputs of price
discovery, of their financial allocations. And the CFTC
provides, obviously, the role to protect these markets,
ensuring oversight, integrity, transparency in the marketplace.
What I want to talk about, which is very important to Iowa
and the 4th District, second-largest ag district in the
country, right behind Congressman Mann, is carbon credits. This
has been a hot topic in my area over the last year and a half.
Obviously, voluntary carbon markets provide a promising
opportunity for our farmers, ranchers, and forest owners to
access new income areas, voluntarily adopting practices that
cater to the different markets.
Last fall, the CFTC issued final guidance on the listing of
voluntary carbon credit derivative contracts, outlining key
criteria to enhance the credibility and integrity of these
markets. The Chairman, the former Chairman, Chairman Behnam,
his leadership in ensuring these markets meet the needs of our
producers is crucial as we develop clear rules, rules of the
road, we should say, for our stakeholders and creating a new
space of added value.
So, Mr. Giancarlo, this is my question, can you provide an
update on voluntary carbon markets and further explain the
CFTC's role to ensure farmers and landowners are being
protected from manipulation and also fraud when it comes to
these carbon credit markets?
Mr. Giancarlo. Thank you, Congressman. I have to confess, I
would be a little embarrassed to say one word about the subject
when sitting to my right is the world's foremost expert, on
carbon credits in the world.
Mr. Feenstra. And we are going to get to him next,
absolutely. Yes.
Mr. Giancarlo. So, at the risk of really making a fool of
myself in front of such expertise, I must say, I was Chairman
when then Commissioner, then Chairman Behnam came to me and
asked me to form his Carbon Credit Committee, and I was pleased
to support that work. I think that is just part of the CFTC's
being in the vanguard of new innovations.
I have to confess, I haven't followed all of the output of
that committee, but I know that there is a lot of very good
work in it. It didn't just originate from his office. He formed
a really stellar committee, and I think Dr. Sandor actually
advised on that. I think he was very concerned about making
sure these markets were not ones that could be unnecessarily
gained. There is always some degree of that, and that is why we
have good regulation. But, again, I will defer to Dr. Sandor on
this.
Mr. Feenstra. Yes, and that is where I would like to go
next with it. Can you talk about this? And it is so important.
I think this is the new added value to our producers, and how
can we protect them? And what is your advice and direction?
Dr. Sandor. I have a particular view that is based on 35
years of working with environmental credits, including the Acid
Rain Program, which was very effective and stopped the
pollution in the Midwest and the Northeast.
I did some research that was published in an academic
journal in 1997, and I still hold to the conclusions of that
article. I think American farmers could totally provide all of
the credits necessary to diminish U.S. emissions, period, full
stop, unambiguously. Between methane, no-till, low-till,
rangeland management, all of those could add to net farm
income, and farmers could provide two services, one, food--
above the ground--and one below the ground, carbon
sequestration. So you are adding a whole new product line to
American farmers.
Mr. Feenstra. That is right.
Dr. Sandor. And I think the exchanges could design products
around that. And I particularly believe that not only new and
obvious products like computing power for AI, I think you could
design a futures contract that would guarantee net farm income.
Mr. Feenstra. I agree. I agree. And it is so important.
Thank you for both of you. My time has run out, but it is just
a hot topic, and it adds value for our producers. They are
excited about it. Thank you, and I yield back.
Mr. Mann. The gentleman yields.
The chair recognizes the gentleman from Illinois, my good
friend, Mr. Jackson, for 5 minutes.
Mr. Jackson of Illinois. Thank you, Mr. Chairman. Honored
to be here today, and great to see so many great Chicagoans
here. I have the privilege of serving the 1st Congressional
District. Thank you for your outstanding leadership, Dr.
Sandor, on creating a market, if you will. You helped regulate
the world for fair pricing, for fair food, and I have very much
a strong interest in making sure we maintain that leadership in
the City of Chicago and in the United States.
Charles, great to see you again, appreciate it. We have
many friends over the years. I was proud, having left
Northwestern University, to join Shatkin Arbor Karlov and
become a runner on the Chicago Board of Trade. And those were
some good old days. I wish we could go back to them and have
fewer computers and more people talking, not just there, but
here as well.
Talking about the future of the industry is something I am
extremely concerned about. As we speak about the future, what
is it that we can do to make sure that we stay on the
innovative edge? I don't want to see this industry go abroad.
First with you, Charles, on the ideas that we should take away
on maintaining this industry at home.
Mr. Carey. Well, I think that the innovations are created
by the need and the users, and so the exchange is working with
a regulator that is flexible, tough on customer abuse and the
financial side of it, but willing to work with people that want
to create products that are used in the marketplace. You have
to stay at the forefront on creating products and bringing
products to the marketplace, in addition to having a well-run
exchange and well regulated. So I think the future in the
exchange, I think you see nothing but growth.
I think the Chicago Mercantile Exchange Group, which is the
exchange in Chicago, traded 67 million contracts in 1 day. When
I started, I don't know if they traded that many in a year? So
we have reached out. I think we have to continue to do the
things that we are doing, and I think we have to continue to
have a regulator like the CFTC that allows for the growth.
Mr. Jackson of Illinois. Well, thank you so much. To you,
Dr. Sandor, this is a question on the future. We have talked a
lot about the past. Let's talk about the future as it relates
to AI. And we have seen this most recently, even with this
Administration, they said AI was the reason that Jackie
Robinson's name was removed from military classifications,
which begs the question, whose AI? All AI isn't the same. This
is programmed learning, and who is feeding these machines? Are
you concerned about not talking to a regulator in the future,
but talking to a program that has been AI-generated to give you
answers and what may be the dangers?
Mr. Carey. Yes, we have had discussions. We think there are
benefits, but we also think there are risks. And I think that
it does require some human intervention to make sure mistakes
aren't made like that. And AI is going to do a lot of functions
extremely well and create tremendous benefits, but it has to be
overseen or basically spell-checked or whatever you want to say
so things like this don't happen.
Dr. Sandor. As a user of it, even in preparing my testimony
today, it is filled with errors. And it also said, as I was
typing in, this is how I would respond, which I found that
remarkable in itself, and so I think it is really dangerous,
and I think Charlie Carey is exactly right. Like any
instrument, it can be used appropriately or inappropriately, a
scalpel or a knife, things for good purposes and things for bad
purposes. So I never see a world where there won't be human
regulation because of what Chairman Giancarlo said, there are
going to be bad actors, and it doesn't matter what you can do.
And it takes other human beings to do it. You can use it to
gain efficiencies, to gather better insights into financial
statements, to look at leverage in different ways that might
not go, but I think human interaction is a critical component
of future regulation.
Mr. Jackson of Illinois. Again, what an honor to be before
you today, Dr. Sandor. You are a legend and Leo Melamed and all
those that have done great things, and thank you for having
your Chicago style and flair. We appreciate you. Thank you,
Charles.
I yield back, Mr. Chairman.
Mr. Mann. The gentleman yields back.
The chair recognizes the gentlewoman from Florida, Mrs.
Cammack, for 5 minutes.
Mrs. Cammack. Thank you, Mr. Chairman, and thank you to our
panel of witnesses for appearing before us here today to talk
about this very important topic.
And, of course, we have heard how for 50 years the CFTC has
played a vital role in regulating and optimizing America's
commodity and derivatives market. As farmers in my district and
across America know, derivatives markets such as crop futures
are essential for protecting American agriculture from
unpredictable risks that are inherent in the industry. But to
make these markets work, greater transparency and trust between
brokers and farmers is necessary to keep our farms profitable
and to feed America.
Now, what I would like to discuss today is how we can use
our technological superiority and innovative advancements such
as blockchain, which I have been listening and you all have
been addressing in a couple of different ways here today, to
make these markets more efficient and transparent. So I am
going to start with you, Mr. Giancarlo. In the world of digital
assets, blockchains, as we all know, are an instrumental tool
in ensuring that transactions are transparent and openly
visible. Do you see the possibility of blockchain being adapted
as a tool in all American commodities and derivatives markets
for purposes of transparency and beyond?
Mr. Giancarlo. Yes, it is happening already. One of the
unfortunate aspects of--and I will just be candid, the last 4
years have been special, the last 2 years of SEC hostility is
that----
Mrs. Cammack. I like the way you say that.
Mr. Giancarlo. Hostility----
Mrs. Cammack. I would say that in a not-so-tactful way.
Mr. Giancarlo. But one----
Mrs. Cammack. Bastards.
Mr. Giancarlo. Well, I will leave that to you. But what I
will say is one of the byproducts has been that traditional
financial firms have stayed away, and therefore, the field has
been dominated by focus on speculation and is the number going
to go up. Now that there is in fact a more welcoming approach,
what I am seeing in my work is traditional financial firms are
moving in, in a big way, and they are bringing with it their
traditional notions of safety and soundness, of doing things
properly, of building out systems, industrial-grade capability.
They are moving into--and they recognize this as a new
technology, and they are going to adopt it for some of their
most core systems, from settlement to clearing to payments.
This is going to become ubiquitous, and now the grownups are
coming into the space in a very big way, and that is going to
be good for the United States. We need to modernize our system.
We go around the world, you find out a lot of our traditional
payment systems and otherwise are antiquated.
Mrs. Cammack. Yes.
Mr. Giancarlo. We have fallen behind. We need to jumpstart
this. Fortunately, we have a new technology that allows us to
do it. So I am very excited about what this means, and it is
going to work its way to every end-user. When people can
actually make transactions with a swipe of their phone, without
all the intermediation, without going to the bank to say, oh,
my goodness, it is 5 o'clock, I missed the window, I can't get
my money out of the bank. Being able to do transactions
directly, especially for people in rural communities that don't
have access to branch banking, this is going to be
revolutionary.
Mrs. Cammack. Well, and to your point about antiquated
systems, I mean, that is largely one of the reasons why our
derivatives market is overseas now, the majority of it, so that
is one of the challenges.
And unfortunately, there is this preconceived notion that
in agriculture particularly, that they are not innovators. Our
producers are actually the original innovators. So I think that
there is a window here for us to really adopt, particularly
leveraging the capabilities of CFTC.
So one of the big concerns with the system and the use of
blockchain with tangible goods versus intangible goods like
cryptocurrencies, how can we get over this hurdle? Because
there is a lot of talk of how do you adopt it into a tangible
good, right? How do we avoid instances of fraud for example?
Mr. Giancarlo. So, Congresswoman it is happening very
rapidly. I think we are going to look back this time next year,
and we are going to see 2025 is the year where traditional
finance moved into digital assets and blockchain in a very big
way. There is a lot happening that you are going to be hearing
about in the months to come that is going to be really
revolutionary where now the game is afoot. It is happening now.
Mrs. Cammack. Okay. I am going to follow up with you
offline because I have some more questions.
Mr. Giancarlo. Please do.
Mrs. Cammack. But, I want to get to Mr. Sexton. So, Mr.
Sexton, you discussed in your testimony how in 2018 the NFA
implemented compliance rule 2-51 to address the risk that comes
when investors trade in digital assets without fully
understanding the products at hand. What lessons and potential
pitfalls would you share with policymakers here in Congress in
trying to craft--and I despise the regulatory environment in
its current form, so being very cautious of that, enforcement
frameworks, regulatory environments when it comes to digital
assets in 18 seconds.
Mr. Sexton. Congresswoman, thank you very much. And the
lesson I will share is you have to be nimble. And the
disclosures that we adopted in 2018, for example, we are again
looking at today because this market has changed, and so we
want to make sure customers are informed. We need to be nimble.
As a self-regulator, that is one of the things that we can do
effectively, working with our members to do so, and will do so.
Mrs. Cammack. Okay. Thank you. My time has expired, and I
yield back.
The Chairman [presiding.] The gentlelady yields back.
I am now pleased to recognize the gentlelady from Ohio, Ms.
Brown, for 5 minutes.
Ms. Brown. Thank you, Mr. Chairman, and thank you to the
panelists today. Your comments have been very insightful.
This hearing is especially timely, not only as we mark the
50 year anniversary of the Commodity Futures Trading
Commission's formation, but also due to the extreme financial
markets volatility we are currently experiencing. From Putin's
ongoing war in Ukraine to the President's reckless economic
agenda, commodity markets have suffered significant
disruptions, creating uncertainty for producers and consumers
alike.
At this critical moment, as my colleagues have noted, it is
more important than ever to ensure that the CFTC is fully
equipped to meet the challenges ahead. As we commemorate 50
years of the agency, we must prioritize its reauthorization,
modernization, and proper funding. Expanding the CFTC's reach
is essential to keeping pace with the evolving markets and
ensuring fair and effective oversight that protects all
participants.
So, Mr. Giancarlo, as the CFTC reaches this milestone, how
do you assess its success in ensuring equitable access to
derivative markets, particularly for smaller market
participants such as community-owned utilities, minority-owned
firms, and under-served producers? What additional steps can
the CFTC and its partners take to reduce systemic barriers and
promote broader, more inclusive benefits from derivative market
participation?
Mr. Giancarlo. Thank you for that, and thank you for your
remarks about adequate funding. I will say I have been a
consistent champion for adequate funding for the CFTC under
both Democratic and Republican Administrations and continue to
believe that is the case.
I actually think the CFTC has done a relatively good job of
ensuring equitable access to its markets both from a breadth
point of view and from a depth point of view in terms of making
sure that access was available, that the education was
available. One of the innovations that I am very proud of
during my time as Chairman of the CFTC is innovating the CFTC's
first podcast series. Young people today are amazing consumers
of podcasts. It is one way of reaching a younger audience, and
we used it to educate young people about our markets, young
farming groups. Some of the community-based groups that you
mentioned are consumers of podcast material. We used it with
different aspects of our work at the CFTC and to educate those
about the market. So I think the CFTC is one agency that has
done a very good job at providing an equitable approach to its
role in the marketplace and making sure that people understand
how the market works and where both the opportunities and the
challenges are in it.
Ms. Brown. Thank you very much. Next, I want to turn to
tariffs because we have seen how this chaos plays out before.
In 2018 during the last Trump Administration, the same tariff-
by-tweet approach to governing wreaked havoc on the farm
economy. A study by Iowa State University found that over 80
percent of Midwest farmers reported negative impacts on their
net farm income due to trade disruptions, with many seeing
losses from 10 to over 20 percent. Such losses are devastating,
and the result was a record number of farm bankruptcies during
the Trump Administration, underscoring the real and lasting
harm caused by reckless trade policies.
So, Mr. Schryver, how have recent tariff threats and
ongoing trade disputes affected price volatility in key
commodity markets such as agriculture, energy, and metals? And
what are the long-term effects to this?
Mr. Schryver. Our members are natural gas end-users, so I
can't speak to agriculture, and APGA as an organization does
not have a position on tariffs, but I do know that our members
are concerned about the long-term impacts on the price of steel
and how that may impact the cost of pipeline infrastructure.
Ms. Brown. All right. Well, thank you for that. I will just
close with this. Time and time again, farmers tell me the same
thing: They want certainty. They want to know. As this
Committee works to pass a full 5 year farm bill to provide the
predictability they need, it is deeply frustrating that,
outside these efforts, President Trump continues to keep
farmers on edge, threatening their markets and livelihood. So
right now, the only predictable thing about farming is its
unpredictability, and that is simply not sustainable for those
who feed our country.
And with that, Mr. Chairman, I yield back.
The Chairman. The gentlelady yields back.
I now recognize the gentleman from Alabama, Mr. Moore, for
5 minutes.
Mr. Moore. Thank you, Mr. Chairman.
It is essential that we take a close look at how the CFTC
has performed its vital missions over the regulating and
ensuring the stability of our commodity markets, which are
critical to the U.S. and our economy, the broader economy I
should say. From agriculture and beyond, these markets provide
a foundation for businesses and consumers alike. I look forward
to seeing a timely reauthorization for the CFTC. The challenges
we face today are different from those of the 50 years, and it
is our job to ensure that CFTC is not only equipped to deal
with these changes, but it is also not stifling innovation and
growth with overly burdensome regulation. I appreciate the work
the agency is doing and has completed thus far to continue the
efforts and look forward to continue the discussions today.
Mr. Carey, in your testimony, you describe U.S. regulations
as clear, transparent, tough, and flexible. Tough and flexible
presents a pretty interesting contrast. Could you describe kind
of those regulations to me and how you see them as tough and
flexible?
Mr. Carey. Well, I think enforcement is tough.
Mr. Moore. Turn your microphone on.
Mr. Carey. Yes, I think the enforcement is tough. I think
the fact that we strive to ensure the integrity of the
marketplace by virtue of the rules they provide. The
flexibility really comes in the dialogue and the ability to
allow the marketplace to innovate appropriately. I think they
apply the standards, whether it be for capital, for trade
practices, for anti-fraud, anti-manipulation type of rulings.
And I think when you say flexible, I think the flexibility
comes with the dialogue to make sure that they understand who
is using the markets and how they should be treated. It came up
in another question earlier about Basel III. And yes, I think
our regulators do a good job there.
Mr. Moore. Yes, I apologize. We also have the Judiciary
markup going, so I have been kind of coming back and forth
between the two.
Mr. Carey. Okay.
Mr. Moore. Ms. Dow and Mr. Giancarlo, is that how you say
that? For Alabama that is okay, right?
Mr. Giancarlo. That will work just fine.
Mr. Moore. You have both been regulators, so do you think
CFTC's regulations are tough and flexible as well? Do you want
to go, Ms. Dow first, and then we will defer to the gentleman
after.
Ms. Dow. Yes, I understand where you see there is some
inconsistency there between tough and flexible, but what is
important to realize is even though these core principles are
flexible, they are rules that have to be followed. The CFTC is
tough in ensuring that these exchanges comply with the rules.
There are rule enforcement reviews where they go out and they
visit and they make sure that these exchanges are enforcing
their rules. And then, in addition, as Charlie said, the
enforcement mechanism is very strong.
Mr. Moore. Mr. Giancarlo?
Mr. Giancarlo. Yes, no, tough and flexible may sound like
an interesting combination of words. I can tell you, as a
father of three, tough but flexible was probably my approach to
raising my three. I don't think it is an incompatible
combination. I actually think when you think about overseeing
an important market, tough and flexible is the right way to go.
What we don't want is tough and inflexible, which we have seen
from time to time with other regulators, and what we don't want
is flexible but not tough, so I actually think it is the right
combination for a regulatory body to have, and it is the one
that the CFTC has long championed.
Mr. Moore. It kind of sounds like guardrails in a sense to
me a little bit.
So, Mr. Giancarlo, I had a follow-up question for you as
well. Could you talk about the role of innovation on our
derivatives and kind of how that plays out?
Mr. Giancarlo. Yes, there is no question that we have
global competitors, and Mr. Carey talked about that. Some of
the markets in India and China are enormous in size, and they
are very much trying to replicate our success in some of our ag
markets, so we have to keep innovating. The American way is
always to innovate ourselves to the future ahead of the
competition. I think innovation is our critical edge. They can
copy what we were successful with. We need to keep moving into
new areas and keep them more than one step behind, but ten
steps behind.
I think innovation is the future of this industry. We have
talked about digital assets. We have talked about events
contracts. We have talked about new versions of old contracts
with different sizes, different settlement dates. Innovation is
what has given us the edge, and innovation will be what keeps
us having an edge going forward.
Mr. Moore. Very good. Mr. Schryver, is that how you say
your name? You represent America's publicly-owned natural gas,
I guess. And I think we have some of those in Alabama. Tell me
a little bit about how those members gain access to the
derivatives market.
Mr. Schryver. Absolutely.
Mr. Moore. And have the CFTC's regulations been able to
help protect you, or have they been more of a hindrance? I
guess that is a----
Mr. Schryver. They have been of great assistance to our
members, ensuring the integrity of the markets. And we do have
a lot--I think we have over 80 systems in Alabama. They take
their football seriously. Our members rely on these markets.
They need these markets to protect their consumers from
volatility, and with changes that have been made, they have
integrity and they have confidence in the market's integrity.
Mr. Moore. Very good. Mr. Chairman, I yield back. I am over
time.
The Chairman. The gentleman yields back.
I am now pleased to recognize the gentlelady from Texas,
Ms. De La Cruz, for 5 minutes.
Ms. De La Cruz. Thank you. There we go.
The Chairman. There we go.
Ms. De La Cruz. I got it now. Okay. Thank you, Mr.
Chairman, and thank you to the witnesses for being here. I am
one of your last ones here, and I am proudly the Congresswoman
of deep south Texas. I sit on the border of Mexico and the
State of Texas, and I would be remiss if I didn't take the
opportunity to talk about what is happening in my district,
although it is running in parallel with this, but equally
important. As I heard the Congresswoman from the other side of
the aisle talking about certainty, dependability, enforcement,
I heard Mr. Giancarlo talking about being a tough parent,
having rules, and how important that is for our children to
grow up straight, right, and to understand what the boundaries
are.
And you actually motivated me to talk about something that
is affecting my farmers in deep south Texas, and that is the
Mexican Government not complying to the 1944 water treaty that
right now is feeding and helping our farmers, or at least
should be, because our farmers are trying to harvest, and
unfortunately, the Mexican Government is not giving us the
water that they need for a full harvest.
That being said, there is uncertainty. There is not any
kind of enforcement or hasn't been by the previous
Administration. And thankfully, now, we are in a White House
that supports our south Texas farmers, that supports the
agriculture industry, and understands that national security is
a matter of food security. Food security is national security.
I have been very strong with the Mexican Government, asking
them and condemning the fact that they will not supply our
farmers with the water that is owed by the 1944 Water Treaty
(Utilization of waters of the Colorado and Tijuana Rivers and
of the Rio Grande). Meanwhile, the Mexican farmers are
harvesting all of the produce that we are able to harvest right
in south Texas. So they are starving our American farmers. Our
American farmers are going out of business. Our generational
farms such as the sugar industry in my district actually
closed. But yet, in Mexico, the Mexican farmers are thriving,
and they are selling us the vegetables, the onions that we
could grow right in south Texas. So it behooves them to not
give us the water that they owe us.
And Mr. Giancarlo, as you said, you got to be tough
sometimes, right? And under the previous Administration, we did
not have a tough White House that wanted to tell the Mexican
Government, hey, give us our water, this is unacceptable. But
there is a change, and elections do matter. Thankfully,
President Trump, along with Secretary Rubio, is holding back
the Colorado water that goes to Mexico because it is not fair
that we are giving Mexico water when they don't give us water
back. And we have made a statement to say this is no longer
going to be acceptable, and the new White House will not
tolerate this type of disobedience and bad behavior.
That being said, I will focus on the topic at hand, and I
will ask Mr. Carey. You have been around the markets that the
CFTC regulates for many years. And could you talk from the
perspective of both as a trader and as an executive what it is
like to work with in a market overseen by the Commission?
Mr. Carey. Well, the marketplace itself provides the
opportunity. And seeing as I started out as a trader for my own
account, it was an exciting business. It was a good business to
be in, and you were involved in all the things you are talking
about every day because, whether it is the weather affecting
the farmer, whether it is his economic decision to plant one
crop or another crop, whether there is something going on--one
of the biggest things I remember is when we put an embargo on
wheat because the Russians marched into Afghanistan. The
regulator was there. The regulator was observing the behaviors
and enforcing the rules and making sure that everything worked
properly, but the markets themselves provided for all the
excitement.
Ms. De La Cruz. Thank you so much. I yield back.
The Chairman. I thank the gentlelady and now recognize the
gentleman from New York, Mr. Riley, for 5 minutes.
Mr. Riley. Thank you, Mr. Chairman, and thank you to our
witnesses for being here.
Mr. Schryver, I was hoping to talk with you a little bit
about utilities. After reviewing your testimony, I went to a
diner in Marathon, which is in Cortland County, last week. The
diner is actually called Reilly's, but they spell it the wrong
way, with an e-i and two L's. And I was sitting down with the
mayor, and we were talking about all the issues around the
area, and the one thing that everybody tells me about, pulls me
aside on the street to talk to me about is the utility prices
are way too high, gas prices, electric prices way too high,
NYSEG, Central Hudson, in the region.
And the mayor in Marathon let me know that they have
municipal electric and gas, and he said that people are really
happy with it. They are paying a lot less. They are getting a
lot more than the utilities in those surrounding areas. And so
I was talking to him over the weekend, and then I read your
testimony last night, and one of the things that stood out in
what you wrote was that your members, the municipal-owned
utilities, are directly accountable to the citizens they serve.
And it occurs to me that it really matters who owns these
critical utilities because in the district I represent, a lot
of the folks are with Central Hudson, and Central Hudson is
owned by a foreign corporation, Fortis, and just a few months
ago, Fortis had their quarterly shareholder report, and they
announced that they were making like $330 million just that
quarter in profits, which is probably like great news for all
the shareholders, but it is terrible for my constituents.
And then, to add insult to injury, the very next day after
announcing $331 million in quarterly profits, the very next
day, you know what Central Hudson did? They announced that they
were going to jack up rates even more on our constituents and
Hudson Valley families who are already being squeezed.
My district is 11 counties, and most of the rest of the
counties are served by NYSEG, which is also owned by a foreign
corporation, Avangrid. And last fall, Avangrid announced that
they had doubled their profits. Year-over-year quarterly
profits doubled from $105 million to $210 million. And
meanwhile, I have constituents pulling me aside every day
telling me that they can't afford the NYSEG bills. They are
going up for reasons we still don't understand, and people are
just getting squeezed.
And so from the conversation I had in Marathon with the
mayor and conversations I am having with my constituents, a lot
of folks are starting to talk about whether it makes sense to
take these utilities out of the hands of these big foreign
corporations that are just out to get profits for their
shareholders and put them back into the hands of the our
communities and our neighbors. And I am just curious from your
perspective and expertise on this if you have some thoughts on
that that you could share.
Mr. Schryver. Thank you for the question. We believe the
public gas system model has worked well. As I mentioned, our
members are not for profit. They are focused on providing
affordable and reliable service there to customers. As a not
for profit that is locally owned by the citizens they serve,
the dollars stay in the community. We believe local control
benefits the community, benefits those who live in community.
Decisions are made locally, so we think it is a very strong
model.
Mr. Riley. Great. I appreciate that. And Mr. Chairman, I
promise you one of these hearings I am going to figure out how
to get the microphone to work. This is my second time where--I
promise one of these I am going to do it.
I want to ask the panel one thing, and anybody can chime in
on this. This is something that has not historically been seen
as a commodities issue, but I think it is now, and that is
housing. And, I believe housing should be for homes, for
families. And what we are seeing instead across a lot of
upstate New York and I think a lot of the country is Wall
Street hedge funds coming in, gobbling up single-family homes,
and then just squeezing them for profits. There is a study that
MetLife Investment Management did and shows that Wall Street
could control 40 percent of U.S. single-family rental homes by
2030.
And what that does is it takes all this housing stock off
the market. It jacks up the prices. I think probably that is
great for Wall Street. It is really bad for folks across
upstate New York who are trying to buy their first home. And so
I think we need to ban Wall Street from buying single-family
homes. I think we got to stop it. The homes should be for
families, not for Wall Street. And I am trying to figure out
the best way legislatively to do that. I know Congress could--
if we had the political willpower, we could enact a ban, but
then we would need somebody to enforce it.
And so my question is, is there any role potentially for
the CFTC to play in that if Congress gave CFTC the legal
authority and the resources to say we can't treat housing as a
commodity? My time is almost expired, so maybe I would just
invite you all to think about that question and let me know if
there is something we could do going forward on that. Thank
you.
The Chairman. Well, I thank the gentleman. And I promise we
won't add a third button for speakers, which I hope not because
I do the same thing you do.
Mr. Riley. It is already complicated, too complicated for
me.
The Chairman. I am pleased to recognize the gentleman from
Indiana, Mr. Messmer, for 5 minutes for questioning.
Mr. Messmer. Thank you, Mr. Chairman.
Mr. Sexton, in your testimony, you draw specific attention
to the new responsibilities of the CFTC and the NFA to regulate
digital asset commodity markets. With the infancy and growing
popularity of these markets, there is an urgency for Congress
to get it right the first time if it builds out new regulatory
framework.
Last Congress, this Committee worked to establish updated
regulatory guidance through FIT21 that really did set standards
of transparency and stability, but there are other legislative
recommendations that would have hamstrung innovation in the
courts. While the courts certainly do have a role in
disciplinary action, what are your concerns for America's
leadership in digital asset markets should Congress fail to
guard the industry from regulatory slowdowns and lengthy non-
disciplinary litigation?
Mr. Sexton. Thank you for the question. Just going back to
FIT21, Congressman, we had the opportunity to testify before
the House Financial Services Committee with regard to FIT21 and
recognize the joint effort of this Committee and that Committee
in formulating that legislation. We thought that FIT21 was
critical in that it addressed many of the customer protections
that have been in place for the regulated derivatives market
for years, everything from customer asset protection, risk
disclosures, capital requirements for firms, certainly anti-
fraud, and recognizing that if we are going to build a model
for centralized marketplaces going forward with regard to
digital assets, that was key to addressing many of those
customer protection concerns. I would advocate that if Congress
is going to move forward again, and it should, then many of
those customer protections should be included again in any new
legislation that is taken up.
Mr. Messmer. Okay. Thank you. Dr. Sandor, I just came over
here from an Education and Workforce hearing, and I think there
is an interesting nexus between this Committee and the
conversations we are having this morning. You mentioned your
teaching career in your testimony and the importance of human
capital to derivative markets. What innovative policies should
Congress be considering to ensure that we are not only
educating the next generation of derivatives experts in the
U.S. but keeping them here to improve our systems?
Dr. Sandor. As somebody who has spent 60 years teaching, it
is a question that is really close to my heart. I think to the
extent that we can make education affordable, that it is
critical. I am the product of state schools, undergraduate and
graduate, and I think they perform an enormous role. And I
think that to the extent that you and the elected Members of
the House and Senate can act, it is to keep up the land-grant
and support of state-based universities that provide access to
education at affordable costs that are not necessarily
available anyplace. So I firmly believe that that is the key in
providing human capital and believe that that is the future of
the United States. It is an inventive activity, and that comes
from an educated workforce.
Mr. Messmer. Thank you. As a graduate of Purdue University,
Indiana's land-grant university, I appreciate that comment.
And with that, I will yield back the rest of my time so I
don't stand between the rest of you and lunch.
The Chairman. The gentleman yields back.
I am pleased to recognize the gentleman from Tennessee, Mr.
Rose, for 5 minutes.
Mr. Rose. Thank you, Chairman Thompson, and I want to also
thank Ranking Member Craig for holding an important hearing,
and particularly thank you to our witnesses for taking time out
of your busy schedules to be with us here today for this
hearing.
Mr. Schryver, in your written testimony, you discussed the
importance of the CFTC's ability to detect and deter market
distortions. Can you expand a little on how CFTC's ability to
detect and deter market distortions helps lead to more stable
energy prices for consumers?
Mr. Schryver. Thank you for the question. If you go back
and look at what happened in 2006, I believe, with Amaranth in
terms of the impact that our natural gas prices, we believe
having a strong cop on the beat--and the CFTC is that strong
cop, especially with the reforms that came out of Dodd-Frank--
it gives our members confidence in the integrity of the
marketplace. It helps them make the best decisions they can to
protect their consumers from price volatility by using the
tools the market affords.
Mr. Rose. Thank you. Ms. Dow, you ended your prepared
testimony by highlighting the importance of guarding against
systemic risk. In your opinion, do you believe the CFTC has
sufficiently addressed the systemic risk that cybersecurity
threats pose to our derivatives markets?
Ms. Dow. So thank you for that question, Congressman. I
would not be able to speak to what they have done in terms of
risk on the cyberspace side, but I do know that the Commission
regularly engages with other regulators, foreign and domestic,
as well as the industry, to stay on top of and abreast of all
kinds of developments and particularly on the cybersecurity
space. So I would expect that the CFTC has done the job, done
the work that needs to be done to ensure that they are prepared
for any cyber risk that might come their way. But I am sure
others on this panel may have more information on that front.
Mr. Rose. All right. Thank you.
Mr. Giancarlo. May I speak to the question?
Mr. Rose. Yes.
Mr. Giancarlo. During my time as Chairman of the agency, we
estimated that we were subject to constant cyber attack trying
to penetrate our systems. I don't remember the exact figure,
but it was something close to 1,000 attack elements a day, and
that is the CFTC. The attack surface of the Federal Government
is enormous.
I recently published a piece,\2\ which I have shared with
the White House and I would be delighted to share with this
Committee, advocating that the President exercise powers
granted to him under the U.S. Constitution that were first used
by James Madison to authorize John Paul Jones to retaliate
against British shipping that was raiding American--these
attackers, these cyber attackers, often cases are state-
sponsored, often sponsored by North Korea. And I think it is
time we go from defense to offense and use the awesome
technological capability that we have in Silicon Valley to
fight back. And we could use these letters of marque available
under the Constitution to authorize our technical capability to
fight back against these cyber hackers that are costing us
billions of dollars in lost revenue, in cyber protection costs.
It is something we really need to take up in the United States.
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\2\ Editor's note: the article referred to, Crypto neo-privateers
could be the solution to hacks, is located on p. 77.
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Mr. Rose. Let me follow up on that, and I will open this up
to the panel in the time that we have left. Does the CFTC have
access to the staff and expertise that it needs to protect the
space?
Mr. Giancarlo. Again, I can speak to that because when I
was Chairman, I tried to recruit some of the best talent to
come to the CFTC in this area. These are people that can make
millions of dollars in compensation in Silicon Valley and Wall
Street, and we are trying to recruit them to the CFTC for
hundreds of thousands. And we have to appeal to other things
other than money and others to come to government. So it is
always a struggle. I don't want to say the resources aren't
there. I certainly don't want to give our adversaries any
indication of any vulnerability. But just candidly, it is
always a struggle for government agencies to have state-of-the-
art people that have that type of cyber defensive capability
just because of the compensation structure.
Mr. Rose. And let me, just in the time we have left, Mr.
Giancarlo, can you talk about the role of innovation in our
derivatives markets and how it leads to a larger variety of
products or bespoke products that provide better opportunities
for market participants to hedge risk? And what has allowed
this innovation to be experienced?
Mr. Giancarlo. When I was preparing my testimony, I did a
quick analysis of the size of U.S. markets. We are still some
of the largest, but we are no longer the largest. Some of the
markets in India and China are larger. But what we have that no
one can compete with is our innovative capability, our ability
to produce new products that attract an audience, attract the
usage, that attract people who have risk and seeing these
products' ability to mitigate that risk. That really is our
edge, and we need to maintain that edge going into the next 50
years.
Mr. Rose. Thank you. My time has expired. I yield back, Mr.
Chairman.
The Chairman. I thank the gentleman from Tennessee.
I am now pleased to recognize the gentleman from Iowa, Mr.
Nunn, for 5 minutes.
Mr. Nunn. Well, thank you, Mr. Chairman, for holding what I
think is a very important hearing today. We have a great panel
in front of us. Your expertise plays a crucial role in helping
both our farmers and our small business guys. As a guy from
Iowa, it is much appreciated. We all know how hard it has been
for farmers across the country.
I would like to start by discussing the commodities market.
Since its inception, the CFTC has reliably partnered with our
nation's farmers to provide effective risk management. And I
think we all know that a tractor that is upwards of $200,000 or
a combine that is costing nearly $1 million makes a real impact
to how farmers budget going forward. It is crucial that Iowa
farmers, and I would say farmers across the country, have
access to the capital they need to remain competitive. So I
will begin with this in saying, how does the CFTC and the
Commodities Exchange Act support deep and liquid markets that
would help folks in my home State of Iowa? I will open that up
to the panel. Mr. Carey, I think you are probably well suited
for this conversation.
Mr. Carey. Well, I don't know, but I will give it a try. I
think the fact that the Commission regulates the products that
the farmers need to basically make their decisions and to hedge
their risks, whether it is corn, wheat, or soybeans, whatever
it is, they can take that and reduce it to a cash-flow that is
reasonable, and then they can go ahead and finance or whatever
else they need to do. And I think the Commission's role is
making sure that there is no fraud, there is no manipulation,
that the markets are transparent, and that the market users
know exactly what they are getting into when they do it. So, I
mean, that is about as simple as it is as far as I am
concerned.
Mr. Nunn. Could not say it better. I think you are
absolutely right. Being able to have not only the transparency
in here, but this is something the CFTC has been a good partner
on.
I would like to take another deep dive down into the CFTC.
Mr. Giancarlo, you have been called--I think your easier title
here is the Crypto Dad, and the CFTC certainly plays a role in
the future of our digital assets. We are in a unique situation
that we sit on a Committee of jurisdiction. I serve on the
other committee, Financial Services. There is a great marriage
that can happen here, and the CFTC has been a huge partner in
this.
We know commodities very well in Iowa. Whether it is corn,
soybean, hogs, the CFTC has been a partner with us on this. It
has overseen those markets. And in downtown Des Moines, our
lenders understand the importance of what the SEC brings to the
fight here in good access to American-backed digital
securities.
Under the last Administration, we saw an SEC that tried to
cut out the CFTC completely. They labeled almost everything in
the digital space, a security. And I asked a predecessor here,
SEC Chairman Gensler, a simple question. Is a digital asset--
called Ether at the time, still there now--a commodity, or is
it a security? Now, he couldn't answer that, but he was happy
to regulate it to death.
So my question now is that we have moved on from the last
Congress. The opportunity becomes the opportunity to provide
comprehensive rules of the road so we can onshore digital
assets here for the future and not see them flee off to the
Bahamas, or worse, fall in the hands of places like Tehran,
China, and others. As we work to get that legislation across
the finish line, what can the CFTC do to help provide clarity
on assets like Ether or others that operate more like a
commodity? I would appreciate your thoughts.
Mr. Giancarlo. Well, truth of matter, CFTC has been crystal
clear on this for almost a decade now. In 2015 the CFTC, in a
bipartisan manner, declared Bitcoin to be the world's first
digital commodity under CFTC jurisdiction. In 2017 we green
lighted the world's first regulated market for any type of
derivative on crypto. That was Bitcoin futures. Eight years
later, that marketplace is deep, it is liquid, it is
transparent, extremely well regulated. So to those efforts to
box the CFTC out totally failed. The CFTC is recognized not
here in the United States but worldwide as the world's primary
crypto regulator with a very successful track record. In your
own state, Iowa was with the first leader in terms of looking
at events contracts out of the University Iowa, and that is one
of the big innovations on the horizon where the United States
has another opportunity to lead the world in setting the
regulatory structure for these new instruments.
Mr. Nunn. Well, as the Crypto Dad, I wish I had a better
Crypto Dad joke for you, but it would take too much energy, ba
da bump. The reality here is, I think you are absolutely right
here. We need to be able to provide the framework for this and
making sure that there are legitimate rules of the road, as it
were, to not only be able to onshore but then, as you just
highlighted here, that there is a key partnership between the
CFTC, the SEC, and then also being able to go after those
illicit actors.
You talked a little about letters of marque. In our few
seconds, talk to me here about what we can do for the illicit
side of this.
Mr. Giancarlo. We have the capacity to knock these people
right on their heels. When I was a boy, there was a bully at
school. My father said it is not enough to put your hands over
the face. You need to punch him in the nose. We have been
putting our hands over our face saying, please don't attack us,
please don't attack us. Those days have to be over. We have to
fight back. And these letters of marque allow us, allow the
President, and it is one area where the Constitution has
expressed the President has the power to issue these letters of
marque. It can be done today to authorize our technical
capability to punch them in the nose.
Mr. Nunn. As a combat veteran, I am ready to punch back.
Thank you, Mr. Chairman. I yield back. Thank you.
The Chairman. The gentleman yields back.
I am now pleased to recognize the gentleman from
California, Mr. Carbajal, for 5 minutes.
Mr. Carbajal. Thank you, Mr. Chairman. And thank you all,
witnesses, for coming today. We are awfully close to one
another. I have never been this close to the witnesses.
Mr. Schryver, I am sure you are a dad of something, maybe
not crypto. In your testimony, you mentioned the importance of
having transparency in market prices, which provides consumer
assurances and prevents manipulation or other abusive market
conduct. What is something Congress can do that is not already
being done to help reduce bad actors in manipulating market
derivatives?
Mr. Schryver. As an association, we are always looking at
things that can be done to give our members more confidence in
the way that markets are functioning. At this point, we don't
have any specific recommendations. A lot of what we asked for
in terms of transparency and giving the CFTC the resources it
needs came about through the Dodd-Frank Act, so we were very
supportive of that legislation and what it accomplished. We
believe we have a strong cop on the beat right now. We defer to
the CFTC and the Committee if additional measures need to be
taken. But what I can do is I can talk to our members and see
if there is any specific recommendations we can make and get
back to you on that.
Mr. Carbajal. Thank you. One more question, Mr. Schryver.
As you may know, the CFTC funding remains at the same levels as
Fiscal Year 2024, $365 million with 701 full-time employees.
The Commission's role is to regulate these markets. However,
without the proper funding from Congress, would you say that
market transparency is reachable?
Mr. Schryver. We support a well-resourced CFTC. We want to
make sure they have the resources they need to be the strong
cop on the beat. APGA supported strong funding for the CFTC in
the past, and we continue to do so. We want to make sure they
have what they need to do their job effectively.
Mr. Carbajal. Thank you. Mr. Carey, in 1980 the Commodity
Futures Trading Commission had to suspend futures trading for
wheat, corn, oats, soybean oil, and soybean meal after then
President Carter announced an embargo on the sale of
agriculture goods to the Soviet Union. That occurred more than
40 years ago while you were at the Chicago Board of Trade,
CBOT, which given some of the recent actions by the current
President, it wouldn't surprise anyone that this Administration
takes some even more radical trade actions against many of our
largest trading partners, which could also lead to extreme
volatility in the markets. Do exchanges in the CFTC have any
better tools to deal with irrational Executive decisions like
the ones we are seeing today on trade, or is emergency
suspension of trading really the only tool available?
Mr. Carey. Well, actually, those prices were limit down,
but I don't believe that they ever suspended trading of those
contracts. What they did was the marketplace was completely
surprised by the Russian invasion into Afghanistan. And seeing
as Russia was our biggest wheat customer at the time, we went
ahead and--wheat immediately fell limit down. Corn also did.
But after that, the markets recovered, and they traded. So I
don't believe that that we suspended trading in those
contracts. Trading was limit down. The announcement was made, I
thought, after the close, and that was it. But the markets
worked. Supply and demand worked. It was a shock to the market,
and the market absorbed it, and it took a price adjustment for
people to determine where they wanted to trade the price of a
bushel of wheat or a bushel of corn. Soybeans came back
immediately because we didn't sell that many soybeans to
Russia. They bought our wheat. So the fundamentals or the
supply and demand was reflected in the marketplace, and the
Commission regulated and the Board of Trade regulated it.
Mr. Carbajal. So are you sure emergency suspension of
trading didn't occur?
Mr. Carey. Well----
Mr. Carbajal. It is just yes or no because I am going to
have to go look myself to make sure if I am right or wrong, so
I am asking you.
Mr. Carey. Okay. I know that the markets were limit down,
but I didn't think that--I could be mistaken, but I don't think
they were suspended.
Mr. Carbajal. Okay.
Mr. Carey. But I might be mistaken because I was trading
the markets actively, so I think it was just limit down because
of the effect of supply and demand.
Mr. Carbajal. Thank you. You made me second guess myself.
Now I have to go look to see if I was wrong.
Mr. Carey. I don't know. I could be wrong, too.
Mr. Carbajal. Thank you very much. With that, Mr. Chairman,
I yield back.
The Chairman. Salud, I won't say anything about how when I
second guess, buddy.
I think that that concludes all of our Members. We had
great participation today, and many thanks to the Members for
robust participation in today's hearing. And I will make some
closing remarks before we actually adjourn.
I specifically want to thank our witnesses for their
testimony today, just an outstanding panel that a depth of
knowledge and experience going back 800 years.
Mr. Carbajal. It was suspended.
The Chairman. He always gets the last word in. And for the
record, I agree with him. The Commission is fulfilling its
statutory mandate. We should all be immensely proud of the work
that the men and women of the Commission do daily. And while we
will, of course, always have policy disagreements, the heart of
their work remains the faithful execution of the law. The
Commission and its staff do this work with skill and, quite
frankly, with integrity.
Similarly, there are registered entities across the
industry who hold regulatory responsibilities, including NFA.
These self-regulatory organizations play a crucial frontline
role every single day in ensuring fair and orderly markets and
resilient risk management safeguards. Congress, the Commission,
and the industry should be proud of the extraordinary success
this system of cooperative regulation has brought. One needs to
look no further than the size and the diversity of American
derivatives market to see the impact of the Commodity Exchange
Act, the Commission, and all the extraordinary men and women
who work in our markets.
As we look to the future, the derivatives market will only
continue to grow in importance. The rise of digital assets,
artificial intelligence, and evolving global markets will
present new challenges. But if the past 50 years have shown us
anything, it is that the Commission and the derivatives
industry are more than capable of innovating to meet those
challenges.
So as the Commission approaches its 50th anniversary, I
want to congratulate the incredible and talented staff and
members of the Commission, both past and present, and all the
hardworking Americans across the derivatives industry on this
milestone. You have built an institution worthy of our trust
and our confidence.
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
witnesses to any questions posed by a Member.
This hearing of the Committee on Agriculture is adjourned.
[Whereupon, at 1:04 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Article by Hon. J. Christopher Giancarlo, Former Chairman,
Commodity Futures Trading Commission
[https://cointelegraph.com/news/crypto-neo-privateers]
Christopher Perkins and J. Christopher Giancarlo \1\
---------------------------------------------------------------------------
\1\ https://cointelegraph.com/authors/christopher-perkins-and-j-
christopher-giancarlo.
Feb. 26, 2025
Crypto neo-privateers could be the solution to hacks
Opinion by: Christopher Perkins and J. Christopher Giancarlo
After a 200 year hiatus, a modern privateer program would protect
American entrepreneurs, enhance national security interests and play an
essential role in reasserting American leadership in technology and
innovation.
Regarding cybersecurity in the crypto industry, 2025 is off to a
terrible start. Lazarus Group, a North Korean-sponsored hacking
organization, recently stole $1.4 billion from Bybit, a major crypto
exchange. This was one of the largest hacks in the crypto industry's
history. In 2024 alone, hackers pillaged their way across the sector,
stealing over $2 billion. Over half can be directly traced to Lazarus
Group, which diverts stolen digital assets to various illicit
activities. The status quo is unacceptable.
Pariah states continue to equip, sponsor and resource hacking
groups that maneuver against entrepreneurs and ravage the digital
economy. Policies and government capabilities have fallen short.
Entrepreneurs remain exposed, and every exploit has obvious national
security implications. Today, these adversaries stand in the way of the
Trump Administration's stated goal of positioning the United States as
the ``crypto capital of the planet.''
To find the solution to this problem on the frontier of technology,
America should look to its past. Though dormant for the last 200 years,
the resurrection of letters of marque and reprisal,\2\ which commission
``privateers'' to seize property or assets belonging to specific
foreign adversaries, would immediately close this gap in national
security. Through financial incentives, a neo-privateer program would
unleash the private sector's talent, ingenuity and sophistication to
hack the hackers--effectively turning the predators into prey.
---------------------------------------------------------------------------
\2\ https://www.law.cornell.edu/wex/letter_of_marque.
---------------------------------------------------------------------------
A brief history of privateering
Privateering is a governmental authorization of private enterprises
to engage in hostilities against the commerce of national enemies. It
allows sovereigns to marshal unconventional resources and supplement
military power at low cost. Privateering has a rich and colorful
history in the United States. The legendary exploits of privateers like
John Paul Jones, who later became the ``Father of the American Navy,''
helped turn the tide of the American Revolution. American privateering
was born out of necessity. In an era when America did not have adequate
public resources to confront the Royal Navy, patriotic private
citizens, further incentivized through the prospect of financial gain,
crippled the British commercial fleet. While letters of marque and
reprisal authorized private citizens to seize property or assets
belonging to specific foreign powers, they also required reporting of
seizures, waived various piracy laws and allowed privateers to keep a
portion of the spoils. Often, privateers had to post bonds to ensure
their conduct complied with regulations.
The United States has a firm legal basis for a modern-day privateer
program. The Founding Fathers enshrined privateering in the
Constitution,\3\ granting Congress the power ``to declare war, grant
letters of marque and reprisal, and make rules concerning captures on
land and water.'' James Madison granted 500 \4\ of these letters to
private citizens during the War of 1812. While European nations
effectively abolished privateering with the Declaration of Paris in
1856, the United States did not sign the treaty, preserving the option
to use privateers in future conflict.
---------------------------------------------------------------------------
\3\ https://www.senate.gov/about/origins-foundations/senate-and-
constitution/constitution.htm.
\4\ https://centerformaritimestrategy.org/publications/reviving-
letters-of-marque/.
---------------------------------------------------------------------------
Neo-privateers
A 21st-century privateer program would issue letters of marque and
reprisal to American companies or individuals to hack wallets and
retrieve funds controlled by OFAC-sanctioned governments, entities or
individuals. Recipients would be immune from U.S. prosecution for their
activities directly related to executing this mission. For example,
neo-privateers could transact directly with OFAC-sanctioned wallets and
entities. Proceeds from the sale of the assets would be shared with the
privateers based on pre-arranged contracts.
Letters of marque and reprisal would deliver a low-cost, flexible
and effective option to address unconventional national security
challenges. At a time when Elon Musk's Department of Government
Efficiency (DOGE) \5\ is seeking to reduce the role of government and
optimize costs, spending incremental public funds to develop the
specialized cryptographic skill sets needed by law enforcement or
intelligence community teams is expensive. Talent acquisition and
retention are other significant challenges. Perhaps for these reasons,
government efforts to stop state-sponsored hackers have been largely
ineffective.
---------------------------------------------------------------------------
\5\ https://cointelegraph.com/news/sec-axe-regional-office-
directors-doge-cost-cuts-reuters.
---------------------------------------------------------------------------
With the rise of artificial intelligence, the sophistication of
hackers is set to increase exponentially. AI ``agents'' can more
efficiently identify vulnerabilities in code. Low-cost, AI-generated
deepfake \6\ video and audio capabilities perfect impersonation,
allowing hackers to more easily swindle unwitting victims. Still,
advanced AI tools and capabilities can work in both directions. Neo-
privateers, indemnified and empowered by letters of marque and
reprisal, could use the most sophisticated technologies to attack the
attackers. By leveraging the private sector to fight back in the crypto
space, government agencies could focus on higher-priority security
concerns.
---------------------------------------------------------------------------
\6\ https://cointelegraph.com/news/decentralization-could-help-
humanity-avoid-an-ai-doomsday-scenario.
---------------------------------------------------------------------------
With nearly 300 pro-crypto members, Congress must act immediately.
Crypto champions like Senator Cynthia Lummis (R-WY) and Congressman Tom
Emmer (R-MN) are well positioned to work across the aisle and partner
with crypto czar David Sacks to prioritize a neo-privateer program that
would restore security to the crypto industry. The crypto industry
would celebrate.
The time has come for the United States to embrace its history and
launch a neo-privateer program. Letters of marque and reprisal provide
an elegant solution to protect American innovation and its national
security.
This article is for general information purposes and is not
intended to be and should not be taken as legal or investment
advice. The views, thoughts, and opinions expressed here are
the author's alone and do not necessarily reflect or represent
the views and opinions of Cointelegraph.
______
Submitted Report by Hon. J. Christopher Giancarlo, Former Chairman,
Commodity Futures Trading Commission
[https://home.treasury.gov/system/files/136/A-Financial-System-Capital-
Markets-FINAL-FINAL.pdf]
U.S. Department of the Treasury
A Financial System That Creates Economic Opportunities_Capital Markets
October 2017
Report to President Donald J. Trump
Executive Order 13772 on Core Principles for Regulating the
United States Financial System
Steven T. Mnuchin
Secretary
Craig S. Phillips
Counselor to the Secretary
Staff Acknowledgments
Secretary Mnuchin and Counselor Phillips would like to thank
Treasury staff members for their contributions to this report. The
staff's work on the report was led by Brian Smith and Amyn Moolji, and
included contributions from Chloe Cabot, John Dolan, Rebekah Goshorn,
Alexander Jackson, W. Moses Kim, John McGrail, Mark Nelson, Peter
Nickoloff, Bill Pelton, Fred Pietrangeli, Frank Ragusa, Jessica Renier,
Lori Santamorena, Christopher Siderys, James Sonne, Nicholas Steele,
Mark Uyeda, and Darren Vieira.
Table of Contents
Executive Summary
Introduction
Scope of This Report
Review of the Process for This Report
The U.S. Capital Markets
Summary of Issues and Recommendations
Capital Markets Overview
Introduction
Key Asset Classes
Key Regulators
Access to Capital
Overview and Regulatory Landscape
Issues and Recommendations
Equity Market Structure
Overview and Regulatory Landscape
Issues and Recommendations
The Treasury Market
Overview and Regulatory Landscape
Issues and Recommendations
Corporate Bond Liquidity
Overview and Regulatory Landscape
Issues and Recommendations
Securitization
Overview
Regulatory Landscape
Issues and Recommendations
Derivatives
Overview
Regulatory Landscape
Issues and Recommendations
Financial Market Utilities
Overview and Regulatory Landscape
Issues and Recommendations
Regulatory Structure and Process
Overview
Issues and Recommendations
International Aspects of Capital Markets Regulation
Overview
Issues and Recommendations
Appendices
Appendix A: Participants in the Executive Order Engagement Process
Appendix B: Table of Recommendations
Acronyms and Abbreviations
------------------------------------------------------------------------
Acronym/
Abbreviation Term
------------------------------------------------------------------------
ABS Asset-Backed Securities
Agency MBS Agency Mortgage-Backed Securities
ANE Arrange, Negotiate, or Execute
ARRC Alternative Reference Rates Committee
ATR Ability to Repay
ATS Alternative Trading System
BCBS Basel Committee on Banking Supervision
BDC Business Development Company
BNY Mellon Bank of New York Mellon
CCAR Comprehensive Capital Analysis and Review
CCP Central Counterparty
CDO Collateralized Debt Obligation
CDS Credit Default Swap
CEA Commodity Exchange Act
CEM Current Exposure Method
CFTC U.S. Commodity Futures Trading Commission
CFMA Commodity Futures Modernization Act
CHIPS Clearing House Interbank Payments System
CLO Collateralized Loan Obligation
CLOBCentral Limit Order Book
CMBS Commercial Mortgage-Backed Securities
CME, Inc. Chicago Mercantile Exchange, Inc.
CMG Crisis Management Groups
CPO Commodity Pool Operator
CPMI-IOSCO Committee on Payments and Market Infrastructures
and the Board of the International Organization of
Securities Commissions
CTU Central Treasury Unit
DCM Designated Contract Market
DCO Derivatives Clearing Organization
DERA SEC Division of Economic and Risk Analysis
DFAST Dodd-Frank Act Stress Test
Dodd-Frank Dodd-Frank Wall Street Reform and Consumer
Protection Act
DtC Dealer-to-Client
DTC Depository Trust Company
DTCC Depository Trust and Clearing Corporation
EC European Commission
EGC Emerging Growth Company
eSLR Enhanced Supplementary Leverage Ratio
ETFs Exchange-Traded Funds
EU European Union
Exchange Act Securities Exchange Act of 1934
FCM Futures Commission Merchant
FDIC Federal Deposit Insurance Corporation
FHFA Federal Housing Finance Agency
FIA Futures Industry Association
FICC Fixed Income Clearing Corporation
FINRA Financial Industry Regulatory Authority
FMU Financial Market Utility
FRB Federal Reserve Board of Governors
FRBNY Federal Reserve Bank of New York
FRTB Fundamental Review of the Trading Book
FSB Financial Stability Board
FSOC Financial Stability Oversight Council
FTE Full-Time Equivalent (Personnel)
FX Foreign Exchange
FY Fiscal Year
GAO U.S. Government Accountability Office
GSA Government Securities Act of 1986
GSD Government Securities Division (of FICC)
GSE Government Sponsored Enterprise
HFT High Frequency Trading
HQLA High-Quality Liquid Assets
HUD U.S. Department of Housing and Urban Development
IDB Interdealer Broker
IOSCO International Organization of Securities
Commissions
IPO Initial Public Offering
IRS Interest Rate Swap
ISDA International Swaps and Derivatives Association
IT Information Technology
JOBS Act Jumpstart Our Business Startups Act
JP Morgan JPMorgan Chase & Co.
JSR Joint Staff Report
LCRLiquidity Coverage Ratio
LIBLondon Interbank Offered Rate
LPRLarge Position Reporting
LSELondon Stock Exchange Group
MAT Made Available to Trade
MBS Mortgage-Backed Securities
MBSD Mortgage Backed Securities Division (of FICC)
MiFID Markets in Financial Instruments Directive
MSRB Municipal Securities Rulemaking Board
NBBO National Best Bid or Offer
NFA National Futures Association
NMS National Market System
NMS Stock ATSs Alternative Trading Systems that trade
NMS stocks
NRSRO Nationally Recognized Statistical Rating
Organization
NSCC National Securities Clearing Corporation
NSFR Net Stable Funding Ratio
NYSE New York Stock Exchange
OCC Options Clearing Corporation (FMU)
OCC Office of the Comptroller of the Currency
(Regulator)
OLA Orderly Liquidation Authority
OTC Over-the-Counter
PLS Private-Label Securities
PTF Principal Trading Firm
QIBs Qualified Institutional Buyers
QM Qualified Mortgage
QRM Qualified Residential Mortgage
RFA Regulatory Flexibility Act
RFQ Request for Quote
SA-CCR Standardized Approach for Counterparty Credit Risk
SDR Swap Data Repository
SEC U.S. Securities and Exchange Commission
SEF Swap Execution Facility
SFA Supervisory Formula Approach
SIP Securities Information Processor
SIFMA Securities Industry and Financial Markets
Association
SIFMUs Systemically Important Financial Market Utilities
SLR Supplementary Leverage Ratio
SPV Special Purpose Vehicle
SRC Smaller Reporting Company
SRO Self-Regulatory Organization
SSB Standard Setting Body
SSFA Simplified Supervisory Formula Approach
TBA To-Be-Announced Market
TCH The Clearing House Payments Company, L.L.C.
Title VII Title VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act
Title VIII Title VIII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act
TRACE Trade Reporting and Compliance Engine
Treasury U.S. Department of the Treasury
USD U.S. Dollar
UTP Unlisted Trading Privileges
------------------------------------------------------------------------
Executive Summary
Introduction
President Donald J. Trump established the policy of his
Administration to regulate the U.S. financial system in a manner
consistent with a set of Core Principles. These principles were set
forth in Executive Order 13772 on February 3, 2017. The U.S. Department
of the Treasury (Treasury), under the direction of Secretary Steven T.
Mnuchin, prepared this report in response to that Executive Order. The
reports issued pursuant to the Executive Order identify laws, treaties,
regulations, guidance, reporting and record keeping requirements, and
other government policies that promote or inhibit Federal regulation of
the U.S. financial system in a manner consistent with the Core
Principles.
The Core Principles are:
A. Empower Americans to make independent financial decisions and
informed choices in the marketplace, save for retirement,
and build individual wealth;
B. Prevent taxpayer-funded bailouts;
C. Foster economic growth and vibrant financial markets through more
rigorous regulatory impact analysis that addresses systemic
risk and market failures, such as moral hazard and
information asymmetry;
D. Enable American companies to be competitive with foreign firms in
domestic and foreign markets;
E. Advance American interests in international financial regulatory
negotiations and meetings;
F. Make regulation efficient, effective, and appropriately tailored;
and
G. Restore public accountability within Federal financial regulatory
agencies and rationalize the Federal financial regulatory
framework.
Scope of This Report
The financial system encompasses a wide variety of institutions and
services, and accordingly, Treasury is delivering a series of four
reports related to the Executive Order covering:
The depository system, covering banks, savings associations,
and credit unions of all sizes, types and regulatory charters
(the Banking Report,\1\ which was publicly released on June 12,
2017);
---------------------------------------------------------------------------
\1\ U.S. Department of the Treasury, A Financial System That
Creates Economic Opportunities: Banks and Credit Unions (June 2017).
Capital markets: debt, equity, commodities and derivatives
markets, central clearing and other operational functions (this
---------------------------------------------------------------------------
report);
The asset management and insurance industries, and retail
and institutional investment products and vehicles; and
Nonbank financial institutions, financial technology, and
financial innovation.
On April 21, 2017, President Trump issued two Presidential
Memoranda to the Secretary of the Treasury. One calls for Treasury to
review the Orderly Liquidation Authority (OLA) established in Title II
of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank). The other calls for Treasury to review the process by which the
Financial Stability Oversight Council (FSOC) determines that a nonbank
financial company could pose a threat to the financial stability of the
United States and will be subject to supervision by the Federal Reserve
and enhanced prudential standards, as well as the process by which the
FSOC designates financial market utilities as systemically important.
While some of the issues described in this report are relevant to OLA
and FSOC designations, Treasury will submit separate reports on those
topics to the President.
Review of the Process for This Report
For this report on capital markets, Treasury incorporated insights
from the engagement process for the Banking Report and also engaged
with additional stakeholders focused on capital markets issues. Over
the course of this outreach, Treasury consulted extensively with a wide
range of stakeholders, including trade groups, financial services
firms, consumer and other advocacy groups, academics, experts,
financial market utilities, investors, investment strategists, and
others with relevant knowledge. As directed by the Executive Order,
Treasury consulted with FSOC member agencies. Treasury also reviewed a
wide range of data, research, and published material from both public-
and private-sector sources.
Treasury incorporated the widest possible range of perspectives in
evaluating approaches to regulation of the U.S. financial system
according to the Core Principles. A list of organizations and
individuals who provided input to Treasury in connection with the
preparation of this report is set forth as Appendix A.
The U.S. Capital Markets
The U.S. capital markets are the largest, deepest, and most vibrant
in the world and of critical importance in supporting the U.S. economy.
The United States successfully derives a larger portion of business
financing from its capital markets, rather than the banking system,
than most other advanced economies. U.S. capital markets provide
invaluable capital resources to our entrepreneurs and owners of
businesses, whether they are large or small, public or private. Both
our equity and debt markets provide investment opportunities to a broad
range of investors, from large institutions to individuals saving for
retirement. Derivatives markets facilitate risk management strategies
for many financial and non-financial businesses. Vibrant securitization
markets support various lending channels, improving consumer access to
credit cards, automobile loans, and a range of other credit products.
Robust financial market infrastructure, including clearing and
settlement operations, underpins each of these markets and is critical
for delivering the benefits of our financial system to the broader
economy.
While the United States has some of the largest capital markets,
capital markets are global and operate around the clock in financial
centers around the world. The largest U.S. financial services firms are
global in nature and benefit from a level playing field to compete in
global markets.
Major public capital markets in the United States include the $29
trillion equity market, the $14 trillion market for U.S. Treasury
securities, the $8.5 trillion corporate bond market, and the $200
trillion (notional amount) derivatives markets. Participants in these
markets include approximately 3,500 domestic public companies, nearly
4,000 broker-dealers, and millions of investors domestically and
abroad.
The current statutory and regulatory framework for U.S. capital
markets dates back to the Great Depression, and has been evolving ever
since. Changes have been driven by launches of new capital markets
products, the increasing complexity of financial products and markets,
the implications of evolving data and technology capabilities, and the
globalization of markets. The primary regulators of U.S. capital
markets are the Securities and Exchange Commission (SEC) and the
Commodity Futures Trading Commission (CFTC), along with state
securities regulators. Additionally, self-regulatory organizations,
including the Financial Industry Regulatory Authority (FINRA), the
Municipal Securities Rulemaking Board (MSRB), and the National Futures
Association (NFA), help regulate and oversee certain parts of the
financial sector. Following its enactment in 2010, Dodd-Frank resulted
in several significant changes to capital markets regulation, such as
mandating risk retention for securitized products, mandating clearing
of certain derivatives through central counterparties (CCPs), and
authorizing the FSOC to designate systemically important financial
market utilities (SIFMUs). More than 7 years after Dodd-Frank's
enactment, it is important to reexamine these rules, both individually
and in concert, guided by free-market principles and with an eye toward
maximizing economic growth consistent with taxpayer protection.
Certain elements of the capital markets regulatory framework are
functioning well and support healthy capital markets. For some
elements, more action is needed to guard against the risks of a future
financial crisis. Other elements need better calibration and tailoring
to help markets function more effectively for market participants.
There are significant challenges with regulatory harmonization and
efficiency, driven by a variety of factors including joint rulemaking
responsibilities, overlapping mandates, and jurisdictional friction.
In order to help maintain the strength of our capital markets, we
need to constantly evaluate the financial regulatory system to consider
how it should evolve to continue to support our markets and facilitate
investment and growth opportunities, while promoting a level playing
field for U.S. and global firms and protecting investors. Treasury has
identified recommendations that can better align the financial system
to serve issuers, investors, and intermediaries to support the
Administration's economic objectives and drive economic growth.
Summary of Issues and Recommendations
Treasury's review of the regulatory framework for capital markets
has identified significant opportunities for reform to advance the Core
Principles. The review has identified a wide range of measures that
could promote economic growth and vibrant financial markets, providing
opportunities for investors and issuers alike, while maintaining strong
investor protection, preventing taxpayer-funded bailouts, and
safeguarding the financial system.
Treasury's recommendations in this report are organized in the
following categories:
Promoting access to capital for all types of companies,
including small and growing businesses, through reduction of
regulatory burden and improved market access to investment
opportunities;
Fostering robust secondary markets in equity and debt;
Appropriately tailoring regulations on securitized products
to encourage lending and risk transfer;
Recalibrating derivatives regulation to promote market
efficiency and effective risk mitigation;
Ensuring proper risk management for CCPs and other financial
market utilities (FMUs) because of the critical role they play
in the financial system;
Rationalizing and modernizing the U.S. capital markets
regulatory structure and processes; and
Advancing U.S. interests by promoting a level playing field
internationally.
Treasury's recommendations to the President are focused on
identifying laws, regulations, and other government policies that
inhibit regulation of the financial system according to the Core
Principles. Because depository institutions are significant service
providers and market makers in capital markets, this report builds on
several themes identified in the Banking Report.
A list of all of Treasury's recommendations within this report is
set forth as Appendix B, including the recommended action, the method
of implementation (Congressional and/or regulatory action), and which
Core Principles are addressed.
Following is a summary of the recommendations set forth in the
report.
Promoting Access to Capital and Investment Opportunities
In the wake of the financial crisis, the U.S. economy has
experienced the slowest economic recovery of the post-war period. While
the Administration is pursuing a range of policies to stimulate
economic growth, one key area will be promoting capital formation for
entrepreneurs and growing businesses. The regulatory burden for public
companies has grown, and many companies are choosing to retain or
return to private ownership. Over the last 20 years, the number of
public companies in the United States has dropped by nearly 50%.
Treasury's recommendations include numerous measures to encourage
companies toward public ownership, including eliminating duplicative
requirements, liberalizing pre-initial public offering communications,
and removing non-material disclosure requirements, among other
recommendations. Improperly tailored regulatory burden can benefit the
largest companies, which are better positioned to absorb the costs, and
discourage competition from new entrants. Treasury has also identified
opportunities to ease challenges for smaller public companies,
including scaled disclosure requirements.
Public companies provide a useful investment vehicle for millions
of retail investors who need investment opportunities to help save for
retirement. If many successful new companies stay private, middle-class
Americans may miss out on the significant returns they generate for
investors. Treasury recommends a series of changes to open private
markets for more investors, including revisiting the ``accredited
investor'' definition and considering ways to facilitate pooled
investments in private or less-liquid offerings.
Our capital markets can also be better harnessed to help America's
entrepreneurs. Through creative funding tools such as crowdfunding,
markets can help provide capital for these innovators to grow their
businesses and create jobs. After a few years of experience following
the 2012 Jump-start Our Business Startups Act (JOBS Act), it is time to
take another look at how these tools can be improved. Treasury's
recommendations also seek to maintain the efficacy of the private
equity markets, which will continue to be important for some companies
and entrepreneurs. These recommendations include maintaining an
appropriate regulatory structure for finders, expanding the range of
eligible investors, empowering investor due diligence efforts, and
modifying the rules for private funds investing in private offerings.
While the burden on both public and private companies needs to be
reduced, maintaining appropriate investor protection is an important
priority. Investor confidence in the integrity of markets, supported by
robust disclosure and regulatory protections, is a critical element of
capital formation.
Fostering Robust Markets for Businesses and Investors
Robust secondary markets are critical to supporting capital
formation, and in turn, economic growth. Aligning regulation to promote
liquid and vibrant markets is an important element of the Core
Principles. While the U.S. equity and debt markets are the best in the
world, regulators need to keep pace with market developments so that
markets continue to function optimally for issuers and investors of all
sizes to best support economic growth and the needs of consumers and
businesses.
In the equity markets, the current ``one-size-fits-all'' market
structure is not working well for smaller companies that are currently
experiencing limited liquidity for their shares. While the largest and
most actively traded companies benefit from a diversity of trading
venues, for the least liquid (and often smallest) companies,
fragmentation of liquidity across 12 equity exchanges and 40
alternative trading systems (ATSs) may inhibit effective liquidity
provision. Treasury recommends that the SEC consider regulatory changes
to promote improved liquidity for these companies. Changes to the price
increment, or ``tick size,'' at which companies trade could play a role
in promoting liquidity provision for less-liquid companies. The SEC
should also consider how to reduce complexity, increase transparency,
and harness competition in other aspects of the equity market,
including market data, order types and routing decisions, and practices
of ATSs.
In the bond market, market liquidity has been challenging,
especially for the least liquid securities. As discussed in the Banking
Report, a combination of the Volcker rule, bank capital rules, and bank
liquidity rules may be limiting market liquidity. This report explores
the effects of these rules on the corporate bond and repo markets in
particular, reiterating many recommendations from the Banking Report.
Safeguarding the Treasury Market
The Treasury market has seen substantial changes over recent
decades, including the growth of electronic trading and principal
trading firms (PTFs), which have reshaped the market in numerous ways.
Despite recent modernization efforts to improve the visibility of
regulators into the Treasury market, data gaps remain, particularly
regarding PTFs, which are now some of the largest participants in the
Treasury market. Treasury recommends steps to close these gaps in
official sector data without imposing significant costs on market
participants.
In addition to data gaps, Treasury market clearing has become
bifurcated, reducing efficiency and presenting potential risks. Our
regulatory regime needs to keep pace with these market developments,
and Treasury recommends further study of potential solutions by
regulators, market participants, and other stakeholders.
Safeguarding the Treasury market is crucial because of the central
role of the Treasury market in the financial system as well as the
importance of financing the U.S. Government at the lowest cost to
taxpayers over time.
Encouraging Lending Through Promotion of Quality Securitization
Securitization, or the process of packaging loans and receivables
into more tradable securities, is a liquidity transformation and risk-
transfer mechanism. When used responsibly, this process can have
significant benefits for borrowers, lenders, and the economy. The
securitization market provides a valuable outlet for the banking
sector, as well as for other nonbank originators, through the placement
of securities backed by loans and other asset pools with a wide range
of investors, including pension funds, insurance companies, asset
managers, sovereign wealth funds, and central banks.
Dodd-Frank and various rulemakings implemented to address pre-
crisis structural weaknesses in the securitization market may have gone
too far toward discouraging securitization. By imposing excessive
capital, liquidity, disclosure, and risk retention requirements on
securitizers, recent financial regulation has created significant
disincentives to securitization. While some changes are helpful in
promoting market discipline, others unduly constrain market activity
and limit securitization's useful role as a funding and risk transfer
mechanism for lending. The Banking Report explored private sector
secondary market activity for residential mortgage lending. This report
will focus on regulatory recommendations pertaining to securitized
products collateralized by other consumer and commercial asset classes.
Recalibrating regulations affecting this market should be viewed
through the lens of making the economics of securitization, not the
regulatory regime governing it, the driver of this market.
Recalibrating Derivatives Regulation
Reforms in the derivatives market, such as mandatory central
clearing of certain swaps and increased data disclosure requirements,
have been effective in promoting greater market liquidity and
transparency. There are, however, numerous opportunities for
improvements in implementation. Derivatives of many forms, including
forward agreements, futures contracts, options, and swaps, are a class
of financial instruments that allow financial and non-financial
concerns to transfer, and thus better manage, a wide range of risks.
Treasury recommends greater harmonization between the SEC and the CFTC,
more appropriate capital and margin treatment for derivatives, allowing
space for innovation and flexibility in execution processes, and
improvements in market infrastructure. Treasury recommends that the
CFTC and the SEC strive to improve cross-border regulatory cooperation
with non-U.S. jurisdictions where possible to avoid market
fragmentation, redundancies, undue complexity, and conflicts of law.
These changes can serve to level the playing field for market
participants while at the same time ensuring healthy, fair, and robust
derivatives markets and preserving our domestic financial interests.
Ensuring Proper Oversight of Clearinghouses and Financial Market
Utilities
FMUs, including CCPs, play crucial and often distinct roles in the
financial system. The capital markets and American public rely on these
entities to work, and their proper functioning supports a broad range
of financial market and broader economic activity. For decades, these
entities have handled tremendous transactional volumes. Dodd-Frank's
derivatives clearing mandate and other regulations pushed even more
trading activity into clearinghouses and authorized the FSOC to
designate FMUs as ``systemically important,'' but left significant
issues for systemic risk management unresolved. It is imperative that
our financial regulatory system prevent taxpayer-funded bailouts and
limit moral hazard. The centralization of risk in a clearinghouse and
resulting implications for systemic risk necessitate appropriate
regulatory oversight, and Treasury recommends improving oversight of
FMUs. Treasury also recommends that the FSOC, working with the
appropriate regulatory agencies, continues to study the role that these
entities play in the financial system. Regulators must finalize an
appropriate regulatory framework for FMU recovery or resolution to
avoid taxpayer-funded bailouts.
Modernizing and Rationalizing Regulatory Structure and Process
Both Congress and the financial regulatory agencies have roles to
play in modernizing and rationalizing the Federal regulatory framework,
and many opportunities for improvement are cited throughout this
report. The roles of the SEC and CFTC, and the management of regulatory
overlaps and areas for harmonization, should be evaluated. Greater
coordination is also required between the market regulators and the
Prudential Regulators of U.S. financial institutions.
Regulatory processes can also be improved. Treasury recommends that
the SEC and CFTC make their rulemaking processes more transparent and
incorporate improved economic analysis, an updated consideration of the
effects on small entities, and public input as appropriate. Treasury
also recommends that the SEC and the CFTC avoid imposing substantive
new requirements by interpretation or other guidance. At the same time,
Treasury believes regulators should have appropriate authority to
provide exemptions to requirements when doing so can facilitate market
innovation.
Finally, Treasury recommends that the CFTC and SEC should conduct
comprehensive reviews of the roles, responsibilities, and capabilities
of self-regulatory organizations (SROs) under their respective
jurisdictions and make recommendations for operational, structural, and
governance improvements of the SRO framework.
Promoting U.S. Interests and Ensuring A Level Playing Field Abroad
U.S. agencies should also continue to advance U.S. interests by
engaging bilaterally and multilaterally to enhance American companies'
competitiveness. Treasury emphasizes the important differences between
market regulation and prudential regulation, and urges international
standard-setting bodies to fully utilize the expertise of market
regulators in formulating international standards for market
regulation.
Treasury recommends increased transparency and accountability in
international financial regulatory standard-setting bodies. Improved
interagency coordination should be adopted to ensure the most effective
harmonization of U.S. participation in applicable international forums.
International regulatory standards should only be implemented through
consideration of their alignment with domestic objectives and should be
carefully and appropriately tailored to meet the needs of the U.S.
financial services industry and the American people.
Capital Markets Overview
Introduction
The proper functioning and efficiency of U.S. capital markets is
critical for ensuring U.S. economic strength and maintaining financial
stability. Vibrant capital markets allow individuals and institutions
to invest in businesses, helping allocate capital where it is needed
and supporting efforts to innovate. Through the efficient allocation of
capital, these markets support efforts by businesses to produce goods,
offer services, and create jobs.
Key participants in capital markets include investors, issuers, and
intermediaries. Investors provide capital, issuers raise capital, and
intermediaries help markets function more efficiently by connecting
buyers and sellers (either directly, or indirectly by providing
liquidity). Investors include institutions, such as pension funds and
insurance companies, and individuals, who own securities directly or
through shares of funds--such as mutual funds, exchange-traded funds
(ETFs), and hedge funds. Issuers of securities include governments,
corporations, and certain specialized institutions like government-
sponsored enterprises. Intermediaries include various institutional
entities, like broker-dealers and proprietary trading firms that engage
in market-making. Other entities that support capital markets
activity--including exchanges and payment, clearing, and settlement
service providers--are critical for maintaining the infrastructure of
these markets. The ability of market participants to transfer risk
efficiently is also critical to the health of capital markets. When
considering the impact of major market developments and regulation, it
is important to consider the effects on each of these categories of
market participants.
Key Asset Classes
The U.S. capital markets can be segmented into several major asset
classes. Each have unique characteristics, including participants,
venues, and functions. A summary of key market characteristics is
provided here:
Key Market Characteristics
----------------------------------------------------------------------------------------------------------------
Market Size Average
(Amount 2016 Daily Representative Representative Representative
Outstanding) Issuance Volume Issuers Investors Intermediaries
----------------------------------------------------------------------------------------------------------------
Equities 2, 3 $29 trillion $200 $270 Corporations Individuals, Exchanges,
billion billion asset managers, broker-dealers
institutions
such as pensions
\2\ SIFMA,
2017 Fact
Book, at 32,
available at:
https://
www.sifma.org/
wp-content/
uploads/2016/
10/US-Fact-
Book-2017-
SIFMA.pdf
(``SIFMA Fact
Book'').
\3\ SIFMA US
Equity
Statistics
(July 2017),
available at:
http://
www2.sifma.or
g/research/
statistics.as
px.
U.S. $14 trillion Bills: $6.1 $510 U.S. Government Individuals, Broker-dealers,
Treasuries 4, (marketable trillion billion banks, pensions, trading
5 securities) Notes: $2.0 insurers, platforms
trillion foreign
Bonds: $190 governments
billion
\4\ U.S.
Department of
the Treasury.
Total
notional
outstanding
of marketable
Treasury
securities
(including
bills, notes,
bonds, and
TIPS) is
$13.9
trillion. Non-
marketable
Treasury
securities
constitute an
additional
$6.1
trillion. The
2016 issuance
figures
include
gross.
\5\ SIFMA US
Treasury
Trading
Volume,
available at:
https://
www.sifma.org/
resources/
research/us-
treasury-
trading-
volume/.
Corporate $8.5 trillion $1.5 $31 Corporations Insurers, Broker-dealers
Bonds \6\ trillion billion pensions, asset
managers
\6\ SIFMA U.S.
Bond Market
Issuance and
Outstanding,
U.S.
Corporate
Bond Issuance
and Trading
Volume (July
2017),
available at:
http://
www2.sifma.or
g/research/
statistics.as
px.
Foreign N/A N/A $5.1 Central banks Central banks, Trading
Currencies \7 trillion asset managers, platforms,
\ corporations broker-dealers
\7\ Bank for
International
Settlements,
Turnover of
OTC Foreign
Exchange
Instruments
(Apr. 2016),
available at:
http://
www.bis.org/
statistics/
d11_1.pdf.
Derivatives \8 Interest rate: N/A Interest N/A Corporations, Central
\ $200 trillion rate: hedge funds, Counterparties,
(notional) $900 individuals exchanges,
Credit: $3.6 billion broker-dealers,
trillion (notional trading
(notional) ) platforms
Credit:
$110
billion
(notional
)
\8\ Figures on
credit
derivatives
include index-
linked
products.
Volume
figures
reflect 12
week moving
averages
ending
December 30,
2016. CFTC
Swaps Report
(Jan. 11,
2017),
available at:
http://
www.cftc.gov/
MarketReports/
SwapsReports/
Archive/
index.htm.
Securitized Mortgage $2.1 Mortgage Banks, nonbank Banks, insurers, Broker-dealers
Products \9\ related: $8.9 trillion related: financial pensions, hedge
trillion $210 companies, funds, asset
Other ABS: $1.3 billion government- managers
trillion Other ABS: sponsored
$1.3 enterprises
billion
\9\ SIFMA U.S.
Structured
Finance (July
2017),
available at:
http://
www2.sifma.or
g/research/
statistics.as
px.
----------------------------------------------------------------------------------------------------------------
Equities
Equity markets are the largest U.S. capital market, with major
equity indexes considered bellwethers for the U.S. economy. At
approximately $29 trillion in publicly traded U.S. corporate stock
outstanding as of 2016 year end,\10\ healthy U.S. equity markets are an
important component of well-functioning capital markets and overall
economic growth. U.S. equities are heavily traded, with an average of
$270 billion in daily volume in 2016.\11\ Despite a shrinking number of
publicly listed U.S. companies, market capitalization of U.S. equities
has increased over the past decade on larger equity issues and equity
market appreciation.
---------------------------------------------------------------------------
\10\ Includes market capitalization of both domestic and foreign
companies. SIFMA Fact Book at 32.
\11\ SIFMA U.S. Equity Statistics (July 2017), available at: http:/
/www2.sifma.org/research/statistics.aspx.
---------------------------------------------------------------------------
Equity issuers include U.S. companies, who raise equity capital to
finance their operations. Individuals own equities either directly or
through funds--including mutual funds and other asset management
products. As of 2016 year end, U.S. mutual funds held 24% of U.S.
equities, while other registered investment companies--ETFs, for the
most part--held another 6%.\12\
---------------------------------------------------------------------------
\12\ Investment Company Institute, 2017 Investment Company Fact
Book, at 14, available at: https://www.ici.org/pdf/2017_factbook.pdf
(``ICI Fact Book'').
---------------------------------------------------------------------------
Investment companies can either be actively managed, in which fund
managers select specific securities for a portfolio, or passively
managed, in which securities are chosen to reflect a market index.
Through inflows into passive mutual funds and ETFs, investors have
shifted their asset allocation away from actively managed funds over
the past decade. Outflows from actively managed funds have totaled
approximately $900 billion since 2009, roughly equal to the inflows
into passive funds over this period.\13\
---------------------------------------------------------------------------
\13\ Morningstar.
---------------------------------------------------------------------------
As of July 2017, approximately 63% of equities trading occurred on
registered exchanges, with the top three exchanges representing over
half of that volume.\14\ A larger fraction of equity trading occurs on
exchanges than in many other asset classes, due to the relatively small
number of actively traded equity issues (for example, relative to a
much larger number of bond issues). Through exchanges, market
participants can gain access to a substantial amount of data on equity
prices, volumes, and liquidity. Equities can also be traded in the
private market, which is less transparent.
---------------------------------------------------------------------------
\14\ Rosenblatt Securities.
---------------------------------------------------------------------------
U.S. Treasuries
U.S. Treasury securities serve a number of roles in the global
financial system. Issuance of Treasury securities finances the U.S.
Government, while also providing a risk-free rate against which
trillions of dollars in financial contracts are benchmarked. Treasury
securities also provide individuals and institutions the ability to
earn a risk-free return.
The Treasury market has expanded significantly in recent years as
government debt levels have increased. At $14 trillion in total
notional marketable debt outstanding,\15\ it is the largest market for
any individual issuer in the world. Treasury securities trade in high
volumes, at approximately $510 billion per day.\16\ Treasury futures--
contracts that promise the delivery of Treasury securities at a future
date--are also actively traded.
---------------------------------------------------------------------------
\15\ U.S. Department of the Treasury.
\16\ SIFMA US Treasury Trading Volume (September 2017), available
at: https://www.sifma.org/resources/research/us-treasury-trading-
volume/.
---------------------------------------------------------------------------
Individuals, institutions, and governments seeking safe assets
remain the dominant provider of credit to the U.S. Government. U.S.
financial institutions, in an effort to increase asset liquidity, have
increased their holdings of Treasury securities. Foreign investors also
constitute a significant source of funding.\17\ While traditional
broker-dealers continue to provide a large portion of Treasury market
intermediation--buying and selling securities for their customers--the
market structure for Treasury trading has shifted in recent years.
Principal trading firms not affiliated with traditional regulated banks
or broker-dealers have become significant participants in market
intermediation.
---------------------------------------------------------------------------
\17\ U.S. Department of the Treasury, Major Foreign Holders of
Treasury Securities, available at: http://ticdata.treasury.gov/Publish/
mfh.txt.
---------------------------------------------------------------------------
Corporate Bonds
In addition to raising equity capital, corporations also use bonds
to borrow funds in the capital markets. Fueled by low interest rates
and strong demand for U.S. credit, issuance of corporate bonds has
increased markedly over the past decade, with total corporate debt
reaching $8.5 trillion as of 2016 year end.\18\ Trading is highly
bifurcated; larger, recently issued, and highly rated corporate bonds
trade relatively frequently, while lower rated and so-called ``aged''
bonds tend to trade much less.
---------------------------------------------------------------------------
\18\ SIFMA U.S. Bond Market Issuance and Outstanding, U.S.
Corporate Bond Issuance and Trading Volume (July 2017), available at:
http://www2.sifma.org/research/statistics.aspx.
---------------------------------------------------------------------------
Institutional investors have a significant presence in the
corporate bond market. As of 2016 year end, insurance companies and
pensions held $3.1 trillion and $1.3 trillion in U.S. corporate and
foreign bonds, respectively.\19\ As in the equity market, individuals
may own corporate bonds directly or indirectly through mutual funds,
ETFs, and other funds. Fixed-income focused mutual funds--which have
witnessed strong inflows over the past decade--hold 16% of bonds issued
by U.S. corporations and foreign bonds held by U.S. residents, with an
additional 3% held by other registered investment companies.\20\
---------------------------------------------------------------------------
\19\ Insurance company data includes holdings by life insurers and
property and casualty insurers. Financial Accounts of the United
States.
\20\ ICI Fact Book, at 14.
---------------------------------------------------------------------------
Intermediation in corporate bonds has also changed in recent years.
Broker-dealers historically have intermediated corporate bond trading
on a principal basis for their customers and have held corporate bond
positions on their balance sheets to support trading. Some market
participants have increasingly turned to electronic platforms for trade
execution. In addition, intermediaries have expanded their agency-based
trading, whereby an order is only executed when buying and selling
customers can be matched and dealers do not need to commit capital to
support trades.
Foreign Exchange
Foreign currencies trade heavily and are in many cases highly
liquid, with $5.1 trillion in USD equivalent changing hands per
day.\21\ Foreign currencies trade in the ``spot'' market, with one
currency traded for another, or via derivatives. Currencies are traded
frequently on multilateral platforms as well as bilaterally with banks
and broker-dealers. Unlike equities and bonds, foreign currencies are
not securities issued by governments or corporations. However, markets
for these products remain important in that they allow investors to
diversify portfolios and manage risk.
---------------------------------------------------------------------------
\21\ Bank for International Settlements, Turnover of OTC Foreign
Exchange Instruments (Apr. 2016), available at: http://www.bis.org/
statistics/d11_1.pdf.
---------------------------------------------------------------------------
Derivatives
In financial markets, ``derivatives'' are a broad class of
financial instruments or contracts whose prices or terms of payment are
dependent upon, or derive from, the value or performance of another
asset or commodity. Unlike securities (e.g., stocks and bonds),
derivatives are originated primarily for the purpose of managing, or
hedging, the risks associated with the underlying assets. Given the
large size of derivatives markets and their ability to make markets and
institutions more interconnected, derivatives are a major feature of
the financial system.
At approximately $200 trillion in total notional outstanding as of
2016 year end,\22\ interest rate derivatives--including interest rate
swaps--constitute the largest derivatives market by notional
outstanding. Credit derivatives on indexes, including credit default
swaps, constitute another major category, with $3.6 trillion in
outstanding notional.\23\ Other major categories include derivatives
linked to equities, foreign currencies, and commodities.
---------------------------------------------------------------------------
\22\ CFTC Swaps Report (Jan. 11, 2017), available at: http://
www.cftc.gov/MarketReports/SwapsReports/Archive/index.htm.
\23\ Id.
---------------------------------------------------------------------------
The market for derivatives has changed considerably in recent
years. In an effort to reduce counterparty risk and to comply with
post-crisis regulations, market participants have increasingly turned
to derivatives cleared by central counterparties over those backed by
other financial institutions like banks and broker-dealers. For
example, approximately 80% of derivatives linked to interest rates and
credit indexes are now centrally cleared, each measured as a percentage
of transaction dollar volume.\24\
---------------------------------------------------------------------------
\24\ Id.
---------------------------------------------------------------------------
Securitization Markets
Securitization--the process of transforming individual loans into
tradable securities--supports the financial system by allowing banks to
transfer credit risks from customer lending to the broader financial
system, broadening the investor base for such loans. Securitization
begins with individuals who borrow money to finance various needs like
housing, automobiles, and education. Securitizers, including special
purpose vehicles sponsored by banks and nonbank financial companies,
purchase such loans and issue securities against them. Investors are
typically institutional investors, including insurance companies,
pensions, and hedge funds. These investors provide capital and are
attracted to these securities for their diversification benefits,
liquidity, and yield. The ability to sell loans to investors through
securitization allows banks to make additional loans available to
customers.
Across all asset classes, housing has the biggest presence in
securitization markets. The notional outstanding for U.S. securities
backed by other assets, such as automobiles, student loans, and credit
card debt, is sizeable as well, totaling $1.3 trillion at 2016 year
end.\25\
---------------------------------------------------------------------------
\25\ SIFMA US ABS Issuance and Outstanding (July 2017), available
at: http://www2.sifma.org/research/statistics.aspx.
---------------------------------------------------------------------------
Key Regulators
The Securities and Exchange Commission (SEC) and the Commodity
Futures Trading Commission (CFTC), along with state securities
regulators, constitute the major U.S. market regulators. Additionally,
self-regulatory organizations, including the Financial Industry
Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board
(MSRB), and the National Futures Association (NFA), help regulate and
oversee certain parts of the financial sector.
The SEC's mission is to protect investors; maintain fair, orderly,
and efficient markets; and facilitate capital formation. Broadly, the
SEC has jurisdiction over brokers and dealers, securities offerings in
the primary and secondary markets, investment companies, investment
advisers, credit rating agencies, and security-based swap dealers. The
SEC was mandated by Dodd-Frank to enact rules in areas including
registration of investment advisers to certain private funds (hedge
funds and private equity funds), the Volcker Rule, security-based
swaps, clearing agencies, municipal securities advisors, executive
compensation, proxy voting, asset-backed securitizations, credit rating
agencies, and non-financial disclosures.
The CFTC's mission is to foster open, transparent, competitive, and
financially sound markets to avoid systemic risk and to protect market
users and their funds, consumers, and the public from fraud,
manipulation, and abusive practices related to derivatives and other
products that are subject to the Commodity Exchange Act.\26\ The CFTC's
jurisdiction includes commodity futures (and options on futures), as
well as futures on financial assets and indexes, interest rates, and
other financial, commercial, or economic contingencies. In 2010,
Congress expanded the CFTC's jurisdiction to include swaps.
---------------------------------------------------------------------------
\26\ U.S. Commodity Futures Trading Commission, Agency Financial
Report, Fiscal Year 2016, available at: http://www.cftc.gov/About/
CFTCReports/ssLINK/2016afr (``CFTC 2016 Financial Report'').
---------------------------------------------------------------------------
Access to Capital
Overview and Regulatory Landscape
Access to capital is crucial to promoting a thriving U.S. economy.
It allows companies to invest in growth and develop new products and
services, leading to increased employment opportunities and wealth
creation. But for companies to have access to capital, investors must
be willing to supply capital. Without robust investor protections that
underpin confidence in the markets, such as the predictable and
consistently applied rule of law and the enforceability of contracts,
investors may be less willing to provide capital. Hence, a well-
designed regulatory structure, one that promotes fairness,
predictability, and efficiency for investors and companies alike, is
crucial to healthy capital markets.
The source and structure of capital can vary depending on what
stage a company is in its lifecycle, as well as market conditions and
company preferences. Early stage companies may access capital from
friends and family, angel investors, and venture capital firms. As
companies mature further, they might attract capital from private
equity or through a public listing via an initial public offering
(IPO).
Historically, companies seeking a significant amount of capital
have often preferred to conduct an IPO and have shares traded on a
national securities exchange. But over the last 2 decades, the number
of domestic public companies listed in the United States has declined
by nearly 50% (see Figure 1).
Figure 1: Number of Public Companies in the United States, 1990-2016
Source: Securities and Exchange Commission staff analysis
using data from the Center for Research in Securities Prices
U.S. Stock and U.S. Index Databases.
2016 Center for Research in Securities
Prices, The University of Chicago Booth School of Business.
The trends in the United States toward fewer public listings are
unusual compared to the trends in other developed countries with
similar institutions and economic development. According to one study,
while U.S. listings dropped by about half since 1996, listings in a
sample of developed countries increased by 48%.\27\ The study indicated
that the decline in the U.S. market was driven by low levels of new
listings and a high number of delistings, many of which were the result
of one public company being acquired by another.\28\ A wave of business
failures following the large number of IPOs during the dot-com era also
contributed to the high number of delistings.\29\
---------------------------------------------------------------------------
\27\ Craig Doidge, G. Andrew Karolyi, and Rene M. Stulz, The U.S.
Listing Gap, 123 Journal of Financial Economics 464 (Mar. 2017), at 467
(``Doidge, Karolyi, and Stulz (2017)'').
\28\ Id. at 465-66.
\29\ Ernst & Young LLP, Looking Behind the Declining Number of
Public Companies: An Analysis of Trends in US Capital Markets (May
2017), at 1, available at: http://www.ey.com/Publication/vwLUAssets/an-
analysis-of-trends-in-the-us-capital-markets/$FILE/ey-an-analysis-of-
trends-in-the-us-capital-markets.pdf.
---------------------------------------------------------------------------
As the number of U.S. listings has decreased, the size of listed
public companies has increased. A recent analysis found that as of
early 2017, the average market capitalization of a U.S.-listed public
company was $7.3 billion compared to an average of $1.8 billion in
1996.\30\ The analysis noted that approximately 140 companies with more
than $50 billion in market capitalization constituted more than half of
the total U.S. market capitalization.\31\
---------------------------------------------------------------------------
\30\ Id. at 2-3. The 1996 average market capitalization has been
adjusted for inflation to reflect current dollars.
\31\ Id. at 3.
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Although IPO activity has dramatically declined since 1996, the
data also shows that the amount of capital raised through IPOs varies
over time in a cyclical pattern that is consistent with overall
economic conditions at the time. As shown in Figure 2, the number of
IPOs peaked at 821 in 1996 and fell to 119 by 2016. Since the financial
crisis, the annual number of IPOs averaged 188--far less than the
average of 325 during the period before.
Figure 2: U.S. Initial Public Offerings by Number and Dollar Volume,
1996-2017
Source: Securities and Exchange Commission staff analysis
based on Securities Data Corporation's New Issues database
(Thomson Financial). Excludes closed-end funds and American
Depository Receipts. The data for 2017 is for the period ending
Aug. 31, 2017.
In general, under the Federal securities laws, a security may
be offered or sold in the United States only if it is
registered with the SEC or subject to an applicable exemption
from registration.
If a company registers its offering, it files extensive
disclosures with the SEC, including audited financial
statements, and becomes subject to continuing disclosure
requirements.
Common exemptions from registration include Regulation A
(mini-public offerings), Regulation D (many types of private
placements), Regulation CF (crowdfunding), Regulation S
(offshore offerings), Rule 144A (qualified institutional
buyers), and Rules 147 and 147A (intrastate offerings).
While robust public markets are critically important to issuers and
investors, private markets also serve as important liquidity tools to
companies. In discussions with market participants, Treasury staff were
told that private markets provide important flexible alternatives for
obtaining financing for entrepreneurial efforts. Moreover, for the
overwhelming majority of U.S. firms, a public listing on a national
securities exchange might not be appropriate given their business size
and circumstances.\32\ For these companies, the nonpublic capital
markets, or private markets, will remain an important source of
potential funding.
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\32\ Less than 0.02% of the estimated 28.8 million firms in the
United States are currently exchange-listed firms. See Division of
Economic and Risk Analysis (DERA), U.S. Securities and Exchange
Commission, Report to Congress: Access to Capital and Market Liquidity
(Aug. 2017), at 37, available at: https://www.sec.gov/files/access-to-
capital-and-market-liquidity-study-dera-2017.pdf (``DERA (2017)'').
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According to a recent SEC staff report, during 2009-2016, the total
amount of debt and equity primary offerings reported in the private
markets was consistently greater than the comparable amount offered in
the public markets.\33\ Amounts raised through private offerings of
debt and equity for 2012 through 2016 combined exceeded amounts raised
through public offerings of debt and equity over the same time period
by approximately 26%.
---------------------------------------------------------------------------
\33\ Id. at 35-36.
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The last major legislative effort to improve access to capital
occurred in 2012. The Jump-start Our Business Startups Act (JOBS Act)
\34\ was enacted on April 5, 2012 in an effort to spur capital
formation.
---------------------------------------------------------------------------
\34\ Public Law No. 112-106.
Key Provisions of the 2012 Jump-start Our Business Startups Act \35\
------------------------------------------------------------------------
Title Also Known As Description
------------------------------------------------------------------------
Title I IPO On-Ramp Creates a category of public
companies called ``emerging
growth companies (EGCs).''
Status available for up to
the first 5 years after an
IPO for companies with less
than $1 billion in annual
revenue and publicly traded
shares of less than $700
million. Permits confidential
review of filings by the SEC
with public release no later
than 21 days before start of
the company's road show,
testing the waters, scaled
disclosure requirements, and
phase-in of certain
requirements following an
IPO.
\35\ On December 4,
2015, the Fixing
America's Surface
Transportation
(FAST) Act was
signed into law
(Public Law No.
114-94). The FAST
Act contained
several amendments
to the JOBS Act,
including a
reduction of the
public release
period for
confidential
submissions from
21 days to 15
days, a revision
to the grace
period for EGCs
whose status
changes, and
permitting an EGC
to file only
financial
information that
will be included
in a preliminary
prospectus.
Title II Regulation D Eliminates the prohibition on
General general solicitation for
Solicitation Regulation D offerings
provided the issuer takes
reasonable steps to verify
accredited investor
status.\36\ Exempts certain
persons--such as online
marketplaces for issuers and
accredited investors that
facilitate private offerings--
from the requirement to
register with the SEC as
broker-dealers if they do not
receive transaction-based
compensation, possess
customer funds or securities,
or negotiate the terms of
issuance.
\36\ SEC rules
define
``accredited
investor.'' See 17
CFR 501(a). One
category of
qualification is
to be a person
with a net worth
of at least $1
million (excluding
primary residence)
or an income of at
least $200,000
($300,000 together
with a spouse)
each year for the
last 2 years.
Title III Crowdfunding Allows private companies to
offer and sell up to $1
million in equity securities
during a 12 month period to
any investor in small amounts
through a broker or funding
portal, with accompanying
disclosure requirements and
investment limitations.
Resales of such securities
are restricted.
Title IV Regulation A+ Increases the size of
offerings from private
companies exempt from
registration under the SEC's
existing Regulation A from $5
million to $50 million during
a 12 month period. The SEC's
implementing regulations
divide this exemption into
two categories: up to $20
million (Tier 1); and up to
$50 million (Tier 2), which
includes ongoing disclosure
requirements and investment
limitations and preempts
state securities registration
requirements.
Titles V and VI Section 12(g) Increases the thresholds for
Amendments registering a class of equity
securities with the SEC until
a company has more than $10
million in assets and
securities that are ``held of
record'' by 2,000 persons, or
500 persons who are not
accredited investors. Banks,
bank holding companies, and
savings and loan holding
companies \37\ are subject to
a modified threshold. The
definition of the term ``held
of record'' excludes
securities received in an
exempt transaction under an
employee compensation plan.
\37\ Savings and
loan holding
companies were not
covered in the
JOBS Act, but were
later added by the
FAST Act.
------------------------------------------------------------------------
The JOBS Act contained a number of provisions intended to
facilitate capital formation and business startups. While the IPO on-
ramp was effective upon enactment, other provisions required SEC
rulemaking for implementation. The removal of the ban on general
solicitation became effective in September 2013, followed by Regulation
A+ in June 2015 and, most recently, crowdfunding in May 2016.
This chapter looks at recommendations to improve the attractiveness
of going public when companies are seeking to raise capital, but also
considers recommendations to expand access to capital more broadly.
Becoming an SEC-reporting company may not be appropriate for many small
enterprises. For example, a small enterprise may be seeking to raise
only a modest amount of capital. Thus, this chapter examines approaches
for improving access to capital in the private markets as well. This
chapter also discusses ways to improve investors' access to
opportunities while maintaining investor protections.
Issues and Recommendations
Why are there Fewer Public Companies and IPOs?
When raising capital, a company generally weighs the relative costs
and benefits of all available options before reaching a decision. Those
costs and benefits are affected by the regulatory environment, but also
by other factors such as the overall state of the economy, interest
rates, market volatility, and investor sentiment.
Historically, an IPO has been an important event in the lifecycle
of a company. Access to the public equity markets means obtaining a
source of permanent capital, usually at a cost lower than other
alternatives. Proceeds from IPOs can be used to hire employees, develop
new products and technologies, and expand operations. Furthermore, IPOs
give institutional and other early stage investors an exit, allowing
them to reallocate their capital and talent to other ventures. IPOs
also have important implications for employees, who may have accepted
pre-IPO compensation in the form of options and stock grants. After an
IPO, an employee can monetize his or her compensation by selling into
the market. This feature can incentivize employee job performance and
work commitment. Despite these benefits, the number of IPOs has
declined over the last 20 years.
As illustrated above, the number of IPOs and amounts raised varies
over time, and it is challenging to identify specific causal factors
that contribute to decisions on whether to go public.
``Well-intentioned regulations aimed at protecting the public
from the misrepresentations of a small number of large
companies have unintentionally placed significant burdens on
the large number of smaller companies. As a result, fewer high-
growth entrepreneurial companies are going public, and more are
opting to provide liquidity and an exit for investors by
selling out to larger companies. This hurts job creation, as
the data clearly shows that job growth accelerates when
companies go public, but often decelerates when companies are
acquired.''
Interim Report, President Obama's Council on Jobs and Competitiveness,
October 2011
However, increased disclosure and other regulatory burdens may
influence a decision to obtain funding in the private markets for a
company that might have previously sought to raise capital in the
public markets. In addition, a company must consider not only current
regulations, but also the potential impact of future regulations.
During Treasury's outreach efforts, stakeholders frequently
highlighted the cumulative impact of new regulations and legal
developments affecting public companies since the Sarbanes-Oxley Act,
rather than any individual regulatory action. Some factors that were
mentioned include:
Heightened compliance costs related to the Sarbanes-Oxley
Act, Regulation FD, shareholder proposal rules, and Dodd-Frank;
Changes in equity market structure that are less favorable
to smaller public companies (e.g., decimalization,
fragmentation of the market, and disappearance of small- and
mid-sized investment banks);
Non-financial disclosure requirements based on social or
political issues, which have tangential, if any, relevance to
the financial performance of a company;
Shareholder litigation risk;
Shareholder pressure to prioritize short-term returns over
long-term strategic growth;
Inadequate oversight and accountability of proxy advisory
firms;
Lack of research coverage for smaller public companies.
There are differing views on the degree to which regulatory burdens
influence a company's decision to undertake an IPO and, once public, to
remain public. Non-regulatory factors, such as changes in the economic
environment due toglobalization, the changing nature of new firms
(e.g., service-based companies may have less intensive capital needs
than industrial companies), the availability of cheaper debt financing,
and increased mergers and acquisitions activity (particularly as an
alternate to internal research and development) may also play a
role.\38\ The increase in size and scale of venture capital and private
equity firms has also had an impact. Globally, private equity assets
under management, for instance, have increased from $1.8 trillion to
$2.5 trillion over the last 5 years.\39\
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\38\ See, e.g., Doidge, Karolyi, and Stulz (2017); Xiaohui Gao, Jay
R. Ritter, and Zhongyan Zhu, Where Have All the IPOs Gone?, 48 Journal
of Finance and Quantitative Analysis 1663 (Dec. 2013) (``Gao, Ritter,
and Zhu (2013)'').
\39\ The Boston Consulting Group, Capitalizing on the New Golden
Age in Private Equity (Mar. 7, 2017), available at: https://
www.bcg.com/en-ca/publications/2017/value-creation-strategy-
capitalizing-on-new-golden-age-private-equity.aspx.
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Opportunities Lost for Investors in the Public Markets
When a company offers securities in the public market, it registers
with the SEC and makes extensive disclosures. The securities exchanges,
over the counter markets, and other trading venues allow investment
opportunities to be made available to the general public. Generally,
any retail investor can participate without significant regulatory
limitations or restrictions.
If a company decides not to go public and instead raises capital in
the private market or as an exempt offering,\40\ it could be subject to
investor qualification requirements and/or offering limitations. This
could result in the average investor being deprived of an opportunity
to consider investing in that enterprise. Instead, those investment
opportunities and potential wealth gains, along with their attendant
risks, might be made available only to a relatively small group of
investors. To the extent that companies decide not to go public due to
anticipated regulatory burdens, regulatory policy may be
unintentionally exacerbating wealth inequality in the United States by
restricting certain investment opportunities to high income and high
net worth investors.
---------------------------------------------------------------------------
\40\ The most common type of exempt offerings is Regulation D. See
DERA (2017).
``Investors, then, and not just entrepreneurs, have a
significant interest in vibrant public markets that foster
IPOs. Investors stand to gain most when successful growth
companies go public as soon as possible.''
SEC Investor Advocate Rick Fleming, May 9, 2017
The trend over the past several decades indicates an increasing
number of Americans investing in capital markets through investment
vehicles, such as mutual funds and ETFs, rather than individual
securities.\41\ However, few mutual funds invest in private companies,
with one analysis indicating that such investments totaled only 0.13%
of $8.6 trillion in assets held by equity and allocation funds as of
June 2016.\42\ Thus, in addition to encouraging companies to become
public, it is equally important to consider methods to increase
investor exposure and opportunity to the private markets as well.
---------------------------------------------------------------------------
\41\ ICI Fact Book, at 112 (showing that the percentage of U.S.
households owning mutual funds increased to 43.6% in 2016 from 14.7% in
1985).
\42\ Katie Rushkewicz Reichart, Morningstar, Unicorn Hunting:
Mutual Fund Ownership of Private Companies is a Relevant, but Minor,
Concern for Most Investors (Dec. 5, 2016), available at: http://
corporate1.morningstar.com/ResearchArticle.aspx?documentId=780716. The
Morning-star report covered $11.5 billion held in open-end investment
companies. By comparison, as of June 30, 2016, business development
companies held approximately $51 billion in assets under management
according to SEC staff analysis.
---------------------------------------------------------------------------
When companies choose the private markets to raise capital, a vast
majority of investors lose out on the opportunity to participate
directly in the potential growth associated with these companies or the
diversification they provide. More importantly, an active public market
has positive spillover effects for the market as a whole. The listed-
market ecosystem, in which prices are based upon information disclosed
and processed by investors, securities analysts, market commentators,
investment advisers, and the public, provides an important layer of
transparency and price discovery which benefits investor protection.
Valuations in the private markets are often based on public markets.
Prohibiting the public from deciding whether to take on
investment risk can potentially preclude them from
participating in opportunities.
Source: The Wall Street Journal, December 12, 1980.
How the JOBS Act IPO On-Ramp Has Worked
Nearly 87% of the firms filing for an IPO after April 2012 have
identified themselves as EGCs under the IPO on-ramp. Of those,
approximately 88% used the confidential review accommodation, 96%
provided reduced executive compensation disclosures, 69% provided only
2 years of audited financial statements (rather than 3 years as
otherwise required), and 15% adopted new accounting standards using
delayed private company effective dates.\43\ In deciding not to delay
their adoption of accounting standards, most EGCs appear to be
reassuring investors that their financial statements will be comparable
to those of other public companies.
---------------------------------------------------------------------------
\43\ Ernst & Young LLP, Update on Emerging Growth Companies and the
JOBS Act (Nov. 2016), available at: http://www.ey.com/Publication/
vwLUAssets/ey-update-on-emerging-growth-companies-and-the-jobs-act-
november-2016/$FILE/ey-update-on-emerging-growth-companies-and-the-
jobs-act-november-2016.pdf.
---------------------------------------------------------------------------
An SEC staff report found that after the JOBS Act, smaller IPOs--
i.e., those seeking proceeds up to $30 million--constituted
approximately 22% of all IPOs from 2012-2016 as compared to 17% from
2007-2011.\44\ One academic study found that the JOBS Act led to
additional IPOs and that the confidential review and testing the waters
provisions particularly benefitted companies with high proprietary
disclosure costs, such as those in the biotechnology and pharmaceutical
industries.\45\ The SEC, through a recent staff action, extended the
confidential review accommodation to all companies filing for an IPO
beginning July 10.\46\ Treasury views this development as a positive
step.
---------------------------------------------------------------------------
\44\ DERA (2017) at 5.
\45\ Michael Dambra, Laura Casares Field, and Matthew T. Gustafson,
The JOBS Act and IPO Volume: Evidence that Disclosure Costs Affect the
IPO Decision, 116 Journal of Financial Economics 121 (Apr. 2015).
\46\ Division of Corporation Finance, U.S. Securities and Exchange
Commission, Draft Registration Statement Processing Procedures Expanded
(June 29, 2017 as supplemented on Aug. 17, 2017), available at: https:/
/www.sec.gov/corpfin/announcement/draft-registration-statement-
processing-procedures-expanded.
---------------------------------------------------------------------------
The passage of the JOBS Act was followed by a revival in public
offerings, which reached a peak of 291 in 2014, the highest level since
2000. However, IPO activity has been relatively muted since then.
Further regulatory changes may be needed to enhance the attractiveness
of public markets.
Remove Non-Material Disclosure Requirements
An important principle underlying Federal securities laws is the
materiality requirement for disclosures. Materiality is an objective
standard based on the reasonable investor, as opposed to a subjective
standard that is based on what a particular investor may view as
important.\47\ Unfortunately, amendments in Dodd-Frank to the Federal
securities laws have imposed requirements to disclose information that
is not material to the reasonable investor for making investment
decisions, including information related to conflict minerals (Section
1502), mine safety (Section 1503), resource extraction (Section 1504),
and pay ratio (Section 953(b)).
---------------------------------------------------------------------------
\47\ In TSC Industries v. Northway, 426 U.S. 438, 445 (1976), the
Supreme Court stated in that ``[t]he question of materiality, it is
universally agreed, is an objective one, involving the significance of
an omitted or misrepresented fact to a reasonable investor.'' The Court
then held that a fact is material ``if there is a substantial
likelihood that a reasonable shareholder would consider it important.''
Id. at 449.
---------------------------------------------------------------------------
Treasury recognizes that the original support for such provisions
was well-intentioned. However, Federal securities laws are ill-equipped
to achieve such policy goals, and the effort to use securities
disclosure to advance policy goals distracts from their purpose of
providing effective disclosure to investors. If the intent is to use
the law to influence business conduct, then this effort will be
undermined by imposing such requirements only on public companies and
not on private companies. In addition, such requirements impose
significant costs upon the public companies that are widely held by all
investors.
Recommendations
Treasury recommends that Section 1502, Section 1503, Section 1504,
and Section 953(b) of Dodd-Frank be repealed and any rules issued
pursuant to such provisions be withdrawn, as proposed by H.R. 10, the
Financial CHOICE Act of 2017. To the extent Congress determines that it
is desirable to require disclosure from all companies, both public and
private, this oversight responsibility could be moved from the SEC to a
more appropriate Federal agency, such as the Departments of State,
Commerce, Homeland Security, Labor, or Energy. In the absence of
legislative action, Treasury recommends that the SEC consider exempting
smaller reporting companies (SRCs) and EGCs from these
requirements.\48\
---------------------------------------------------------------------------
\48\ The JOBS Act amended Section 953(b) of Dodd-Frank to exclude
EGCs.
---------------------------------------------------------------------------
Eliminate Duplicative Requirements
SEC Regulation S-K \49\ specifies the disclosure requirements for
public companies. Since at least 2013, SEC staff has been reviewing
whether the disclosure requirements should be modified or eliminated
and can be presented in a manner that is more effective.\50\ An update
to the regulation is long overdue, particularly with a view to removing
provisions that are duplicative, overlapping, outdated, or unnecessary.
---------------------------------------------------------------------------
\49\ 17 CFR Part 229.
\50\ Staff of the U.S. Securities and Exchange Commission, Report
on the Simplification and Modernization of Regulation S-K (Nov. 23,
2016), available at: https://www.sec.gov/files/sec-fast-act-report-
2016.pdf.
---------------------------------------------------------------------------
Recommendations
Treasury recommends that, as required by the Fixing America's
Surface Transportation Act, the SEC proceed with a proposal to amend
Regulation S-K in a manner consistent with its staff's recent
recommendations. To the extent that there are other provisions of
Regulation S-K or elsewhere not described in the staff report that are
duplicative, overlapping, outdated, or unnecessary, Treasury encourages
inclusion of those provisions in the proposal. Treasury also recommends
that the SEC move forward with finalizing its current proposal to
remove SEC disclosure requirements that duplicate financial statement
disclosures required under generally accepted accounting principles by
the Financial Accounting Standards Board.\51\
---------------------------------------------------------------------------
\51\ Disclosure Update and Simplification (Jul. 13, 2016) [81 Fed.
Reg. 49431 (Aug. 26, 2016)].
---------------------------------------------------------------------------
Permit Additional Pre-IPO Communications
Under the JOBS Act, EGCs may communicate with qualified
institutional buyers (QIBs) \52\ and institutional accredited investors
prior to filing a registration statement with the SEC to determine
whether they might be interested in a contemplated securities offering.
This ability is known as ``testing the waters,'' which allows a company
to gauge investor interest in a potential offering before undertaking
the expense of preparing a registration statement.
---------------------------------------------------------------------------
\52\ As defined in 17 CFR 230.144A.
---------------------------------------------------------------------------
When combined with the ability to file a registration statement
confidentially with the SEC, testing the waters reduces the company's
risk associated with an IPO. The company has a better gauge of investor
interest prior to undertaking significant expense and, in the event the
company elects not to proceed with an IPO, information has been
disclosed only to potential investors and not to the company's
competitors.
Recommendations
Given that the SEC now permits all companies to file for IPOs
confidentially,\53\ Treasury recommends that companies other than EGCs
be allowed to ``test the waters'' with potential investors who are QIBs
or institutional accredited investors.
---------------------------------------------------------------------------
\53\ See footnote 46.
------------------------------------------------------------------------
-------------------------------------------------------------------------
Proxy Advisory Firms
During outreach meetings, Treasury staff heard differing views on
proxy advisory firms. Public companies expressed concerns with the role
of proxy advisory firms in advising shareholders on how to vote their
shares and the limited competition between, and the resulting market
power of, the two dominant firms.\54\ Public companies also expressed
their desire for greater transparency into the process by which proxy
advisory firms develop recommendations. Public companies also had
concerns about potential conflicts of interest that arise when a proxy
advisory firm provides voting advice to its clients on public companies
while simultaneously offering consulting services to those same
companies to improve their corporate governance rankings. In addition,
others have expressed concern that institutional investors have become
too reliant on proxy advisory firms, which may reduce market
discipline.\55\
\54\ One firm is an SEC-registered investment adviser and the other firm
has not registered with any regulator.
\55\ David F. Larcker, Allan L. McCall, and Gaizka Ormazabal,
Outsourcing Shareholder Voting to Proxy Advisory Firms, 58 Journal of
Law and Economics 173 (Feb. 2015).
On the other hand, institutional investors, who pay for proxy advice
and are responsible for voting decisions, find the services valuable,
especially in sorting through the lengthy and significant disclosures
contained in proxy statements.
Several government agencies have identified and studied these
issues. For example, in a recent report on proxy advisory firms, the
U.S. Government Accountability Office (GAO) reviewed studies and
obtained stakeholders perspectives. The report concluded that proxy
advisory firms influenced shareholder voting and corporate governance
practices, but was mixed on the extent of their influence and whether
it was helpful or harmful.\56\ The SEC also raised issues with respect
to proxy advisory firms in a concept release in 2010 \57\ and a
roundtable held in December 2013.\58\ Treasury recommends further study
and evaluation of proxy advisory firms, including regulatory responses
to promote free market principles if appropriate.
\56\ U.S. Government Accountability Office, Proxy Advisory Firms' Role
in Voting and Corporate Governance Practices (Nov. 2016).
\57\ Concept Release on the U.S. Proxy System; Proposed Rule (July 14,
2010) [75 Fed. Reg. 42982 (July 22, 2010)].
\58\ U.S. Securities and Exchange Commission, Press Release No. 2013-253
(Nov. 27, 2013), available at: https://www.sec.gov/news/press-release/
2013-253. Subsequently, SEC staff issued additional guidance regarding
the proxy voting responsibilities of investment advisers and the
availability of exemptions from the proxy rules for proxy advisory
firms. See Staff of the U.S. Securities and Exchange Commission, Staff
Legal Bulletin No. 20 (June 30, 2014), available at: https://
www.sec.gov/interps/legal/cfslb20.htm.
------------------------------------------------------------------------
Address Concerns on Shareholder Proposals
Exchange Act Rule 14a-8 \59\ allows a shareholder to have his or
her proposal placed in a company's proxy materials. The rule requires
the company to include the proposal unless the shareholder has not
complied with procedural requirements or it falls within one of 13
bases for exclusion. To be eligible under the rule, a shareholder must
have held, for at least 1 year before the proposal is submitted, either
(1) company securities with at least $2,000 in market value, or (2) at
least 1% of the company's securities entitled to vote on the proposal.
---------------------------------------------------------------------------
\59\ 17 CFR 240.14a-8.
---------------------------------------------------------------------------
According to one study, six individual investors were responsible
for 33% of all shareholder proposals in 2016, while institutional
investors with a stated social, religious, or policy orientation were
responsible for 38%.\60\ During the period between 2007 and 2016, 31%
of all shareholder proposals were a resubmission of a prior proposal.
---------------------------------------------------------------------------
\60\ James R. Copland and Margaret M. O'Keefe, Manhattan Institute,
Proxy Monitor: An Annual Report on Corporate Governance and Shareholder
Activism (2016), available at: https://www.manhattan-institute.org/
sites/default/files/pmr_2016.pdf.
---------------------------------------------------------------------------
One trade association asserted that it costs companies tens of
millions of dollars and significant management time to negotiate with
proponents of shareholder proposals, seek SEC no-action relief to
exclude proposals from proxy statements, and prepare opposition
statements, all of which divert attention from operating the
business.\61\ During outreach meetings with Treasury, however, some
groups representing investors countered that the ability to submit
proposals is a key right that allows them to hold management
accountable and that many shareholder proposals have been adopted that
have become widely accepted best practices in corporate governance.
---------------------------------------------------------------------------
\61\ The Business Roundtable, Responsible Shareholder Engagement
and Long-Term Value Creation (Oct. 2016), at 5, available at: http://
businessroundtable.org/sites/default/files/reports/
BRT%20Shareholder%20proposal%20paper-final.pdf.
---------------------------------------------------------------------------
Recommendations
Treasury recommends that the $2,000 holding requirement, which was
instituted over 30 years ago, be substantially revised. The SEC might
also want to explore options that better align shareholder interests
(such as considering the shareholder's dollar holding in company stock
as a percentage of his or her net liquid assets) when evaluating
eligibility, rather than basing eligibility solely on a fixed dollar
holding in stock or percentage of the company's outstanding stock.
Treasury also recommends that the resubmission thresholds for
repeat proposals be substantially revised from the current thresholds
of 3%, 6%, and 10% to promote accountability, better manage costs, and
reduce unnecessary burden.\62\
---------------------------------------------------------------------------
\62\ Under Rule 14a-8(i)(12), if a shareholder proposal is
substantially similar to another proposal that has been previously
included in a company's proxy materials during the preceding 5 calendar
years, the new proposal may be excluded from proxy materials for any
shareholder meeting held within 3 calendar years of the last submission
if the proposal received (i) less than 3% of the vote if proposed once
during the preceding 5 years, (ii) less than 6% of the vote on its last
submission if proposed twice previously within the preceding 5 years,
or (iii) less than 10% of the vote on its last submission if proposed
three times or more within the preceding 5 years.
------------------------------------------------------------------------
-------------------------------------------------------------------------
Concerns on Class Action Litigation
The potential for class action securities litigation may discourage
companies from listing their shares on public markets and encourage
companies that are already public to ``go private'' rather than face
the cost and uncertainty of securities litigation. Section 10(b) of the
Exchange Act, and Rule 10b-5 thereunder, create a private right of
action for investors to sue a securities issuer for the issuer's
misrepresentations or omissions.
The number of securities class action lawsuits filed in the U.S. has
steadily increased from 151 in 2012 to 272 last year, though this total
is significantly below the recent peak in 2001, when 498 securities
class action lawsuits were filed. In the first 9 months of 2017, 317
such lawsuits have been filed.\63\ This increase in lawsuits is
particularly notable given the smaller number of public companies,
meaning that securities issuers face a greater likelihood of lawsuits.
In 2016, a record 3.9% of exchange-listed companies faced a class
action securities lawsuit (not including additional securities lawsuits
related to mergers and acquisitions or Chinese reverse mergers).\64\
\63\ Data from Stanford Law School Securities Class Action
Clearinghouse, available at: http://securities.stanford.edu/charts.html
(last accessed on Oct. 2, 2017).
\64\ Cornerstone Research, Securities Class Action Filings: 2016 Year in
Review, at 1, available at: http://securities.stanford.edu/research-
reports/1996-2016/Cornerstone-Research-Securities-Class-Action-Filings-
2016-YIR.pdf.
The majority of class action securities lawsuits resolved since 1996
have settled before going to trial. Since 1996, 55% of completed class
action securities lawsuits were settled for an amount totaling over $90
billion.\65\ Of the settled cases since 2007, approximately 27% were
settled before the first hearing on motion to dismiss, while
approximately \2/3\ were settled after a ruling occurred on motion to
dismiss, but prior to summary judgment.\66\ Only 21 cases since the
adoption of the Private Securities Litigation Reform Act of 1995 have
gone to trial.\67\
\65\ Data from Stanford Law School Securities Class Action
Clearinghouse, available at: http://securities.stanford.edu/stats.html
(last accessed on Oct. 2, 2017).
\66\ Laarni T. Bulan, Securities Class Action Settlements: 2016 Review
and Analysis (Apr. 18, 2017), available at: https://
corpgov.law.harvard.edu/2017/04/18/securities-class-action-settlements-
2016-review-and-analysis/.
\67\ Stefan Boettrich and Svetlana Starykh, Recent Trends in Securities
Class Action Litigation: 2016 Full-Year Review (Jan. 2017), at 41,
available at: http://www.nera.com/content/dam/nera/publications/2017/
PUB_2016_Securities_Year-End_Trends_Report_0117.pdf.
Some observers have argued that securities class action lawsuits are
a means for shareholders to hold company managers accountable and
potentially deter future securities law violations. However, class
action securities lawsuits have been criticized as an economically
inefficient way to address securities law violations. Because judgments
and settlements are funded from corporations' assets or their insurance
policies, the shareholder plaintiffs' recovery is funded indirectly
from the investments of other shareholders. Transaction costs are also
high, as plaintiffs' and defendants' legal fees in securities
litigation have totaled billions of dollars over the last 20 years,
reducing payments to shareholders.\68\ Thus, securities class actions
can significantly benefit attorneys at the expense of shareholders.
\68\ In 2006 and 2007 alone, securities class action settlements totaled
$24.766 billion and judges awarded attorneys' fees of $3.366 billion,
or approximately 13.6% of the settlement amounts. Brian T. Fitzpatrick,
Class Action Settlements and Their Fee Awards, 7 The Journal of
Empirical Legal Studies 811, at 825 and 831 (Dec. 2010). The median
attorneys' fee award in securities suits when judges used the
percentage of settlement amount as a basis (the more common method) was
25% of the settlement amount. Id. at 835.
Treasury recommends that the states and the SEC continue to
investigate the various means to reduce costs of securities litigation
for issuers in a way that protects investors' rights and interests,
including allowing companies and shareholders to settle disputes
through arbitration.
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Shareholder Rights and Dual Class Stock
Corporate governance and shareholders rights are a matter of state
law. Some companies have dual classes of common stock, where
shareholders may have equal economic interests but different voting
rights, to the extent permitted by the company's state of
incorporation. The difference in voting power allows holders of one
class, often a founder or group of insiders, to control the outcome of
a shareholder vote. During outreach meetings with Treasury, some
participants stated that dual class stock represents a defense
mechanism against short-term investors who may not support a longer-
term strategy for the company. Conversely, some participants
representing investors expressed concern with the move away from a one
share, one vote principle.
The Federal securities laws provide the SEC with limited ability to
substantively regulate corporate governance.\69\ The national
securities exchanges currently permit listed companies with dual
classes of stock. Major index providers are considering to what extent
companies with dual class stock should be included in widely followed
stock indexes.
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\69\ In 1988, the SEC issued a rule prohibiting the exchanges from
listing companies that took any action to disenfranchise shareholder
voting rights. The D.C. Circuit vacated the rule as exceeding the SEC's
authority. Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990).
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Recommendations
State law remains the principal authority for determining issues of
corporate governance and shareholder rights. Treasury recommends that
the SEC continue its efforts, when reviewing company offering
documents, to comment on whether the documents provide adequate
disclosure of dual class stock and its effects on shareholder voting.
Allow Business Development Companies to Use Securities Offering
Reform
In 2005, the SEC adopted its securities offering reform rules,
which modernized the registered offering process under the Securities
Act.\70\ Many of these changes did not apply to business development
companies (BDCs). BDCs are ineligible to be considered ``well-known
seasoned issuers.'' \71\ In addition, BDCs may not use the safe harbor
for factual business information and forward-looking information, may
not use the expanded communications provisions in connection with
filing a registration statement, and may not utilize the ``access
equals delivery'' model for prospectus delivery.\72\ BDCs were created
as a means of making capital more readily available to small,
developing, and financially troubled companies that do not have access
to public markets or other forms of conventional financing.\73\ BDCs
provide significant managerial assistance to their portfolio companies.
Although BDCs are a type of closed-end fund, they are not required to
register under the Investment Company Act and have greater flexibility
in certain areas, such as in use of leverage, than registered
investment companies.\74\ However, unlike registered investment
companies, BDCs are subject to the full reporting requirements under
the Exchange Act, including the requirements to file Forms 10-K, 10-Q,
and 8-K.
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\70\ Securities Offering Reform (July 19, 2005) [70 Fed. Reg. 44722
(Aug. 3, 2005)] (``Securities Offering Reform'').
\71\ 17 CFR 230.405.
\72\ Securities Offering Reform. ``Access equals delivery'' is
where investors are presumed to have access to the Internet, and
issuers and intermediaries can satisfy their prospectus delivery
requirements if the filings or documents are posted on a web site.
\73\ Definition of Eligible Portfolio Company under the Investment
Company Act of 1940 (Oct. 25, 2006) [71 Fed. Reg. 64086 (Oct. 31,
2006)].
\74\ See 15 U.S.C. 80a-2(a)(48).
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Recommendations
Treasury recommends that the SEC revise the securities offering
reform rules to permit BDCs to utilize the same provisions available to
other issuers that file Forms 10-K, 10-Q, and 8-K.\75\
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\75\ See also Financial CHOICE Act of 2017, H.R. 10, 115th Cong.
438 (2017).
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Disproportionate Challenges for Smaller Public Companies
Access to capital is a persistent challenge for small and young
companies and has remained weak relative to access to capital by larger
firms following the financial crisis. Small companies are particularly
well positioned to make beneficial use of capital because they tend to
be more innovative than large companies and account for a significant
percentage of jobs created every year.\76\
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\76\ Salim Furth, Heritage Foundation, Who Creates Jobs? Start-up
Firms and New Businesses (Apr. 4, 2013), available at: http://
www.heritage.org/jobs-and-labor/report/research-review-who-creates-
jobs-start-firms-and-new-businesses.
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The substantial drop in the number of IPOs in the United States is
characterized by the disappearance of small IPOs. One review found that
IPOs with an initial market capitalization of $75 million or below
constituted 38% of IPOs in 1996, but had declined to only 6% of IPOs by
2012.\77\ During this same time period, large IPOs--those with an
initial market capitalization of $700 million and more--grew from 3% of
IPOs in 1996 to 33% in 2012.\78\
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\77\ Paul Rose and Steven Davidoff Solomon, Where Have All the IPOs
Gone? The Hard Life of the Small IPO, 6 Harvard Business Law Review 83,
at 103-04 (2016).
\78\ Id.
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The challenges facing smaller public companies are driven in part
by increased regulatory burden, but also by other factors such as the
growth in mutual fund sizes (which makes holding smaller positions less
attractive),\79\ and broader equity market structure changes, which are
reviewed in detail in the following chapter.
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\79\ See, e.g., Jeffrey M. Solomon, Presentation to the SEC
Investor Advisory Committee (June 22, 2017), at 5-8, available at:
https://www.sec.gov/spotlight/investor-advisory-committee-2012/jeffrey-
solomon-presentation.pdf.
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Institutional investors have historically favored large public
companies over smaller ones. As of October 2013, institutional
investors held over 83% of equity ownership in companies with more than
$750 million in market capitalization but only 31% in companies with a
smaller market capitalization.\80\ One working paper has also observed
that while mutual funds were historically a strong source of demand for
small IPOs, they have invested only sparingly in such offerings since
the late 1990s.\81\
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\80\ Equity Capital Formation Task Force, From the On-Ramp to the
Freeway: Refueling Job Creation and Growth by Reconnecting Investors
with Small-Cap Companies (Nov. 11, 2013), at 19, available at: https://
www.scribd.com/document/193918638/From-the-on-Ramp-to-the-Freeway-
Refueling-Job-Creation-and-Growth-by-Reconnecting-Investors-With-Small-
Cap-Companies.
\81\ Robert P. Bartlett III, Paul Rose, and Steven Davidoff
Solomon, The Small IPO and the Investing Preferences of Mutual Funds,
working paper (July 27, 2017), available at: https://papers.ssrn.com/
sol3/papers.cfm?abstract_id=2718862.
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Increased regulatory burdens under Federal securities laws since
the enactment of the Sarbanes-Oxley Act appear to have had a
disproportionate impact on smaller companies when compared to their
larger counterparts, despite measures to limit such effects. For
instance, the annual attestation by outside auditors of management's
report on the effectiveness of internal controls under Section 404(b)
of the Sarbanes-Oxley Act imposes significant costs for smaller public
companies.\82\ A recent working paper suggests that corporate
innovation may be declining due to compliance costs, citing as evidence
the reduction in the number of patents and patent citations for
companies subject to Section 404.\83\
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\82\ Peter Iliev, The Effect of SOX Section 404: Costs, Earnings
Quality, and Stock Prices, 65 The Journal of Finance 1163 (June 2010).
\83\ Huasheng Gao and Jin Zhang, The Real Effects of SOX 404:
Evidence from Corporate Innovation, working paper (Jan. 2017),
available at: https://www3.ntu.edu.sg/home/hsgao/
SOX404Innovation20170119.pdf. See also Testimony of John Blake, aTyr
Pharma, Inc., before the House Financial Services Subcommittee on
Capital Markets, Securities, and Investment (July 18, 2017)
(``expensive regulatory requirements siphon innovation capital from the
lab, diverting funds from science to compliance on a quarterly and
annual basis'').
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Modify Eligibility Requirements for Scaled Regulation
Companies with less than $75 million in public float are considered
smaller reporting companies and non-accelerated filers. SRCs may elect
to provide scaled disclosure requirements for reporting issuers. Non-
accelerated filers are given additional time to file periodic reports
with the SEC and are exempt from the requirement under Section 404(b)
of the Sarbanes-Oxley Act to have an independent auditor attest to
management's assessment of internal controls. EGCs currently may not
hold such status for more than 5 years.
Recommendations
Treasury supports modifying rules that would broaden eligibility
for status as an SRC and as a non-accelerated filer to include entities
with up to $250 million in public float, an increase from the current
limit of $75 million in public float.\84\
---------------------------------------------------------------------------
\84\ Amendments to Smaller Reporting Company Definition (June 27,
2016) [81 Fed. Reg. 43130 (July 1,2016)].
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Consistent with the H.R. 1645, the Fostering Innovation Act of
2017, Treasury further recommends extending the length of time a
company may be considered an EGC to up to 10 years, subject to a
revenue and/or public float threshold.\85\ These measures would more
appropriately tailor compliance costs associated with being a smaller
public company.
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\85\ See also Financial CHOICE Act of 2017, H.R. 10, 115th Cong.
441 (2017).
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Review Rules for Interval Funds
Smaller public companies have expressed concerns that they are
overlooked by institutional investors such as mutual funds. Fund
managers have indicated that SEC rules restrict their ability to invest
in illiquid securities and that the relative size and market
capitalization of smaller public companies means that an investment
will not meaningfully impact fund returns. To date, trends show
relatively less interest by institutional investors in investments in
smaller public companies compared to larger public companies.
Registered investment companies are either open-end (i.e., offer
daily redemption) or closed-end (no redemption rights but often
tradable, at a discount to net asset value, on an exchange). Open-end
funds will be subject to the additional liquidity requirements under
new SEC rules.\86\ Because of their limited redemption rights, closed-
end funds can more easily invest in thinly traded securities and
private startup companies. The SEC adopted Rule 23c-3 under the
Investment Company Act in 1993 to permit closed-end funds to be
``interval funds'' in which periodic redemptions are offered, but the
number of interval funds is small. SEC staff reports there are 34
interval funds with about $12.1 billion in assets under management.\87\
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\86\ Investment Company Liquidity Risk Management Programs (Oct.
13, 2016) [81 Fed. Reg. 82142 (Nov. 18, 2016)].
\87\ By comparison, at the end of 2016, total net assets was $262
billion for closed-end funds, $16.3 trillion for mutual funds, and $2.5
trillion for ETFs. ICI Fact Book, at 9.
---------------------------------------------------------------------------
Recommendations
Treasury recommends that the SEC review its interval fund rules to
determine whether more flexible provisions might encourage creation of
registered closed-end funds that invest in offerings of smaller public
companies and private companies whose shares have limited or no
liquidity. For example, rather than requiring redemptions on a fixed
time basis, the rules could permit redemptions based on a liquidity
event of a portfolio company in a manner similar to a venture capital
fund.
Review and Consolidate Research Analyst Rules
In 2003 and 2004, securities regulators settled with 12 major
broker-dealer firms for conflicts of interest between their research
analysts and investment bankers (Global Settlement).\88\ Under the
Global Settlement, broker-dealers were required to reform their
structures and practices to insulate research analysts from investment
banking pressures. The Global Settlement only applies to the firms that
are parties to the settlement. The terms of the Global Settlement were
modified in 2010, but have otherwise remained unchanged.\89\ Other
broker-dealers are subject to rules on research analyst reports adopted
by the SEC and FINRA, but the rules may differ in part from the Global
Settlement.\90\ In 2012, the JOBS Act modified the research analyst
rules for communications in connection with the IPO of an EGC.
---------------------------------------------------------------------------
\88\ U.S. Securities and Exchange Commission, Press Release No.
2003-54 (Apr. 28, 2003), available at: https://www.sec.gov/news/press/
2003-54.htm; U.S. Securities and Exchange Commission, Press Release No.
2004-120 (Aug. 26, 2004), available at: https://www.sec.gov/news/press/
2004-120.htm. Of the 12 settling firms, Bear, Stearns & Co. and Lehman
Brothers Inc. are no longer in existence.
\89\ U.S. Government Accountability Office, Additional Actions
Could Improve Regulatory Oversight of Analyst Conflicts of Interest
(Jan. 2012), at 30-31. In 2012, GAO recommended that the SEC formally
assess and document whether any of the Global Settlement's remaining
terms should be codified.
\90\ In 2015, the SEC approved FINRA rule 2241, which consolidated
prior NASD rule 2711 and NYSE rule 472. Exchange Act Release No. 75471
(July 16, 2015) [80 Fed. Reg. 43482 (July 22, 2015)]. Although FINRA
considered the provisions of the Global Settlement in modifying rule
2241, it specifically disclaimed any intent to supersede the Global
Settlement.
---------------------------------------------------------------------------
In outreach meetings with Treasury, smaller public companies
asserted that sell-side research coverage of their firms has become
sparse, or has even been discontinued, due in part to the increase in
regulation and compliance costs caused by the Global Settlement.
Another possible reason for the decline in analyst coverage could be
the mergers among investment banks.\91\ If this is the case, then
recent studies would suggest that the decline in the number of analysts
can negatively affect the quality of information in the overall market.
For example, one study found that an increase in the number of analysts
covering an industry improved the quality of analyst forecasts and
information flow to market participants, which suggests that a decline
in the number of sell-side analysts would have the opposite effect.\92\
Despite assertions of a decline in the number of analysts, however, one
study found no empirical evidence indicating a decline in post-IPO
analyst coverage for either small company or large company IPOs since
the Global Settlement.\93\
---------------------------------------------------------------------------
\91\ See, e.g., Bryan Kelly and Alexander Ljungqvist, Testing
Asymmetric-Information Asset Pricing Models, 25 The Review of Financial
Studies 1366, at 1370 (May 2012).
\92\ Kenneth Merkley, Roni Michaely, and Joseph Pacelli, Does the
Scope of the Sell-Side Analyst Industry Matter? An Examination of Bias,
Accuracy, and Information Content of Analyst Reports, 72 Journal of
Finance 1285 (June 2017).
\93\ Gao, Ritter, and Zhu (2013).
---------------------------------------------------------------------------
Recommendations
Treasury recommends a holistic review of the Global Settlement and
the research analyst rules to determine which provisions should be
retained, amended, or removed, with the objective of harmonizing a
single set of rules for financial institutions.
Expanding Access to Capital Through Innovative Tools
In order to foster a healthy economy, the regulatory framework
should provide innovative tools to companies at every stage of their
lifecycle, particularly to new companies that are not contemplating an
IPO. Regulation A+ and crowdfunding represent innovative capital
raising frameworks that are targeted to support pre-IPO companies. The
JOBS Act also sought to make matching investors with companies seeking
to raise capital easier by removing the prohibitions on general
solicitation and advertising under certain conditions.
Increase Flexibility for Regulation A Tier 2
In adopting final rules implementing Regulation A+, the SEC kept
the prior Regulation A exemption as Tier 1, while increasing the
aggregate offering amount from $5 million to $20 million, and created
Tier 2 for offerings of up to $50 million.\94\ Regulation A+ has
enabled more companies to take advantage of the ``mini IPO'' process
than under the previously existing Regulation A registration exemption
for small offerings. A Tier 2 offering may be less costly than an IPO,
particularly for companies seeking relatively smaller amounts of
capital. Companies' continuing disclosure obligations under Tier 2 are
particularly useful to broker-dealers to satisfy their obligations to
review information about a company before making quotations, which
permits them to publish quotes for Tier 2 securities under SEC rules,
thereby facilitating secondary trading.\95\
---------------------------------------------------------------------------
\94\ Amendments for Small and Additional Issues Exemptions under
the Securities Act (Regulation A) (Mar. 25, 2015) [80 Fed. Reg. 21806
(Apr. 20, 2015)].
\95\ 17 CFR 240.15c2-11.
---------------------------------------------------------------------------
In the year after implementation, 147 Regulation A+ offerings were
filed by companies seeking to raise $2.6 billion in financing. Of
these, approximately 81 offerings totaling $1.5 billion were qualified
under Regulation A+ by the SEC, 60% of which were Tier 2. By
comparison, there were 27 qualified Regulation A offerings in the
preceding 4 years. The average size of the Regulation A+ offerings was
approximately $18 million, with most of the issuers having previously
engaged in private offerings.\96\ Despite the increase in offerings
after the adoption of Regulation A+, companies making Regulation A+
offerings sought significantly lower amounts of capital than companies
making use of other exemptions, such as Regulation D.
---------------------------------------------------------------------------
\96\ Anzhela Knyazeva, Regulation A+: What Do We Know So Far?, Nov.
2016, available at: https://www.sec.gov/dera/staff-papers/white-papers/
18nov16_knyazeva_regulation-a-plus-what-do-we-know-so-far.html.
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A recent study by the SEC's Division of Economic and Risk Analysis
suggests that the ongoing disclosure requirements for issuers in Tier 2
offerings might encourage the development of a secondary market for
Regulation A securities.\97\ There are various obstacles to the
development of a secondary market. For example, although Federal
securities laws do not impose trading restrictions on Tier 2
securities, state securities laws may prohibit secondary transactions
without registration at the state level. In addition, issuers may elect
to impose such restrictions to have a stable investor base or avoid
triggering thresholds that would require registering the securities
with the SEC.
---------------------------------------------------------------------------
\97\ DERA (2017), at 51-52.
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Tier 2 permits companies to conduct offerings of up to $50 million
in a 12 month period exempt from registration under the Securities Act
using a scaled offering document. Tier 2 issuers are subject to an
ongoing reporting regime, including requirements for semi-annual,
annual, and current reports, as well as audited financial statements.
These disclosures are electronically available on the SEC's Electronic
Data Gathering and Retrieval (EDGAR) system. Tier 2 offerings are
subject to investment limits for unaccredited investors and are
preempted from state ``blue sky'' requirements. Tier 2 issuers may also
test the waters with any investor prior to qualification of an offering
statement.
Although the JOBS Act does not include any specific issuer
eligibility requirements, SEC rules prohibit Exchange Act reporting
companies from using Tier 2.\98\ During the related SEC rulemaking, a
number of commenters supported extending eligibility to Exchange Act
reporting companies but the SEC declined to expand eligibility until it
had an opportunity to observe the use of Tier 2.\99\
---------------------------------------------------------------------------
\98\ 17 CFR 230.251(b)(2).
\99\ 80 Fed. Reg. at 21811.
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Recommendations
Given the relatively modest use of Tier 2 since it became available
in June 2015, particularly in comparison to other exemptions such as
Regulation D, Treasury recommends expanding Regulation A eligibility to
include Exchange Act reporting companies. This modification will
provide already public companies with a lower-cost means of raising
additional capital and potentially increase awareness and interest in
Regulation A offerings by market participants.
Treasury further recommends steps to increase liquidity in the
secondary market for Tier 2 securities. Although Federal securities
laws do not impose trading restrictions on Tier 2 securities, state
``blue sky'' laws may impose registration requirements. Treasury
recommends that state securities regulators promptly update their
regulations to exempt secondary trading of Tier 2 securities or,
alternatively, the SEC use its authority to preempt state registration
requirements for such transactions.
Finally, Treasury recommends that the Tier 2 offering limit be
increased to $75 million. The JOBS Act requires the SEC to review the
Tier 2 offering limit every 2 years and, if needed, revise to an amount
the SEC determines ``appropriate.'' The increase to $75 million is
consistent with the House-passed Financial CHOICE Act (H.R. 10) and
would allow private companies to consider a ``mini-IPO'' under
Regulation A as a potentially less costly alternative to raise capital.
Crowdfunding
The crowdfunding rules implementing Title III of the JOBS Act
became effective in May 2016. In the 12 month period following
effectiveness, 335 companies filed crowdfunding offerings with the SEC
and there were 26 portals registered with FINRA for unaccredited
investors. Of the filed crowdfunding offerings, 43% were funded, 30% of
campaigns ended unsuccessfully, and the others are still ongoing. Total
capital committed was in excess of $40 million. On average, each funded
offering raised $282,000 and included participation from 312
investors.\100\
---------------------------------------------------------------------------
\100\ Crowdfund Capital Advisors, One Year into Regulation
Crowdfunding and It Is Off to the Portal Races (May 19, 2017),
available at: http://crowdfundcapitaladvisors.com/one-year-regulation-
crowdfunding-off-portal-races/.
---------------------------------------------------------------------------
However, in conversations with Treasury staff, market participants
have expressed concerns about the cost and complexity of using
crowdfunding compared to private placement offerings. Participants
cited regulatory constraints, such as disclosure requirements and
issuance costs, as well as structural factors, such as the challenges
associated with having a large number of investors, as potentially
limiting the use of this capital raising method. Some participants also
expressed concern that unless crowdfunding platforms can demonstrate
clear advantages relative to the ease and availability of private
placements, such as meaningfully increasing the amount of investor
capital available from unaccredited investors, crowdfunding may lead to
adverse selection where only less-attractive companies pursue funding
from less sophisticated investors, who may lack the expertise to
properly evaluate such investments.
Recommendations
Treasury recommends allowing single-purpose crowdfunding vehicles
advised by a registered investment adviser, which may mitigate issuers'
concerns about vehicles having an unwieldy number of shareholders and
tripping SEC registration thresholds (2,000 total shareholders, or over
500 unaccredited shareholders). These vehicles could potentially
facilitate the type of syndicate investing model that has developed in
accredited investor platforms, whereby a lead investor conducts due
diligence, pools the capital of other investors, and receives carried
interest compensation.
However, risks exist that such vehicles may weaken investor
protections by creating layers between investors and the issuer, and
present potential conflicts of interest. Appropriate investor
protections are critical in the crowdfunding market given the
participation of unaccredited investors. Therefore, Treasury recommends
that any rulemaking in this area prioritize alignment of interests
between the lead investor and the other investors participating in the
vehicle, regular dissemination of information from the issuer, and
minority voting protections with respect to significant corporate
actions.
Treasury recommends that the limitations on purchases in
crowdfunding offerings be waived for accredited investors as defined by
Regulation D. Crowdfunding might become more attractive if a company
can more easily reach its fund-raising goals. Treasury further
recommends that the crowdfunding rules be amended to have investment
limits based on the greater of annual income or net worth for the 5%
and 10% tests, rather than the lesser.\101\ The current rules
unnecessarily limit investors who have a high net worth relative to
annual income, or vice versa, which is inconsistent with the approach
taken for Regulation A Tier 2 offerings.\102\
---------------------------------------------------------------------------
\101\ A crowdfunding investor is limited as to how much can be
invested during any 12 month period based on net worth and annual
income. Under current rules, if either annual income or net worth is
less than $107,000, then an amount up to the greater of either $2,200
or 5% of the lesser of annual income or net worth may be invested. If
both annual income and net worth are equal to or more than $107,000,
then an amount up to 10% of annual income or net worth, whichever is
lesser, but not to exceed $107,000 may be invested. 17 CFR 227.100.
\102\ 17 CFR 230.251(d)(2)(i)(C) (using a ``greater of'' annual
income or net worth test).
---------------------------------------------------------------------------
Treasury also recommends that the conditional exemption from
Section 12(g) be modified by raising the maximum revenue requirement
from $25 million to $100 million. The higher threshold will allow
crowdfunded companies to stay private longer. These companies likely
lack the necessary size to be a public company and should not be forced
to register as public companies until reaching higher revenues.
Finally, Treasury recommends increasing the limit on how much can
be raised over a 12 month period from $1 million to $5 million, as it
will potentially allow companies to lower the offering costs per dollar
raised.
------------------------------------------------------------------------
-------------------------------------------------------------------------
Women and Entrepreneurship
Female entrepreneurs have been historically under-served by sources
of venture capital. Between 2010 and 2015, 12% of venture funding
rounds and 10% of venture dollars globally went to startups with one or
more female founders.\103\ Innovative funding tools may disrupt
traditional networks, resulting in better access to capital for women
and other under-served communities.
\103\ Gene Teare and Ned Desmond, The First Comprehensive Study on Women
in Venture Capital and their Impact on Female Founders (Apr. 19, 2016),
available at: https://techcrunch.com/2016/04/19/the-first-comprehensive-
study-on-women-in-venture-capital/.
Equity-based crowdfunding may help female entrepreneurs raise
capital for their businesses. Regulation Crowdfunding has been in
effect for only a little more than a year, so data is limited. However,
evidence from the previously existing rewards-based crowdfunding market
shows its promise for increasing opportunities for female
entrepreneurs.
In rewards-based crowdfunding, run by platforms like Kickstarter and
Indiegogo, backers receive a ``reward'' or prize in exchange for their
investment, rather than an equity share in the company. 47% of
successful Indiegogo funding campaigns are run by women, a
significantly higher percentage when compared to venture capital
funding.\104\ Analysis of Kickstarter data shows that from 2009 to
2012, women had a 69.5% success rate in crowdfunding compared to a
61.4% success rate for men. A separate study looking at crowdfunding
globally in 2015 and 2016 shows that women had a 22% success rate in
reaching their funding goals while men had a 17% success rate.\105\
While this is still a fairly nascent field, many point to the fact that
the ``crowd'' tends to be more balanced in terms of female versus male
participants, which may contribute to the more representative success
of female-led crowdfunding campaigns.
\104\ Elena Ginebreda-Frendel, Women's Day Should Be Every Day,
Indiegogo Blog (Mar. 8, 2016), available at: https://go.indiegogo.com/
blog/2016/03/women-entrepreneurs.html.
\105\ PricewaterhouseCoopers, Women Unbound: Unleashing Female
Entrepreneurial Potential (July 2017), available at: http://
womenunbound.org/download/Women_Unbound_-_PwC_PCrowdfunding_Report.pdf.
Equity crowdfunding is relatively new, but many companies have
already used it successfully as discussed in this report. While equity
crowdfunding is not a perfect substitute for traditional venture
capital investments, making changes to equity crowdfunding to increase
its flexibility and cost effectiveness may further improve an
innovative tool that broadens access to capital for female
entrepreneurs.
------------------------------------------------------------------------
Maintaining the Efficacy of the Private Markets
Treasury believes that regulators can increase the attractiveness
and efficiency of public markets while preserving the current vibrancy
of private markets. Although some have suggested that restricting
access to capital in private markets might force more companies to seek
financing in public capital markets, Treasury does not believe that
removal of choices from the marketplace is an appropriate path forward.
Treasury observes that measures can be taken to improve access to
capital for small business enterprises in the private markets. Certain
provisions of the JOBS Act were intended to address this gap and the
SEC has adopted rules to implement those provisions. Appropriate
regulatory adjustments should be made based on how market participants
have reacted to and utilized these provisions.
Title II of the JOBS Act required the SEC to revise Securities Act
Rule 506 to remove the prohibition against general solicitation or
advertising, provided that all purchasers are accredited investors. In
implementing Title II, the SEC retained the prior exemption, which
prohibits general solicitation or advertising but allows participation
by unaccredited investors, as Rule 506(b). The new provision permitting
general solicitation and advertising was codified as Rule 506(c).
According to SEC data, for the approximately 3 year period through
the end of 2016, $107.7 billion was raised in debt and equity offerings
under Rule 506(c), while $2.2 trillion was raised under Rule 506(b)
during the same period.\106\ Thus, Rule 506(c) offerings amount to only
3% of the capital reportedly raised under Rule 506. Although Rule
506(b) offerings are permitted to be sold to unaccredited investors,
relatively few companies reported an intention to do so.\107\
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\106\ DERA (2017) at 39. For the period between September 23, 2013
and December 31, 2016, initial Form D filings reported that $70.6
billion was raised under Rule 506(c), with an additional $37.1 billion
reported in amended Form D filings. By comparison, new Rule 506(b)
offerings reported raising nearly $2.2 trillion in initial Form D
filings and an additional $1.9 trillion in amended Form D filings. The
data on Regulation D offerings may not accurately reflect the true
amount of capital raised, because a Form D filing is not a condition to
the exemption provided by the rule. In addition, there is no
requirement to update Form D to report the total amount actually raised
in the offering.
\107\ Id. at 66 (reporting only 6% of Rule 506(b) offerings were
sold or intended to be sold to unaccredited investors).
---------------------------------------------------------------------------
Title II also provided an exemption for online marketplaces. The
last 3 years have seen nearly $1.5 billion in commitments raised in
over 6,000 private offerings on 16 online marketplaces for accredited
investors.\108\ Although annual capital commitments and success rates
(in terms of raising the amount of capital sought) for online capital
offerings to accredited investors have steadily increased over the last
3 years, reaching over $600 million and 30%, respectively, the number
of annual new offerings has declined from approximately 4,700 to nearly
550 over this period.\109\
---------------------------------------------------------------------------
\108\ Crowdnetic, Annual Title II Data Analysis for the Period
Ending September 23, 2016, at 5, available at: https://
www.crowdwatch.co/hosted/www/download-report?report_month=oct_
2016.
\109\ Id. at 7.
---------------------------------------------------------------------------
Online marketplaces thus far represent only a very small share of
the Regulation D private placement securities offerings and venture
capital investments. Activity in online marketplaces, however, is
growing, with a number of third-party firms now providing critical
services including accredited investor verification, compliance, legal
documentation, and reporting to meet the needs of issuers, investors,
and platforms.
Create Appropriate Regulatory Structure for Finders
For a small business seeking to raise capital, identifying and
locating potential investors can be difficult. It becomes even more
challenging if the amount sought (e.g., less than $5 million) is below
a level that would attract venture capital or a registered broker-
dealer, but beyond the levels that can be provided by friends and
family and personal financing. The number of registered broker-dealers
has been falling, and few registered broker-dealers are willing to
raise capital in small transactions. Thus, finders, individuals or
firms who connect a firm seeking to raise capital with an investor for
a fee, can play an important role in filling this gap to help small
businesses obtain early stage financing.
Finders have operated in an uncertain regulatory environment, one
that has developed more from no-action letters and enforcement actions
than rules. Frequently, the role of the finder in a private capital-
raising transaction is limited and does not involve handling of any
securities or funds. However, finders who seek to receive transaction-
based compensation may be required to register as a broker-dealer with
the SEC, FINRA, and the applicable states. Resolving issues regarding
finders has been a frequent topic of the SEC Government-Business Forum
on Small Business Capital Formation and the SEC Advisory Committee on
Small and Emerging Companies.
Recommendations
Treasury recommends that the SEC, FINRA, and the states propose a
new regulatory structure for finders and other intermediaries in
capital-forming transactions. For example, a ``broker-dealer lite''
rule that applies an appropriately scaled regulatory scheme on finders
could promote capital formation by expanding the number of
intermediaries who are able to assist smaller companies with capital
raising.
Allow Additional Categories of Sophisticated Investors to
Participate in Regulation D Offerings
Rules 506(b) and (c) of Regulation D provide an exemption from
registration for offerings made to accredited investors. Natural
persons can qualify as an accredited investor if they have a net worth
of at least $1 million (excluding primary residence) or have income of
at least $200,000 ($300,000 together with a spouse) for each year for
the last 2 years. Certain legal entities with over $5 million in assets
are accredited investors, while certain regulated entities such as
banks, broker-dealers, registered investment companies, BDCs, and
insurance companies are automatically designated as accredited
investors. In December 2015, SEC staff published a report that
suggested potential modifications to the definition of accredited
investor.\110\
---------------------------------------------------------------------------
\110\ Division of Corporation Finance, U.S. Securities and Exchange
Commission, Report on the Review of the Definition of ``Accredited
Investor'' (Dec. 18, 2015), available at: https://www.sec.gov/corpfin/
reportspubs/special-studies/review-definition-of-accredited-investor-
12-18-2015.pdf.
---------------------------------------------------------------------------
Recommendations
Treasury recommends that amendments to the accredited investor
definition be undertaken with the objective of expanding the eligible
pool of sophisticated investors. The ``accredited investor'' definition
could be broadened to include any investor who is advised on the merits
of making a Regulation D investment by a fiduciary, such as an SEC- or
state-registered investment adviser. Furthermore, financial
professionals, such as registered representatives and investment
adviser representatives, who are considered qualified to recommend
Regulation D investments to others, could also be included in the
definition of ``accredited investors.''
Review Rules for Private Funds Investing in Private Offerings
Investing in a well-diversified portfolio of private placement
offerings instead of a single offering can potentially reduce
investment risk. For unaccredited investors, exposure to Rule 506
offerings through a fund could provide diversification benefits to an
investment portfolio.
Recommendations
Treasury recommends a review of provisions under the Securities Act
and the Investment Company Act that restrict unaccredited investors
from investing in a private fund containing Rule 506 offerings.
Empower Investor Due Diligence Efforts
Investment opportunities allow all Americans to participate as
investors in the capital markets. But to effectively empower investors,
government should ensure that the public has access to information to
make informed investment decisions. Given that financial markets also
present opportunities for bad actors to take advantage of investors, it
is critical that investors have information to protect themselves.
Information on bad actors is currently fragmented across databases
maintained by different agencies and organizations. FINRA maintains a
database on investment advisers, which compiles information from the
SEC and the states, called Investment Adviser Public Disclosure. The
SEC and FINRA jointly maintain a database on broker-dealers called
BrokerCheck.\111\ The National Futures Association maintains a database
on firms involved with futures, options on futures, and foreign
currency called Background Affiliation Status Information Center
(BASIC).\112\ No centralized databases are available to the public,
free of charge, that provide information on other disciplinary actions
handed out by the SEC, Public Company Accounting Oversight Board, or
state regulators. Information on criminal convictions for financial
fraud obtained by Federal, state, or local prosecutors is also not
available in a centralized database.
---------------------------------------------------------------------------
\111\ BrokerCheck includes some but not all state level information
on broker-dealer discipline. Investors may need to use BrokerCheck and
additional state databases to obtain full information on an individual
broker.
\112\ The CFTC has launched an effort, called Smartcheck (https://
smartcheck.cftc.gov/
check/), which provides a portal for investors to separately search
records on BASIC and BrokerCheck as well as a general Internet search.
---------------------------------------------------------------------------
Recommendations
Treasury recommends that Federal and state financial regulators,
along with their counterparts in self-regulatory organizations, work to
centralize reporting of individuals and firms that have been subject to
adjudicated disciplinary proceedings or criminal convictions, which can
be searched easily and efficiently by the investing public free of
charge.
Equity Market Structure
Overview and Regulatory Landscape
The fairness, soundness, and efficiency of the U.S. capital markets
promote investment in the enterprises that fuel innovation and jobs.
The previous section focused on primary markets for equity capital
formation. This section will turn to market structure and liquidity,
with a focus on secondary market activity--that is, the markets for
buying and selling previously issued securities. Secondary markets
facilitate investment opportunities for individuals and companies,
establish market-based valuations to help investors efficiently
allocate capital, and provide liquidity for entrepreneurs, workers, and
investors who wish to cash out of all or part of their investments.
Secondary markets for equity in the United States, including stock
exchanges, options exchanges, and alternative trading systems (ATSs),
provide investors with access to a broad array of securities to fulfill
myriad investment objectives. For the largest companies and most liquid
stocks, the secondary equity market is operating very well, with strong
competition, low transaction costs for investors, and generally strong
liquidity conditions. However, this same market is not serving less
liquid (often smaller and newer) companies as well. For these
companies, liquidity provision, trading activity, and research coverage
have declined. Accordingly, many of the recommendations in this section
focus on improving the market for less liquid stocks by more
appropriately tailoring regulation. In addition, our recommendations
aim to promote greater transparency, reduce unnecessary complexity, and
improve the overall vibrancy of equity markets to foster economic
growth.
The National Market System and Regulation NMS
Recent U.S. equity market regulation has focused on encouraging
competition between multiple venues to enhance trade execution pricing
and innovation. All securities exchanges, which are key components of
the National Market System, provide a venue for securities buyers to
establish prices for and execute securities transactions. While
securities are listed on a primary exchange, they can be traded on any
national securities exchange (or other trading venues such as
alternative trading systems) through a system of Unlisted Trading
Privileges (UTP). UTP allows companies that do an initial public
offering (IPO) and list on New York Stock Exchange (NYSE), for example,
to be traded on other trading venues such as NASDAQ and BATS. Because
of UTP, there is intense competition among trading venues to capture
secondary market trading and the revenue it generates. While UTP is one
important element of today's framework, regulatory changes adopted over
the last 20 years underpin the current equity market structure.
In 2005, the SEC adopted Regulation NMS, which updated earlier
rulemakings that were intended to strengthen and modernize the National
Market System.\113\ Regulation NMS included new substantive rules to
modernize and strengthen the regulatory structure of the U.S. financial
markets.
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\113\ Regulation NMS (June 9, 2005) [70 Fed. Reg. 37495 (June 29,
2005)]. This rulemaking helped to satisfy certain key objectives of
1975 amendments to the Exchange Act, including: (1) promoting more
efficient and more effective market operations, (2) enhancing
competition, (3) improving price transparency, and (4) contributing to
the best execution of customer orders. Public Law No. 94-29.
Regulation NMS
------------------------------------------------------------------------
Features of NMS Description
------------------------------------------------------------------------
Order Protection Rule (Rule Requires trading centers \114\ to
611, also called the Trade establish, maintain, and enforce
through Rule) written policies and procedures
reasonably designed to prevent the
execution of trades at prices inferior
to protected quotations displayed by
other trading centers, subject to an
applicable exception. To be protected,
a quotation must be immediately and
automatically accessible.\115\
Impact: The price and speed incentives
created by the rule encouraged trading
venues to move to electronic execution
and discouraged open outcry markets.
\114\ ``Trading centers''
include any national
securities exchange, national
securities association that
operates an SRO (self-
regulating organization)
trading facility, alternative
trading system, exchange
market maker, over-the-counter
market maker, or any other
broker or dealer that executes
orders internally by trading
as principal or crossing
orders as agent. See 17 CFR
242.600(b)(78).
\115\ See 17 CFR
242.600(b)(57)(iii) (defining
a ``protected bid'' or
``protected offer'' to include
only automated quotations) and
17 CFR 242.600(b)(3)
(defining ``automated
quotation'').
Access Rule (Rule 610) Requires fair and non-discriminatory
access to quotations, establishes a
limit on access fees to harmonize the
pricing of quotations across different
trading centers, and requires each
national securities exchange and
national securities association to
adopt, maintain, and enforce written
rules that prohibit their members from
engaging in a pattern or practice of
displaying quotations that lock or
cross automated quotations.
Impact: Promotes competition among
trading venues by allowing any trading
venue to compete for any order on any
other venue.
Sub-penny Rule (Rule 612) Prohibits market participants from
accepting, ranking, or displaying
orders, quotations, or indications of
interest in a pricing increment
smaller than a penny, except for
orders, quotations, or indications of
interest that are priced at less than
$1.00 per share.
Impact: Encouraged broker
internalization which continued to
allow trading (though not quoting) at
sub-penny prices.
Market Data Rules (Rules 601 Updated the requirements for
and 603) consolidating, distributing, and
displaying market information, as well
as amendments to the joint industry
plans for disseminating market
information that modify the formulas
for allocating plan revenues.
Impact: Helped to create an environment
where market information becomes an
increasingly valuable commodity.
------------------------------------------------------------------------
Regulation NMS has been credited with reducing trading costs to
some of the lowest levels in the world, reducing bid-ask spreads, and
generally increasing liquidity. However, Regulation NMS has also faced
criticism for its role in adding to the complexity of equity markets as
well as facilitating the rise of high-frequency trading practices,
which many have criticized as harming true liquidity and market
quality.\116\ Regulatory change that had been underway before
Regulation NMS also contributed to significant market structure
changes.
---------------------------------------------------------------------------
\116\ See, e.g., Larry Tabb, Regulation NMS Part I: Loved or
Loathed and Why Many Want It to Die (May 13, 2013), available at:
https://research.tabbgroup.com/report/v11-018-regulation-nms-part-i-
loved-or-loathed-and-why-many-want-it-die; and Christopher Groskopf,
The Modern Stock Market is a Badly Designed Computer System (June 15,
2016), available at: https://qz.com/662009/the-sec-tried-to-fix-a-
finance-problem-and-created-a-computer-science-problem-instead/.
Regulatory Changes Before Regulation NMS
------------------------------------------------------------------------
Changes Description
------------------------------------------------------------------------
Decimalization The gradual reduction in ``tick
sizes,'' or the minimum increment of
price for the trading of stocks on
exchanges. Prior to 1992, stocks had
traded in \1/8\ of $1 tick sizes,
which effectively created a minimum
bid-ask spread for a stock of 12.5 .
This wide bid-ask spread created high
transaction costs for buyers and
sellers but also sustained large
profit margins for dealers.
In the 1990s, the SEC and stock
exchanges progressively narrowed tick
sizes, first to \1/16\ of $1 and
culminating in April 2001 with the
full implementation of decimalization,
or the pricing of most stocks in 1
increments.\117\
Impact: Decimalization reduced the
spreads on the most heavily traded
stocks to as little as 1 ,
dramatically reducing trading
costs.\118\
\117\ See Securities and
Exchange Commission, Report to
Congress on Decimalization
(July 2012) at 4-6, available
at: https://www.sec.gov/news/
studies/2012/decimalization-
072012.pdf.
\118\ Id.
Regulation ATS Adopted in 1998, exempts certain
alternative trading systems (ATSs)
from registration as a national
securities exchange, while applying
core elements of exchange regulation.
Requires ATSs to provide order display
and execution access when market share
thresholds are reached.
Imposes capacity, integrity, and
systems--security standards and
requires ATSs to register as broker-
dealers.
Impact: Institutionalized ATSs,
allowing them to operate and grow with
modest regulatory oversight compared
to exchanges. They grew significantly
upon enactment of Regulation NMS
(national market system). Today, these
ATSs, operated by broker-dealers
registered with the SEC, have become
important sources of liquidity.
------------------------------------------------------------------------
Electronification and Increased Competition
Technological evolution, in addition to regulatory changes, has
driven changes to equity market structure. Electronification has
facilitated an extraordinary increase in the speed of trading, with
trading activity now measured in milliseconds and microseconds. Market
participants are often keenly focused on the speed by which trade data
travels between data centers or in collocating their own servers on
exchanges' premises to minimize data latency. Electronification has
also been critical to promoting market participant and venue
competition. Barriers to entry for a new electronic market maker or
electronic venue are much lower than those of the human-centered past.
Equities trading has been on the cutting edge of this transition for
decades.
These regulatory and structural changes spurred the conversion of
manual stock markets, which executed trades through floor brokers, to
largely automated operations, which placed a premium on high-speed
computers, sophisticated execution algorithms, and rich data about the
financial market prices and orders.\119\ These changes also helped
ensure widespread and near-instantaneous dissemination of market prices
electronically, which enabled ATSs to compete with exchanges.
---------------------------------------------------------------------------
\119\ CFA Institute, Liquidity in Equity Markets: Characteristics,
Dynamics, and Implications for Market Quality (Aug. 2015), at 4-5,
available at: http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2015.n7.1.
---------------------------------------------------------------------------
Another trend of note during this period was the
``demutualization'' of stock exchanges beginning in 2005. Demutualizing
stock exchanges went from nonprofit institutions owned by their broker-
dealer members to for-profit entities. These for-profit exchanges then
consolidated into larger entities operating multiple exchanges within
and across national borders.\120\
---------------------------------------------------------------------------
\120\ See Ernst & Young LLP, IPO Insights: Comparing Global Stock
Exchanges (2007), at 5-6, available at: http://www.ey.com/Publication/
vwLUAssets/IPO_Insights:_Comparing_global_
stock_exchanges/$FILE/IPO_comparing-globalstockexchanges.pdf.
---------------------------------------------------------------------------
When considering the operational effects, electronification has
been a double-edged sword. Electronic trading has made the everyday
trading process more efficient and reduced the frequency of human
error. On the other hand, operational risk has grown significantly. As
an example, at Knight Capital in 2012, a series of errors relating to
an internal software update triggered more than $400 million of losses
and ultimately led to the sale of the firm.\121\
---------------------------------------------------------------------------
\121\ See In re: Knight Capital Americas LLC (Oct. 16, 2013),
available at: https://www.sec.gov/litigation/admin/2013/34-70694.pdf.
---------------------------------------------------------------------------
Technological and regulatory changes have also promoted increased
competition between equity trading venues. Investors looking to buy and
sell securities may now do so at any of 12 registered national
securities exchanges, 40 broker-dealer operated ATSs that trade
equities,\122\ and numerous other internal trading systems run by
registered broker-dealers. The changes in market share for the NYSE and
NASDAQ underscore the dramatic shift that occurred in the equity
markets in the mid-2000s. Exchanges now handle only a minority of the
trading in their stock listings.
---------------------------------------------------------------------------
\122\ Financial Industry Regulatory Authority, Equity ATS Firms as
of Sept. 1, 2017, available at: http://www.finra.org/industry/equity-
ats-firms (last accessed Sept. 14, 2017).
---------------------------------------------------------------------------
Figure 3: NYSE-Listed Equities by Exchange
Sources: Office of Financial Research analysis, U.S. Equities
Trade and Quote (TAQ), calculated (or derived) based on data
from Daily Stock File 2017 Center for
Research in Security Prices (CRSP'), the University
of Chicago Booth School of Business.
Figure 4: NASDAQ-Listed Equities by Exchange
Sources: Office of Financial Research analysis, U.S. Equities
Trade and Quote (TAQ), calculated (or derived) based on data
from Daily Stock File 2017 Center for
Research in Security Prices (CRSP'), the University
of Chicago Booth School of Business.
Market share is now dispersed amongst trading venues, including a
substantial portion of trading flow being internalized by broker-
dealers in lieu of being executed on the exchanges.
Figure 5: Equities Market Share by Venue
Source: Rosenblatt Securities, July 2017.
To attract volume, some venues offer incentives for directing
orders to the exchange or for entering orders. Some offer novel order
types, causing an increasingly complex trading environment. Some offer
preferential access to data at a price, which may enable high-frequency
traders to engage in practices that disadvantage institutional sellers
and may contribute to higher volatility. The proliferation of
electronic trading venues has given rise to high-frequency trading
(HFT) activities, which rely on high-speed computers and sophisticated
algorithms to effectively make markets on multiple venues and in
multiple securities simultaneously. HFT strategies have been used by
new entrants, often trading with their own capital, as well as by some
established market participants such as broker-dealers that are part of
banks.
An increasing share of trading is also done in dark pools and other
unlit venues. Institutional investors may elect to use dark pools to
effect large transactions without impacting market prices, and some
dark pools may offer lower transaction costs and spreads. Dark
liquidity includes certain ATSs on which broker-dealers' customers may
trade with each other or with the broker-dealer anonymously; exchange-
executed hidden orders; and other OTC venues, such as broker-dealers
who internalize orders. Dark pools are controversial because they may
reduce the effectiveness of the lit markets' price discovery
function,\123\ may enable abusive trading by high-frequency traders,
and may conceal trading by broker-dealers that is disadvantageous to
their customers.\124\ However, dark pools may benefit investors by
reducing trading costs, facilitating the sale of lower-volume
securities, and permitting investors to trade without triggering
unfavorable price changes.\125\
---------------------------------------------------------------------------
\123\ Linlin Ye, Understanding the Impacts of Dark Pools on Price
Discovery (Oct. 2016), available at: https://arxiv.org/pdf/
1612.08486.pdf (finding that dark pools impair price discovery when
information risk is high but enhance price discovery when information
risk is low). See also PricewaterhouseCoopers, An Objective Look at
High-Frequency Trading and Dark Pools (May 6, 2015), available at:
http://www.pwc.com/us/en/pwc-investor-resource-institute/publications/
assets/pwc-high-frequency-trading-dark-pools.pdf (``PwC HFT Report'')
(suggesting price discovery is harmed when a significant portion of a
security's trading is in dark pools). Other researchers find that dark
pools improve price discovery. See, e.g., Haoxiang Zhu, Do Dark Pools
Harm Price Discovery? (Nov. 16, 2013), available at: https://
papers.ssrn.com/sol3/papers.cfm?abstract_id=1712173.
\124\ Various settled enforcement actions involving ATS operators
are described in footnote 140.
\125\ See PwC HFT Report.
---------------------------------------------------------------------------
The SEC's regulation and oversight of securities exchanges and ATSs
differs meaningfully. A registered national securities exchange is a
self-regulatory organization (SRO) that must fulfill certain
responsibilities defined by statute and SEC rules. A national
securities exchange must, among other obligations, register with the
SEC (unless an exemption or exception applies); \126\ enforce its
members' compliance with Federal securities laws and its own rules;
\127\ adopt listing requirements for securities on its exchange (if the
exchange lists securities); \128\ equitably allocate reasonable dues,
fees, and other charges among its members and other users; and have
rules designed to prevent fraudulent and manipulative acts and
practices to promote just and equitable principles of trade and to
protect investors and the public interest.\129\ SROs must also file any
new rule or rule change with the SEC for approval.\130\ Although an ATS
matches buyers and sellers like an exchange, an ATS is exempt from the
definition of exchange and thus is not required to register as an
exchange or to fulfill the regulatory obligations of an SRO.\131\
Instead, an ATS must comply with the requirements of the SEC's
Regulation ATS.\132\ Among the requirements are that an ATS must be
registered with the SEC as a broker-dealer and become a member of
FINRA,\133\ file Form ATS with the SEC before beginning
operations,\134\ and update the form to maintain its accuracy.\135\
---------------------------------------------------------------------------
\126\ 15 U.S.C. 78e.
\127\ 15 U.S.C. 78f(b)(1).
\128\ 15 U.S.C. 78f(h)(3).
\129\ 15 U.S.C. 78f(b)(4).
\130\ 15 U.S.C. 78s(b)(1).
\131\ See 17 CFR 240.3a1-1 (exempting any organization,
association, or group of persons from the definition of ``exchange'' if
it complies with Regulation ATS).
\132\ 17 CFR 242.300 et seq.
\133\ 17 CFR 242.301(b)(1).
\134\ 17 CFR 242.301(b)(2).
\135\ 17 CFR 242.301(b)(2)(ii).
---------------------------------------------------------------------------
Form ATS is merely a notice filing, which the SEC does not approve
in any way. An ATS must also report information to the SEC quarterly on
Form ATS-R, including the volume of specified categories of securities
traded on the ATS and a list of all subscribers that were participants
during the quarter.\136\ These forms tell the SEC about ATSs'
operations, but the forms otherwise remain confidential and are not
disclosed to the public.\137\
---------------------------------------------------------------------------
\136\ Id.
\137\ Regulation of NMS Stock Alternative Trading Systems (Nov. 18,
2015) [80 Fed. Reg. 80998 at 81005-06 (Dec. 28, 2015)] (``Regulation
NMS Proposal'').
---------------------------------------------------------------------------
An ATS is required to provide ``fair access'' if the ATS's market
share is more than 5% of the average daily volume of national market
system (NMS) stocks (e.g., exchange-listed stocks) or certain other
securities for 4 of the preceding 6 calendar months.\138\ ``Fair
access'' requires an ATS to publicly display its best bid or offer and
to provide equal access to those orders. Accordingly, an ATS must
establish standards for granting access to its platform and fairly
apply those standards without unreasonably prohibiting or limiting any
person from trading in any equity securities.\139\ An ATS must also
notify the SEC on Form ATS-R when it has denied or limited access to
the ATS.
---------------------------------------------------------------------------
\138\ 17 CFR 242.301(b)(5). The fair access provisions apply on a
security-by-security basis. 17 CFR 242.301(b)(5)(ii).
\139\ See Regulation of Exchanges and Alternative Trading Systems
(Dec. 8, 1998) [63 Fed. Reg. 70844 (Dec. 22, 1988)].
---------------------------------------------------------------------------
The opaque operations of ATSs and limited public disclosure
requirements have created the conditions for numerous instances of
malfeasance by ATS operators. ATS operators have been accused of making
inadequate or false disclosures about their operations and failing to
disclose conflicts of interest. In the last 5 years, the SEC has
settled enforcement actions against several ATS operators for making
inadequate or false disclosures about their operations, failing to
update their Forms ATS as required, or for failing to disclose
conflicts of interest.\140\
---------------------------------------------------------------------------
\140\ See, e.g., In re: ITG Inc. and Alternet Securities, Inc.
(Aug. 12, 2015) (failing to disclose the operation of a proprietary
trading desk that traded algorithmically against customers' order based
on live feeds of an ATS's order book while purporting to be an
``agency-only'' broker that would protect the confidentiality of its
customers' data). See also In re: UBS Securities LLC (Jan. 15, 2015)
(illegally accepting sub-penny orders from high-frequency traders, who
were allowed to use special order types marketed exclusively to them to
jump the queue ahead of lawful whole-penny orders); In re: LavaFlow,
Inc. (July 25, 2014) (giving an affiliate access to its customers'
confidential order information, which affiliate then used the knowledge
of those orders to determine how to route orders for others); In re:
Liquidnet, Inc. (June 6, 2014) (selectively providing favored private
equity and venture capital customers with confidential information
about Liquidnet members' indications of interest and executions in
contravention of confidentiality assurances it gave to its members);
and In re: eBX, LLC (Oct. 3, 2012) (using ATS members' confidential
order flow information in contravention of its promises to members to
inform and improve the order routing process of an ATS affiliate).
---------------------------------------------------------------------------
Market Quality
The U.S. capital markets are the most liquid in the world and a
powerful force in promoting economic growth and investment. Liquidity
is difficult to define precisely, and its characteristics vary by asset
class. However, it generally relates to the ease, speed, and cost with
which investors can buy or sell assets. Some commonly used metrics for
liquid markets include:
Breadth of market: the width of the bid-ask spread, or the
difference between the price at which investors may purchase
shares (the ``ask'' or ``offer'') and the price at which they
may sell shares (the ``bid'').
Depth of market: the number of shares of stock available at
the best bid or offer.
Robust market depth and breadth combine to give investors and
traders the ability to buy or sell shares of stock with limited effects
on the market price, a characteristic that has been called
``resilience.'' Companies that enjoy good liquidity can more easily
raise money in the capital markets to fund investments and provide
jobs. Investors rely on the liquidity in our financial markets to make
new investments and to realize returns from their earlier investments.
Liquid markets also allow investors to transfer risks among themselves
at low cost, further helping the process of allocating capital among
competing business opportunities.
Liquidity relies on having a large pool of investors who are
willing to buy and sell securities and venues upon which they can
interact. Market makers, floor specialists, institutions, day traders,
and retail investors are all important contributors of liquidity.
As discussed in the last section, regulatory and market changes
have affected the sources of liquidity in the last two decades. These
structural market changes have contributed to reduced direct trading
costs (both bid-ask spreads and commissions), but have also caused
liquidity to fragment among many venues.
Figure 6: Value-Weighted Effective Spreads on NASDAQ
Trading costs have fallen
Note: Securities traded in NYSE/AMEX/NASDAQ/ARCA.
\1\ Stocks priced below $10 per share traded in sixteenths.
\2\ Decimalization test covering selection of 15
representative stocks began on 3/2/2001.
Source: Center for Research in Security Prices.
One particular complaint is that while share volume in the United
States is substantial, executing large transactions has become harder.
The average trade size in U.S. markets fell precipitously in just 15
years, though some of this effect may be due to increasing
electronification and greater reliance on algorithms to split trades
and minimize market impact. The average trade size for large
capitalization stocks in 1999 was 988 shares, but by 2014 it had fallen
to 195 shares.\141\ For small capitalization stocks, average trade size
dropped from 732 shares to 118 shares in the same period.\142\ Block
trades, trades of 10,000 shares or more, have become much less
frequent. Block trades account for less than 8% of volume on the NYSE,
compared with over 50% in the 1990s.\143\ Average transaction sizes for
NYSE-listed stocks declined by 14% from 2004 to 2014.\144\
---------------------------------------------------------------------------
\141\ CFA Institute, Liquidity in Equity Markets: Characteristics,
Dynamics, and Implications for Market Quality, Exhibit 4 (Aug. 2015),
available at: http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2015.n7.1.
\142\ Id.
\143\ BlackRock, The Liquidity Challenge: Exploring and Exploiting
(Il)liquidity (June 2014), available at: https://www.blackrock.com/
corporate/en-mx/literature/whitepaper/bii-the-liquidity-challenge-us-
version.pdf.
\144\ PricewaterhouseCoopers, Global Financial Markets Liquidity
Study (Aug. 2015), at 88, available at: http://www.pwc.se/sv/pdf-
reports/global-financial-markets-liquidity-study.pdf (``PwC Liquidity
Study'').
---------------------------------------------------------------------------
Figure 7: Average Trading Size in U.S. Equities Markets
Sources: Office of Financial Research analysis, Muzan Trade
and Quote Data.
Liquidity is also unevenly distributed across the equities market,
with small- and mid-capitalization stocks enjoying much less liquidity
than large-capitalization stocks. A study of liquidity among companies
with market capitalizations of less than $5 billion found that in
general, companies with the smallest market capitalizations (less than
$100 million) had larger quoted and effective spreads than the largest
capitalization companies (between $2 billion and $5 billion).\145\ The
smallest capitalization companies also had shallower depths of book, or
pending orders at prices outside the best bid or offer.\146\ The gap
between the ``liquidity haves'' and the ``liquidity have-nots'' may be
expanding. Trading volume in the mid-capitalization stocks in the
Standard & Poor's 400 Mid-Cap index dropped 25% between 2008 and
2014.\147\
---------------------------------------------------------------------------
\145\ Charles Colliver, A Characterization of Market Quality for
Small Capitalization US Equities, white paper (Sept. 2014), available
at: https://www.sec.gov/marketstructure/research/
small_cap_liquidity.pdf.
\146\ Id.
\147\ PwC Liquidity Study, Figure 4.83 at 92.
---------------------------------------------------------------------------
Figure 8: Quoted Bid-ask Spreads
Source: NYSE TAQ data/James J. Angel, Lawrence E. Harris,
Chester S. Spatt, Equity Trading in the 21st Century: An Update
at 5 (June 21, 2013).
Issues and Recommendations
Fragmentation of Liquidity and Promoting Liquidity in Less Liquid
Stocks
Regulatory, technology, and market factors have fueled an increase
in the number of trading venues. Competition has increased and trading
activity has fragmented among these venues.
While competition in trading venues has been a significant driver
in the reduction of transaction costs over the past decade, the
benefits have not been shared evenly by all listed securities.
Competition among venues has garnered the most benefits for heavily
traded stocks, where volumes are sufficient to support many venues. In
thinly traded stocks, venue fragmentation can be especially
problematic, as light volumes are thinly spread across many venues. The
primary function of markets is to facilitate the meeting of buyers and
sellers, but with so little volume spread across so many venues,
finding the other side of a trade has become harder. Excessive
fragmentation can complicate provision of liquidity as market-makers
limit the size they post to each market to manage their risk, which in
total reduces the available liquidity.
Recommendations
Treasury recognizes that one size may not fit all when it comes to
trading venue regulation. Treasury recommends exploring policies that
would consolidate liquidity for less-liquid stocks on a smaller number
of trading venues. Consolidating trading to fewer venues would simplify
the process of making markets in those stocks and thereby encourage
more market makers to provide more liquidity in those issues.
To accomplish this goal, Treasury recommends that issuers of less-
liquid stocks, in consultation with their underwriter and listing
exchange, be permitted to partially or fully suspend UTP for their
securities and select the exchanges and venues upon which their
securities will trade. Issuers have a unique interest in promoting the
liquidity of their stocks and balancing the interests of market-makers
and investors. While issuers may not be experts in market structure,
they could consult their underwriter and the listing exchange on these
important issues.
Accordingly, the SEC should consider amending Regulation NMS to
allow issuers of less-liquid stocks to choose to have their stock trade
only on a smaller number of venues until liquidity in the stock reaches
a minimum threshold. To maintain a basic level of competition for
execution, broker-internalization should remain as a trading option for
all stocks.
A number of measures could be used to determine which stocks are
``illiquid'' for these purposes. While definitions of and metrics used
to measure liquidity differ,\148\ one simple approach would be to use
average daily volume as the metric to differentiate between liquid and
illiquid stocks for these purposes.
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\148\ See, e.g., Ruslan Y. Goyenko, Craig W. Holden, and Charles A.
Trzcinka, Do Liquidity Measures Measure Liquidity?, 92 Journal of
Financial Economics 153 (May 2009) for a discussion of alternative
measures of liquidity. A sample of these measures include bid-ask
spreads, ``Effective Tick,'' and ``Effective Tick2.''
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Dynamic Tick Sizes
As explained previously, decimalization, or the conversion of
quoting conventions to decimals instead of fractions, coincided with a
reduction in the tick size (or minimum increment) for most stocks to
1 .\149\ Decimalization and the associated reduction in tick size is
one of the many factors cited as contributing to the long-term
reduction in equities trading costs.
---------------------------------------------------------------------------
\149\ 17 CFR 242.612(a) generally requires all tick sizes to be
at least 1 per share for NMS stocks if the bid or offer, order, or
indication of interest is equal to or greater than $1.00 per share.
---------------------------------------------------------------------------
The tick size creates an arbitrary minimum cost to trade, and also
establishes at what increments market participants can interact. From
the perspective of a market operator, tick size is a useful tool to
balance the minimum cost to trade with the rewards of liquidity
provision. A tick size that is too large imposes costs on participants
who choose to cross the spread, and such large transaction costs can
discourage trading activity and investment. On the other hand, a tick
size that is too small fails to consolidate liquidity at a given price
because a small tick size encourages free-riding on the quotes others
have made (by improving the price by economically insignificant
amounts), discouraging liquidity provision.
Beginning in October 2016, the SEC launched a pilot to evaluate the
effects of larger tick sizes (three different technical variations of
moving from a penny to a nickel) on small cap stocks.\150\ While the
pilot is still ongoing, some observers are beginning to draw
preliminary conclusions. Research suggests displayed depth of book
(i.e., the number of shares available at the best bid or offer)
increased, but return volatility increased as average trade volume
dropped.\151\ The tick size pilot may also be driving volume off
exchanges and onto inverted markets.\152\ However, the tick pilot did
not distinguish between small cap stocks that had previously traded
with narrow spreads and those with wide spreads. Some stocks which
previously traded well at 1 have seen unnecessary cost increases,
while other stocks that had typical bid-ask spread of 10 or wider have
not seen significant changes.
---------------------------------------------------------------------------
\150\ Order Approving the National Market System Plan to Implement
a Tick Size Pilot Program by BATS Exchange, Inc., BATS Y-Exchange,
Inc., Chicago Stock Exchange, Inc., NASDAQ OMX BX, Inc., NASDAQ OMX
PHLX LLC, The Nasdaq Stock Market LLC, New York Stock Exchange LLC,
NYSE MKT LLC, and NYSE Arca, Inc., as Modified by the Commission, For a
Two-Year Period (May 6, 2015) [80 Fed. Reg. 27513 (May 13, 2015)].
\151\ Peter Reinhard Hansena et al., Mind the Gap: An Early
Empirical Analysis of SEC's ``Tick Size Pilot Program,'' working paper
(May 22, 2017), available at: https://sites.google.com/site/
peterreinhardhansen/research-papers/
mindthegapanearlyempiricalanalysisofsecsticksizepilotpro
gram. See also Jose Penalva and Mikel Tapia, Revisiting Tick Size:
Implications from the SEC Tick Size Pilot, working paper (Aug. 3,
2017), available at: https://papers.ssrn.com/sol3/
papers.cfm?abstract_id=2994892 (finding that the tick size pilot has
increased depth of book but has also increased cost of execution).
\152\ Yiping Lin, Peter Swan, and Vito Mollica, Tick Size is Little
More Than an Impediment to Liquidity Trading: Theory and Market
Experimental Evidence, working paper (Aug. 10, 2017).
---------------------------------------------------------------------------
Recommendations
Tick size is another area where ``one-size-fits-all'' changes may
need to be better tailored to individual stocks. Treasury recommends
that the SEC evaluate allowing issuers, in consultation with their
listing exchange, to determine the tick size for trading of their stock
across all exchanges. Such a change would borrow a good idea from the
futures markets, where each listed contract has a different tick, and
the ticks are updated periodically to improve market quality. More-
liquid stocks would likely have lower tick sizes (reflecting their low
cost and extremely competitive liquidity provision), and less-liquid
stocks higher tick sizes (reflecting the need to coalesce liquidity to
improve market functioning). As companies grow and their liquidity
profile changes, they could update their tick size.
While different tick sizes for different stocks would increase the
complexity of the market, this could be managed by limiting the
potential choices to a small number of standard options, e.g., 10 , 5 ,
1 , or \1/2\ per share. Similar to the tick size pilot, exceptions
could also be made for retail orders as appropriate.
Maker-Taker and Payment for Order Flow
Traditional securities markets charge both buyers and sellers a
transaction fee for executing transactions in addition to other fees
they may charge for other services. In contrast, on ``maker-taker
markets,'' the venues charge fees to some parties and pay rebates to
others based on their order types. The fees and rebates are intended to
help maker-taker markets attract a higher volume of transactions. In
the traditional maker-taker market, ``takers'' who purchase or sell
shares at a quoted price (and are therefore taking liquidity from the
market) are charged a fee. ``Makers'' who provide resting quotes (and
are therefore supplying liquidity to the market) receive a rebate of a
portion of the taker fee if their bids or offers are executed. The
rebates create an incentive for market makers to provide displayed
liquidity while increasing costs for participants who cross the spread
to execute their transaction. The exchange realizes a profit based on
the difference between the taker's fee and the rebate paid to the
maker.
The rebate system of maker-taker and inverted markets (where venues
actually pay rebates to the liquidity taker) may distort the incentives
of broker-dealers executing customers' trades. It could also encourage
broker-dealers to direct trades to venues where they can receive
greater payments for order flow rather than venues where their
customers will receive the fastest execution or the greatest likelihood
of execution. While best execution obligations and the Order Protection
Rule require (in different ways) a broker-dealer to execute its
customers' trades at the best available price, if multiple venues have
the same price, the broker-dealer may choose to effect the transaction
on the exchange that will provide it the greatest rebate.
Recommendations
Treasury is concerned that maker-taker markets and payment for
order flow may create misaligned incentives for broker-dealers.
Accordingly, Treasury recommends that the SEC consider rules to
mitigate the potential conflicts of interest that arise due to these
compensation arrangements.
First, Treasury recommends that the SEC require additional
disclosures regarding these arrangements. Specifically, Treasury
recommends that the SEC adopt a final rule implementing the changes it
proposed in 2016 to Exchange Act Rules 600 and 606.\153\ The proposed
rule changes would require broker-dealers to provide institutional
customers with specific disclosures related to the routing and
execution of their orders, and also require broker-dealers to make
aggregated information about their handling of customers' institutional
orders publicly available. The proposed rule changes would also require
that retail customers receive additional information about their
orders, including the disclosure of the net aggregate amount of any
payment for order flow received, payment from any profit-sharing
relationship received, transaction fees paid, and transaction rebates
received by a broker-dealer from certain venues; and descriptions of
any terms of payment for order flow arrangements and profit-sharing
relationships.
---------------------------------------------------------------------------
\153\ Disclosure of Order Handling Information (July 13, 2016) [81
Fed. Reg. 49431 (July 27, 2016)].
---------------------------------------------------------------------------
Second, Treasury supports a pilot program to study the impact
reduced access fees would have on investors' execution costs or
available liquidity. Reducing access fees reduces the direct funding
source for maker-taker arrangements by limiting the fees paid by
takers, which generally fund the rebates paid to makers. If the study
showed that the reduction in fees did not have material negative order
flow arrangements. The SEC could also consider whether it should
require broker-dealers acting as agents to refund rebates and payments
for order flow to their customers. If payments went directly to
customers rather than intermediaries, incentives would be more
appropriately aligned.
Rebates are another area where tailoring to the situations of more-
and less-active stocks may be appropriate. While the issues affecting
the market for less-liquid stocks are many, and a potential rebate is a
small part of the equation, Treasury is hesitant to recommend any
course of action that could worsen liquidity for less actively traded
stocks. Accordingly, Treasury recommends that the SEC exempt less
liquid stocks from the restrictions on maker-taker rebates and payment
for order flow if such exemptions promote greater market making.
Market Data
As noted above, Regulation NMS included new Market Data Rules,
which were intended to promote the wide availability of market data and
reward trading exchanges which produce the most useful information for
investors.\154\ Under the Market Data Rules, an exchange or broker-
dealer must make the best bids and offers available to a Securities
Information Processor (SIP) on terms that are fair and reasonable. Each
trading venue has only a single SIP, which then resells the
consolidated data to broker-dealers and others. The SIP is responsible
for consolidating the data it receives and determining the national
best bid or offer (NBBO) for each security.
---------------------------------------------------------------------------
\154\ Regulation NMS (June 9, 2005) [70 Fed. Reg. 37495 (June 29,
2005)].
---------------------------------------------------------------------------
The Market Data Rules also allow venues to sell additional non-core
data at additional cost. This has allowed venues to make considerable
revenue as a provider of additional data not provided to the SIPs (such
as depth of book and odd-lot orders), and by delivering that
information more quickly than SIPs are able to deliver the consolidated
feed. Many HFT firms rely on these proprietary data feeds to inform
their trading, in part by consolidating information from exchanges'
proprietary feeds faster than it can be delivered by the SIP, and by
using their knowledge of the depth of book to anticipate price changes
driven by executions.
Many broker-dealers report that they feel compelled to purchase
these enhanced data feeds from the trading venues both to provide
competitive execution services to their clients and to meet their best
execution obligations. Exchange Act provisions and FINRA rules require
broker-dealers to give their customers ``best execution'' of the
customers' securities transactions.\155\ Broker-dealers interpret their
best execution obligations as requiring them to use the best available
data to find their customers the best reasonably available price.
Broker-dealers' customers may also demand that firms employ proprietary
data feeds to identify the best prices. Broker-dealers must also
compete with HFT firms that use enhanced data feeds to trade at an
advantage to retail investors and institutional investors with slower
data connections. In addition, the market for proprietary data feeds is
not fully competitive. For use in making routing and trading decisions
for active or institutional size order flow, data from one exchange's
feed cannot substitute for data from another exchange's feed.
---------------------------------------------------------------------------
\155\ See 15 U.S.C. 78j(b) 17 CFR 240.10b-10; FINRA Rule 5310.
---------------------------------------------------------------------------
Competitive pressure among broker-dealers and limited constraints
on exchange pricing power has allowed exchanges to regularly raise
prices. Consequently, exchange data fees made up nearly \1/3\ of
exchanges' $28.3 billion in revenue in 2016.\156\
---------------------------------------------------------------------------
\156\ Joe Parsons, Exchange Data Made Up a Third of Revenues in
2016 (July 11, 2017), available at: https://www.thetradenews.com/
Trading-Venues/Exchange-data-made-up-a-third-of-revenues-in-2016/.
---------------------------------------------------------------------------
Recommendations
Treasury recommends that the SEC and FINRA issue guidance or rules
clarifying that broker-dealers may satisfy their best execution
obligations by relying on SIP data rather than proprietary data feeds
if the broker-dealer does not otherwise subscribe to or use those
proprietary data feeds. This should help to eliminate the need for
broker-dealers to defensively subscribe to these costly data feeds to
ensure that they meet increasingly cautious interpretations of their
best execution obligations. Such guidance might help reduce the
barriers to entry for new broker-dealers and benefit smaller broker-
dealers who would otherwise find the cost of proprietary data
prohibitive.
Treasury recommends that the SEC also recognize that markets for
SIP and proprietary data feeds are not fully competitive. The SEC has
the authority under the Exchange Act to determine whether the fees
charged by an exclusive processor for market information are ``fair and
reasonable,'' ``not unreasonably discriminatory,'' and an ``equitable
allocation'' of reasonable fees among persons who use the data.\157\
The SEC should consider these factors when determining whether to
approve SRO rule changes that set data fees.
---------------------------------------------------------------------------
\157\ 15 U.S.C. 78k-1(c)(1)(B) and (D).
---------------------------------------------------------------------------
To foster competition and innovation in the market for SIP data,
the SEC should also consider amending Regulation NMS as necessary to
enable competing consolidators to provide an alternative to the SIPs.
Competing consolidators should be permitted to purchase exchanges'
proprietary data feeds, including last sale and depth of book, on a
non-discriminatory basis. The competing consolidators would aim to
provide faster consolidation and distribution, improved breadth of
data, and lower cost than the SIPs.
Order Protection Rule
The Order Protection Rule requires a broker-dealer to route a
customer's order to the trading venue with the best available price,
referred to as the NBBO. One purpose of the rule is to help customers
get the best available price regardless of the market which displays
that order. The rule has been credited with improving prices and
reducing transaction costs for retail investors.
The Order Protection Rule has helped to foster competition among
execution venues because it allows a venue to attract some order flow
any time that venue has the best available bid or offer. But the same
feature of the rule has also contributed to the proliferation of
execution venues and the fragmentation of the equities market. To meet
their best execution obligations, broker-dealers are effectively
required to continuously check even small venues that rarely offer
meaningful liquidity or the best available prices. This means that even
small execution venues with little liquidity can continue to exist and
thrive, notwithstanding their low volume, by selling their data streams
to broker-dealers.
The rule has also been criticized as overly simplistic and price
focused, as it does not account for the likelihood of execution, the
depth of available liquidity on a venue, or even the cost of executing
on the venue. To execute large transactions, institutional investors
have had to rely on electronic algorithms (their own or those operated
by their broker-dealers) to break large orders into smaller ones to
take available liquidity on multiple markets without tipping off other
traders to their large trade, or by moving their transactions to dark
pools, which further fragments the equity markets.
The Order Protection Rule can also cause unintended outcomes in
trade execution. The rule protects only round lot orders (orders of 100
shares or larger orders in increments of 100 shares). Some have noted
that the execution of a round lot order against an odd lot order can
cause the round lot order to become an odd lot residual. For example,
an investor may have a bid at the top of the book for 100 shares at $50
per share. If a sell order for one share executes against the standing
round lot order, an unprotected 99 share residual will remain.
Recommendations
The Order Protection Rule is intended to help investors receive the
best bid or offer available in any market. However, the rule has
fragmented liquidity among small venues that rarely offer significant
price improvement and driven up the value of data accumulated by those
exchanges. The SEC should consider amending the Order Protection Rule
to give protected quote status only to registered national securities
exchanges that offer meaningful liquidity and opportunities for price
improvement. Furthermore, protected quote status should go to exchanges
only if the cost of connecting to the market offsets the burden in
market complexity and data costs that connecting would impose on
broker-dealers and other market participants. Accordingly, the SEC
should consider amending the Order Protection Rule to withdraw
protected quote status for orders on any exchange that do not meet a
minimum liquidity threshold, measured as a percentage of the average
daily trading volume executed on the particular exchange versus the
volume of all such securities transactions executed on all exchanges.
The SEC should carefully consider the appropriate threshold,
including evaluating the benefits received by broker-dealers' customers
in the form of price improvement obtained on exchanges with different
levels of volume, as well as the costs broker-dealers face executing
transactions on those exchanges.
Treasury recognizes that instituting a minimum volume test on
exchanges could have anticompetitive effects. The proposed changes
could undermine transaction revenue and data revenue at smaller
exchanges, thus reducing their ability to compete with larger exchanges
for volume. A minimum volume test could also create a barrier to entry,
whereby a new exchange would need sufficient volume to earn the
coverage of the Order Protection Rule. Without the rule, the exchange
might never be able to attract the necessary volume. Accordingly, the
SEC should consider proposing that any newly registered national
securities exchange also receive the benefit of protected order status
for some period of time to allow the new exchange an opportunity to
thrive.
If a broker-dealer's best execution obligations require it to seek
price improvement from every exchange, the broker-dealer may not be
able to benefit from the simplification this proposal might otherwise
offer. If the SEC proposes the rule described above, the SEC should
also consider issuing interpretive guidance concerning whether broker-
dealers' best execution obligations could be satisfied without checking
the best bid or offer available on marginal exchanges.
Reducing Complexity in Equity Markets
Trading venues also compete by offering alternative order types
beyond bids and offers. For example, one trading venue offers order
types that vary on times of execution (pre-market, post-market, regular
session, or all sessions); time in force (day orders, immediate or
cancel, fill or kill orders, or good til time); market vs. limit
orders; routable, non-routable, and non-routable by design orders with
several variants; displayed or non-displayed orders; aggressive or
super-aggressive orders, etc. Many of these order types can be combined
creating multiple permutations. One source estimated that exchanges
offer 2,000 variations of order types.\158\ Some large institutional
investors are concerned that other short-term traders, such as HFT
firms, may exploit these order types to learn about the institutions'
trading intentions. These participants can then use this information to
effectively trade ahead of the institutions, increasing their cost of
execution. Exchanges assert that these order types are transparent and
fully disclosed because all new order types on exchanges are approved
by the SEC and fully documented. They are also available for all
traders to use. Others assert that order type proliferation has made
the trading environment so complex that even professional investors may
not understand how others are exploiting the information advantages
that may be gained from different order types.
---------------------------------------------------------------------------
\158\ Herbert Lash, Complaints Rise over Complex U.S. Stock Orders,
Reuters (Oct. 19, 2012), available at: http://www.reuters.com/article/
us-exchanges-ordertypes/analysis-complaints-rise-over-complex-u-s-
stock-orders-idUSBRE89I0YU20121019. See also Paul G. Mahoney and
Gabriel Rauterberg, The Regulation of Trading Markets: A Survey and
Evaluation, Virginia Law and Economics Research Paper No. 2017-07 (Apr.
19, 2017), available at: https://papers.ssrn.com/sol3/
papers.cfm?abstract_id=2955112.
---------------------------------------------------------------------------
Recommendations
Because market complexity is exacerbated by the proliferation of
order types, Treasury recommends that the SEC review whether exchanges
and ATSs should harmonize their order types and make recommendations as
appropriate. The SEC should consider whether particular order types
sustain sufficient volume to merit continuation.
Regulation ATS
In 2015, the SEC proposed to amend Regulation ATS to increase
public information about ATSs that trade NMS stocks (NMS Stock ATSs)
and to facilitate better SEC oversight of those ATSs.
The proposed rule would:
Require an ATS to publicly disclose information about its
operator (and any affiliates) and the ATS's operations,
including information about potential conflicts of interest.
Give the SEC authority to approve an ATS's disclosure as
well as revoke an ATS's ability to operate under appropriate
circumstances.
Require ATSs to maintain written safeguards and procedures
to protect subscribers' confidential trading information.
Some industry participants are concerned, however, that the
proposed rule may be unnecessarily burdensome. They also believe that
the rule encompasses overbroad categories of information and would
require ATSs to disclose confidential material that would not give
participants any useful insight into the ATS operations. Among the
problematic disclosures that would be required under the proposal are:
``[A]ny materials provided to subscribers or other persons
related to the operations of the NMS Stock ATS or the
disclosures on Form ATS-N.'' \159\
---------------------------------------------------------------------------
\159\ Regulation NMS Proposal, 80 Fed. Reg. at 81140.
Disclosures about affiliates that do not present potential
---------------------------------------------------------------------------
conflicts of interest with ATS participants.
Disclosure about a broker-dealer operator's or its
affiliate's use of smart order routers or algorithms to send or
receive orders or indications of interest to or from the NMS
Stock ATS and details on how the ATS and smart order routers or
algorithms interact.
Details of an NMS Stock ATS's outsourcing arrangements
concerning any of its operations, services, or functions.
Recommendations
Treasury agrees with the SEC's goals of amending Regulation ATS to
increase public information about NMS Stock ATSs. Additional
transparency regarding an NMS Stock ATS's operations will allow
participants and investors to make more informed decisions about
whether to execute transactions on the venue.
Treasury recommends that the SEC adopt the amendments to Regulation
ATS substantially as proposed to promote improved information about ATS
operations. However, Treasury recommends that the SEC revise aspects of
the proposal that would require public disclosure of confidential
information that is unnecessary and unhelpful to investors deciding
where to send their orders. Treasury recommends that the SEC instead
require only confidential disclosure of such information to the agency
if the agency can demonstrate that the information would improve its
ability to oversee the industry. Treasury suggests that the SEC also
ensure disclosures related to conflicts of interest are tailored to
provide useful information to market participants. Finally, Treasury
recommends that the SEC consider ways to simplify the disclosures to
reduce the compliance burden and to increase their readability and
comparability across competing ATSs.
The Treasury Market
Overview and Regulatory Landscape
Overview of Treasury Market Structure
The U.S. Treasury market is the deepest and most liquid government
securities market in the world and serves as the primary means of
financing the U.S. Government. Treasury securities play a critical role
in global finance as a risk-free benchmark from which many other
financial instruments are priced. Domestic and foreign investors use
Treasury securities as a vehicle for investment and the Federal Reserve
uses Treasury securities in its implementation of monetary policy.
In recent years, the structure of the U.S. Treasury market has
changed in many important ways. As with many other financial markets,
advances in technology have facilitated growth in electronic trading
for large segments of the Treasury market. At the same time,
extraordinary monetary policy has attended a shift in the composition
of Treasury end investors. Additionally, the roles played by dealers in
the Treasury market are shifting, and new types of intermediaries--
particularly those specializing in electronic trading--have entered and
recently come to dominate major segments of the market.
Recent Trends and Developments
Over the last decade, Treasury marketable debt outstanding has
grown sharply to about $14 trillion as of June 30, 2017, up from $4.3
trillion as of June 30, 2007, just before the onset of the financial
crisis.
Figure 9: Treasury Marketable Debt Outstanding ($ trillions)
Source: U.S. Department of the Treasury, Office of Debt
Management.
Ownership of Treasury securities has also changed over the last
decade. For example, as the use of diversified portfolio and passive
investment strategies has grown generally, so have mutual fund holdings
of Treasury securities.\160\ Holdings of Treasury securities outside
the United States have grown significantly as well. According to
Treasury International Capital and Federal Reserve data, foreign
holdings of Treasury securities increased from about $2.2 trillion in
June 2007, to about $6.2 trillion in June 2017.\161\
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\160\ Board of Governors of the Federal Reserve System, Financial
Accounts of the United States--Z.1, L.210 Treasury Securities (1),
available at: https://www.federalreserve.gov/releases/z1/current/html/
l210.htm (showing mutual fund holdings have grown from just fewer than
4% of marketable Treasury debt outstanding in the years preceding the
financial crisis to over 6% in 2017).
\161\ Id.
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Changes to regulation since the financial crisis have driven
changes in holdings of Treasury securities by the domestic banking
sector and money market mutual funds. According to Federal Reserve
data, U.S. chartered bank holdings of Treasury securities have grown
from about $78 billion in 2007 to over $500 billion in the first
quarter of 2017, due in part to U.S. Basel III capital requirements to
hold greater amounts of high quality liquid assets (HQLA) since the
financial crisis. Money market mutual fund holdings have grown from $92
billion to about $741 billion over the same period, primarily as a
result of revised SEC rules on the securities money market funds can
hold to retain a fixed net asset value.\162\ The Federal Reserve,
through the System Open Market Account, is also a significant holder of
Treasury securities; the Federal Open Market Committee recently
announced it will begin normalizing its balance sheet.\163\
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\162\ Id.
\163\ Board of Governors of the Federal Reserve System,
Implementation Note issued September 20, 2017, available at: https://
www.federalreserve.gov/newsevents/pressreleases/monetary20170
920a1.htm.
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According to the Securities Industry and Financial Markets
Association (SIFMA), Treasury market daily volume has remained steady
since 2010 at about $510 billion per day.\164\
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\164\ SIFMA US Treasury Trading Volume, available at: https://
www.sifma.org/resources/research/us-treasury-trading-volume/.
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Treasury Market Ecosystem
The cash Treasury market ecosystem consists broadly of two
segments: the dealer-to-client (DtC) market, and the interdealer
market. In addition, activity in the Treasury futures market is closely
related to the cash market. Treasury repurchase agreements (repo) are
often used by market participants, particularly intermediaries, to
finance positions in Treasury securities.
Figure 10: Treasury Cash Market Structure
Source: Treasury.
Dealer-to-Client Trading
Institutional investors and other end-users of Treasury
securities--including mutual funds, pension funds, insurers, hedge
funds, foreign central banks and sovereign wealth funds--transact in
the DtC segment of the market. Bank-owned SEC registered dealers,
referred to as bank dealers, hold inventory in Treasury securities and
stand ready to make markets upon request from investors and end-users.
The bank dealer side of the DtC market is dominated by 23 primary
dealers, as designated by the Federal Reserve Bank of New York (FRBNY).
The DtC market for Treasury securities is an over-the-counter (OTC)
market. Transactions do not occur on central trading venues, but rather
bilaterally between market participants. Though data on the size and
composition of the DtC market is not widely available,\165\ it is
estimated to account for roughly half of all daily Treasury
transactions. According to the FRBNY's weekly survey of primary
dealers, primary dealers have transacted $313 billion on average per
day outside the interdealer broker market in 2017, serving as a proxy
for DtC activity.\166\
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\165\ In July 2017, FINRA began requiring its members to report
transactions in certain Treasury securities to its Trade Compliance and
Reporting Engine (TRACE). The data is available to regulators and to
Treasury.
\166\ Federal Reserve Bank of New York, Primary Dealer Statistics,
available at: https://www.newyorkfed.org/markets/gsds/search.html.
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Figure 11: Primary Dealer Transactions Not With Interdealer Brokers ($
million)
Source: Federal Reserve Bank of New York.
Trading in the DtC market has been traditionally conducted by phone
(i.e., voice). In recent years, electronic request-for-quote platforms
(RFQ), such as Bloomberg and Tradeweb, have arisen. These platforms
allow clients to electronically solicit bids and offers for Treasury
securities from multiple dealers simultaneously (rather than serially
by phone). As a result, the DtC market has become more automated
operationally, without changing the fundamental nature of transactions
between bank dealers and clients.
Interdealer Trading
The interdealer market is where wholesale trading between large
institutional intermediaries, such as bank dealers, takes place. Most
institutional investors and end-users of Treasury securities, such as
the mutual funds, pension funds, etc. mentioned above, do not access
this market, and instead trade bilaterally with bank dealers. Bank
dealers then use the interdealer market to manage inventory and hedge
client trading activity.
Interdealer brokers (IDBs) intermediate trades between dealers in
the interdealer market. IDBs manage central limit order books (CLOBs)
and enable dealers to post anonymous bids and offers for Treasury
securities to the order book, which are made available for other
dealers to transact on. The majority of trading in the interdealer cash
Treasury market is electronic and occurs on one of a few electronic
interdealer platforms, such as BrokerTec, NASDAQ Fixed Income, and
Dealerweb. Voice-brokered and manual electronic (as opposed to
automated electronic) interdealer broker platforms still exist and
intermediate significant interdealer volumes.
Along with bank dealers, principal trading firms (PTFs) also
transact in the interdealer Treasury market. The Joint Staff Report:
The U.S. Treasury Market on October 15, 2014 \167\ (JSR) concluded that
PTFs account for a majority of trading in the interdealer market, while
bank dealers account for approximately 30-40% of volume. In contrast to
bank dealers, PTFs do not have customers, trade only for their own
account, and focus on automated trading methods executed on interdealer
electronic platforms. While bank dealers will conduct large trades to
service their clients' needs and often carry inventory in Treasury
securities, PTFs commonly act as short-term liquidity providers,
frequently buying and selling in small amounts but rarely carrying
inventory overnight.
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\167\ U.S. Department of the Treasury, Board of Governors of the
Federal Reserve System, Federal Reserve Bank of New York, U.S.
Securities and Exchange Commission, and U.S. Commodity Futures Trading
Commission, Joint Staff Report: The U.S. Treasury Market on October 15,
2014 (July 13, 2015), available at: https://www.treasury.gov/press-
center/press-releases/Documents/Joint_Staff_Report_Treasury_10-15-
2015.pdf (``Joint Staff Report'').
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Recently, some PTFs (and bank dealers) have developed the means to
electronically stream executable bids and offers to bank dealers and
other market participants. These direct streams are targeted at
individual firms rather than available to the market as a whole, and
the terms of the streams can be negotiated bilaterally between the
participants. While still a small part of the market overall, this
development illustrates how electronic execution methods are changing
the structure of the Treasury market.
The vast majority of trading in the interdealer cash Treasury
market takes place in the most recently issued Treasury securities,
often referred to as on-the-run securities. Two of the major electronic
interdealer platforms trade on-the-run securities exclusively.
Futures
Futures on Treasury securities, and options on these futures, are
traded at the Chicago Board of Trade, a futures exchange regulated by
the CFTC. The exchange is owned by the CME Group, Inc., and the vast
majority of futures trades occur electronically on an anonymous CLOB,
though larger or more complex trades may take place off exchange as
block trades. All trades are reported publicly in real time.
As with the Treasury cash interdealer market, according to the JSR,
PTFs dominate the Treasury futures market and account for over half of
Treasury futures trading. Futures trading can be used by market
participants to hedge cash Treasury positions or to take speculative
positions in futures that closely track the returns of underlying
Treasury securities. Market forces ensure that the prices of Treasury
futures and their underlying Treasury securities remain tightly
coupled.
Treasury Repo
Treasury repo plays a central role in U.S. securities financing
markets. Repo transactions are used by market intermediaries to finance
long positions in Treasury securities. Long-only investors use repo to
invest cash with safe collateral. Some investors use repo to implement
short positions in Treasury securities. All of this activity
contributes to the Treasury market being the deepest and most liquid
government securities market in the world.
In a repo transaction, one firm agrees to sell a security to
another firm, with a simultaneous agreement to buy back the security at
a later date at a specified price. Repo transactions are often
conducted on an overnight basis, but the term of the trade can be
extended to any length the two counterparties agree to. These
transactions entail short-term loans of Treasury securities in exchange
for cash. Like the DtC market, the Treasury repo market is an OTC
market, and bank dealers are at its center. Treasury repo transactions
can be settled either triparty--i.e., with a settlement bank such as
the Bank of New York Mellon (BNY Mellon) or JPMorgan Chase & Co. (JP
Morgan) providing back-office support for the trade--or bilaterally
between the two parties to the transaction. Relatedly, these
transactions can be cleared, via the Fixed Income Clearing
Corporation's (FICC) General Collateral Financing repo service in the
case of tri-party transactions or via FICC's delivery--versus--payment
(DVP) repo service for bilateral ones. Conversely, bilateral repo
transactions can be managed between the parties directly and hence be
uncleared.
Estimates of the current size of the repo market vary. Joint OFR-
FRBNY research estimates that in the post-crisis era, total repo
activity is around $5 trillion.\168\ This is likely lower than levels
prior to the financial crisis. Statistics collected by the FRBNY
indicate that primary dealer Treasury financing volumes, a large
component of repo outstanding, are approximately \2/3\ the size they
were prior to the financial crisis.
---------------------------------------------------------------------------
\168\ Viktoria Baklanova, Adam Copeland, and Rebecca McCaughrin,
Reference Guide to U.S. Repo and Securities Lending Markets, Federal
Reserve Bank of New York Staff Report No. 740 (Sept. 2015 and revised
Dec. 2015), available at: https://www.newyorkfed.org/medialibrary/
media/research/staff_reports/sr740.pdf.
---------------------------------------------------------------------------
Figure 12: Primary Dealer Treasury Financing Volumes
Source: Federal Reserve Bank of New York.
Treasury Market Oversight
Several agencies, under a range of authorities, are responsible for
regulating various entities transacting in the Treasury market. The
Government Securities Act of 1986 (GSA) established a Federal system
for the regulation of brokers and dealers in the U.S. Government
securities market.\169\ The GSA required previously unregistered
brokers and dealers that limit their business to government and other
exempt securities to register with the SEC and join a self-regulatory
organization.\170\ Few firms fall within this category; most broker-
dealers transacting a business in government securities do not do so
exclusively and have the more general securities broker-dealer
registration with the SEC. The GSA also specified that firms registered
as general securities brokers or dealers, and financial institutions
that conduct a government securities business, are required to file a
written notice with the SEC, Financial Industry Regulatory Authority
(FINRA), or bank regulator, respectively, if they conduct government
securities transactions.\171\ The GSA registration and notice
requirements provide, among other things, information and
identification of government securities market participants.
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\169\ Public Law No. 99-571.
\170\ As used in this report, the term ``registered government
securities broker or dealer'' means a broker or dealer conducting a
business exclusively in government and other exempted securities
(excluding municipal securities) registered pursuant to 15 U.S.C.
78o-5(a)(1)(A). The term ``registered broker or dealer'' means a broker
or dealer conducting a general securities business that is registered
pursuant to 15 U.S.C. 78o, and has filed written notice pursuant to
15 U.S.C. 78o-5(a)(1)(B) that it is acting as a broker or dealer of
government securities.
\171\ The SEC is the designated regulatory agency for securities
brokers and dealers, and the Federal bank regulators (Office of the
Comptroller of the Currency, FRB, and FDIC) are the designated
regulatory agencies for financial institutions.
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Congress, in enacting the GSA, largely relied on the existing
Federal agency structure when assigning registration, examination,
reporting, and enforcement responsibility.\172\ The GSA authorized
Treasury to promulgate rules to provide safeguards with respect to the
financial responsibility of government securities brokers and dealers,
including capital adequacy standards, acceptance of custody and use of
customers' securities, record keeping, and financial reporting. In
consultation with Treasury, the SEC, Federal bank regulators, and FINRA
also have authority to issue sales practice rules for the U.S.
Government securities market. Transactions in government securities are
also subject to the anti-fraud provisions of Section 10(b) of the
Securities Exchange Act of 1934 (Exchange Act) and the SEC's Exchange
Act Rule 19b-5.
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\172\ The history of the GSA made clear that it was intended to
address identified weakness in the market without creating duplicative
requirements, unnecessarily impairing the operation of the market,
increasing the costs of financing the public debt, or compromising the
execution of monetary policy.
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Congress included a large position reporting (LPR) provision in the
1993 amendments to the GSA.\173\ Treasury was provided the authority to
prescribe LPR rules for purposes of monitoring the impact in the
Treasury securities market of concentrations of positions, assisting
the SEC in enforcing the GSA, and providing Treasury with information
to better understand supply and demand dynamics in certain Treasury
securities.
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\173\ Public Law No. 103-202 [codified at 15 U.S.C. 78o-5(f)].
---------------------------------------------------------------------------
Treasury futures and options are regulated by the CFTC under the
Commodity Exchange Act (CEA) and CFTC rules. The CEA establishes a
comprehensive regulatory structure to oversee futures and swaps
trading, including surveillance of the markets under the CFTC's
jurisdiction. The CFTC exercises surveillance and enforcement authority
over participants in these markets. The CFTC, as the futures regulator,
receives a transaction audit trail identifying market participants,
which aids in ongoing market surveillance and enforcement.
Clearing Treasury Security Transactions
Since the 1980s, Treasury security transactions in major segments
of the market have been cleared (prior to settlement) by a central
counterparty, which supports efficient and predictable settlement.
Prior to the settlement of Treasury securities transactions, firms may
clear trades through a central counterparty. The primary purpose of
clearing trades through a central counterparty is to ``net down'' gross
trading activity among participants that transact frequently together
in both directions (such as bank dealers) into a lower net trading
amount. By submitting the lower net trading amounts to BNY Mellon and
JP Morgan for settlement (rather than the larger gross amounts),
clearing participants are able to eliminate unnecessary transfers of
cash and ownership of securities when a trading day's business is
settled.
FICC, a subsidiary of the Depository Trust and Clearing Corporation
(DTCC), serves as a central clearing counterparty for major segments of
the Treasury market. FICC provides trade comparison, netting, and
settlement for the government securities market, including many major
SEC-registered brokers and dealers. FICC members pay fees for these
services and must meet FICC's standards of membership, including
minimum capital requirements. The central clearing function that FICC
provides to its members promotes the safety and soundness of the
Treasury market as a whole.
------------------------------------------------------------------------
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Settlement in Treasury Markets
Treasury market liquidity depends on the smooth and predictable
settlement of transactions. While the clearing function provides an
important role in trade reconciliation and netting, settlement is the
final step in a trade between two market participants. The business of
settling transactions (that is, finalizing the transfer of ownership in
Treasury securities after trades are completed) is conducted
predominantly by two firms: BNY Mellon, with approximately 85% of the
market share, and JP Morgan, representing the majority of the
remainder.
In July 2016, JP Morgan announced its intention to exit the
government securities services business, which will leave BNY Mellon as
the remaining large provider of these services to the Treasury market.
The transition of clients from JP Morgan to BNY Mellon is currently in
progress, and is expected to be completed in 2018. As part of this
process, in May 2017, BNY Mellon announced the formation of a wholly
owned subsidiary, BNY Mellon Government Securities Services, intended
to house the settlement business under a separate governance structure
and focus on enhancing and protecting its services and technology. The
activities of BNY Mellon Government Securities Services fall under the
supervision of the Federal Reserve.
Treasury market participants are watching this transition carefully
to measure the sustainability of such a concentration in service and
what, if any changes might need to be made to the settlement landscape.
------------------------------------------------------------------------
Issues and Recommendations
Treasury Market Data Gaps
On October 15, 2014, the U.S. Treasury cash market experienced a
very high level of volatility that also affected the Treasury futures
market and other closely related markets. In response to this event,
staff of Treasury, the Board of Governors of the Federal Reserve
System, FRBNY, the SEC, and the CFTC (Joint Staff) prepared a report
analyzing the events of the day.\174\
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\174\ See Joint Staff Report.
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Because data on Treasury market transactions is not widely
available to the public, the Joint Staff relied on participant-level
transaction data collected from a few trading venues--namely BrokerTec,
eSpeed,\175\ and CME Group, Inc.--to conduct the analysis. In other
words, only data from the interdealer and futures segments of the
Treasury market was available for study. The report did not analyze any
transactions occurring in the dealer-to-client segment, because a
comprehensive source of data did not exist.
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\175\ eSpeed was rebranded as NASDAQ Fixed Income in 2017.
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In July 2016, the SEC approved a FINRA rule proposal to require its
members to report certain transactions in Treasury securities to
FINRA's Trade Reporting and Compliance Engine (TRACE).\176\ FINRA began
collecting the data in July 2017. Because FINRA's membership includes
all SEC registered broker-dealers, the data collected by TRACE includes
significant volumes from the dealer-to-client segment of the Treasury
cash market. The data also contains reports of trades conducted by
broker-dealers in the IDB market. Post-trade data on Treasury security
transactions across so many venues and at the level of detail found on
TRACE had not previously been available. The data on Treasury
transactions is not being publicly disseminated and is available to
regulators and Treasury only, with the policy concerning public
dissemination of the data currently under review by Treasury.
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\176\ Self-Regulatory Organizations; Financial Industry Regulatory
Authority, Inc.; Notice of Filing of Amendment No. 1 and Order Granting
Accelerated Approval of a Proposed Rule Change, as Modified by
Amendment No. 1, Relating to the Reporting of Transactions in U.S.
Treasury Securities to TRACE (Oct. 18, 2016) [81 Fed. Reg. 73167 (Oct.
24, 2016)].
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Though the amount of data recently made reportable through TRACE
greatly enhances the ability of regulators and Treasury to understand
and monitor activity in the Treasury securities market, significant
gaps in the data available to regulators and Treasury still exist.
Closing some of these gaps would improve Treasury's ability to
understand market activity, which will assist Treasury in its mission
to fund the deficit at the lowest cost to the taxpayer over time.
PTF Trade Reporting
Most PTFs are not regulated because they do not meet the definition
of ``dealer,'' as set forth in the Exchange Act and interpreted by the
SEC.\177\ Because they are not dealers, they are not required to
register with the SEC, become members of FINRA, or report their
activity to TRACE. Trading activity on the major electronic interdealer
platforms is dominated by PTFs, however, and collectively they account
for over half of all transaction volumes in the interdealer broker
segment of the market, according to the JSR.
---------------------------------------------------------------------------
\177\ 15 U.S.C. 78c(5).
---------------------------------------------------------------------------
Because all of the major interdealer brokers in the Treasury
securities market are registered with the SEC and are members of FINRA,
the activity of unregistered PTFs in the IDB market is captured by
TRACE through the reports of these interdealer brokers. The trade
reports of PTF activity submitted by the interdealer brokers do not
identify the unregistered PTF trade counterparts, however, because the
PTFs are not FINRA members. Instead the PTF trade counterparty is
identified only generically as a customer. In essence, a significant
portion of PTF activity is anonymized in the TRACE data.
Recommendations
Treasury recommends closing the gap in the granularity of PTF data.
To close this gap, trading platforms operated by FINRA member broker-
dealers that facilitate transactions in Treasury securities would be
required to identify customers in their reports of Treasury security
transactions to TRACE. Treasury intends to work with SEC and FINRA to
assess the feasibility of, and implement, this policy. Because most PTF
activity occurs on electronic IDB platforms, requiring them to identify
customers would capture a large fraction of total PTF trading volume,
according to the results of the JSR.
Bank Trade Reporting
Some Federal Reserve member banks that conduct a government
securities business under the GSA are not brokers-dealers or members of
FINRA. As such, their trading activity in Treasury securities is not
reported to TRACE. In 2016, the Federal Reserve Board announced that it
plans to collect data from banks for transactions in Treasury
securities and that it has entered into negotiations with FINRA to
potentially act as collection agent.\178\
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\178\ Board of Governors of the Federal Reserve System, Press
Release (Oct. 21, 2016), available at: https://www.federalreserve.gov/
newsevents/pressreleases/other20161021a.htm.
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Recommendations
Treasury supports the Federal Reserve Board's efforts to collect
Treasury transaction data from its bank members.
Treasury Futures Data Availability
The CFTC collects data from CME Group, Inc. on Treasury futures
transactions, but the data is not available on a regular basis to other
market regulators or Treasury. In order to effectively study and
monitor the Treasury cash market, regulators and Treasury require
comprehensive data that covers closely related securities, such as
Treasury futures, as the Joint Staff Report demonstrated.
Recommendations
To improve cross-market monitoring of Treasury cash and futures
trading activity, as well as to improve the overall efficiency of
government data collection and consumption, Treasury recommends that
the CFTC share daily its Treasury futures security transaction data
with Treasury.
Clearing and Reporting
Treasury Market Central Clearing
As mentioned above, central clearing for cash Treasury transactions
has existed for many years in the IDB segment of market. In the late
1980s, firms in the IDB market began clearing through FICC, which is
overseen by the SEC. FICC's model for central clearing and the
regulatory framework surrounding it has worked well for many years.
Furthermore, FICC's largest and most important member firms are all
registered broker-dealers and are regulated by one or several agencies,
including the SEC and the Federal Reserve.
FICC's model was formulated before the existence of electronic IDB
platforms. The advent of electronic platforms enabled new types of
participants--namely PTFs--to enter the IDB market in the early 2000s
and grow rapidly. While the registered broker-dealers that are members
of FICC clear their transactions through FICC, transactions between
PTFs that are not FICC members must be settled bilaterally.
Transactions by PTFs with other PTFs conducted on electronic IDB
platforms must clear through the FICC account of the electronic
platform\179\ if they are to be centrally cleared.
---------------------------------------------------------------------------
\179\ That is, the platform must act as principal to the trade,
rather than in an agency capacity.
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The ultimate consequence of these changes in clearing practices is
twofold. First, there is less netting down of settlements than there
would be if all interdealer market participants were FICC members.
Second, if a large PTF with unsettled trading volumes were to fail, the
failure could introduce risk to the market and market participants.
Despite the disadvantages that result from the bifurcation of
clearing and settlement in the Treasury IDB market, any effort to
include PTFs in FICC's membership is complicated by the current fee
structure and capital requirements imposed by FICC on its members,
which could pose an economic barrier to entry for these firms.
Recommendations
Clearing and settlement arrangements in the Treasury IDB market
have evolved greatly in recent years and continue to evolve rapidly,
particularly those utilized by PTFs. It is important for the regulatory
regime to keep up with these developments. However, we are at the early
stages of this work. For example, the fees and other standards that
FICC imposes on its members, and how those fees compare to fees for
similar services in other markets, such as DTCC's National Securities
Clearing Corporation (NSCC), are not widely understood, even by many
market participants. To better understand these arrangements and the
consequences of reform options available in the clearing of Treasury
securities, Treasury recommends further study of potential solutions by
regulators and market participants.
Effect of Regulation on Secured Repurchase Agreement (Repo)
Financing
It is generally acknowledged that the interaction of the U.S.
banking regulators Basel III capital requirement's supplementary and
enhanced supplementary leverage ratios (SLR, eSLR) and other rules
enacted following the financial crisis have discouraged some banking
functions, including the provision of secured repo financing. The
Banking Report recommended amendments to several regulations which, if
enacted, would increase the availability of secured repo financing,
according to market participants generally.
Specifically, those amendments that would have the most direct
impact on repo availability are:
Adjustments to the SLR and eSLR, namely exceptions from the
denominator of total exposure for cash on deposit with central
banks, U.S. Treasury securities, and initial margin for
centrally cleared derivatives;
Recalibration of the U.S. Global Systemically Important
Banks (G-SIB) risk-based capital surcharge, including its
treatment of short-term wholesale funding reliance; and
Basing prudential standards for Foreign Banking
Organizations on U.S. risk profile rather than global
consolidated assets, and raising the threshold for Intermediate
Holding Companies from the current $50 billion level for
participation in the U.S. Comprehensive Capital Analysis and
Review.
Recommendations
Treasury reiterates its recommendations from the Banking Report
\180\ to improve the availability of secured repo financing.
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\180\ The Banking Report, at 54, 56, and 70.
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Corporate Bond Liquidity
Overview and Regulatory Landscape
The corporate bond market helps companies borrow to grow their
businesses and provides assets to fixed income investors. Compared with
traditional bank lending that is more prominent internationally, the
U.S. corporate bond market allows companies to access a broader
spectrum of potential lenders as investors in their debt and
diversifies the provision of credit in the economy, making it more
competitive and resilient. This section will discuss the structure of
the corporate bond market, challenges to liquidity, and our
recommendations.
Market Structure and Intermediation
The market structure of the corporate bond market differs greatly
from the equities and Treasury markets covered earlier in this report.
The corporate bond market consists of tens of thousands of distinct
securities, as companies have issued bonds at different times, with
different tenors, and in different structures. Issuance in the
corporate bond market has hit record highs 5 years running, with over
$1.5 trillion issued in 2016. After issuance, corporate bonds trade
``over-the-counter'' (OTC) in the secondary market; some corporate
bonds (often the largest and most recently issued securities) trade
frequently, while most rarely trade.
Figure 13: Trade Frequency (Total 29,363 Bonds)
Source: FINRA TRACE.
Because of the vast array of distinct securities, corporate bond
intermediation has traditionally centered on bank dealers making
markets on a principal basis (i.e., buying and selling for their own
account to make markets for customers). Treasury believes that market
making serves a critical function in financial markets. Market making
may include, from time to time, absorbing temporary order imbalances,
such as buying a large amount of bond inventory that a customer wants
to sell, with the intention of selling the bonds as soon as possible.
In this way, market makers play an important role in the secondary
market as a provider of liquidity and facilitator of capital markets
activity. In the decade leading up to the financial crisis, corporate
bond dealers supported their market making business with significant
inventories and were generally able to offer customers immediate
liquidity.
In the past decade there has been a significant shift away from
market making based on principal intermediation and toward agency
intermediation, where dealers connect buyers and sellers but do not
take risk themselves.\181\ This shift has been driven both by
regulations such as the Volcker rule and bank capital requirements as
well as by market forces, as banks that suffered losses on large
inventories in the financial crisis look to better manage their risks.
Accordingly, dealer inventories have declined dramatically and now
stand at about half the levels seen before the financial crisis.\182\
Despite this shift in intermediation and reduction in inventories,
secondary market trading volumes in the corporate bond market have
actually doubled since the financial crisis,\183\ suggesting
improvements in dealer efficiency.
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\181\ Hendrik Bessembinder et al., Capital Commitment and
Illiquidity in Corporate Bonds, Journal of Finance (forthcoming Aug.
2017), draft available at: https://papers.ssrn.com/sol3/
papers.cfm?abstract_id=2752610 (showing for the most active dealers the
share of agency intermediated trades has roughly doubled from 7% to 14%
since the pre-crisis period); Larry Harris, Transactions Costs, Trade
Throughs, and Riskless Principal Trading in Corporate Bonds Markets,
working paper (Oct. 2015), available at: https://papers.ssrn.com/sol3/
papers.cfm?
abstract_id=2661801 (estimating the total agency trading rate to be as
high as 42%).
\182\ Federal Reserve Bank of New York, Primary Dealer Statistics,
available at: https://www.newyorkfed.org/markets/gsds/search.html. It
should be noted that the data pre- and post-April 2013 is not directly
comparable as prior to April 2013 reported inventories included
commercial paper, CMOs and REMICs issued by entities other than Federal
agencies and GSEs. Comparable figures have been estimated by industry.
\183\ SIFMA US Corporate Bond Issuance and Trading Volume (July
2017), available at: http://www2.sifma.org/research/statistics.aspx.
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Another significant trend has been the growth of electronic trading
of corporate bonds, which has grown to about 19% for investment grade
securities and 8% for high yield securities.\184\ However, most of the
activity has been on request for quote (RFQ) based trading platforms
where instead of calling a dealer for a quote, the customer can solicit
a quote electronically. These platforms create operational
efficiencies, but they do not fundamentally change the nature of
corporate bond liquidity because they rely on the same dealers and
customers interacting through a different medium. Platforms that use
central limit order books or more fundamental changes in intermediation
have not yet gained significant market share.
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\184\ Greenwich Associates, Corporate Bond Electronic Trading
Continues Growth Trend (July 28, 2016), available at: https://
www.greenwich.com/fixed-income-fx-cmds/corporate-bond-electronic-
trading-continues-growth-trend.
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Liquidity
Liquidity has been challenged in parts of the corporate bond
market, especially for the least-traded securities. Though definitions
of liquidity differ, most observers agree that a central element of
liquidity is the ability to buy or sell a financial instrument quickly,
in large volumes, at a low cost, without materially changing the price
of the instrument. In corporate bonds, the different measures of
liquidity tell a mixed story.\185\ Record trading volumes and low bid-
ask spreads indicate good liquidity, while reduced frequency of block
trades suggest more difficulty in moving large blocks of risk. However,
these oft-cited measures do not capture the full story. For example,
bid-ask spreads have decreased primarily for retail investors, rather
than for institutional investors.
---------------------------------------------------------------------------
\185\ See DERA (2017).
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Figure 14: Corporate Bond Bid-Ask Spreads (Percent of Par)
Source: Federal Reserve Bank of New York staff calculations,
based on Supervisory TRACE data.
Notes: The chart plots 21 day moving averages of realized
bid-ask spreads for retail (under $100,000) and institutional
($100,000 and more) trades of corporate bonds. Originally
published at: http://libertystreeteco
nomics.newyorkfed.org/2017/06/market-liquidity-after-the-
financial-crisis.html.
Moreover, measures of trading activity only capture activity that
has occurred, not trades foregone by market participants because
liquidity was not available or the cost was too high. Liquidity metrics
also generally do not convey the reduction in immediately available
trading opportunities. Such opportunities have declined as more dealers
act as agents, and accordingly customers must wait until the opposite
side of the trade has been found. Finally, market participants report
that dealer willingness to make markets in size, take on risk, and
provide firm quotes have all declined.
Issues and Recommendations
While these changes in liquidity and market structure have many
causes, regulatory changes are likely a contributing factor. As
detailed in the Banking Report, the Volcker rule's market-making
exception has not been implemented effectively, and firms are hesitant
to make markets, especially in illiquid securities where predicting
near-term customer demand is difficult. Although findings are still
preliminary, some research has found that the Volcker rule has reduced
market-making activity and liquidity in times of stress.\186\ In
addition, heightened capital and liquidity standards have combined to
further disincentivize market-making and liquidity provision by banks.
Liquidity will offer the greatest benefit to our capital markets if it
is resilient and available during times of stress. If liquidity
vanishes during periods of market stress, it can exacerbate significant
price movements and reduce confidence in our markets.
---------------------------------------------------------------------------
\186\ Jack Bao, Maureen O'Hara, and Alex Zhou, The Volcker Rule and
Market Making in Times of Stress, Finance and Economics Discussion
Series Paper No. 2016-102, Board of Governors of the Federal Reserve
System (Sept. 2016), available at: https://www.federalreserve.gov/
econresdata/feds/2016/files/2016102pap.pdf.
---------------------------------------------------------------------------
Recommendations
Treasury reiterates its recommendations from the Banking Report to
improve secondary market liquidity.\187\
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\187\ The Banking Report, at 14-15.
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Securitization
Overview
The practice of securitizing cash flows through the issuance of
associated debt obligations has existed as a successful financing tool
for centuries.\188\ Modern securitization, characterized by more
complex cash flow structuring, is a relatively recent development
dating to the 1970s. Problems related to certain types of securitized
products, primarily those backed by subprime mortgage loans,
contributed to the financial crisis that precipitated the Great
Recession.\189\ As a result, the securitization market has acquired a
popular reputation as an inherently high-risk asset class and has been
regulated as such through numerous post-crisis statutory and rulemaking
changes.\190\ Such treatment of this market is counterproductive, as
securitization, when undertaken in an appropriate manner, can be a
vital financial tool to facilitate growth in our domestic economy.
Securitization has the potential to help financial intermediaries
better manage risk, enhance access to credit, and lower funding costs
for both American businesses and consumers. Rather than restrict
securitization through regulations, policymakers and regulators should
view this component of our capital markets as a byproduct of, and
safeguard to, America's global financial leadership.
---------------------------------------------------------------------------
\188\ Bonnie Buchanan, Back to the Future: 900 Years of
Securitization, 15 The Journal of Risk Finance 316 (2014).
\189\ Financial Crisis Inquiry Commission, The Financial Crisis
Inquiry Report: Final Report of the National Commission on the Causes
of the Financial and Economic Crisis in the United States (Jan. 2011)
(``FCIC Report'').
\190\ The securitization market referenced here generally refers to
the structured finance market exclusive of mortgage-backed securities
issued by Ginnie Mae, Fannie Mae, and Freddie Mac.
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Securitization in its simplest form is the process by which cash
flows from individual, often homogeneous illiquid assets are
aggregated, referred to as ``pooling,'' and sold as a new financial
instrument to investors. By pooling cash flows and creating new, more
readily tradable securities, these vehicles are able to diversify the
credit risk associated with the underlying collateral and facilitate
improved liquidity. Greater liquidity and risk diversification may
attract a deeper pool of investor capital, with the resulting cost
savings ultimately flowing to borrowers in the form of lower financing
costs.
Securitization involves numerous financial actors across its supply
chain. In a simplified example (see Figure 15), a securitizer or
sponsor, which may include the loan originator, will arrange for the
sale or transfer of a group of loans to a newly created, bankruptcy-
remote trust referred to as a special purpose vehicle, or SPV.\191\
This SPV has a balance sheet comprised of assets (the underlying loans
or leases) funded by a combination of debt and equity. A structuring
agent will tailor the mix and structure of debt and equity of the SPV,
which sells or issues asset-backed securities (ABS) to investors from
across the capital markets depending on their individual risk
tolerance.
---------------------------------------------------------------------------
\191\ See Board of Governors of the Federal Reserve System, Report
to the Congress on Risk Retention (Oct. 2010), available at: https://
www.federalreserve.gov/boarddocs/rptcongress/securitization/
riskretention.pdf (``Board Report'').
---------------------------------------------------------------------------
Figure 15: Simplified Illustrative Securitization Structure
In an illustrative senior-subordinate ABS, the issuer will sell
numerous classes, or tranches, of notes to match the specific needs of
ABS investors. In a complex deal, there may be many classes of notes
issued to investors. Generally, tranches are divided into senior,
mezzanine, and junior classes. Senior and mezzanine classes typically
carry an investment-grade rating by a nationally recognized statistical
rating organization (NRSRO), with the senior bond often carrying a AAA
rating. The junior, or subordinate, class is typically unrated.
Principal and interest payments from the underlying collateral
``waterfall'' down the capital structure of the SPV's balance sheet,
while losses associated with the default of the underlying assets are
absorbed beginning with the most junior, or first-loss, classes. More
senior classes typically do not bear credit-related cash shortfalls
until the credit enhancement from subordinate classes is
exhausted.\192\
---------------------------------------------------------------------------
\192\ Suleman Baig and Moorad Choudhry, The Mechanics of
Securitization (2013).
---------------------------------------------------------------------------
By creating tranches with various risk profiles from the same pool
of underlying assets, a securitization vehicle allows investors to
purchase assets most suited to their risk profile. For instance, asset
managers at insurance companies may prefer the relative security of the
senior securitized tranches, while hedge funds seeking higher returns
may prefer the higher risk of the junior or mezzanine tranches. By
attracting capital from such a wide range of investors, a well-
functioning securitization market provides lenders another source of
funding outside of corporate debt, or in the case of banks, customer
deposits, giving originators greater ability to make new loans.
Modern securitization markets emerged in the 1970s, first at Ginnie
Mae and subsequently at Freddie Mac and Fannie Mae (the government-
sponsored enterprises, or GSEs).\193\ Mortgage-backed securities (MBS)
with a credit guaranty from these entities are commonly referred to as
agency MBS.\194\ Agency MBS are backed by hundreds of individual
mortgage loans to U.S. borrowers. In their more common form, these
securities are referred to as pass-throughs, as the cash flow from the
principal and interest on the mortgages underlying the securities, less
applicable fees, are passed through pro rata to the end investor.
Ginnie Mae provides a guaranty backed by the full faith and credit of
the United States for the timely payment of principal and interest on
MBS secured by pools of government home loans. The GSEs provide a
guaranty for the timely payment of principal and interest on MBS
secured by pools of home loans that meet their respective credit
quality guidelines. Although the GSEs' guaranty obligations are not
backed by the full faith and credit of the U.S. Government, the GSEs
receive capital support under agreements with Treasury. Agency MBS
trade largely in a unique, liquid forward market referred to as the to-
be-announced (TBA) market. As of the end of 2016, the agency MBS market
exceeded $7.5 trillion and represented the largest debt market after
U.S. Treasury securities.\195\ While agency MBS is by far the largest
and most liquid component of the U.S. securitization market, its unique
characteristics mean it is often discussed separately from other
securitized products that structure credit risk.\196\
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\193\ See Thomas N. Herzog, A Brief History of Mortgage Finance
with an Emphasis on Mortgage Insurance, available at: https://
www.soa.org/library/monographs/finance/housing-wealth/2009/september/
mono-2009-mfi09-herzoghistory.pdf.
\194\ See Federal Reserve Bank of New York Staff Reports, TBA
Trading and Liquidity in the MBS Market (Aug. 2010), available at:
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/
sr468.pdf.
\195\ See SIFMA US Bond Market Issuance and Outstanding (July
2017), available at: www.sifma.org/research.
\196\ Id.
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Figure 16: U.S. Securitized Products Outstanding FY 2016 ($ billions)
Source: SIFMA US Bond Market Issuance and Outstanding (July
2017).
Securitized products discussed in this chapter comprise a wide
range of consumer, commercial, and corporate debt obligations.
Securities backed by cash flows from consumer loans may be divided
between structured products comprised of residential mortgage
collateral, often referred to as private-label securities (PLS) given
their distinction from the agency MBS market; and ABS, typically
collateralized by auto loans and leases, student loans, and credit card
receivables. The largest security classes backed by pools of business
and commercial collateral consist of syndicated corporate loans through
the collateralized loan obligation (CLO) market, or commercial real
estate loans through the commercial mortgage-backed securities (CMBS)
market, but may also comprise other commercial credit products,
including equipment floorplans and other commercial leases.
Additionally, tranches of asset-backed securities may themselves be
resecuritized to collateralize structured credit vehicles as part of
the collateralized debt obligation (CDO) market.
Modern computing advances in the 1970s and 1980s catalyzed
securitization through the development of computational and analysis
software permitting the structuring and analysis of thousands of loans
packaged into increasingly complex deals. In the 1980s, as short-term
interest rates rose, securitization offered banks an attractive method
to remove interest rate risk from their balance sheets while reducing
regulatory capital requirements.\197\ By the early 2000s,
securitization markets were reaching new heights, supported by
accommodative monetary policy and an influx of capital from emerging
economies. By 2007, the U.S. securitized product market exceeded $5
trillion outstanding, up from $150 billion only twenty years
prior.\198\
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\197\ FCIC Report.
\198\ Internal Treasury Analysis. Data from SIFMA US Bond Market
Issuance and Outstanding (July 2017),available at: www.sifma.org/
research.
---------------------------------------------------------------------------
Figure 17: U.S. Structured Products Outstanding 1986-2016 ($ billions)
Note: Series are cumulative.
Sources: Internal Treasury Analysis, SIFMA US Bond Market
Issuance and Outstanding (July 2017).
The proliferation of securitization combined with a lack of
discipline in the loan origination process and improperly aligned
incentives across the securitization production chain contributed to
and exacerbated the severity of the Great Recession. Bank capital
requirements for securitization exposures based on external ratings and
investor reliance on these ratings created perverse incentives for and
mechanistic over-reliance on the NRSROs. Originators, incentivized by
investor demand for loans that could be bought and packaged into
securities, expanded underwriting into high-risk non-traditional
products. Leverage in the system multiplied as issuers developed novel
securitized products to invest in and gain exposure to existing
securitized products through CDOs of PLS and other ABS.\199\
---------------------------------------------------------------------------
\199\ FCIC Report.
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When the credit bubble burst and the inherent weakness in pre-
crisis credit underwriting became apparent, limited transparency into
the quality of the collateral supporting securitizations exacerbated
broader capital market illiquidity. Investors were unable to accurately
assess their risk exposures and many faced capital shortages as NRSROs
downgraded credit ratings across the structured product market.
Additionally, issuers faced a liquidity crisis as financing for ABS had
increasingly come to rely on short-term funding vehicles, such as repo
lines and asset-backed commercial paper collateralized by non-agency
MBS and ABS. These lines seized as the value of the collateral became
less certain. The result was billions of dollars in collateral losses,
ratings downgrades, company failures, and borrower foreclosures.\200\
---------------------------------------------------------------------------
\200\ Standard & Poors Global Market Intelligence, Ten Years After
the Financial Crisis, Global Securitization Lending Transformed by
Regulation and Economic Growth, (July 21, 2017).
---------------------------------------------------------------------------
Today, the excesses that precipitated the financial crisis
negatively color popular opinion of securitized products. Indeed,
numerous statutory and regulatory changes were passed and implemented
in recent years with the intention to remedy the pre-crisis
vulnerabilities and misaligned incentives across parties to a
securitization. Unfortunately, post-crisis reforms have gone too far
toward penalizing securitization relative to alternative, often more
traditional funding sources such as bank deposits. The result has been
to dampen the attractiveness of securitization, potentially cutting off
or raising the cost of credit to thousands of corporate and retail
consumers.
In its review of the securitization market, Treasury found:
The current regulatory regime discourages securitization as
a funding vehicle, instead encouraging lenders to fund loans
through more traditional methods such as bank deposits;
Regulatory bank capital requirements treat investment in
non-agency securitized instruments punitively relative to
investments in the disaggregated underlying collateral;
Regulatory liquidity standards unfairly discriminate against
high-quality securitized product classes compared to other
asset classes with a similar risk profile;
The requirement that sponsors retain a residual interest in
securitizations adds unnecessary costs to securitization as a
funding source, thereby inhibiting the prudent expansion of
credit through securitized products; and
Expanded disclosure requirements, while an important post-
crisis reform, are unnecessarily burdensome and could be more
appropriately tailored.
Regulatory Landscape
The performance of certain classes of securitized products during
the crisis, particularly PLS, demonstrated the need for reforms to the
securitization market. Poor underwriting in the mortgage market
represented one of the most significant drivers of losses for
securitized products. In the wake of the crisis, Congress mandated, and
the Consumer Financial Protection Bureau implemented, an ability to
repay (ATR) requirement for residential mortgage loans. This
requirement specifies certain minimum underwriting and documentation
factors for mortgage originators to use to determine a borrower's
ability to repay a mortgage and offers a presumption of compliance with
ATR for loans that meet the definition of a qualified mortgage
(QM).\201\ Treasury articulated in the Banking Report its belief that
the ATR/QM requirement currently unduly limits access to mortgage
credit and should be clarified and modified. However, the imposition of
this standard has helped eliminate the types of non-traditional
mortgage products behind many non-agency securitizations prior to the
crisis. As securitization cannot fundamentally change the aggregate
risk of the underlying collateral, efforts to improve the quality of
the assets going into securitizations are essential to improve the
securitization market more broadly.
---------------------------------------------------------------------------
\201\ 12 CFR Part 1026.
---------------------------------------------------------------------------
Additionally, Dodd-Frank eliminated regulatory reliance on NRSRO
ratings by requiring that references to credit ratings be removed from
Federal laws and regulations, and that alternative measures of
creditworthiness be used in their place.\202\ Today, capital
requirements for securitized classes are no longer based on the ratings
assigned to them by the NRSROs even though ratings agencies continue to
play an important gatekeeper role in this market.\203\ Further, Dodd-
Frank built on the Credit Rating Agency Reform Act of 2006 by enhancing
the SEC's supervisory authority over registered NRSROs,\204\ including
new requirements pertaining to internal controls, reporting,
disclosure, and accountability. Dodd-Frank also established the Office
of Credit Ratings within the SEC with a mandate to carry out annual
compliance examinations of each NRSRO.\205\ Collectively, these reforms
have improved the process by which ratings are assigned to securitized
products and helped mitigate the systemic risk associated with reliance
on such ratings.
---------------------------------------------------------------------------
\202\ See Dodd-Frank 939A.
\203\ 12 CFR Parts 208, 217, and 225.
\204\ Public Law No. 109-291.
\205\ Public Law No. 111-203.
---------------------------------------------------------------------------
Other post-crisis reforms require recalibration. Presently, rules
related to capital, liquidity, risk retention, and disclosures overly
burden activity in securitized products. In response to losses at
depository banks, regulators introduced complex, increased capital
requirements for securitized products. Additionally, due to illiquidity
attributable to securitization exposures during the financial crisis,
banking regulators excluded these assets from eligibility toward post-
crisis liquidity standards. Legislation and rulemaking also introduced
expanded disclosure requirements in response to limited transparency of
securitized assets, and most notably, imposed requirements for sponsors
to retain credit risk in securitizations in response to a perceived
misalignment of incentives between securitizers and investors. As
defined currently, these rules add unnecessary cost and complexity to
the securitization market and apply broadly across securitized product
classes, irrespective of their differences and performance history.
Below, we review securitization regulations for bank capital and
liquidity, risk retention, and disclosures, and provide recommendations
for their recalibration.
Issues and Recommendations
Capital Requirements
In July 2013, U.S. banking regulators finalized rules implementing
the Basel III capital framework \206\ and Sections 171 and 939A of
Dodd-Frank, which prohibited reliance on credit ratings and required
banking regulators to consider securitized products in establishing
risk-based capital standards.\207\ These rules established risk-based
capital requirements for the banking book (i.e., exposures not captured
in the trading book) for U.S. banks.\208\
---------------------------------------------------------------------------
\206\ See Bank for International Settlements, Basel III: A Global
Regulatory Framework for More Resilient Banks and Banking Systems (Dec.
2010 and revised Jun. 2011), available at: http://www.bis.org/publ/
bcbs189.htm.
\207\ See Dodd-Frank 171 and 939A.
\208\ 12 CFR 217.142.
---------------------------------------------------------------------------
Federal banking regulators generally require banking institutions
to derive a risk weight for securitization exposures based on a set of
prescriptive factors, primarily through what is known as the simplified
supervisory formula approach (SSFA).\209\ The SSFA considers risk
factors such as the capital required of the underlying assets,
delinquencies, and the attachment and detachment points of the exposure
to determine an aggregate risk weight. The SSFA formula additionally
imposes a supervisory surcharge, referred to as the p factor, which
represents the multiple above the disaggregated loan capital charge
assigned to hold the collateral as a securitization.\210\ Under the
current capital regulation, p is specified at 0.5, which may be
interpreted as a 50% surcharge on holding the underlying asset in
securitized form. In revisions to its capital framework, the Basel
Committee on Banking Supervision (BCBS) has proposed raising the p-
factor for traditional securitizations to 1.0.\211\ Furthermore, SSFA
does not recognize unfunded forms of credit support as added credit
enhancement in determining the attachment point of a securitization
interest. As such, a bank is not able to recognize added credit
protection when it carries or purchases a securitization interest at
less than its par value.\212\
---------------------------------------------------------------------------
\209\ Id. at 217.144.
\210\ Id. at 217.144(b)(5).
\211\ See Bank for International Settlements, Revisions to the
Securitisation Framework (Dec. 2013), available at: http://www.bis.org/
publ/bcbs269.pdf (``Basel III Revisions'').
\212\ See Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition Provisions,
Prompt Corrective Action, Standardized Approach for Risk-weighted
Assets, Market Discipline and Disclosure Requirements, Advanced
Approaches Risk-Based Capital Rule, and Market Risk Capital Rule [78
Fed. Reg. 62017, 62120 (Oct. 11, 2013)] (``Bank Capital Rules'').
---------------------------------------------------------------------------
In order to mitigate model risk and provide a level of
standardization, securitization exposures, excluding agency MBS, are
subject to a risk-weight floor of 20%.\213\ While this risk-weight
floor, finalized in 2013, was consistent with the BCBS's recommended
floor, the BCBS has since revised its securitization framework to lower
the recommended floor to 15%.\214\ The European Banking Authority has
similarly recommended that European regulatory bodies lower the minimum
capital floor for qualifying senior tranches.\215\ For U.S. banks, the
risk-weight floor remains 20% for structured securities. If this
recommendation is adopted, U.S. banks may be placed at a competitive
disadvantage to their European peers.
---------------------------------------------------------------------------
\213\ 12 CFR 217.144(c).
\214\ See Basel III Revisions.
\215\ See European Banking Authority, Report on Qualifying
Securitisation (July 2015), available at: https://www.eba.europa.eu/
documents/10180/950548/EBA+report+on+qualifying+
securitisation.pdf.
---------------------------------------------------------------------------
A smaller number of regulated bank holding companies use the
supervisory formula approach (SFA) under the advanced approach risk-
based capital rule.\216\ The SFA requires additional parameters beyond
SSFA.\217\ While the standard and advanced approaches differ in
complexity and application, they both, by design, may result in the
same higher capital charge for securitized assets versus holding the
same underlying assets on balance sheet.\218\
---------------------------------------------------------------------------
\216\ 12 CFR 217.143.
\217\ See Office of the Comptroller of the Currency, Guidance on
Advanced Approaches GAA 2015-01: Supervisory Guidance for
Implementation of the Simplified Supervisory Formula Approach for
Securitization Exposures Under the Advanced Approaches Risk-Based
Capital Rule (May 19, 2015), available at: https://www.occ.treas.gov/
topics/capital/gaa-2015-01.pdf.
\218\ See Bank Capital Rules, at 62119.
---------------------------------------------------------------------------
Under bank capital rules, risk-based capital for securitizations is
required to be held against consolidated balance sheet assets, as
determined by accounting treatment.\219\ Under generally accepted
accounting principles implemented in 2010, a bank securitizer may be
required to consolidate ABS trusts onto its balance sheet if it
maintains a controlling financial interest in the vehicle.\220\ A
securitization consolidated for accounting purposes on the sponsoring
bank's balance sheet would require the sponsor to hold capital against
that exposure.\221\ Thus, for certain securitized asset classes, even
when risk has been effectively sold or transferred to investors through
the issuance of asset-backed notes, a sponsoring bank may still be
required to hold capital against the underlying assets. By tying
capital requirements for securitized products to an accounting
treatment rather than a risk transfer treatment, this practice may
result in the financial system holding duplicative capital against the
same exposure.
---------------------------------------------------------------------------
\219\ Id. at 62083 [codified at 12 CFR 217.2].
\220\ Financial Accounting Standards Board (FASB): Accounting
Standards Codification Topic 860, Transfers and Servicing (ASC 860,
commonly FAS 166); and FASB Accounting Standards Codification Topic
810, Consolidation (ASC 810, commonly FAS 167).
\221\ See Board Report.
---------------------------------------------------------------------------
Banks have additional capital requirements for securitized products
held in their trading books. In January 2016, the BCBS issued its final
update on the revised minimum capital standard for market risk, known
as the Fundamental Review of the Trading Book (FRTB).\222\ U.S. banking
regulators have not announced how they might implement FRTB. The
revised standard increases capital requirements for securitizations by
changing the capital calculation under the current trading book capital
requirements to a revised standardized approach for market risk. Under
this approach, banks would be required to hold capital sufficient to
withstand large credit spread shocks in securitized products held for
trading, even if the severity of those shocks are disconnected from the
credit quality of the underlying collateral.
---------------------------------------------------------------------------
\222\ See Basel Committee on Banking Supervision, Fundamental
Review of the Trading Book: A Revised Market Risk Framework (Oct.
2013), available at: http://www.bis.org/publ/bcbs265.pdf.
---------------------------------------------------------------------------
The implied capital required under FRTB would make secondary market
activity uneconomical for many banks, thereby hindering ABS liquidity.
Without ABS liquidity, securitization may be a far less economical
funding proposition. Under FRTB, the additional capital requirements
would be additive to SSFA requirements. As such, this duplicative
capital requirement could dramatically exceed the economic exposure on
the bond itself. Such requirements would act as a disincentive for
banks to participate in secondary market trading for securitized
products, thereby reducing liquidity vital to the success of this
market.
Securitized product liquidity is further hindered by the punitive
capital treatment of these products under bank stress testing
requirements. Comprehensive Capital Analysis and Review (CCAR) and
Dodd-Frank Act Stress Test (DFAST) regimes were mandated by Dodd-Frank
and implemented by Federal banking regulators to assess capital
sufficiency during adverse economic environments.\223\ Currently, the
Federal Reserve's global market shock assumptions for the trading book
require banks to apply the peak-to-trough changes in comparable asset
valuations from the 2007-09 period without sufficiently tailoring such
shocks to the collateral quality or safeguards implemented since the
crisis.\224\ For example, under CCAR, a AAA-rated non-agency
residential security is subject to a price shock of 31.5%, regardless
of the quality of the mortgages collateralizing the exposure and the
expected associated price decline.\225\
---------------------------------------------------------------------------
\223\ 12 U.S.C. 5365(i).
\224\ See Board of Governors of the Federal Reserve, 2017
Supervisory Scenarios for Annual Stress Tests Required under the Dodd-
Frank Act Stress Testing Rules and the Capital Plan Rule (Feb. 2017),
available at: https://www.federalreserve.gov/newsevents/pressreleases/
files/bcreg20170203a5.pdf.
\225\ See SIFMA, Rebalancing the Financial Regulatory Landscape
(Apr. 2017), available at: https://www.sifma.org/wp-content/uploads/
2017/05/SIFMA-EO-White-Paper.pdf.
---------------------------------------------------------------------------
The current treatment of securitization exposures in DFAST and CCAR
along with punitive treatment under bank capital rules have imposed an
outsized cost on market makers for securitized products and contributed
to these participants reducing their holdings and trading activity of
structured products. Given the vital role our depositories play in the
intermediation of consumer and corporate financing, regulations that
discourage additional funding sources like securitization should be
recalibrated.
Recommendations
Treasury recommends that banking regulators rationalize the capital
required for securitized products with the capital required to hold the
same disaggregated underlying assets. Capital requirements should be
set such that they neither encourage nor discourage funding through
securitization, thereby allowing the economics of securitization
relative to other funding sources to drive decision making.
Rationalizing banking and trading book capital requirements may
encourage additional bank participation in this asset class.
U.S. banking regulators should adjust the parameters of both the
SSFA and the SFA. The p factor, already set at a punitive level that
assesses a 50% surcharge on securitization exposures, should, at
minimum, not be increased. Furthermore, SSFA should recognize the added
credit enhancement that exists when a bank holds a securitization at a
discount to par value.
U.S. banking regulators should align the risk weight floor for
securitization exposures with the Basel recommendation. In today's
global capital markets, regulations should ensure U.S. banks are on a
level playing field with their global competitors.
Additionally, bank capital for securitization exposures should
sufficiently account for the magnitude of the credit risk sold or
transferred in determining required capital instead of tying capital to
the amount of the trust that is consolidated for accounting purposes.
Concerning bank trading book requirements, regulators should
consider the impact that capital standards, such as FRTB, would have on
secondary market activity. Capital requirements should be recalibrated
to prevent the required amount of capital from exceeding the maximum
economic exposure of the underlying bond.
For stress testing requirements, the Federal Reserve Board should
consider adjusting the global market shock scenario for trading
exposures to more fully consider the credit quality of the underlying
collateral and reforms implemented since the crisis.
Liquidity Requirements
Among the Basel III reforms introduced following the financial
crisis were two global liquidity standards: the Liquidity Coverage
Ratio (LCR) and the Net Stable Funding Ratio (NSFR).\226\ U.S. banking
regulators finalized LCR rules in 2013.\227\ The final LCR was
implemented to help ensure designated banks maintained a sufficient
amount of unencumbered high-quality liquid assets (HQLA) to weather
cash outflows during a prospective 30 calendar-day period of economic
stress. Assets deemed to be liquid and readily marketable were
designated as HQLA under three categories: level 1 liquid assets, level
2A liquid assets, and level 2B liquid assets, with the latter two
categories subject to haircuts and caps toward total HQLA.\228\
---------------------------------------------------------------------------
\226\ See Basel Committee on Banking Supervision, Basel III: The
Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools (Jan.
2013), available at: http://www.bis.org/publ/bcbs238.pdf, and Basel
III: The Net Stable Funding Ratio (Oct. 2014), available at: http://
www.bis.org/bcbs/publ/d295.pdf.
\227\ 12 CFR Part 249.
\228\ Id.
---------------------------------------------------------------------------
While the final Basel III LCR rule laid out a framework for
national regulators to consider including non-agency residential
securities as level 2B HQLA, U.S. banking regulators elected to exclude
all non-agency securitized products from counting toward a bank's LCR
requirement as HQLA regardless of their seniority and performance
history.\229\ By excluding even senior tranches of securitizations from
LCR, regulators signaled that they consider all securitized products
illiquid during a period of market stress. This assumption ignores both
changes made to the market in recent years and the outsized role the
lack of transparency into underlying collateral quality played in
causing illiquidity during the crisis.
---------------------------------------------------------------------------
\229\ See Liquidity Coverage Ratio: Liquidity Risk Measurement
Standards (Sept. 3, 2014) [79 Fed. Reg. 61440 (Oct. 10, 2014)].
---------------------------------------------------------------------------
Under the current LCR rule, other asset classes that experienced
similar, or worse, illiquidity during the crisis have been made
eligible to count toward HQLA. Investment-grade corporate debt, for
example, experienced price declines of 18% through the financial
crisis, greater than both AAA auto and card securitizations; yet a
depository may count investments in investment-grade corporate debt, at
a 50% haircut to fair value, as level 2B HQLA for purposes of
satisfying the LCR requirement.\230\ To be eligible for treatment as
HQLA, these corporate debt securities must meet certain requirements,
including that the issuing entity's obligations have a track record of
liquidity during risk-off markets and that they are not obligations of
a regulated financial company.\231\
---------------------------------------------------------------------------
\230\ See Structured Finance Industry Group, Regulatory Reform:
Securitization Industry Proposals to Support Growth in the Real Economy
(Apr. 2017), available at: http://www.sfindustry.org/images/uploads/
pdfs/SFIG_White_Paper_-_Regulatory_Reform_%28Digi
tal%29.pdf.
\231\ 12 CFR 249.20(c).
---------------------------------------------------------------------------
Recommendations
High-quality securitized obligations with a proven track record
should receive consideration as level 2B HQLA for purposes of LCR and
NSFR. Regulators should consider applying to these senior securitized
bonds a prescribed framework, similar to that used to determine the
eligibility of corporate debt, to establish criteria under which a
securitization may receive HQLA treatment.
Risk Retention
The imposition of securitizer or sponsor risk retention
requirements has generated substantial controversy among market
participants. Section 941 of Dodd-Frank amended the Exchange Act to
require the sponsor of an asset-backed security to retain not less than
5% of the credit risk of the assets collateralizing the
securities.\232\ Six agencies--the SEC, Office of the Comptroller of
the Currency, Federal Reserve Board, FDIC, Federal Housing Finance
Agency, and Department of Housing and Urban Development (HUD)--were
required to jointly prescribe regulations to implement the Section 941
requirements; the agencies published a final rule in December 2014,
referred to as the Credit Risk Retention Rulemaking.\233\ The rule
became effective for residential-backed new issues in December 2015 and
for all other classes of ABS in December 2016. Under the Credit Risk
Retention Rulemaking, sponsors of asset-backed securitizations must
retain an economic interest in the credit risk of the structure either
in the form of an eligible horizontal (first loss) interest, an
eligible vertical interest, or a combination of both (L-shaped
interest).
---------------------------------------------------------------------------
\232\ 15 U.S.C. 78o-11.
\233\ Credit Risk Retention [79 Fed. Reg. 77602 (Dec. 24, 2014)].
---------------------------------------------------------------------------
Dodd-Frank specifically exempts sponsors from risk retention where
the collateral satisfies the definition, established under joint
rulemaking, of a qualified residential mortgage, which the rulemaking
agencies aligned with the qualified mortgage definition set by Dodd-
Frank amendments to the Truth in Lending Act for ATR/QM.\234\ Section
941 also required the banking agencies to include underwriting
standards that indicate a low credit risk for commercial mortgages,
commercial loans, and automobile loans. As such, the rule-writing
agencies could require risk retention that is less than 5% if the asset
underwriting standards are met.
---------------------------------------------------------------------------
\234\ 17 CFR 246.13.
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The banking agencies do not appear to have undertaken a
sufficiently robust economic analysis on the impact of the thresholds
when setting the exemption requirements for commercial loans,
commercial mortgages, and high-quality automobile loans, with the
result that the eligible nonresidential classes seldom qualify for the
exemptions provided under the Credit Risk Retention Rulemaking. For
example, loans backing auto securitizations are required to have a
minimum 10% down payment, among other standards, to qualify for
exemption.\235\ Auto loans, however, are often financed with lower down
payment requirements (or none at all), rendering even well-underwritten
collateral subject to issuer risk retention.
---------------------------------------------------------------------------
\235\ Id. at 246.18.
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In the Credit Risk Retention Rulemaking, agencies also subjected
managers of CLOs to the risk retention rule under the determination
that CLO managers fell within the statutory definition of
securitizers.\236\ CLOs are structured products backed by leveraged
loans from both large and small U.S. companies. Unlike other
securitized products, where an originator may originate loans with the
intent to sell them, CLO managers do not originate the underlying loans
that they select for the CLO vehicle and are typically compensated with
management fees contingent on the performance of the underlying loans.
These attributes makes CLO managers more like asset managers in this
regard. The imposition of the retention requirement on CLO managers has
the potential to create particular burdens given the more limited
access to capital for these market participants. Furthermore, the
departure of smaller CLO managers lacking the ability to raise the
necessary capital to comply with the retention requirement could force
an unhealthy consolidation of the number of issuers who are able to
service this important sector of corporate borrowing in the United
States.
---------------------------------------------------------------------------
\236\ See Credit Risk Retention, 79 Fed. Reg. at 77650.
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Finally, the Credit Risk Retention Rulemaking required that
qualified third-party purchasers and sponsors of CMBS horizontal
interests, as well as non-QRM residential sponsors, retain their
interest for a minimum of 5 years, with non-QRM residential sponsors
also subject to a minimum balance threshold, to allow sufficient time
for losses resulting from underwriting defects to become evident.\237\
Other asset-backed securities subject to risk retention require
sponsors to hold the residual interest for a minimum of 2 years or
until the aggregate unpaid balance of ABS interests has been reduced to
33%.
---------------------------------------------------------------------------
\237\ 17 CFR 246.7(b)(8)(ii)(A) and 246.12(f)(2)(A).
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Recommendations
Risk retention is an imprecise mechanism by which to encourage
alignment of interest between sponsors and investors. However, sponsor
``skin-in-the-game'' can serve as a complement to other regulatory
reforms, such as enhanced disclosure requirements and underwriting
safeguards, to provide added confidence to investors in securitized
products. Instead of recommending an across-the-board repeal of the
retention requirement, Treasury recommends that Federal banking
regulators expand qualifying risk retention exemptions across eligible
asset classes based on the unique characteristics of each securitized
asset class, through notice-and-comment rulemaking.
Well-documented and conservatively underwritten loans and leases,
regardless of asset class, should not require signaling, through
retention, from the sponsor as to the creditworthiness of the
underlying collateral. Asset-specific disclosure requirements should
provide investors with confidence that securitizations of assets that
are deemed ``qualified'' are sound enough to warrant exemption. This
expanded exemption would reduce the cost to issue and could encourage
additional funding through securitization. Treasury reiterates the
prior recommendations regarding risk retention for residential mortgage
securitizations, as stated in the Banking Report.\238\
---------------------------------------------------------------------------
\238\ The Banking Report, at 101.
---------------------------------------------------------------------------
Additionally, regulators should review the mandatory 5 year holding
period for third-party purchasers and sponsors subject to this
requirement. To the extent regulators determine that the emergence
period for underwriting-related losses is shorter than 5 years, the
associated restrictions on sale or transfer should be reduced
accordingly.
Regarding the requirement that CLO managers retain risk even though
they do not originate the loans that they select for inclusion in their
securitization, Treasury recommends that the rulemaking agencies
introduce a broad qualified exemption for CLO risk retention. CLO
managers, like other sponsors who are subject to risk retention, do
have discretion in the quality of the loans they select for their
vehicles. In the same vein as the broader recommendation that risk
retention not be statutorily eliminated but should instead be right-
sized, Treasury recommends creating a set of loan-specific requirements
under which managers would receive relief from being required to retain
risk.
Finally, as stated in the Banking Report, Congress should designate
a lead agency, from among the six that promulgated the Credit Risk
Retention Rulemaking, to be responsible for future actions related to
the rulemaking.\239\ Designating one agency with responsibility for the
rulemaking going forward would avoid the challenge of coordinating the
agencies to issue interpretative guidance or exemptive relief.
---------------------------------------------------------------------------
\239\ Id.
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Disclosure Requirements
In 2004, the SEC introduced registration, disclosure, and reporting
requirements for the rapidly growing asset-backed securities
market.\240\ These requirements, known as Regulation AB, implemented
changes to the Securities Act and the Exchange Act. Due in part to the
lack of transparency regarding the collateral quality of asset-backed
securities during the financial crisis, the SEC proposed additional ABS
disclosure requirements, referred to as Reg AB II, in the aftermath of
the crisis. The SEC published final rules for certain asset classes in
2014.\241\
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\240\ See Asset-Backed Securities (Dec. 22, 2004) [70 Fed. Reg.
1506 (Jan. 7, 2005)] (``Regulation AB'').
\241\ See Asset-Backed Securities Disclosure and Registration
(Sept. 4, 2014) [79 Fed. Reg. 57184 (Sept. 24, 2014)] (``Regulation AB
II'').
---------------------------------------------------------------------------
For the ABS market, issuers had historically provided pool-level
information rather than detailed asset-level information. Issuers
provided information at a more granular level for only a small number
of data fields. A standardized format did not exist, nor did agreed-
upon data points across issuances, even within the same asset class.
Reg AB II, by implementing disclosure requirements for registered,
public issuances, was intended to provide an additional level of
transparency to the market to address these perceived shortcomings of
the pre-crisis securitization market.
Section 942 of Dodd-Frank required the SEC to adopt disclosure
requirements for asset-backed securities in order that these securities
include ``asset-level or loan-level data, if such data is necessary for
investors to independently perform due diligence.'' \242\ In its final
rules implementing this provision and other reforms, the SEC extended
loan-level disclosure requirements to ABS backed by residential
mortgages, commercial mortgages, auto loans or leases,
resecuritizations of these types of ABS, and securities backed by
corporate debt. Specifically, the rule required 270 unique asset-level
fields for PLS, 152 for CMBS, 72 for auto loan ABS, and 60 for debt
security ABS resecuritizations.\243\
---------------------------------------------------------------------------
\242\ See Dodd-Frank 942(b).
\243\ See Regulation AB II, 79 Fed. Reg. at 57210, 57222, 57225,
and 57229.
---------------------------------------------------------------------------
In addition to the requirements above, the final Reg AB II rule
required that issuers of registered securitizations publish this asset-
level information at least 3 days before bringing a deal to
market.\244\ With these rules, the SEC hoped to address a persistent
problem in the ABS market prior to the crisis, whereby investors felt
pressured to forego independent diligence of collateral, amidst an
aggressive demand for structured products, and instead rely on the
credit ratings assigned by the NRSROs.
---------------------------------------------------------------------------
\244\ 17 CFR 230.424(h)(1).
---------------------------------------------------------------------------
In both Regulation AB and Reg AB II, the SEC undertook an
inherently difficult balancing act--weighing the need to provide
investors sufficient transparency into the risk profile of the
underlying assets against the burden placed upon issuers to furnish
detailed, asset-specific information. In Regulation AB, the SEC elected
to set collateral-specific disclosure requirements at a principles-
based level to prevent ``the accumulation of unnecessary detail,
duplicative or uninformative disclosure and legalistic recitations of
transaction terms that obscures material information.'' \245\ This
standard is reasonable to measure the adequacy of disclosure
requirements. Current regulations that require up to 270 unique data
fields at the loan level are inconsistent with this goal.
---------------------------------------------------------------------------
\245\ See Regulation AB, 70 Fed. Reg. at 1532.
---------------------------------------------------------------------------
Investors in securitized products broadly welcomed the enhanced
disclosure requirements mandated by Dodd-Frank. However, issuers have
stated that the increased cost and compliance burdens, lack of
standardized definitions, and sometimes ambiguous regulatory guidance
has had a negative impact on the issuance of new public
securitizations.
Under the final rule, the SEC noted that the proposals to expand
asset-level disclosure requirements to private placement of securitized
products, as 144A offerings, as well as additional securitized asset
classes in registered offerings, including those structures backed by
equipment floorplan leases, revolving consumer credit (credit card),
and student loans, remained outstanding.\246\ However, the SEC has not
taken additional action relative to disclosure requirements for 144a
offerings or for these additional asset classes.
---------------------------------------------------------------------------
\246\ See Regulation AB II, 79 Fed. Reg. at 57190.
---------------------------------------------------------------------------
Recommendations
The scope of asset-level data required by Reg AB II warrants review
and recalibration. The number of required reporting fields for
registered securitizations should be reduced. Additionally, the SEC
should continue to refine its definitions to better standardize the
reporting requirements on the remaining required fields. Treasury
agrees with the SEC that standardization and transparency can better
enable the investor community to compare asset quality across deals.
However, Treasury suggests that a sufficient level of transparency and
standardization can be achieved at fewer than the current number of
required fields.
Additionally, the SEC should explore adding flexibility to the
current asset-level disclosure requirements by instituting a ``provide
or explain regime'' for pre-specified data fields. Under such a
framework, certain asset-level data fields would be required. However,
other fields may be omitted provided an issuer identifies the omitted
field in the prospectus and includes an explanation for the omission.
Such opt-out flexibility may lower costs for issuers and incentivize
them to bring additional deals to market without sacrificing
transparency.
In addition, the SEC should review its mandatory 3 day waiting
period for registered issuance. Issuers face additional risk of price
movement during that 3 day period, which does not include weekends,
thus extending the lock-out to 5 days for offerings that become
effective on a Thursday or Friday. Proper standardization of required
fields should facilitate accelerated analysis of the collateral on the
part of prospective investors, potentially only requiring one or two
business days, dependent on securitized asset class, instead of the
current three.
Finally, the SEC should signal that it will not extend Reg AB II
disclosure requirements to unregistered 144A offerings or to additional
securitized asset classes. ABS collateralized by equipment loans or
leases, floorplan financings, student loans, and revolving credit card
debt lack uniformity across the underlying loans and loan terms. As
such, while disclosure remains an important tool to bolster investor
confidence and provide sufficient market transparency, cohort-level or
grouped-account disclosures as currently provided should suffice for
these additional asset classes.
Derivatives
Overview
Overview of Derivatives and their Uses
In financial markets, ``derivatives'' are a broad class of
financial instruments or contracts whose prices or terms of payment are
dependent on, or derive from, the value or performance of another asset
or commodity.\247\ Unlike stocks and bonds, which are generally used by
issuers to raise capital for their business and traded by investors
hoping to earn a return on their investment, derivatives originated
primarily for the purpose of managing, or hedging, the risks associated
with the underlying assets. Such risks stem from unknown future changes
in commodity prices, interest rates, foreign currency exchange rates,
or other factors. The greater the degree of uncertainty around such
changes--i.e., the volatility--the greater the risk that must be
managed. While their usage has grown and become more complex,
derivatives have been used in one form or another since ancient times,
for example by farmers and merchants managing risks regarding the
future delivery and price of livestock or crops.
---------------------------------------------------------------------------
\247\ For a full discussion of derivatives, see, e.g., John C.
Hull, Options, Futures and Other Derivatives (8th edition), Pearson/
Prentice Hall (2012); and
---------------------------------------------------------------------------
Derivatives are also used for speculative purposes. In contrast to
hedgers who seek to manage existing risks, speculators use derivatives
to take on risk with the aim of profiting from their trading
activities. Essentially, speculators take on a derivatives position
betting either that the price of the underlying commodity or reference
price will increase or decrease. When speculators correctly anticipate
price movements, they profit; when prices move against them,
speculators incur losses. Through their trading activity, speculators
provide an important source of liquidity for the markets, often taking
the opposite side of hedgers' positions.
The term derivatives encompasses several specific types of
financial instruments--for example, forwards, futures, options, and
swaps.
Types of Derivatives
------------------------------------------------------------------------
Derivative Features Simplified Example
------------------------------------------------------------------------
Forward Agreements A private A farmer plans to grow
agreement to buy or 1,000 bushels of
sell a commodity or wheat but wants to be
asset at a certain sure he will get a
future date for a good price for his
certain price crop. He enters into
Traded a forward agreement
bilaterally in the with a grain merchant
over-the-counter to sell his wheat for
markets, each an agreed-upon price
agreement may be at harvest time. With
customized (e.g., in a locked-in price,
terms of delivery the farmer is
time, or quality and protected if wheat
quantity of goods to prices fall, but he
bedelivered) will still only
Generally not receive the price in
regulated the agreement even if
wheat prices are
higher at harvest
time.
Futures Contracts \248\ A highly An airline that
standardized, exchange- expects fuel prices
traded contract to buy to rise wants to
or sell a commodity hedge its costs for
for delivery in the an upcoming purchase
future of jet fuel. To do
The exchange so, the airline takes
specifies certain a long position in
standardized features exchange-traded, cash-
of the contract, such settled oil futures
as quality and contracts that are
quantity of goods to correlated with cash-
be delivered market jet fuel
Both buyer and prices. When it is
seller are obligated time to purchase the
to fulfill the jet fuel, the airline
contract at the price takes an offsetting
agreed at the short position in the
initiation of the oil futures
contract, whether contracts. If oil
profitable or not prices have
May be settled increased, the
by delivery of the airline will earn a
underlying commodity, profit on its oil
by cash, or by futures position,
purchasing an which should serve to
offsetting contract offset the ``loss''
through the exchange arising from
Regulated by purchasing the jet
the Commodity Futures fuel it needs at the
Trading Commission higher price. The
(CFTC) (exclusive converse happens if
jurisdiction) oil prices have
decreased. The better
the correlation
between the cash and
futures markets
prices, the more
effective the hedge
will be.
\248\ The CFTC and the
SEC jointly regulate
``security futures,''
a statutorily defined
separate class of
derivatives. Security
futures are contracts
for the sale or future
delivery of a single
security or of a
narrow-based security
index and can be based
on a variety of
reference securities
or prices.
Options A contract A currency trader
that gives the buyer believes the U.S.
the right, but not the dollar/euro exchange
obligation, to buy (a rate is trending
call option) or sell upward. Hoping to
(a put option) a profit from her view,
specified quantity of she buys a call
a commodity or other option on euros
instrument at a expiring in 3 months
specific price within which gives her the
a specified period of right, but not the
time, regardless of obligation, to buy
the market price of euros at the option's
that instrument strike price. The
The buyer of trader has to pay a
an option pays a premium for this
premium for the right right. (Conversely,
to buy or sell the seller of the
Traded both on option receives the
exchanges and over-the- premium, but is
counter obligated to sell
Regulated euros at the strike
either by the CFTC or price if the trader
the Securities and exercises the
Exchange Commission, option.) Three months
depending on later, if the U.S.
underlying asset or dollar/euro exchange
index rate is above the
strike price (i.e.,
the option is in-the-
money), the trader
will exercise the
option and realize a
gain on the currency
trade. Her gain,
however, is offset by
the premium she paid
for the call option.
She will not exercise
the call option at
maturity if the U.S.
dollar/euro exchange
rate is below the
strike price (it is
out-of-the-money),in
which case her loss
is limited to the
premium paid.
Swaps \249\ A contract Two companies, each
between two with an outstanding 5
counterparties year $10 million
providing for the loan, have different
exchange of cash flows views of the future
based on differences path of interest
or changes in the rates. Company A,
value or level of the with a floating-rate
underlying commodity, loan, is concerned
asset, or index interest rates will
Swaps go up, leading to
categories: Interest higher interest costs
rate swaps, credit on its loan. Company
index swaps, foreign B, with a fixed-rate
exchange swaps, equity loan, thinks interest
index (broad-based) rates will stay the
swaps, and other same or even decline
commodity swaps over the 5 years of
Previously its loan. The two
unregulated. Post-Dodd- companies enter into
Frank, regulated by a 5 year interest
the CFTC (security- rate swap under which
based swaps regulated Company A will pay
by the SEC) interest to Company B
at a fixed rate, and
Company B will pay
interest to Company A
at a variable rate
(for example, prime +
0.1%) that matches
Company A's floating
rate loan. Both sets
of interest payments
are calculated based
on a principal amount
of $10 million (but
the principal is only
``notional;'' it is
not exchanged).
Through the swap,
Company A has
transformed its
floating-rate loan
into a fixed-rate
liability. For
Company B, if
interest rates go
down as it
anticipates, its
payments to Company A
will be lower while
it continues to
receive fixed
payments from Company
A.
\249\ For a legal
definition of
``swap,'' see 7 U.S.C.
1a(47) and 17 CFR
1.3(xxx); for
``security-based
swap,'' see 15 U.S.C.
78c(a)(68).
------------------------------------------------------------------------
Derivatives have distinctive attributes depending on whether they
are listed and traded on an exchange or whether they are trading
bilaterally between two parties to the transaction--the so-called
``counterparties''--in the over-the-counter (OTC) marketplace.
Exchange-traded derivatives--such as futures and options--are highly
standardized as to their terms and conditions, including the quality,
quantity or other specification of the underlying assets.\250\ Because
they are standardized, exchange-traded derivatives tend to be more
liquid than OTC derivatives and are characterized by a higher degree of
price transparency. Moreover, the exchanges themselves (as well as the
exchange intermediaries who carry out trades for customers) are highly
regulated entities with enforced standards for collateralization and
risk management. Because of these protections, exchange-traded markets
tend to be accessible by a wider range of participants, including so-
called ``retail investors,'' such as individuals and small businesses.
Finally, exchange-traded derivatives are generally cleared through a
clearinghouse (often affiliated with the exchange), which mutualizes
credit and liquidity risk.
---------------------------------------------------------------------------
\250\ For clarity, options can be listed and traded on an exchange
or traded OTC, but ``futures'' always refers to an exchange-traded
contract.
---------------------------------------------------------------------------
By contrast, OTC derivatives commonly have terms that are privately
negotiated between the counterparties, and they tend to be less liquid
than exchange-traded derivatives. OTC derivatives transactions--
including forward agreements, swaps, and some options--often are much
larger than typical trades in exchange-traded markets, and some can be
extremely complex. Unless they are cleared, OTC derivatives tend to
entail a greater degree of bilateral counterparty credit risk.
For these reasons, OTC derivatives market participants are
generally limited to large institutional investors such as banks,
insurance companies, pension funds, state and local governments, and
other eligible non-financial end-users. Though many OTC derivatives are
highly customized to meet the needs of a specific party, some types of
OTC transactions have become sufficiently standardized to permit
centralized clearing and more exchange-like trading. Despite their
generally greater risks, OTC derivatives have become a significant
alternative to exchange-traded products.
Though the first derivatives originated as a means for farmers and
merchants to manage risks in agricultural markets, today derivatives
are used in virtually every segment of the U.S. and global economies,
covering nearly every conceivable type of commodity and underlying
asset. Highly complex financial contracts based on security indexes,
interest rates, foreign currencies, Treasury bonds, and other products
now greatly exceed the agricultural contracts in trading volume.\251\
It is through this growth and innovation that businesses and
organizations across every sector of the U.S. economy have become users
of both exchange-traded and OTC derivatives. Manufacturers of nearly
every variety, banks, insurance companies, importers and exporters,
pension funds, service and transportation industries and more use these
instruments as a means to manage the underlying risks associated with
their businesses and operations and benefit from the price discovery
function they provide. Indeed, derivatives have become essential
financial tools that, when used properly, allow companies to grow and
create jobs, produce goods and services for the economy, and provide
stable prices for American consumers.
---------------------------------------------------------------------------
\251\ See CFTC 2016 Financial Report, at 18-21.
---------------------------------------------------------------------------
The Commodity Exchange Act and the Commodity Futures Trading Commission
In the United States, the organized trading of futures contracts
originated in the middle of the 19th century in Chicago. As with the
securities markets, there was no Federal regulation or oversight of the
nascent futures markets. Instead, the markets operated under a form of
self-regulation, imposed through agreement among the members of an
organized exchange. The first such exchange was the Chicago Board of
Trade, established in 1848. In 1919, the Chicago Mercantile Exchange
was established. It was not until the 1920s that Congress enacted
Federal regulation of futures markets. The Grain Futures Act of 1922,
the first effective Federal law to govern trading in grain futures, was
administered by the Grain Futures Administration, an agency of the U.S.
Department of Agriculture. In 1936, Congress enacted the Commodity
Exchange Act (CEA), broadening the types of commodities on which
futures contracts could trade and transforming the Grain Futures
Administration into the Commodity Exchange Authority.
The CEA, amended and expanded numerous times since 1936, remains
today the primary Federal statute governing U.S. derivatives markets.
In 1974, the Commodity Futures Trading Commission Act amended the CEA
and established several fundamental changes in the regulation of U.S.
derivatives markets. Most significantly, Congress created the Commodity
Futures Trading Commission (CFTC) as a new independent Federal
regulatory agency. Congress transferred the authority over the futures
markets previously exercised by the Commodity Exchange Authority, the
CFTC's predecessor agency in the Department of Agriculture, to the
CFTC.\252\ In addition, Congress mandated the CFTC should have
exclusive jurisdiction over futures.\253\
---------------------------------------------------------------------------
\252\ The CFTC was officially established in 1975 when authority
for the regulation of futures trading was transferred from the
Commodity Exchange Authority, an agency in the Department of
Agriculture, to the CFTC.
\253\ For example, while U.S. states have a role in regulating
aspects of the securities markets and banking system, they are
precluded by the Commodity Exchange Act from regulating ``transactions
involving swaps or contracts of sale of a commodity for future
delivery.'' See 7 U.S.C. 2(a)(1)(A). Section 722 of Dodd-Frank
extended the CFTC's exclusive jurisdiction to include swaps other than
security-based swaps, which are regulated by the SEC.
---------------------------------------------------------------------------
When the CFTC was established, the majority of derivatives trading
consisted of futures contracts on agricultural commodities.\254\ These
contracts gave farmers, ranchers, distributors, and end-users of
products ranging from grains to livestock an efficient and effective
set of tools to hedge against price risk. Beginning in the 1970s,
however, the futures industry began to diversify beyond agricultural
products. The first futures on financial assets were on foreign
currencies, and in 1975, the newly established CFTC approved the first
futures contract on U.S. Government debt.\255\ Ultimately, the markets
overseen by the CFTC grew to encompass contracts based on metals,
energy products, and a long list of other financial products and
indexes, providing new opportunities for risk management to a wide
range of businesses across the economy. In 2010, Dodd-Frank amended the
CEA to expand the CFTC's jurisdiction to include many types of swaps.
---------------------------------------------------------------------------
\254\ The historical link between futures markets and agricultural
commodities also helps explain why the CFTC's Congressional oversight
is carried out through the Senate and House Agriculture Committees.
\255\ See Timeline of CME Achievements, available at: http://
www.cmegroup.com/company/history/timeline-of-achievements.html; and
CFTC History in the 1970s, available at: http://www.cftc.gov/About/
HistoryoftheCFTC/history_1970s.
---------------------------------------------------------------------------
The CFTC's mission is to foster open, transparent, competitive, and
financially sound markets to avoid systemic risk and protect market
users and their funds, consumers, and the public from fraud,
manipulation, and abusive practices related to derivatives and other
products subject to the CEA.\256\ To promote market integrity, the CFTC
monitors the markets and participants under its jurisdiction for abuses
and brings enforcement actions.
---------------------------------------------------------------------------
\256\ CFTC 2016 Financial Report, at 18.
---------------------------------------------------------------------------
The CFTC oversees industry self-regulatory organizations, including
traditional organized futures exchanges or boards of trade known as
designated contract markets (DCMs). The CEA generally requires futures
contracts to be traded on regulated exchanges, with futures trades
cleared and settled through clearinghouses, referred to as derivatives
clearing organizations (DCOs).
The Commodity Futures Modernization Act of 2000
In the 1980s and 1990s, the emergence and proliferation of new
types of off-exchange derivatives tested the CEA and the limits of the
CFTC's jurisdiction. End users often preferred these transactions--
broadly referred to as OTC derivatives or swaps--over standardized
exchange-traded futures and options, since they permitted end-users to
customize the terms and conditions of the transactions with greater
precision to meet their specific risk management needs. The markets for
OTC derivatives, however, operated under a cloud of legal uncertainty,
because it was unclear whether such transactions were subject to the
CEA and CFTC regulation.\257\
---------------------------------------------------------------------------
\257\ Lynn Stout, Derivatives and the Legal Origin of the 2008
Credit Crisis, 1 Harvard Business Law Review 1, at 19-20 (2011).
---------------------------------------------------------------------------
In response to these concerns and following the recommendations of
the President's Working Group on Financial Markets, Congress passed the
Commodity Futures Modernization Act (CFMA) of 2000 to provide legal
certainty for OTC swap agreements.\258\ The CFMA explicitly prohibited
the CFTC from regulating the OTC swaps markets and provided that even
purely speculative OTC derivatives contracts were legally
enforceable.\259\ Though most OTC derivatives market participants were
regulated, OTC derivatives instruments were shielded from regulation
and oversight under the CFMA. As a result, volumes in OTC derivatives
surged (see Figure 18). According to The Financial Crisis Inquiry
Report, the 2011 report of the Financial Crisis Inquiry Commission:
---------------------------------------------------------------------------
\258\ See Report of the President's Working Group on Financial
Markets, Over-the-Counter Derivatives Markets and the Commodity
Exchange Act (Nov. 1999), available at: https://www.treasury.gov/
resource-center/fin-mkts/Documents/otcact.pdf.
\259\ Lynn Stout, Why We Need Derivatives Regulation, N.Y. Times
(Oct. 7, 2009), available at: https://dealbook.nytimes.com/2009/10/07/
dealbook-dialogue-lynn-stout/. The Commodity Futures Modernization Act
also prohibited the SEC from regulating OTC swaps.
At year-end 2000, when the CFMA was passed, the notional
amount of OTC derivatives outstanding globally was $95.2
trillion, and the gross market value was $3.2 trillion. In the
7\1/2\ years from then until June 2008, when the market peaked,
outstanding OTC derivatives increased more than sevenfold to a
notional amount of $672.6 trillion; their gross market value
was $20.3 trillion.\260\ (Footnotes omitted.)
---------------------------------------------------------------------------
\260\ FCIC Report at 49.
---------------------------------------------------------------------------
Figure 18: Global OTC Derivatives by Asset Class
Source: Bank for International Settlements.
Critics of the CFMA have argued it was overly deregulatory and, as
such, helped create the conditions that allowed the financial crisis to
occur.\261\
---------------------------------------------------------------------------
\261\ Ron Hera, Forget About Housing, the Real Cause of the Crisis
was OTC Derivatives, Business Insider (May 11, 2010), available at:
http://www.businessinsider.com/bubble-derivatives-otc-2010-5.
---------------------------------------------------------------------------
Challenges During the Financial Crisis
Leading up to the financial crisis, many OTC derivatives were not
collateralized, backed by reserves, or hedged, resulting in financial
vulnerability for market participants and the U.S. financial system.
More generally, the OTC derivatives markets were characterized by
complexity, interconnectivity, and lack of transparency, as
demonstrated by the case of the Lehman Brothers failure and bankruptcy.
At the time of its bankruptcy in September 2008, Lehman had total
assets of more than $600 billion. The net worth of its total
derivatives portfolio amounted to $21 billion, approximately 96% of
which represented OTC positions. Lehman's OTC derivatives portfolio
consisted of more than 6,000 contracts involving over 900,000
transactions with myriad counterparties.
As Lehman began to experience trouble, regulators lacked
information about Lehman's claims on, and obligations to, its OTC
derivatives counterparties. This information was necessary to assess
the impact of a potential Lehman bankruptcy on its counterparties and
the broader financial system. Lehman's extensive derivatives operations
``greatly complicated its bankruptcy, and the impact of its bankruptcy
through interconnections with derivatives counterparties and other
financial institutions contributed significantly to the severity and
depth of the financial crisis.'' \262\ Approximately 80% of Lehman's
derivative counterparties terminated their contracts with Lehman
following its bankruptcy filing, as permitted by law.\263\ The
spillover effects of these terminations resulted in a massive and
direct loss of value to counterparties--whose costs included
unrecovered claims and loss of hedged positions--as well as to Lehman's
bankruptcy estate, not to mention the indirect costs including legal
and administrative fees and other externalities.
---------------------------------------------------------------------------
\262\ FCIC Report, at 343.
\263\ U.S. Government Accountability Office, Financial Regulatory
Reform: Financial Crisis Losses and Potential Impacts of the Dodd-Frank
Act (Jan. 16, 2013), at 46.
------------------------------------------------------------------------
-------------------------------------------------------------------------
Interest Rate Benchmark Reform
The London Interbank Offer Rate (LIBOR) is one of the most widely
referenced financial benchmarks and critical to the functioning of
derivatives markets. More than $300 trillion in notional value of
derivatives contracts are tied to LIBOR, primarily through the floating
leg of interest rate swaps. LIBOR was famously manipulated in the
financial crisis, and despite important reforms, its future is
increasingly threatened by a long-term decline in unsecured bank
borrowing underlies the rate. In 2014, following recommendations from
the Financial Stability Oversight Council and Financial Stability
Board, the Federal Reserve convened the Alternative Reference Rates
Committee (ARRC) to identify an alternative to LIBOR and promote market
adoption. As an ex officio member of the ARRC, Treasury believes the
adoption of a new reference rate is critical and supports the ARRC's
selection of the Secured Overnight Financing Rate. Adoption of a new
rate should be market-led, and Treasury encourages market participants
to provide input and engage in transition planning.
------------------------------------------------------------------------
Regulatory Landscape
Dodd-Frank Title VII
Title VII of Dodd-Frank was framed around four principal elements
of OTC derivatives reform:
1. Require clearing of standardized OTC derivatives transactions
through regulated central counterparties.
2. Require trading of standardized transactions on exchanges or
electronic trading platforms, where appropriate.
3. Require regular data reporting so regulators and market
participants have greater transparency into market
activity.
4. Subject OTC derivatives contracts that are not centrally cleared
to higher capital requirements.
Title VII established a comprehensive new regulatory framework for
most OTC derivatives, including new regulatory oversight for market
intermediaries, clearing requirements for certain transactions,
requirements that trade execution occur on regulated platforms, and
trade reporting to provide post-trade transparency to regulators and
the public. Title VII also required registration, oversight, and
business conduct standards for large swap entities, including swap
dealers and major swap participants, and provided enhanced rulemaking
and enforcement authorities for both the CFTC and SEC.
Dodd-Frank divided regulatory jurisdiction over swap agreements
between the CFTC and the SEC. In addition, the U.S. banking regulators,
such as the Federal Reserve, set capital and margin requirements for
swap entities that are banks. Title VII gave the CFTC authority over
the U.S. swaps market, representing approximately 95% of the overall
U.S. OTC derivatives market and covering interest rate swaps, index
credit default swaps (CDS), foreign exchange (FX) swaps, certain types
of equity swaps, and other commodity swaps (including swaps on energy
and metals). Dodd-Frank directed the CFTC to write rules implementing
registration and other regulatory requirements for swap dealers, as
well as for new market infrastructures such as swap execution
facilities (SEFs) and swap data repositories (SDRs). Title VII also
amended the Exchange Act to provide SEC authority to implement parallel
reforms for the smaller security-based swaps market. This market
comprises about 5% of the overall U.S. OTC derivatives market and
consists primarily of swaps on individual securities or loans. Common
security-based swaps include single-name CDS and total return
swaps.\264\ The following table shows an overview of the key terms and
concepts arising from the Title VII derivatives reforms.
---------------------------------------------------------------------------
\264\ The CFTC and SEC share authority over ``mixed swaps,'' which
are security-based swaps that also have a commodity component. See U.S.
Securities and Exchange Commission, Derivatives (modified May 4, 2015),
available at: https://www.sec.gov/spotlight/dodd-frank/
derivatives.shtml.
Dodd-Frank Title VII--Key Terms and Concepts
------------------------------------------------------------------------
------------------------------------------------------------------------
What key products are covered under Title VII derivatives reform?
------------------------------------------------------------------------
8Derivatives0 Any financial instrument or
contract whose price or terms of
payment is dependent upon/derived
from underlying assets
Used (a) to hedge risk in
underlying asset/commodity, or (b)
for speculative purposes
Generic term that includes
forwards, futures, options, swaps,
etc.
6Swaps0 Any agreement, contract, or
transaction that is commonly known
to the ``trade'' as a swap
Excludes futures contracts,
options on futures, forward
contracts on non-financial
commodities, and certain retail
transactions
Swaps asset categories:
Interest rate swaps, credit index
swaps, foreign exchange swaps,
equity index swaps (broad-based),
and other commodity swaps
Approximately 95% of U.S.
over-the-counter derivatives market
Regulated by the Commodity
Futures Trading Commission
6Security-based Swaps0 Any agreement, contract, or
transaction that is a swap AND based
on
------------------------------------------------------------------------
Who are the key market participants?
------------------------------------------------------------------------
8End-users0 A commercial entity that
uses swaps to hedge or mitigate
commercial risk
Non-financial end-users are
exempt from clearing, margin, etc.
Non-financial end-users are
those that are ``not a financial
entity'' as the latter term is
defined
6Swap Dealers0 Any person who:
6Major Swap Participants0 Any person who is not a swap
dealer and who:
6Security-based Swap Dealers and Regulated by the SEC
Major Security-based Swap
Participants0
4Clearing Members0 A member of a clearing
organization or central
counterparty, such as broker-
dealers, futures commission
merchants (FCMs), and swap dealers
Subject to stringent
financial, risk management and
operational requirements, and
monitored for ongoing compliance
Non-clearing members must
clear their trades through a
clearing member
Regulated by the CFTC and
SEC
------------------------------------------------------------------------
What are the key swaps and security-based swaps market structures under
Title VII?
------------------------------------------------------------------------
4Derivatives Clearing A clearinghouse, clearing
Organizations (DCOs) *0 association, or similar entity that:
4Designated Contract Markets An organized exchange or
(DCMs)0 other trading facility designated by
the CFTC that:
6Swap Execution Facilities (SEFs) A trading system or platform
*0 that provides multiple participants
the ability to execute or trade
swaps by accepting bids and offers
made by multiple participants
SEFs, unlike DCMs, may not
facilitate futures trading or retail
trading
6Swap Data Repositories (SDRs) *0 Any facility that collects,
maintains, and disseminates swaps
trade data and provides a
centralized recordkeeping facility
for swaps
------------------------------------------------------------------------
What activities are taking place under Title VII derivatives reform? *
------------------------------------------------------------------------
4Clearing0 Dodd-Frank requires certain
swaps to be submitted to a DCO for
clearing, which will result in daily
margining of all risk positions
CFTC must determine which
swaps are required to be cleared
DCOs may determine which
swaps to accept for clearing
(subject to CFTC review)
6Uncleared Swaps0 Swaps that are not cleared
by a DCO
Under Dodd-Frank, are
subject to higher risk management
standards (e.g., initial margin and
variation margin) than cleared swaps
6SEF Trading0 Swaps subject to mandatory
clearing must be traded on a SEF or
DCM, unless no SEF or DCM makes the
swap ``available to trade''
6Real-time Public Reporting0 Dodd-Frank requires real-
time public reporting of all swaps,
whether cleared or uncleared
(similar to TRACE in the bond
markets)
Involves reporting swap
transaction data (e.g., price,
volume) ``as soon as technologically
practicable'' after the execution of
the swap
------------------------------------------------------------------------
Color Key
------------------------------------------------------------------------
8Term not defined in statute.0
6Dodd-Frank definition/concept.0
4Existing or amended statutory or regulatory term/concept.0
------------------------------------------------------------------------
* Security-based swaps subject to corresponding requirements.
The CFTC has finalized substantially all of its major rulemakings
required under Title VII and has implemented the major reforms for the
swaps market. Although many CFTC rules have been implemented smoothly,
several are the subject of exemptive, no-action, and interpretive
letters or are under review by the CFTC. While the SEC has finalized
most of its major rulemakings required under Title VII, it has not yet
finalized certain key Title VII derivatives reforms for security-based
swaps.
CFTC Swaps Framework
Intermediary Oversight--Swap Dealers
Following the financial crisis, Congress determined to require
supervision and oversight of previously unregulated dealers and other
intermediaries in the OTC derivatives markets. Title VII directed the
CFTC to establish rules for the registration and regulation of swap
dealers and major swap participants. The CFTC completed its swap dealer
registration rules in 2012.\265\ The rules provide that certain
entities may be exempt from registering as swap dealers if their swap
dealing activity is below a de minimis threshold.\266\ Swap dealers
must also be registered with the National Futures Association, an
industry self-regulatory organization, which conducts examinations of
swap dealers on behalf of the CFTC, among other responsibilities. As of
Sept. 26, 2017, 102 swap dealers were provisionally registered with the
CFTC.\267\
---------------------------------------------------------------------------
\265\ Registration of Swap Dealers and Major Swap Participants
(Jan. 11, 2012) [77 Fed. Reg. 2613 (Jan. 19, 2012)].
\266\ Swap dealer registration is based in part on the aggregate
gross notional amount of the swaps that an entity enters into over the
previous 12 months in connection with dealing activities. Currently,
the de minimis threshold is $8 billion.
\267\ U.S. Commodity Futures Trading Commission, Provisionally
Registered Swap Dealers (last accessed Sep. 26, 2017), available at:
http://www.cftc.gov/LawRegulation/DoddFrankAct/registerswapdealer.
---------------------------------------------------------------------------
The CEA and CFTC rules define a swap dealer in part as a market
intermediary that holds itself out as a dealer in swaps, makes a market
in swaps, regularly enters into swaps with counterparties in the
ordinary course of business for its own account, or engages in any
activity causing the person to be commonly known in the trade as a
dealer or market maker in swaps. To ensure appropriate safeguards over
swap dealing activities, the CFTC has adopted rules intended to promote
strong risk management and high standards of business conduct among
swap dealers. For example, the CFTC released final rules in January
2016 for initial and variation margin requirements for uncleared swaps
entered into by swap dealers, and it is currently working to finalize a
rule on swap dealer capital requirements.\268\
---------------------------------------------------------------------------
\268\ Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants (Dec. 18, 2015) [81 Fed. Reg. 636 (Jan. 6,
2016)] (``CFTC Margin Requirements for Uncleared Swaps''); Capital
Requirements of Swap Dealers and Major Swap Participants (Dec. 2, 2016)
[81 Fed. Reg. 91333 (Dec.16, 2016)].
---------------------------------------------------------------------------
The CFTC's business conduct framework for swap dealers establishes
both external and internal requirements. When dealing with
counterparties, for example, swap dealers are prohibited from engaging
in abusive practices and are required to make disclosures of certain
material information to counterparties. Swap dealers must also ensure
that all counterparties are eligible to enter into swaps and must have
a reasonable basis to believe that a recommended swap is suitable for a
counterparty.\269\ Internal business conduct requirements include
standards for documentation and confirmation of transactions, as well
as dispute resolution procedures.\270\ Swap dealers are also subject to
portfolio reconciliation and portfolio compression requirements to
reduce the risks arising from multiple transactions.\271\
---------------------------------------------------------------------------
\269\ Business Conduct Standards for Swap Dealers and Major Swap
Participants with Counterparties (Jan. 11, 2012) [77 Fed. Reg. 9734
(Feb. 17, 2012)].
\270\ Confirmation, Portfolio Reconciliation, Portfolio
Compression, and Swap Trading Relationship Documentation Requirements
for Swap Dealers and Major Swap Participants (Aug. 24, 2012) [77 Fed.
Reg. 55904 (Sept. 11, 2012)].
\271\ Id.
---------------------------------------------------------------------------
Clearing Mandate and Derivatives Clearing Organizations
Title VII required that certain standardized swaps must be
centrally cleared, and it directed the CFTC to establish rules
implementing this requirement by mandating which swaps must be cleared
through CFTC-registered derivatives clearing organizations (DCOs).
Central clearing, which has long been a fundamental feature of CFTC-
regulated futures markets, serves to reduce the risk that one market
participant's default or failure could have an adverse economic impact
on its counterparty, other market participants, or the financial system
as a whole.\272\
---------------------------------------------------------------------------
\272\ Some commenters have raised policy concerns about the fact
that central clearing centralizes risk in a small number of large
entities. These issues are discussed in the Financial Markets Utilities
chapter.
---------------------------------------------------------------------------
In 2011, the CFTC finalized rules under Title VII establishing the
process the CFTC would use to review swaps to determine when swaps are
required to be cleared by eligible CFTC-registered DCOs.\273\ Under the
rules, a clearing determination takes into consideration five statutory
factors of the suitability of swaps for mandatory central clearing. In
2013, the CFTC issued its first mandatory clearing determination,
covering certain types of interest rate swaps denominated in U.S.
dollars, euros, pounds and yen, as well as credit default swaps on
certain North American and European credit indexes.\274\ In 2016, the
CFTC expanded the clearing requirement to cover interest rate swaps
denominated in nine additional foreign currencies, including the
Canadian dollar, Hong Kong dollar, and Swiss franc.\275\ This expanded
mandate is being phased in based on the date that corresponding
clearing requirements go into effect in non-U.S. jurisdictions, or
within 2 years, whichever occurs earlier.
---------------------------------------------------------------------------
\273\ Process for Review of Swaps for Mandatory Clearing (July 19,
2011) [76 Fed. Reg. 44464 (July 26, 2011)].
\274\ U.S. Commodity Futures Trading Commission, Press Release No.
6607-13 (Jun. 10, 2013), available at: http://www.cftc.gov/PressRoom/
PressReleases/pr6607-13.
\275\ U.S. Commodity Futures Trading Commission, Press Release No.
7457-16 (Sept. 28, 2016), available at: http://www.cftc.gov/PressRoom/
PressReleases/pr7457-16.
---------------------------------------------------------------------------
In 2007, only about 15% of swap transactions were cleared.\276\ By
contrast, most new interest rate swaps and index credit default swaps
are now being cleared through CFTC-registered DCOs. Based on data
reported to CFTC-registered SDRs, for the year ending June 2017,
approximately 87% of all new interest rate swap transactions were
cleared, while about 79% of index credit default swaps were cleared, as
measured by notional value (see Figure 19).
---------------------------------------------------------------------------
\276\ Chairman Timothy Massad, Remarks before the London School of
Economics (Jan. 10, 2017), available at: http://www.cftc.gov/PressRoom/
SpeechesTestimony/opamassad54.
---------------------------------------------------------------------------
Figure 19: Cleared and Uncleared Interest Rate Swaps and Index Credit
Default Swaps ($ billions)
Average daily notional volume, year ending June
Source: SDR data, as compiled by ISDA.
Along with mandatory clearing, CFTC oversight of DCOs was updated
in response to other Dodd-Frank reforms, including the CFTC's new
regulatory oversight of swaps. These updates include adopting
regulations to implement preexisting core principles for DCOs,\277\ and
finalizing rules on DCO financial resources and risk-management.\278\
Currently, there are 16 DCOs registered with the CFTC, though not all
clear swaps.\279\ The majority of swaps clearing under the CFTC's
oversight is conducted through Chicago Mercantile Exchange, Inc. (CME,
Inc.), ICE Clear Credit LLC (ICE), and LCH Ltd.
---------------------------------------------------------------------------
\277\ Derivatives Clearing Organization General Provisions and Core
Principles (Oct. 18, 2011) [76 Fed. Reg. 69334 (Nov. 8, 2011)].
\278\ Enhanced Risk Management Standards for Systemically Important
Derivatives Clearing Organizations (Aug. 9, 2013) [78 Fed. Reg. 49663
(Aug. 15, 2013)].
\279\ U.S. Commodity Futures Trading Commission, Derivatives
Clearing Organizations, available at: https://sirt.cftc.gov/sirt/
sirt.aspx?Topic=ClearingOrganizations.
---------------------------------------------------------------------------
DCOs, and central counterparties (CCPs) in general, raise a number
of policy issues in connection with their activities. As more swaps
become subject to mandatory clearing, for example, the demand for
additional collateral to be pledged for cleared transactions is
expected to increase significantly. Further, though CCPs mitigate
credit risk between counterparties, they essentially concentrate credit
risk exposure, raising questions about their risk-management, as well
as their resiliency and ability to recover in cases of market stress.
These issues are discussed in more detail in the ``Financial Market
Utility'' section of this report.
Trading Mandate and Swap Execution Facilities
Another key tenet of Title VII is to promote trading of
standardized derivatives products on regulated platforms. Specifically,
Congress required that certain swaps must be traded on a SEF or an
exchange registered as a DCM. Title VII also provided that SEFs must
register with the CFTC and comply with a set of 15 statutory core
principles that were to be further defined by the CFTC via a
rulemaking.\280\ A SEF is defined as ``a trading system or platform in
which multiple participants have the ability to execute or trade swaps
by accepting bids and offers made by multiple participants in the
facility or system, through any means of interstate commerce.'' \281\
Defined in this way, SEFs can facilitate greater pre-trade price
transparency and liquidity for market participants, while the SEF core
principles are designed to promote a more open and competitive
marketplace.
---------------------------------------------------------------------------
\280\ 7 U.S.C. 7b-3.
\281\ 7 U.S.C. 1a(50).
---------------------------------------------------------------------------
In June 2013, the CFTC finalized its rulemaking on core principles
for SEFs, which also established permitted trade execution methods for
SEFs.\282\ Concurrently, the CFTC adopted final rules establishing the
process by which SEFs and DCMs can make swaps ``available to trade.''
\283\ Under the core principles, each SEF has a general obligation to
comply with Section 5h of the CEA, both initially at registration and
on an ongoing basis. The core principles cover a number of areas,
including establishing and enforcing rules for trading and product
requirements, compliance by market participants, market surveillance
obligations, operational capabilities, and financial resource
requirements. SEFs are also required to provide impartial access to
market participants and make trading information publicly available.
---------------------------------------------------------------------------
\282\ Core Principles and Other Requirements for Swap Execution
Facilities (May 17, 2013) [78 Fed. Reg. 33476 (Jun. 4, 2013)] (known as
``SEF Core Principles Rule'').
\283\ 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 (May 17, 2013) [78 Fed. Reg. 33606 (Jun. 4,
2013)].
---------------------------------------------------------------------------
Trading on SEFs began in October 2013 and soon after, several SEFs
filed ``made available to trade'' determinations, leading to the first
trade execution mandates. Beginning in February 2014, transactions in
interest rate swaps and index credit default swaps subject to mandatory
clearing were required to take place on a SEF or DCM. Other types of
swaps, in addition to those that are required to trade on SEFs, are
also trading on the new platforms, including certain foreign exchange
swaps. For the year-ended June 2017, the average daily trading volume
of interest rate swaps across all SEFs amounted to approximately $470
billion, while index credit default swaps and FX swaps showed average
daily trading volumes of $25 billion and $41 billion, respectively (see
Figure 20). To date, 25 SEFs are fully registered with the CFTC, though
most swap trading is concentrated among a few SEFs.\284\ Nearly 75% of
trading in index credit default swaps, for example, occurs on one SEF,
with five others accounting for most of the remaining volume. In
interest rate swaps, two SEFs account for more than 50% of trading
volume, while six more SEFs make up most of the balance of trading.
Trading in FX swaps is somewhat less concentrated, with more than 90%
of volume taking place on five SEFs.\285\
---------------------------------------------------------------------------
\284\ U.S. Commodity Futures Trading Commission, Trading
Organizations--Swap Execution Facilities (SEF), available at: https://
sirt.cftc.gov/SIRT/SIRT.aspx?Topic=SwapExecution
Facilities.
\285\ See FIA's SEF Tracker for detail on SEF trading volumes,
available at: https://fia.org/.
---------------------------------------------------------------------------
Figure 20: Swaps Traded on Swap Execution Facilities ($ billions)
Average Daily Volume, Year Ending June
Source: Data reported by SEFs, compiled by FIA.
Data Reporting and Swap Data Repositories
The final element of swaps reform was ongoing reporting of swap
activity to achieve greater post-trade transparency for regulators and
the public. For this purpose, Title VII established SDRs, a new type of
market entity under CFTC jurisdiction, and tasked these organizations
with the responsibility for collecting, maintaining, and disseminating
swap trade data. SDRs are subject to registration and core principle
requirements under CFTC rules.\286\ The CFTC phased in mandatory
reporting of swaps by asset class and type of counterparty between
December 2012 and August 2013. There are currently four SDRs
provisionally registered with the CFTC.\287\
---------------------------------------------------------------------------
\286\ Swap Data Repositories: Registration Standards, Duties and
Core Principles (Aug. 4, 2011) [76 Fed. Reg. 54538 (Sept. 1, 2011)].
\287\ U.S. Commodity Futures Trading Commission, Swap Data
Repository Organizations, available at: https://sirt.cftc.gov/sirt/
sirt.aspx?Topic=DataRepositories.
---------------------------------------------------------------------------
Title VII included both regulatory and public reporting
requirements for swap transactions. All swap trades entered into by
U.S. persons must be reported to SDRs, even if they are not cleared or
executed on a centralized platform. Pricing data and certain other
transaction details are publicly released. To promote price discovery
and market efficiency, the CFTC's swap data reporting rules require
real-time public dissemination of much of this data.\288\ The full
scope of swaps trade data collected by SDRs is available to the CFTC.
This data is used by the CFTC to conduct oversight and surveillance of
the markets and to carry out its statutory responsibilities.
---------------------------------------------------------------------------
\288\ Real-Time Public Reporting of Swap Transaction Data (Dec. 20,
2011) 77 Fed. Reg. 1182 (Jan. 9, 2012). A separate rulemaking provides
for reporting delays for certain block trades.
---------------------------------------------------------------------------
SEC Security-based Swaps Framework
The SEC has proposed all of the major rules it is required to
complete under Title VII relating to the regulation of security-based
swaps. While several of these rules have been finalized, several
critical rulemakings have not yet been finalized. In particular, the
SEC has either not finalized or not yet fully implemented the following
key Dodd-Frank reforms relating to security-based swaps: registration
and regulation of security-based swap dealers, trade reporting,
mandatory central clearing of standardized security-based swaps, and
trade execution requirements. Key rules relating to security-based
swaps that the SEC still needs to finalize include:
regulation of security-based swap dealers and major
security-based swap participants, including capital, margin,
and segregation requirements for security-based swaps;
security-based swaps clearing, including a clearing mandate
for specific instruments (e.g., single-name credit default
swaps or swaps based on a narrow-based security index) as well
as an end-user exemption;
platform trading of security-based swaps, especially
registration and regulation of security-based swap execution
facilities; and
rules prohibiting fraud and manipulation in connection with
security-based swaps.
Role of Banking Agencies
Many swap dealers and security-based swap dealers are depository
institutions or subsidiaries of banks and have a Prudential Regulator
in addition to being subject to regulation by the CFTC or SEC. Title
VII provided a limited role in the regulation of OTC swaps to the U.S.
banking regulators.\289\ Specifically, Dodd-Frank--through amendments
to the CEA and the Exchange Act--gave the banking agencies authority to
determine the capital and margin requirements for swap dealers and
major swap participants that have a Prudential Regulator.\290\ The
margin requirements include both initial and variation margin
requirements for swaps and security-based swaps that are not centrally
cleared. In addition, the Prudential Regulators, the CFTC, and the SEC
are required to consult at least annually on minimum capital
requirements and minimum initial and variation margin requirements to
establish and maintain, ``to the maximum extent practicable,''
comparable capital and margin requirements for swap dealers and major
swap participants.\291\
---------------------------------------------------------------------------
\289\ As used here, the term ``Prudential Regulator,'' has the
meaning in 7 U.S.C. 1a(39). The term ``U.S. banking agencies'' and
similar terms are also used to refer to Prudential Regulators or a
subset thereof.
\290\ 7 U.S.C. 6s(e) and 2(a)(1)(A) (CEA); 15 U.S.C. 78o-10
(Exchange Act).
\291\ See 7 U.S.C. 6s(e)(3)(D) and 15 U.S.C. 78o-10(e)(3)(D).
---------------------------------------------------------------------------
Issues and Recommendations
In general, we have found--and our broad outreach throughout the
process of preparing this report has confirmed--there to be widespread
support for mandated central clearing and platform trading of
standardized derivatives, as well as trade reporting. However, there
have also been criticisms regarding numerous details of how these
market modifications have been implemented. The challenge now facing
the CFTC, the SEC and other regulators is to identify problem areas and
seek solutions that level the playing field for market participants and
ensure healthy, fair, and robust derivatives markets. Though the
specific issues in the following discussion are varied, and some are
quite technical, they tend to fall into several broad categories
including regulatory harmonization, cross-border issues, capital
treatment of derivatives, end-user issues, and market infrastructure.
Regulatory Coordination and Harmonization
Harmonization Between CFTC and SEC
The regulatory distinction between ``swaps'' and ``security based
swaps'' did not reflect previous market practice, and the resulting
split jurisdiction between SEC and CFTC has posed challenges for market
participants.
In a few areas, such as further defining entities and product
terms, the CFTC and SEC issued joint rules. In other areas, Dodd-Frank
required the CFTC and SEC to consult and coordinate with one another,
and with the Prudential Regulators, in a number of areas ``for purposes
of assuring regulatory consistency and comparability, to the extent
possible.'' \292\ Despite CFTC and SEC efforts in this regard,
important differences in their Title VII rules remain.
---------------------------------------------------------------------------
\292\ Dodd-Frank 712(a)(1)-(2).
---------------------------------------------------------------------------
Examples touch all areas of Dodd-Frank OTC derivatives reforms, and
include differences in trade reporting requirements, trading and
clearing rules, compliance requirements for registration for swap
dealers and security-based swap dealers, and capital and margin
requirements, among others. Sometimes, these differences in approach
might not be incompatible, but more frequently they are inconsistent
with or duplicative of one another, increasing the cost and complexity
of compliance programs. Consequently, many market participants are or
will be required to comply with different requirements to address the
same regulatory goals, sometimes for the same entity, depending on the
products they transact, even within the same asset classes, such as
credit derivatives.
One area of concern, for example, is the SEC's security-based swap
dealer registration rules, which market participants say contain
certain compliance requirements that have no comparable requirement
under the CFTC's rules. As another example, key requirements of the two
agencies' trade reporting rules diverge in several respects, including
the timing by which swap data repositories may publicly disseminate
trade data. Even in areas where there was broad agreement between the
two agencies, for example in the joint CFTC-SEC product definitions,
improvements could be made. For example, market participants have noted
the need for a clearer and simpler distinction between ``swaps'' and
``security-based swaps,'' and have suggested that the term ``mixed
swap'' be eliminated so every swap is subject either to CFTC or SEC
jurisdiction, but not both.
CFTC Chairman Christopher Giancarlo and SEC Chairman Jay Clayton
both have expressed support for resolving unnecessary divergences,
complexity, and duplication in their respective rules and reducing
compliance burdens in areas of jurisdictional overlap.\293\
---------------------------------------------------------------------------
\293\ CFTC Chairman Giancarlo letter to Treasury Secretary Mnuchin
(May 15, 2017); Chairman Jay Clayton, Remarks at the Economic Club of
New York (Jul. 12, 2017), available at: https://www.sec.gov/news/
speech/remarks-economic-club-new-york. Though committed to
harmonization with the CFTC, Chairman Clayton further made the
practical and cautionary observation that ``all such efforts will need
to take into account statutory variances as well as differences in
products and markets.''
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Recommendations
Treasury recommends that the CFTC and the SEC undertake and
give high priority to a joint effort to review their respective
rulemakings in each key Title VII reform area. The goals of
this exercise should be to harmonize rules and eliminate
redundancies to the fullest extent possible and to minimize
imposing distortive effects on the markets and duplicative and
inconsistent compliance burdens on market participants.
As part of this review, the SEC should finalize its
Title VII rules with the goal of facilitating a well-
harmonized swaps and security-based swaps regime.
This effort should also include consideration of the
prospects for alternative compliance regimes--for example,
a framework of interagency substituted compliance or mutual
recognition--for any areas in which effective harmonization
is not feasible.
Public comment should be part of this process.
Congress should consider further action to achieve maximum
harmonization in the regulation of swaps and security-based
swaps.
Margin Requirements for Uncleared Swaps
One of the key reforms of Title VII was to require that
standardized OTC derivatives be centrally cleared through a CCP.
However, not all swaps can be sufficiently standardized to be suitable
for central clearing. Rather than prohibiting such transactions, Title
VII determined to treat such uncleared swaps in accordance with risks
associated with such transactions. Dodd-Frank Section 731 directed that
capital requirements and initial margin \294\ and variation margin
\295\ requirements should be imposed on all swaps not cleared by a DCO
or other CCP, and that such requirements should be ``appropriate for
the risk associated with'' the uncleared swaps.\296\ Margin
requirements on uncleared swaps are intended, in general, to reduce
systemic risk by requiring collateral to be available to offset any
losses arising from the default of a swap counterparty, limiting
contagion and spillover effects. Further, margin requirements, by
reflecting the generally higher risk associated with uncleared swaps,
are intended to promote central clearing.
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\294\ Initial margin refers to funds put up as collateral at the
time a derivatives transaction or contract is established (and adjusted
during the life of the transaction as needed) to minimize losses if a
derivatives counterparty defaults on its obligations under the terms of
the transaction. Initial margin reflects the potential future exposure
of a swap transaction.
\295\ Variation margin is the amount paid by one swap counterparty
to another to reflect daily changes in the mark-to-market value of the
transaction after it has been executed. Variation margin reflects the
current exposure of a swap transaction. Variation margin is usually
paid in cash or other high-quality and liquid collateral.
\296\ 7 U.S.C. 6s(e)(2)-(3). Analogous requirements for security-
based swaps are contained in 15 U.S.C. 78o-10(e).
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The U.S. banking agencies and the CFTC finalized margin rules for
the uncleared swaps of bank-affiliated swap dealers in November 2015
and nonbank swap dealers in January 2016, respectively.\297\ Market
participants argue that U.S. regulators have taken a stricter approach
than non-U.S. jurisdictions with respect to many of the particular
requirements of the uncleared margin rules, and as a result, U.S. firms
are placed at a competitive disadvantage relative to their non-U.S.
competitors. Moreover, non-U.S. firms may decide not to transact with
U.S. firms, so long as these transactions are subject to the more
stringent requirements.
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\297\ Prudential Regulators, Margin and Capital Requirements for
Covered Swap Entities [80 Fed. Reg. 74840 (Nov. 30, 2015)]
(``Prudential Regulators Margin and Capital Requirements''); CFTC
Margin Requirements for Uncleared Swaps. The SEC initially proposed its
margin rules for uncleared security-based swaps in 2012 before the
release of the framework of the Basel Committee on Banking Supervision-
International Organization of Securities Commissions (BCBS-IOSCO) and
has not yet reproposed or finalized its rules in this area.
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Among these differences in approach are the treatment of
interaffiliate transactions, the timing of margin settlement, and the
scope of end-user entities subject to the requirements.
Interaffiliate transactions. Many banks and other companies use
swaps transactions between affiliates (``interaffiliate swaps'') as a
means to centralize their company-wide risk management activities.\298\
The CFTC has exempted interaffiliate transactions from its initial
margin requirements and its mandatory clearing requirements--
conditioned, in part, on the ``market facing'' affiliates collecting
initial margin or centrally clearing their swaps with unaffiliated
counterparties.\299\ By contrast, the U.S. banking regulators imposed
initial margin requirements for interaffiliate transactions of
prudentially regulated swap dealers. Differences between CFTC and U.S.
banking regulators' margin requirements run counter to the goal of
regulatory harmonization. While posting of initial margin between
affiliates of a bank or bank holding company may help in the case of a
resolution, it also creates additional liquidity demands and locks up
margin that could be deployed for more productive uses. The
International Swaps and Derivatives Association (ISDA) estimates that
the 14 largest derivatives dealers have posted $29 billion of initial
margin for interaffiliate swaps.\300\
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\298\ In general, counterparties are considered ``affiliated'' if
one counterparty, directly or indirectly, holds a majority ownership
interest in the other counterparty, or a third party, directly or
indirectly, holds a majority ownership interest in both counterparties.
See 17 CFR 50.52(a)(1).
\299\ 17 CFR 23.159 (special initial margin rules for
affiliates); 17 CFR 50.52 (clearing exemption for swaps between
affiliates).
\300\ Some market participants claim that for some banking groups,
the margin held internally due to the initial margin requirements on
interaffiliate transactions exceeds the initial margin held for all
third-party-facing transactions.
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Market participants argue that interaffiliate swaps are risk-
reducing, internally insulated, and do not present systemic risk.
Moreover, market participants observe that the U.S. banking regulators'
initial margin requirements diverge from the Basel Committee on Banking
Supervision-International Organization of Securities Commissions (BCBS-
IOSCO) international framework on which they were based, as well as
from analogous rules being implemented in the European Union (EU). This
difference puts U.S. bank swap dealers at a disadvantage to both
domestic and non-U.S. competitors.
Sizing of margin requirements. Under the rules of the CFTC and
banking regulators (and based on the BCBS-IOSCO international
framework), the size of required initial margin for uncleared swaps is
based on a 10 day market move, in comparison to a 5 day move for
cleared swaps.\301\ While the higher margin requirement is meant to
reflect the greater risk of uncleared swaps and encourage clearing
where possible, market participants have pointed out that the 10 day
window is arbitrary and not well tailored to the risk of specific
products and counterparties. For example, certain swaps such as equity
index total return swaps, which are primarily uncleared, could easily
be liquidated well within a 10 day window.
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\301\ See Prudential Regulators Margin and Capital Requirements;
CFTC Margin Requirements for Uncleared Swaps.
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Timing of margin settlement. Under the rules of the CFTC and the
U.S. banking regulators, any initial margin and variation margin
payments that must be posted to a swap counterparty must be settled
within one business day (called ``T+1'' settlement). This timing
requirement can place a significant burden on smaller U.S. entities
such as pension funds and other asset managers that lack the
operational or funding capability of larger swaps counterparties to
settle within a single business day. Moreover, the U.S. T+1 settlement
requirement is more stringent than in non-U.S. jurisdictions, such as
the European Union, which typically allow 2 days for more margin
settlement. This difference in timing potentially puts U.S. firms at a
disadvantage to non-U.S. firms, particularly when dealing with
counterparties in widely dispersed time zones or when the collateral
being posted is denominated in different currencies.
Scope of end-users. The initial and variation margin requirements
of the uncleared swap margin rules issued by the CFTC and the U.S.
banking regulators are generally applicable to swaps in which both
counterparties are swap dealers, major swap participants, or financial
end-users. The rules generally do not apply to a swap in which one of
the counterparties is a non-financial end-user that qualifies for the
end-user exception to the clearing mandate in Section 2(h)(7) of the
CEA.\302\
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\302\ 7 U.S.C. 2(h)(7). This exemption is further available to
certain small financial institutions and captive finance companies,
certain cooperative entities that qualify for an exemption from the
clearing requirements, and certain treasury affiliates acting as agent
and that satisfy the criteria for an exception from clearing in section
2(h)(7)(D) of the CEA.
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The U.S. margin rules define ``financial end-user'' by enumerating
the various types of entities the CFTC and the U.S. banking regulators
intended to cover.\303\ This list is expansive, and market participants
argue it goes far beyond analogous requirements in the uncleared margin
rules of non-U.S. jurisdictions.
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\303\ See, e.g., 17 CFR 23.151.
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Recommendations
Treasury recommends that U.S. regulators take steps to harmonize
their margin requirements for uncleared swaps domestically and
cooperate with non-U.S. jurisdictions that have implemented the BCBS-
IOSCO framework to promote a level playing field for U.S. firms.
The U.S. banking agencies should consider providing an
exemption from the initial margin requirements for uncleared
swaps for transactions between affiliates of a bank or bank
holding company in a manner consistent with the margin
requirements of the CFTC and the corresponding non-U.S.
requirements, subject to appropriate conditions.\304\
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\304\ With regard to interaffiliate transactions generally,
Treasury sees value in preserving the flexibility of regulators in this
area. While Treasury is not at this time prepared to recommend a
statutory amendment to exclude interaffiliate swap transactions from
the requirements of Dodd-Frank Title VII, as some have proposed, we
support the CFTC's use of its exemptive and rulemaking authorities to
provide targeted exemptions for interaffiliate transactions. Treasury
calls on the CFTC and SEC to consider further actions to provide
appropriate relief to interaffiliate transactions that are consistent
with the public interest.
The CFTC and U.S. banking agencies should work with their
international counterparts to amend the uncleared margin
framework so it is more appropriately tailored to the relevant
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risks.
Where warranted based on logistical and operational
considerations, the CFTC and the U.S. banking agencies should
consider amendments to their rules to allow for more realistic
time frames for collecting and posting margin.
The CFTC and the U.S. banking agencies should reconsider the
one-size-fits-all treatment of financial end-users for purposes
of margin on uncleared swaps and tailor their requirements to
focus on the most significant source of risk.
Consistent with these objectives, the SEC should re-propose
and finalize its proposed margin rule for uncleared security-
based swaps in a manner that is aligned with the margin rules
of the CFTC and the U.S. banking regulators.
CFTC Use of No-Action Letters
Throughout the process of implementing the swaps reforms of Dodd-
Frank, CFTC staff made frequent use of no-action letters and other
guidance to smooth the implementation of the new requirements. CFTC
staff issues written guidance concerning the CEA and CFTC regulations,
principally in the form of responses to requests for exemptive, no-
action, and interpretative letters. CFTC Regulation 140.99 defines
three types of staff letters--exemptive letters,\305\ no-action
letters,\306\ and interpretative letters \307\--that differ in terms of
scope and effect. Before Dodd-Frank, CFTC staff generally issued a
relatively small number of no-action and interpretive letters each
year. Since 2012, CFTC staff has typically issued dozens of such
letters each year, including 160 staff letters issued in 2014
alone.\308\ These figures include the many no-action letters issued
during this period that have been extended multiple times.
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\305\ Under CFTC Regulation 140.99(a)(1), ``exemptive letter''
means ``a written grant of relief issued by the staff of a Division of
the Commission from the applicability of a specific provision of the
Act or of a rule, regulation or order issued thereunder by the
Commission. An exemptive letter may only be issued by staff of a
Division when the Commission itself has exemptive authority and that
authority has been delegated by the Commission to the Division in
question. An exemptive letter binds the Commission and its staff with
respect to the relief provided therein. Only the Beneficiary may rely
upon the exemptive letter.'' 17 CFR 140.99(a)(1).
\306\ Under CFTC Regulation 140.99(a)(2), ``no-action letter''
means ``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.'' 17 CFR
140.99(a)(2).
\307\ Under CFTC Regulation 140.99(a)(3), ``interpretive letter''
means ``written advice or guidance issued by the staff of a Division of
the Commission or the Office of the General Counsel. An interpretative
letter binds only the issuing Division or the Office of the General
Counsel, as applicable, and does not bind the Commission or other
Commission staff. An interpretative letter may be relied upon by
persons in addition to the Beneficiary.'' 17 CFR 140.99(a)(3).
\308\ An archive of CFTC staff letters is available on the CFTC
website: http://www.cftc.gov/LawRegulation/CFTCStaffLetters/index.htm.
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The CFTC has been criticized for over-relying on relief granted to
market participants through no-action letters (which are frequently
extended), rather than codifying the relief granted through the
rulemaking process. Taking such a step through formal rulemaking would
provide an updated estimate of costs and benefits and allow affected
market participants to comment on the proposals. A rulemaking codifying
previously issued no-action letters would also simplify and clarify the
obligations currently stated in a number of interlocking no-action
letters and provide permanent, rather than temporary, relief from
certain obligations.
Market participants have raised a number of additional concerns
about the CFTC's reliance on no-action letters. These include concerns
that reliance on no-action letters can facilitate regulatory capture
and undermine regulatory quality, and that no-action letters can impose
substantive new requirements that should appropriately be introduced
through notice and comment rulemaking under the Administrative
Procedures Act.\309\ No-action letters also fail to provide regulatory
certainty to market participants on which to make business decisions.
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\309\ See Hester Peirce, Regulating through the Back Door at the
Commodity Futures Trading Commission, Mercatus working paper (Nov.
2014), at 50, available at: https://www.mercatus.org/system/files/
Peirce-Back-Door-CFTC.pdf; see also Donna M. Nagy, Judicial Reliance on
Regulatory Interpretations in SEC No-Action Letters: Current Problems
and a Proposed Framework, 83 Cornell Law Review 921, 957 (1998).
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No-action letters and other forms of written guidance are
nevertheless important regulatory tools. In implementing the Dodd-Frank
swaps reforms, the CFTC was operating under tight statutory time frames
to impose a wholly new regulatory framework essentially from scratch.
This course of action inevitably compelled the CFTC to make extensive
use of regulatory guidance and no-action relief. Yet had it not had
these tools, the resulting market disruptions could have been more
consequential. Several years into the implementation phase of the new
swaps reforms, it is now incumbent on the CFTC to provide certainty for
market participants by reviewing staff guidance and no-action relief
issued over the past several years to determine which rule changes
might be warranted or which relief might be made permanent.
Recommendations
Treasury recommends that the CFTC take steps to simplify and
formalize all outstanding staff guidance and no-action relief
that has been used to smooth the implementation of the Dodd-
Frank swaps regulatory framework. This should include, where
necessary and appropriate, amendments to any final rules that
have proven to be infeasible or unworkable, necessitating
broadly applicable or multiyear no-action relief.
Cross-border Issues
Cross-border issues are in many ways about cooperation with foreign
authorities that are implementing OTC derivatives reforms in their own
jurisdictions. Such international cooperation is critical given the
global nature of the OTC derivatives markets. The goal is to achieve
efficient and fair treatment of U.S. and foreign firms and to promote a
level playing field. While cross-border issues impact many of the key
issues discussed elsewhere in this chapter, we address them here as a
separate set of issues.
Dodd-Frank established the scope of the CFTC's and the SEC's
jurisdiction over cross-border swaps and security-based swaps,
respectively. Specifically, Dodd-Frank provided that the swap
provisions of the CEA enacted by Title VII ``shall not apply to
activities outside the United States unless those activities: (1) have
a direct and significant connection with activities in, or effect on,
commerce of the United States; or (2) contravene such rules or
regulations as the [CFTC] may prescribe or promulgate as are necessary
or appropriate to prevent the evasion of any provision'' of Title
VII.\310\ Similarly, Dodd-Frank provided that the new security-based
swaps provisions of the Securities Exchange Act do not apply ``to any
person insofar as such person transacts a business in security-based
swaps without the jurisdiction of the United States, unless such person
transacts such business in contravention of such rules and regulations
as the [SEC] may prescribe as necessary or appropriate to prevent the
evasion of any provision'' of Title VII.\311\
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\310\ Dodd-Frank 722 [codified at 7 U.S.C. 2(i)]
\311\ Dodd-Frank 772 [codified at 15 U.S.C. 78dd(c)].
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Beginning in 2013, the CFTC issued a series of interpretive
guidance, staff advisories, and rulemakings laying out various aspects
of its approach to the cross-border implementation of its swaps rules.
This included the CFTC's July 2013 Cross-Border Guidance, which
addressed the scope of the term ``U.S. person''; swap dealer
registration requirements, including aggregation of dealing activity;
and the treatment of swaps involving certain foreign branches of U.S.
banks or non-U.S. counterparties guaranteed by a U.S. person.\312\ The
Cross-Border Guidance also laid out the permissible scope and
procedures for the CFTC's substituted compliance framework, which
permits certain non-U.S. swap dealers to comply with a foreign
jurisdiction's law and regulations governing swaps transactions in lieu
of compliance with the corresponding CFTC requirements. For purposes of
substituted compliance determinations, the Cross-Border Guidance
divided the CFTC's swaps provisions applicable to swap dealers into two
sets, ``entity-level requirements,'' which apply to a swap dealer or
firm as a whole, and ``transaction-level requirements,'' which apply on
a transaction-by-transaction basis.\313\
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\312\ Interpretive Guidance and Policy Statement Regarding
Compliance with Certain Swap Regulations (July 17, 2013) [78 Fed. Reg.
45292 (Jul. 26, 2013)] (the ``Cross-Border Guidance'').
\313\ Entity-level requirements include capital adequacy, chief
compliance officer duties and requirements, risk management policies
and procedures, books and records requirement, and reporting to swap
data repositories, among other requirements. Transaction-level
requirements include, for example, required clearing and swap
processing, margining and segregation of collateral for uncleared
swaps, mandatory trade execution, and external business conduct
requirements.
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Following the Cross-Border Guidance, the CFTC issued a staff
advisory in November 2013 concluding that CFTC transaction-level
requirements (clearing, trading, margin, etc.) apply to a swap between
a non-U.S. swap dealer and a non-U.S. person if personnel in the United
States regularly arrange, negotiate, or execute (ANE) swaps.\314\ The
staff advisory on so-called ``ANE transactions'' prompted immediate
alarm among market participants engaged in cross-border swaps, and less
than 2 weeks later, CFTC staff granted time-limited no-action relief
with respect to the staff advisory.\315\ Since then, this no-action
relief--which was initially available through Jan. 14, 2014--has been
extended several times and was extended again for the sixth time on
July 25, 2017.\316\
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\314\ Division of Swap Dealer and Intermediary Oversight, U.S.
Commodity Futures Trading Commission, Staff Advisory No. 13-69--
Applicability of Transaction-Level Requirements to Activity in the
United States (Nov. 14, 2013), available at: http://www.cftc.gov/idc/
groups/public/@lrlettergeneral/documents/letter/13-69.pdf.
\315\ Staff of the U.S. Commodity Futures Trading Commission,
Letter No. 13-71, No-Action Relief: Certain Transaction-Level
Requirements for Non-U.S. Swap Dealers (Nov. 26, 2013), available at:
http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/
letter/13-71.pdf.
\316\ Staff of the U.S. Commodity Futures Trading Commission,
Letter No. 17-36, Extension of No-Action Relief: Transaction-Level
Requirements for Non-U.S. Swap Dealers (Jul. 25, 2017), available at:
http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/
letter/17-36.pdf.
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Another publication that has impacted how market participants must
comply with CFTC requirements in the context of cross-border swaps is
the CFTC's November 2013 staff guidance on swap execution facilities.
Among other things, this guidance addressed registration requirements
under CFTC rules for platforms located outside the U.S. ``where the
trading or executing of swaps on or through the platform creates a
`direct and significant' connection to activities in, or effect on,
commerce of the United States.'' \317\ This guidance, combined with
other aspects of the CFTC's final SEF rules, prompted non-U.S. trading
platforms to exclude U.S. persons to avoid falling under the CFTC's SEF
registration and other regulatory requirements, contributing to market
fragmentation in certain products.
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\317\ Division of Market Oversight, U.S. Commodity Futures Trading
Commission, Guidance on Application of Certain Commission Regulations
to Swap Execution Facilities (Nov. 15, 2013), available at: http://
www.cftc.gov/idc/groups/public/@newsroom/documents/file/dmosefguid
ance111513.pdf.
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The SEC issued a comprehensive cross-border proposed rule in May
2013 but subsequently determined to implement the cross-border aspects
of its security-based swaps rules concurrently with completing its
separate rulemakings. For example, the SEC finalized a rulemaking in
August 2014 defining ``U.S. person'' and stipulating rules for
determining which cross-border security-based swap transactions have to
be counted toward the security-based swap dealer registration
threshold.\318\ More recently, the SEC has adopted final rules on
business conduct standards for security-based swap dealers, and final
rules pertaining to reporting and dissemination of security-based swap
data, each addressing the cross-border application of the rules and the
availability of substituted compliance.\319\ Compliance with these
rules, however, has yet to go into effect pending finalization by the
SEC of its rules pertaining to registration and regulation of security-
based swap dealers.
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\318\ Application of ``Security-Based Swap Dealer'' and ``Major
Security-Based Swap Participant'' Definitions to Cross-Border Security-
Based Swap Activities (June 25, 2014) [79 Fed. Reg. 47278 (Aug. 12,
2014)].
\319\ Business Conduct Standards for Security-Based Swap Dealers
and Major Security-Based Swap Participants (Apr. 14, 2016) [81 Fed.
Reg. 29960 (May 13, 2016)]; and Regulation SBSR--Reporting and
Dissemination of Security-Based Swap Information (July 14, 2016) [81
Fed. Reg. 53546 (Aug. 12, 2016)].
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Market participants and non-U.S. regulators, among others, have
raised concerns that the application of U.S. rules to cross-border
swaps activities has led to conflicts and inefficiencies between U.S.
and non-U.S. compliance regimes, in turn causing considerably higher
operational costs and decreased competitiveness of U.S. entities in
relation to foreign entities. More broadly, they argue, the cross-
border application of U.S. rules has contributed to market
fragmentation, diminished liquidity, and other distortive effects as
foreign entities avoid trading with U.S. counterparties for fear of
being captured by the U.S. regulatory regime. The CFTC, in particular,
has been subject to criticism that it has misinterpreted the scope of
its cross-border mandate under CEA Section 2(i) \320\ and has
inappropriately dismissed the mandate not to apply CEA swaps reforms to
non-U.S. transactions, ``unless those activi-
ties . . . have a direct and significant connection with activities in,
or effect on, commerce of the United States.'' Consequently, these
critics allege, the CFTC has significantly over-reached in applying its
rules to certain non-U.S. and cross-border transactions.
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\320\ 7 U.S.C. 2(i).
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Likewise, market participants have raised concerns with aspects of
the SEC's cross-border rules, and have highlighted those that conflict
with privacy, blocking and secrecy laws in non-U.S. jurisdictions. The
SEC's security-based swap dealer registration rules, for example,
require entities to provide certification and opinion of counsel
regarding SEC access to their books and records as a condition of
registration. Many non-U.S. security-based swap dealers may not be able
to comply with this requirement without violating local laws.
Recommendations
Treasury recommends that CFTC and the SEC should: (1) make their
swaps and security-based swaps rules compatible with non-U.S.
jurisdictions, (2) adopt outcomes-based substituted compliance regimes,
and (3) reconsider their approaches to transactions that are arranged,
negotiated, or executed by personnel in the United States. These
recommendations are described in more detail below.
Cross-border Application and Scope: Treasury recommends that
the CFTC and the SEC provide clarity around the cross-border
scope of their regulations and make their rules compatible with
non-U.S. jurisdictions where possible to avoid market
fragmentation, redundancies, undue complexity, and conflicts of
law. Examples of areas that merit reconsideration include:
whether swap counterparties, trading platforms, and
CCPs in jurisdictions compliant with international
standards should be required to register with the CFTC or
the SEC as a result of doing business with a U.S. firm's
foreign branch or affiliate;
whether swap dealer registration should apply to a
U.S. firm's non-U.S. affiliate on the basis of trading with
non-U.S. counterparties if the U.S. firm's non-U.S.
affiliate is effectively regulated as part of an
appropriately robust regulatory regime or otherwise subject
to Basel-compliant capital standards, regardless of whether
the affiliate is guaranteed by its U.S. parent;
whether U.S. firms' foreign branches and affiliates,
guaranteed or not, should be subject to Title VII's
mandatory clearing, mandatory trading, margin, or reporting
rules when they trade with non-U.S. firms in jurisdictions
compliant with international standards; and
providing alternative ways for regulated entities to
comply with requirements that may conflict with local
privacy, blocking, and secrecy laws.
Substituted Compliance: Treasury recommends that effective
cross-border cooperation include meaningful substituted
compliance programs to minimize redundancies and conflicts.
The CFTC and SEC should be judicious when applying
their swaps rules to activities outside the United States
and should permit entities, to the maximum extent
practicable, to comply with comparable non-U.S. derivatives
regulations, in lieu of complying with U.S. regulations.
The CFTC and the SEC should adopt substituted
compliance regimes that consider the rules of other
jurisdictions, in an outcomes-based approach, in their
entirety, rather than relying on rule-by-rule analysis.
They should work toward achieving timely recognition of
their regimes by non-U.S. regulatory authorities.
The CFTC should undertake truly outcomes-based
comparability determinations, using either a category-by-
category comparison or a comparison of the CFTC regime to
the foreign regime as a whole.
Meaningful substituted compliance could also include
consideration of recognition regimes for non-U.S. CCPs
clearing derivatives for certain U.S. persons and for non-
U.S. platforms for swaps trading.
ANE Transactions: Treasury recommends that the CFTC and the
SEC reconsider any U.S. personnel test for applying the
transaction-level requirements of their swaps rules.
The CFTC should provide certainty to market
participants regarding the guidance in the CFTC ANE staff
advisory (CFTC Letter No. 13-69), which has been subject to
extended no-action relief, either by retracting the
advisory or proceeding with a rulemaking.
In particular, the CFTC and the SEC should reconsider
the implications of applying their Title VII rules to
transactions between non-U.S. firms or between a non-U.S.
firm and a foreign branch or affiliate of a U.S. firm
merely on the basis that U.S.-located personnel arrange,
negotiate, or execute the swap, especially for entities in
comparably regulated jurisdictions.
Capital Treatment in Support of Central Clearing
As discussed in Banking Report, ``the supplementary leverage ratio
(SLR) imposes significant capital requirements requirements on initial
margin for centrally cleared derivatives.'' Banks that hold segregated
customer client margin through their affiliates that are futures
commission merchants (FCMs) incur higher capital charges via the SLR as
a result of the FCMs' clearing services. These higher capital costs, in
turn, discourage FCMs from clearing derivatives transactions for
clients. In recognition of these disincentive effects, the Banking
Report recommended deducting initial margin for centrally cleared
derivatives from the leverage ratio denominator.
Beyond initial margin, however, the SLR has other distorting
effects related to derivatives exposures, notably through its use of
the current exposure method (CEM) to measure derivatives exposures. CEM
is insensitive to risk and results in higher leverage ratio capital
requirements for certain derivatives products (including exchange-
traded derivatives) relative to risk-based measures. The CEM model, for
example, requires options contracts to be sized on their notional face
value rather than allowing for a risk adjustment to notional to reflect
the actual exposure associated with these derivatives. Specifically,
CEM does not permit a delta adjustment for the notional value
measurement of options.
Moreover, the CEM methodology measures exposures on a gross basis
and is, therefore, overly restrictive in permitting netting and the
offsetting of long and short positions. Typically, for example, market
makers and others who maintain hedged positions will execute and clear
offsetting trades. When done through the same CCP, the risk of such
hedged positions is reduced, or even eliminated. CEM, however, applies
separately--on a gross basis--to each of the offsetting positions,
compounding the capital that hedged traders' FCMs must set aside, even
though the hedged position has reduced exposure overall. By contrast, a
trader with an unhedged, directional position--by definition more risky
than a hedged position--will, from a CEM perspective, have less
exposure than a hedger with two offsetting trades.
In light of these issues, in 2014, the Basel Committee on Banking
Supervision (BCBS) developed the Standardized Approach for Counterparty
Credit Risk (SA-CCR) as a replacement for CEM for certain capital
calculations.\321\ SA-CCR was supposed to become effective in 2017, but
adoption in the United States has been delayed. Even though SA-CCR
improves on many of the shortcomings of CEM, market participants note
that it requires certain modifications before implementation to fully
support central clearing. Market participants have commented, for
example, that SA-CCR should be modified to ensure appropriate
calibration and full recognition of initial margin, recognition of the
risk-reducing offsets between diversified but correlated products, and
appropriate calibration of add-on calculations, including supervisory
factors.\322\
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\321\ Basel Committee on Banking Supervision, The Standardised
Approach for Measuring Counterparty Credit Risk Exposures (Mar. 2014
and rev. Apr. 2014), available at: http://www.bis.org/publ/bcbs279.pdf.
\322\ Vijay Albuquerque, et al., Repeal CEM; Reform SA-CCR,
Risk.net, (Jul. 24, 2017), available at: http://www.risk.net/
regulation/5307456/repeal-cem-reform-sa-ccr.
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Many market participants and observers have noted the decline in
the number of CFTC-registered FCMs in recent years. In a speech given
this past May, CFTC Chairman Christopher Giancarlo stated: ``The FCM
marketplace has declined from 100 CFTC-registered entities in 2002 to
55 at the beginning of 2017. Of these 55, just 19 were holding customer
funds for swaps clearing. Many large banks have exited the business,
including State Street, Bank of New York-Mellon, Nomura, Royal Bank of
Scotland and Deutsche Bank.'' \323\ The decline in the number of FCMs
is due to multiple factors, including increased regulatory burden as
well as factors such as consolidations and pricing pressures.\324\
Moreover, FCM client clearing activity is concentrated in a few large
firms. Market participants claim that of the currently registered FCMs,
only about eight to 12 firms are capable of clearing the types of swaps
subject to mandatory clearing under Dodd-Frank. In the market for
listed options, there are even fewer choices, with only three large
FCMs clearing for market makers and other customers.\325\
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\323\ Acting Chairman J. Christopher Giancarlo, Remarks before the
International Swaps and Derivatives Association 32nd Annual Meeting
(May 10, 2017), available at: http://www.cftc.gov/PressRoom/
SpeechesTestimony/opagiancarlo-22.
\324\ See, e.g., Hester Peirce, Dwindling Numbers in the Financial
Industry, Brookings (May 15, 2017), available at: https://
www.brookings.edu/research/dwindling-numbers-in-the-financial-industry/
\325\ Some observers have noted that the FCM business is not highly
concentrated by certain metrics--such as the Herfindahl-Hirschman
Index--or as compared with other industries. See, e.g., Tod Skarecky,
The Truth about FCM Concentration, Clarus Financial Technology blog
(Apr. 4, 2017), available at: https://www.clarusft.com/the-truth-about-
fcm-concentration/.
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The ability to quickly and easily transfer customer positions has
long been an indispensable feature of the central clearing model, and
has allowed for the continued smooth functioning of the cleared
derivatives markets even when one or more clearing firms fail, such as
happened during the financial crisis. The decline in the number of
FCMs, however, means that clearing customers have fewer options for
their business and makes it more difficult for customers of a
defaulting clearing firm to move their positions and collateral to
another firm. In addition, market participants have widely reported
that the current SLR framework and the CEM model have harmed market
liquidity and adversely impacted the ability and willingness of FCMs to
clear for end-users, limiting their access to markets and ability to
hedge risks. FCMs have reportedly dropped out of the clearing business
due to it being a low-margin business, driven in part by the capital
costs. Meanwhile, remaining FCMs are hesitant to take on new business
due to the capital costs, and in some cases they are addressing the
costs of current clients' activity by placing limits on their risk
exposures. Some FCMs reportedly assess each of their clearing clients
on a regular basis to determine whether or not to keep their business.
Another issue raised by U.S. clearing members and market
participants was whether U.S. banking regulators would permit variation
margin to be treated as the settlement of the exposure of certain
centrally cleared derivatives when calculating the potential future
exposure amounts used to determine regulatory capital requirements. In
response to this issue, the U.S. banking regulators issued guidance in
August 2017 about the treatment of cleared ``settled-to-market
contracts'' under the agencies' regulatory capital rules.\326\
Specifically, the guidance clarified that the existing capital rules,
under certain conditions, recognize that daily variation margin for
certain centrally cleared derivatives constitutes a settlement of
exposure, potentially providing significant capital relief for
banks.\327\
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\326\ Board of Governors of the Federal Reserve, Office of the
Comptroller of the Currency, and Federal Deposit Insurance Corporation,
Guidance: Regulatory Capital Treatment of Certain Centrally-cleared
Derivative Contracts under the Board's Capital Rule (Aug. 14, 2017),
available at: https://www.federalreserve.gov/supervisionreg/srletters/
sr1707.pdf.
\327\ Banks would have to ensure, for example, that settlement of
any outstanding exposure would generally involve ``a clear and
unequivocal transfer of ownership of the variation margin from the
transferor to the transferee, the transferee taking possession of the
variation margin, and termination of any claim of the transferor on the
variation margin transferred, including any security interest in the
variation margin.'' Id. at 3.
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Overall, one of the CEM's methodological shortcomings is that it
requires FCMs and other CCP clearing members to maintain significantly
more capital relative to the actual risks arising from their customers'
derivatives activities. The CEM may be responsible for a corresponding
reduction in banks' ability and willingness to facilitate access for
their market maker clients who are the primary liquidity providers in
these markets. End users face increased risk of being unable to
transfer their positions and margin to another FCM if their FCM
defaults or exits the business. In a period of market stress, this risk
would be exacerbated and could become systemic.
Recommendations
Treasury recommends that regulators properly balance the post-
crisis goal of moving more derivatives into central clearing with
appropriately tailored and targeted capital requirements.
As a near-term measure, Treasury:
reiterates the recommendation of the Banking Report
and calls for the deduction of initial margin for centrally
cleared derivatives from the SLR denominator; \328\ and
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\328\ The Banking Report, at 54.
recommends a risk-adjusted approach for valuing
options for purposes of the capital rules to better reflect
the exposure, such as potentially weighting options by
---------------------------------------------------------------------------
their delta.
Beyond the near-term, Treasury recommends that regulatory
capital requirements transition from CEM to an adjusted SA-CCR
calculation that provides an offset for initial margin and
recognition of appropriate netting sets and hedged positions.
In addition, Treasury recommends that U.S. banking
regulators and market regulators conduct regular comprehensive
assessments of how the capital and liquidity rules impact the
incentives to centrally clear derivatives and whether such
rules are properly calibrated.
End-user Issues
Swap Dealer De Minimis Threshold
Under CFTC rules, a person must register as a swap dealer if its
swap dealing activity exceeds an aggregate gross notional amount
threshold of $3 billion over the previous 12 month period (the ``de
minimis'' threshold).\329\ When the rule was finalized, the de minimis
threshold was set at a phase-in level of $8 billion through December
2017, but in October 2016 the CFTC extended the $8 billion phase-in
level through Dec. 31, 2018. Unless the CFTC takes action before Dec.
31, 2018, to set a different termination date or to modify the de
minimis exception, the swap dealer registration de minimis threshold
will drop to $3 billion.
---------------------------------------------------------------------------
\329\ 17 CFR 1.3(ggg).
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A 2016 CFTC staff report on this issue found that lowering the swap
dealer registration threshold to $3 billion would provide
``insignificant additional regulatory coverage'' for dealing activity
in interest rate swaps and index credit default swaps as compared to
the $8 billion level. Specifically, lowering the threshold to $3
billion would require an estimated 58% increase in registered swap
dealers while capturing less than 1% of additional notional
activity.\330\ Moreover, the staff analysis found that at the current
$8 billion threshold, 98% of interest rate swaps, 99% of credit default
swaps, and 89% of non-financial commodity swaps reported to swap data
repositories during the period reviewed for the report involved at
least one CFTC-registered swap dealer.\331\
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\330\ Staff of the U.S. Commodity Futures Trading Commission, Swap
Dealer De Minimis Exception Final Staff Report (Aug. 15, 2016), at 21,
available at: http://www.cftc.gov/idc/groups/public/@swaps/documents/
file/dfreport_sddeminis081516.pdf. Table 1 in the CFTC staff report
shows that ``potential swap dealing entities'' would increase by
approximately 84 entities, from 145 at the $8 billion threshold level
to 229 if the threshold were lowered to $3 billion, a change of 58%.
\331\ Id. at 22.
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Market participants argue that the de minimis threshold is
appropriately set at $8 billion and should not be lowered.\332\
Moreover, they report that uncertainty about what future actions, if
any, the CFTC will take regarding the de minimis level is causing many
market participants to limit their U.S. trading activity to avoid the
swap dealer designation and related regulatory requirements. Not only
does this potentially result in fewer counterparties, increased costs,
and reduced liquidity in the swaps markets, it has adverse effects on
certain commercial market participants' willingness to enter into risk-
hedging transactions.
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\332\ Of the 24 comment letters the CFTC received on a preliminary
version of its staff report, 20 supported either maintaining the $8
billion threshold or raising it.
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Recommendations
Treasury recommends that the CFTC maintain the swap dealer
de minimis registration threshold at $8 billion and establish
that any future changes to the threshold will be subject to a
formal rulemaking and public comment process.
Definition of Financial Entity
Title VII's swaps clearing mandate provides an exception for non-
financial entities using swaps to hedge or mitigate commercial
risk.\333\ Non-financial end-users eligible for the clearing exception
are also exempted from the margin requirements for uncleared
swaps.\334\
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\333\ Dodd-Frank 723 [codified at 7 U.S.C. 2(h)(7)]. An
analogous exception for clearing security-based swaps is provided in
the Exchange Act. This discussion, therefore, is applicable both to
swaps and security-based swaps. However, because the SEC has not yet
implemented a clearing mandate for security-based swaps, the Report
focuses on swaps.
\334\ 7 U.S.C. 6s(e)(4). Section 731 of Dodd-Frank added section
4s(e) to the CEA to require capital requirements and margin
requirements for uncleared swaps for swaps dealers and major swap
participants. Subclause (4) of section 4s(e), providing an explicit
exemption for the margin requirements for certain end-users, was added
by the Terrorism Risk Insurance Program Reauthorization Act of 2015
(Public Law No. 114-1).
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The types of non-financial entities Congress had in mind when
providing this exception were farmers, ranchers, energy producers,
manufacturers and other end-users of derivatives, whose activities did
not contribute to the crisis and who rely on the swaps markets to help
manage the risks arising from their businesses. Using swaps and other
risk management tools helps these end-users supply food, energy, and
other consumer necessities for American consumers at stable prices.
Congress excluded non-financial end-users from the Dodd-Frank swaps
clearing requirement in acknowledgement that failure to do so would
increase their costs and lead to higher and more volatile prices in the
economy. Relief from the clearing exception is also provided for
certain affiliates of non-financial end-users, subject to specific
criteria.\335\
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\335\ 7 U.S.C. 2(h)(7)(D).
---------------------------------------------------------------------------
The CEA does not define the term ``non-financial entity.'' Instead,
CEA Section 2(h)(7)(C) defines the term ``financial entity'' to
describe the universe of entities that cannot take advantage of the
clearing exception. Swap dealers, major swap participants, commodity
pools, private funds, and employee benefit plans are among the types of
financial entities that are specifically ineligible for the exception
to the clearing mandate. However, the definition of financial entity
also includes a broader, catch-all prong. Persons ``predominantly
engaged in activities that are in the business of banking, or in
activities that are financial in nature, as defined in section 1843(k)
of title 12'' are also defined as financial entities and cannot take
advantage of the clearing exception.\336\ CEA Section 2(h)(7)(C) also
permits the CFTC to exclude certain entities from the definition of
financial entity, potentially making them eligible for the clearing
exemption. Specifically, the CFTC is given authority to exempt small
financial institutions from the definition of financial entity--that
is, ``small banks, savings associations, farm credit system
institutions, and credit unions'' with $10 billion or less in total
assets.\337\ Finally, the definition of financial entity does not
include certain entities whose primary business is providing financing
and who use derivatives to hedge certain commercial risks within their
corporate structure.\338\
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\336\ 7 U.S.C. 2(h)(7)(C)(i)(VIII).
\337\ 7 U.S.C. 2(h)(7)(C)(ii).
\338\ 7 U.S.C. 2(h)(7)(C)(iii). Specifically, this provision
states that the definition of financial entity ``shall not include an
entity whose primary business is providing financing, and uses
derivatives for the purpose of hedging underlying commercial risks
related to interest rate and foreign currency exposures, 90 percent or
more of which arise from financing that facilitates the purchase or
lease of products, 90 percent or more of which are manufactured by the
parent company or another subsidiary of the parent company.''
---------------------------------------------------------------------------
Since passage of Dodd-Frank, there have been numerous proposals to
modify the definition of financial entity and clarify the scope of the
exception for non-financial end-users' affiliates. Market participants
from various industries, including insurance, equipment financing,
foreign exchange, and payments processing, among others, argue that the
definition of financial entity is too broad and unfairly captures the
hedging activities of certain end-users, preventing these entities from
qualifying for the clearing exception. Moreover, it is not always clear
which entities are ``predominantly engaged'' in activities that are
financial in nature and therefore captured under the financial entity
definition. For example, certain commercial enterprises use special
purpose vehicles and similar subsidiary structures to engage in
derivatives transactions. Market participants argue that enterprises
using such structures, which are ostensibly financial in nature, should
nonetheless be deemed non-financial end-users and therefore eligible
for the clearing exception. Market participants also cite a
competitiveness issue, pointing out that certain non-U.S.
jurisdictions, such as the European Union, have de minimis tests to
ensure that certain entities are afforded exemptions based on their
derivatives activities and not simply because they are financial in
nature.
Some of these proposals for further clarification of the scope of
the clearing exception have met with both legislative and regulatory
success. The Consolidated Appropriations Act of 2016, for example,
amended CEA Section 2(h)(7)(D) to expand and clarify the scope of
entities that may qualify as affiliates of non-financial end-users and
be eligible for the clearing exception.\339\ The CFTC also has taken
steps to accommodate certain end-users. In its final rule on the end-
user exception to the clearing requirement, for example, the CFTC
exempted small financial institutions from the definition of financial
entity, permitting those entities to avail themselves of the clearing
exception.\340\ The CFTC has issued staff no-action relief from the
clearing requirement for swaps entered into by eligible treasury
affiliates.\341\ These affiliates, also known as ``central treasury
units'' (CTUs), are centralized corporate affiliates of commercial end-
users that aggregate and manage the company-wide need for treasury
services and risk-management.
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\339\ Public Law No. 114-113, Title VII (Financial Services) 705
(Dec. 18, 2015).
\340\ End-User Exception to the Clearing Requirement for Swaps
(July 10, 2012) [77 Fed. Reg. 42560, 42587-42588 (Jul. 19, 2012)].
\341\ Division of Clearing and Risk, U.S. Commodity Futures Trading
Commission, Letter No. 14-144, No-Action Relief from the Clearing
Requirement for Swaps Entered into by Eligible Treasury Affiliates
(Nov. 26, 2014), available at: http://www.cftc.gov/idc/groups/public/
@lrlettergeneral/documents/letter/14-144.pdf.
---------------------------------------------------------------------------
Despite these developments, many market participants continue to
raise concerns about the scope of the financial entity definition and
seek further rulemaking or statutory solutions. Some market
participants report, for example, that they have corporate policies
that preclude them from relying on the CFTC's no-action relief for
CTUs, because these are staff letters and not formal Commission-
sponsored rulemakings.
Recommendations
To provide regulatory certainty and better facilitate
appropriate exceptions from the swaps clearing requirement for
commercial end-users engaged in bona fide hedging or mitigation
of commercial risks, Treasury would support a legislative
amendment to CEA Section 2(h)(7) providing the CFTC with
rulemaking authority to modify and clarify the scope of the
financial entity definition and the treatment of affiliates.
Such authority should include consideration of non-
prudentially regulated entities that currently fall under
subclause VIII of CEA Section 2(h)(7)(c)(i)--i.e., entities
that are ``predominantly engaged. in activities that are
financial in nature''--but which might warrant exception
from the clearing requirement if they engage in swaps
primarily to hedge or mitigate the business risks of a
commercial affiliate.
Such authority should also be flexible enough to
permit, for example, the CFTC to formalize its no-action
relief for CTUs in a rulemaking.
Further, any exceptions provided by the CFTC under
such authority should be subject to appropriate conditions
and allow the CFTC to appropriately monitor exempted
activity. The conditions could include, for example, making
the exception dependent on the size and nature of swaps
activities, demonstration of risk-management requirements
in lieu of clearing, and reporting requirements.
Any legislative amendment should provide the SEC analogous
rulemaking authority under Exchange Act Section 3C(g) with
respect to exceptions from the clearing requirement for
security-based swaps.
Position Limits
Position limits refer to the maximum position that a trader or
group of traders working together is permitted to hold in a given
contract. Such limits have long been used in the futures markets to
prevent speculators from amassing positions that can potentially have
undue influence on market prices or deliverable supply to the detriment
of commercial end-users seeking to hedge risks arising from their
business activities. In the futures markets, position limits are set by
the DCMs (i.e., the exchanges) or by the CFTC itself. An exemption from
speculative position limits is generally available for bona fide
hedgers and certain other market participants who meet the eligibility
requirements of the DCM and CFTC rules.
The CEA gives the CFTC statutory authority to set speculative
position limits. Dodd-Frank expanded this authority by requiring the
CFTC to establish, as necessary and appropriate, aggregate position
limits on all physical commodity derivative positions across U.S.
futures exchanges, foreign boards of trade providing ``direct access''
to U.S. entities, and swaps that are ``either economically equivalent''
to a commodity futures contract or that serve a ``significant price
discovery function.'' \342\ However, the CEA's intent is not to unduly
restrict legitimate speculation, which serves valuable functions such
as ``assuming price risks, discovering prices, or disseminating pricing
information through trading in liquid, fair and financially secure
trading facilities.'' \343\
---------------------------------------------------------------------------
\342\ Dodd-Frank 737 [amending 7 U.S.C. 6a].
\343\ 7 U.S.C. 5(a).
---------------------------------------------------------------------------
The CFTC finalized a position limits rule pursuant to Dodd-Frank in
November 2011,\344\ but it was vacated in September 2012 by the U.S.
District Court for the District of Columbia \345\ after a legal
challenge brought by the International Swaps and Derivatives
Association and other plaintiffs, who argued the CFTC misinterpreted
its statutory authority and failed to properly consider the rule's
costs and benefits. Since that time, the CFTC has undergone several
rounds of proposals and comments on a new position limits rule but has
yet to take final action. The lack of a clear definition of ``excessive
speculation'' has impeded progress on what specific limits should be
established.
---------------------------------------------------------------------------
\344\ Position Limits for Futures and Swaps (Oct. 18, 2011) [76
Fed. Reg. 71626 (Nov. 18, 2011)]. The associatedproposed rule issued by
the CFTC in January 2011 drew more than 15,000 comments from the
public. According to the CFTC, only about 100 comments overall provided
``detailed comments and recommendations'' regarding the proposals.
Approximately 55 comments requested that the CFTC either significantly
alter or withdraw the proposal. The majority of the more than 15,000
comments consisted of submissions by individuals in one or more form
letter formats and generally supported the proposed position limits.
\345\ The rule's amendments to CFTC Regulation 150.2 were
excepted from the court's action.
---------------------------------------------------------------------------
Appropriately tailored position limits protect market participants
from real threats of manipulation, cornering, and other disruptive
practices but avoid hindering legitimate speculative activity.
Moreover, any rule must not unnecessarily constrain end-users in their
ability to hedge. If end-users are unable to hedge in an efficient and
effective way, they may be discouraged from hedging at all.
Recommendations
Treasury recommends that the CFTC complete its position
limits rules as contemplated by its statutory mandate, with a
focus on detecting and deterring market manipulation and other
fraudulent behavior. Among the issues to consider in completing
a final position limits rule, the CFTC should:
ensure the appropriate availability of bona fide
hedging exemptions for end-users and explore whether to
provide a risk management exemption;
consider calibrating limits based on the risk of
manipulation, for example, by imposing limits only for spot
months of physical delivery contracts where the risk of
potential market manipulation is greatest; and
consider the deliverable supply holistically when
setting the limits (e.g., for gold, consider the global
physical market, not just U.S. futures).
Market Infrastructure
SEF Execution Methods and MAT Process
Under the CEA, as amended by Dodd-Frank, certain swaps are subject
to a ``trade execution requirement,'' and must be executed on a SEF or
a DCM. Swaps subject to the trade execution requirement are those that
(1) the CFTC has determined are subject to mandatory clearing, and (2)
have been ``made available to trade'' by a SEF (or a DCM).\346\ The CEA
defines a SEF as ``a trading system or platform in which multiple
participants have the ability to execute or trade swaps by accepting
bids and offers made by multiple participants in the facility or
system, through any means of interstate commerce'' (emphasis
added).\347\ The determination by which certain swaps have been ``made
available to trade'' by a SEF is known as a ``MAT determination.''
---------------------------------------------------------------------------
\346\ U.S. Commodity Futures Trading Commission, Fact Sheet: Final
Rulemaking Regarding Core Principles and Other Requirements for Swap
Execution Facilities (``SEF Core Principles Fact Sheet''), available
at: http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/
sef_factsheet_final.pdf.
\347\ 7 U.S.C. 1a(50).
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Under CFTC rules, swaps subject to the trade execution requirement
are known as ``required transactions.'' Required transactions must be
traded on a SEF through an order book or through a request-for-quote
system that operates in conjunction with an order book.\348\ A request-
for-quote (RFQ) system means a trading system or platform in which a
market participant transmits a request for a quote to buy or sell a
specific instrument to one or more market participants in the trading
system or platform, to which all such market participants may respond.
The CFTC's SEF rules impose an ``RFQ-3'' requirement, meaning that
requests for quotes must be transmitted to at least three other market
participants in the SEF.\349\ In contrast to required transactions,
``permitted transactions'' are swap transactions that may be executed
on SEFs but are not subject to the trade execution requirement.\350\
---------------------------------------------------------------------------
\348\ ``Order book'' is defined to mean an electronic trading
facility or trading facility (as such terms are defined in Section 1a
of the CEA), or a trading system or platform in which all market
participants in the trading system or platform have the ability to
enter multiple bids and offers, observe or receive bids and offers
entered by other market participants, and transact on such bids and
offers. 17 CFR 37.3(a)(3).
\349\ 17 CFR 37.9(a)(3).
\350\ SEF Core Principles Fact Sheet.
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Market participants have raised the concern that limiting trading
to order book and RFQ-3 methods is overly restrictive, undermines
Congressional intent, discourages trading swaps on SEFs, and harms pre-
trade price transparency. CFTC Chairman Giancarlo echoed these concerns
in a January 2015 white paper, shortly after he joined the CFTC as a
commissioner. The white paper cautioned that the ``avoidance by non-
U.S. person market participants of the CFTC's ill-designed U.S. swaps
trading rules is fragmenting global swaps markets between U.S. persons
and non-U.S. persons and driving away global capital. Global swaps
markets have divided into separate liquidity pools: those in which U.S.
persons are able to participate and those in which U.S. persons are
shunned.'' \351\
---------------------------------------------------------------------------
\351\ Commissioner J. Christopher Giancarlo, Pro-Reform
Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank
(Jan. 29, 2015), at 49, available at: http://www.cftc.gov/idc/groups/
public/@newsroom/documents/file/sefwhitepaper012915.pdf (``Giancarlo
White Paper'').
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CFTC rules permit a SEF to make a MAT determination on
consideration of six specified factors, which triggers the trade
execution requirement for a class of swaps.\352\ Many market
participants have commented that the six factors that SEFs must
consider before making a MAT determination are not robust enough to
demonstrate sufficient liquidity for mandatory trading. CFTC Chairman
Giancarlo has stated that, ``Since the MAT process is platform-
controlled, a nascent SEF attempting to gain a first-mover advantage in
trading liquidity may force certain swaps to trade exclusively through
the SEF's restrictive methods of execution (i.e., order book or RFQ-3
system), potentially before sufficient liquidity is available to
support such trading.'' \353\ Commenters have recommended giving the
CFTC greater control over the MAT determination process by empowering
the CFTC, rather than SEFs, to trigger the trade execution requirement.
---------------------------------------------------------------------------
\352\ For a discussion of the MAT determination process, see U.S.
Commodity Futures Trading Commission, Fact Sheet: Process for a
Designated Contract Market or Swap Execution Facility to Make a Swap
Available to Trade under Section 2(h)(8) of the Commodity Exchange Act,
available at: http://www.cftc.gov/idc/groups/public/@newsroom/
documents/file/mat_factsheet_fi
nal.pdf.
\353\ Giancarlo White Paper, at 30.
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Finally, when the CFTC finalized its SEF rules in June 2013, it was
clear that SEFs temporarily registered with the CFTC would have to come
into full compliance with all applicable SEF rules beginning on Oct. 2,
2013, to the extent that they traded swaps subject to the trade
execution requirement. However, the preamble of the final SEF rules
included a footnote--namely, footnote 88--that essentially required all
multiple-to-multiple trading platforms to register as SEFs, even if
they only offered for trading swaps not subject to the trading mandate,
i.e., ``permitted transactions.'' \354\ This interpretation caused most
non-U.S. trading platforms to exclude U.S. participants for fear of
falling under the CFTC's SEF registration and other regulatory
requirements, resulting in fragmented markets and separate liquidity
pools and prices for similar transactions.\355\
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\354\ Specifically, footnote 88 of the SEF Core Principles Rule
states ``The Commission notes that it is not tying the registration
requirement in CEA section 5h(a)(1) to the trade execution requirement
in CEA section 2(h)(8), such that only facilities trading swaps subject
to the trade execution requirement would be required to register as
SEFs. A facility would be required to register as a SEF if it operates
in a manner that meets the SEF definition even though it only executes
or trades swaps not subject to the trade execution mandate.''
\355\ ISDA, Footnote 88 and Market Fragmentation: An ISDA Survey
(Dec. 2013), available at: http://www2.isda.org/attachment/NjE3Nw==/
Footnote%2088%20Research%20Note%2020131
218.pdf.
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Recommendations
Treasury recommends that the CFTC:
consider rule changes to permit SEFs to use any means of
interstate commerce to execute swaps subject to a trade
execution requirement that are consistent with the ``multiple-
to-multiple'' element of the SEF definition (CEA Section
1a(50)).\356\ Such rule changes should be undertaken in
recognition of the statutory goals of impartial access for
market participants and promoting pre-trade price transparency
in the swaps market; \357\
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\356\ 7 U.S.C. 1a(50).
\357\ 7 U.S.C. 7b-3(f)(2)(B); 7 U.S.C. 7b-3(e).
reevaluate the MAT determination process to ensure
sufficient liquidity for swaps to support a mandatory trading
---------------------------------------------------------------------------
requirement; and
consider clarifying or eliminating footnote 88 in its final
SEF rules to address the associated market fragmentation.
Swap Data Reporting
One of the key goals of Dodd-Frank was to promote post-trade
transparency for both market participants and regulators through the
establishment of SDRs and trade reporting requirements. The full
potential of swaps market transparency has been impeded, however, by
the technical complexity of the CFTC's rules, which imposes unnecessary
burdens on market participants, as well as by the failure of the CFTC
to standardize reporting fields across SDRs and harmonize reporting
requirements with other regulators, among other issues. Market
participants have raised concerns, for example, about the numerous
types of reporting required for each transaction, including realtime,
primary economic terms, confirmation, snapshot, and valuation
reporting, and the burdens that such requirements have imposed on
reporting parties.
The current swap data reporting framework has resulted in an
infusion of data accessible by both regulators and the public, but this
data is often of questionable quality, making it difficult for
regulators to make efficient use of it in overseeing the markets.
Market participants have questioned, for example, whether the CFTC
currently has the ability to manage and process the large volume of
data collected and to extract useful information from it. Market
participants have also called for greater harmonization of swap data
reporting and swap data repository requirements between the SEC and
CFTC, as well as between the United States and EU.
The CFTC has previously attempted to address some of these data
quality issues, but these efforts were unrealized.\358\ Most recently,
the CFTC announced in July 2017 that it was launching a new review of
the swap data reporting regulations in Parts 43, 45, and 49 of the
CFTC's Regulations.\359\ The CFTC's review is focused on two goals:
``(a) to ensure that the CFTC receives accurate, complete, and high
quality data on swaps transactions for its regulatory oversight role;
and (b) to streamline reporting, reduce messages that must be reported,
and right-size the number of data elements reported to meet the
agency's priority use-cases for swaps data.'' \360\ The CFTC also
announced a ``Roadmap to Achieve High Quality Swaps Data'' in July
2017, which will address SDR operations and the confirmation of data
accuracy by swap counterparties. The Roadmap will also address
reporting workflows generally, including standardization of data fields
and potential delayed reporting deadlines.\361\
---------------------------------------------------------------------------
\358\ The CFTC's Technology Advisory Committee, for example,
initiated an SDR data harmonization effort in April 2013. Further, in
2014, data experts from the Office of Financial Research teamed with
CFTC staff to address additional data quality issues.
\359\ U.S. Commodity Futures Trading Commission, Press Release No.
7585-17 (Jul. 10, 2017), available at: http://www.cftc.gov/PressRoom/
PressReleases/pr7585-17.
\360\ Id.
\361\ U.S. Commodity Futures Trading Commission, Roadmap to Achieve
High Quality Swaps Data (Jul. 10, 2017), available at: http://
www.cftc.gov/idc/groups/public/@newsroom/documents/file/
dmo_swapdataplan071017.pdf.
---------------------------------------------------------------------------
While the post-crisis establishment of SDRs and swaps data
reporting requirements has brought much-needed post-trade transparency
to the previously opaque OTC derivatives market, full realization of
the benefits of post-trade transparency by both market participant and
regulators is unlikely without high-quality and timely data.
Recommendations
Treasury supports the CFTC's newly launched ``Roadmap'' effort as
announced in July 2017 to standardize reporting fields across products
and SDRs, harmonize data elements and technical specifications with
other regulators, and improve validation and quality control processes.
Treasury recommends that CFTC secure and commit adequate
resources to complete the Roadmap review, undertake notice and
comment rulemaking, and implement revised rules and harmonized
standards within the timeframe outlined in the Roadmap.
Treasury recommends that CFTC leverage third-party and
market participant expertise to the extent necessary to develop
a coherent, efficient, and effective reporting regime.
Financial Market Utilities
Overview and Regulatory Landscape
Financial Market Utilities (FMUs) exist in many markets to support
and facilitate the transfer, clearing, or settlement of financial
transactions. Their smooth operation is integral to the soundness of
the financial system and the overall economy. FMUs cover a large number
of systems and a larger number of system operators.
This section is organized around nine FMUs--eight of which have
been designated by the Financial Stability Oversight Council as
systemically important financial market utilities (SIFMUs) and a ninth
that accounts for a substantial share of activity in its respective
markets. These include central counterparties (Chicago Mercantile
Exchange, Inc.'s (CME, Inc.) CME Clearing division; Depository Trust
and Clearing Corporation's (DTCC) Fixed Income Clearing Corporation and
the National Securities Clearing Corporation; Intercontinental
Exchange, Inc.'s ICE Clear Credit LLC; LCH, Ltd., the only FMU covered
that is not FSOC designated; and the Options Clearing Corporation); a
central securities depository (Depository Trust Company), and payment
and settlement systems (CLS Bank International and The Clearing House
Payments Company, L.L.C.).
Treasury has arrived at the following conclusions:
Each FMU is distinct, with its own market segment, products,
business model, ownership, and governance structures.
The regulatory reforms after the financial crisis, such as
the Dodd-Frank clearing mandate and capital treatments for
cleared derivatives, are only part of several reasons why FMUs,
and in particular central counterparties (CCPs), are critical
financial infrastructures. FMUs have historically played
important roles in financial markets through clearing and other
related functions, even decades before Dodd-Frank's enactment.
There are also a number of economic incentives inherent to
CCPs' business models that may contribute to a market
participant's motivations to clear.
Certain FMUs are highly interconnected to other U.S.
financial institutions and facilitate significant transaction
volumes and values. Risk concentrations in some FMUs have risen
dramatically following the passage of Dodd-Frank. Distress at
or failure of one of these FMUs could pose systemic risk.
Because of this risk, the FSOC has designated eight as SIFMUs.
However, the regulatory oversight and resolution regime for
these institutions remains insufficient.
SIFMUs may be authorized to access the Federal Reserve
discount window in unusual or exigent circumstances under Dodd-
Frank. As set forth in the Executive Order, our financial
regulatory system must avoid creating moral hazard.\362\
Private firms can not anticipate provisioning of emergency
liquidity from the Federal Reserve in their risk management
planning. Accordingly, while SIFMUs may be authorized to access
the discount window in unusual or exigent circumstances under
Dodd-Frank, a SIFMU must exhaust credible private sources of
borrowing first.
---------------------------------------------------------------------------
\362\ Exec. Order No. 13772 [82 Fed. Reg. 9965 (Feb. 8, 2017)].
---------------------------------------------------------------------------
Core Functions and History
FMUs have been important infrastructures in financial markets for
many years. The existence of clearinghouses dates back to the late 19th
century when they were used to net payments in commodities futures
markets.\363\ In the United States, the New York Stock Exchange (NYSE)
established a clearinghouse in 1892; outside the United States,
securities exchanges established clearinghouses later in the 20th
century.\364\ Central securities depositories, which facilitate the
safekeeping of securities, have existed in the United States since at
least the 1970s.\365\
---------------------------------------------------------------------------
\363\ Amandeep Rehlon, Central Counterparties: What Are They, Why
Do They Matter and How Does the Bank Supervise Them?, The Bank of
England Quarterly Bulletin, (2013 Q2), at 2, available at: http://
www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2013/
qb1302ccpsbs.pdf.
\364\ Asaf Bernstein, Eric Hughson, and Marc D. Weidenmier,
Counterparty Risk and the Establishment of the New York Stock Exchange
Clearinghouse, NBER Working Paper Series (Sept. 2014), at 5, available
at: http://www.nber.org/papers/w20459.
\365\ Bank for International Settlements, Payment, Clearing and
Settlement Systems in the United States (2012), available at: https://
www.bis.org/cpmi/publ/d105_us.pdf.
---------------------------------------------------------------------------
Today, FMUs are in place in nearly all major securities markets. A
wide range of market participants, from end-users using derivatives for
hedging to institutional investors and large broker-dealers, use FMUs
to mitigate risks in a variety of currency, securities, and derivative
transactions, among other purposes. Because of the level and
concentration of financial transactions handled by FMUs and their
interconnectedness to the rest of the financial system, FMUs represent
a significant systemic risk to the U.S. financial system. Much of this
systemic risk is the result of inherent interdependencies, either
directly through operational, contractual, or affiliation linkages or
indirectly through payment, clearing, and settlement
processes.366, 367
---------------------------------------------------------------------------
\366\ Authority to Designate Financial Market Utilities as
Systemically Important (July 20, 2011) [76 FR 44763 (July 27, 2011)]
(``FSOC FMU Final Rule'').
\367\ Unless otherwise noted, information regarding the history,
structure, governance, and volume figures for each FMU was received
directly from the respective FMU.
---------------------------------------------------------------------------
Central Counterparties
CCPs are a type of FMU that serve important risk-mitigating
functions and have long been core components in a range of markets
including exchange-traded derivatives and cash markets. CCPs simplify
and centralize risk management for particular financial markets by
assuming the role of buyer to every seller and seller to every buyer.
CCPs are the counterparty for their direct clearing members, which
include major derivatives dealer banks and other large financial
institutions. These clearing members interact directly with the CCP
both as principal and as agent for their clients, which range from
smaller financial institutions to insurance companies and non-financial
firms. In addition, a CCP reduces risks to individual participants
through multilateral netting of trades, imposing risk controls on
clearing members, and maintaining financial resources commensurate with
risks it carries. Clearing organizations and their members must work
together to strike an appropriate balance between the clearing
organization's resources (``skin-in-the-game'') and mutualized
resources of clearing members.
CME Group Inc.: Chicago Mercantile Exchange, Inc.
CME Clearing, a division of the CME, Inc., operates one of the
largest central counterparty clearing services in the world and
provides clearing services for futures, options, and over-the-counter
interest rate swaps and CDS.\368\ Its futures and options are linked to
interest rates, equities, foreign exchange, energy, agricultural
commodities, and metals. CME, Inc. maintains three default funds for
clearing members, one for futures and options, one for cleared interest
rate swaps, and one for cleared CDS.\369\ CME, Inc. was designated as a
SIFMU by the FSOC in 2012.
---------------------------------------------------------------------------
\368\ On September 14, 2017, CME Group Inc. announced that it will
exit the CDS clearing business by mid-2018.
\369\ CME Group Inc., Annual Report 2016, at 48, available at:
http://investor.cmegroup.com/investor-relations/
secfiling.cfm?filingID=1156375-17-16.
---------------------------------------------------------------------------
Transaction volume has seen steady growth as the notional value and
volume of contracts cleared at CME Clearing has risen every year over
the past few years.
------------------------------------------------------------------------
CME Clearing 2010 2016
------------------------------------------------------------------------
Annual Volume (# of Futures 2,638 MM 3,153 MM
Contracts Traded)
Annual Volume (# of Options 442 MM 789 MM
Contracts Traded)
Annual Volume (# of Swaps 195 238,518
Contracts Traded)
Annual Value (Notional Value of $1,037 MM $29,476,885 MM
Swaps Contracts in USD)
Peak Daily Volume (# of Futures 22 MM 36 MM
Contracts Traded)
Peak Daily Volume (# of Options 4 MM 8 MM
Contracts Traded)
Peak Daily Volume (# of CDS 20 393
Contracts Traded)
Peak Daily Volume (# of IRS 15 3,158
Contracts Traded)
Peak Daily Volume (Notional Value $15 MM $2,361,639 MM
of CDS Contracts in USD)
Peak Daily Value (Notional Value $267 MM $2,380,701 MM
of IRS Contracts in USD)
------------------------------------------------------------------------
Data as of year-end 2010 and 2016. Figures include index and single-name
credit default swaps. Multi-lateral compression is reflected in the
2016 annual notional value of swaps contracts in USD and 2016 peak
daily notional value of IRS contracts in USD.
The Chicago Mercantile Exchange was founded in 1898 as a not-for-
profit corporation. In 2000, the Chicago Mercantile Exchange
demutualized, adopting a for-profit structure and the members exchanged
their ownership interests for stock in the newly formed CME, Inc. In
2002, Chicago Mercantile Exchange Holdings Inc. completed an initial
public offering, the first U.S. exchange to be publicly traded.
CME Group, Inc., the parent company of Chicago Mercantile Exchange
Inc., also owns four futures exchanges: Chicago Mercantile Exchange
Inc., Board of Trade of the City of Chicago, Inc., New York Mercantile
Exchange, Inc., and Commodity Exchange, Inc. The CME organization
offers trade repository services in the United States and around the
world.
Depository Trust and Clearing Corporation: Fixed Income Clearing
Corporation/National Securities Clearing Corporation
Fixed Income Clearing Corporation (FICC), a subsidiary of DTCC,
plays a prominent role in the fixed-income market as the sole clearing
agency in the United States, acting as central counterparty and
provider of significant clearing and settlement services for cash
settled U.S. Treasury and agency securities and the agency mortgage-
backed securities market. FICC provides clearing, settlement, risk
management, central counterparty services, and guarantee of trade
completion. FICC was established in 2003 through a combination of
previous government and mortgage-backed securities (MBS) clearing
organizations. The company operates these clearing services through two
divisions, the Government Securities Division (GSD) and the Mortgage
Backed Securities Division (MBSD).
National Securities Clearing Corporation (NSCC), another subsidiary
of DTCC, plays a prominent role in providing clearing, settlement and
central counterparty services for nearly all broker-to-broker equity as
well as corporate and municipal debt trades executed on major U.S.
exchanges and other venues. Established in 1976, NSCC guarantees the
settlement of matched trades, and as a central counterparty, is the
legal counterparty to all of its members' net settlement obligations.
Allowing market participants to settle on a net basis (rather than
sending and receiving payments for each individual trade) reduces the
value of payments that need to be exchanged by about 98%.\370\ These
efficiencies reduce the risks of settlement and the amount of liquidity
in the settlement process and create a more uniform approach to
managing counterparty risk. FICC and NSCC were designated as SIFMUs by
the FSOC in 2012.
---------------------------------------------------------------------------
\370\ See http://www.dtcc.com/about/businesses-and-subsidiaries/
nscc.
---------------------------------------------------------------------------
Transaction volumes for FICC and NSCC have been consistently high
or increasing since the financial crisis. But, in contrast to
derivatives clearing organizations that clear interest rate swaps and
CDS, FICC and NSCC are not directly affected by the Dodd-Frank swaps
clearing mandate. FICC and NSCC have nearly exclusive market share for
the services they provide, and a large number of members are dependent
on their services.
------------------------------------------------------------------------
FICC (Fixed Income Clearing
Corporation) 2010 2016
------------------------------------------------------------------------
Annual Volume (# of GSD Contracts 34 MM 40 MM
Traded)
Annual Volume (# of MBSD Contracts 3.2 MM 3.8 MM
Traded)
Annual Value (Notional Value of $779,168 B $761,323 B
GSD Contracts in USD)
Annual Value (Notional Value of $104,245 B $74,402 B
MBSD Contracts in USD)
Peak Daily Volume (# of GSD 255,617 375,031
Contracts Traded)
Peak Daily Volume (# of MBSD 23,098 26,308
Contracts Traded)
Peak Daily Value (Notional Value $4,058 B $3,831 B
of GSD Contracts in USD)
Peak Daily Value (Notional Value $920 B $673 B
of MBSD Contracts in USD)
------------------------------------------------------------------------
Data as of year-end 2010 and 2016.
------------------------------------------------------------------------
NSCC (National Securities Clearing
Corporation) 2010 2016
------------------------------------------------------------------------
Annual Volume (# of Contracts 20,538 MM 25,771 MM
Traded)
Annual Volume (Notional Value in $219,411 B $243,627 B
USD)
Peak Daily Volume (# of Contracts * 177 MM
Traded)
Peak Daily Value (Notional Value * $1,911 B
in USD)
------------------------------------------------------------------------
Data as of year-end 2010 and 2016.
* Denotes a data point that the DTCC was unable to provide.
As noted above, FICC and NSCC are subsidiaries of DTCC, which has a
range of operations, including securities depository services, clearing
services, trade matching and settlement, trade repository, and data
services. In total, DTCC handles on a consolidated basis over $1
quadrillion in transactions every year.\371\
---------------------------------------------------------------------------
\371\ See DTCC press releases for a description of the company,
including volume figures, available at: http://www.dtcc.com/news/2017/
august/29/major-japanese-trust-banks-adopt-dtccs-omgeo-alert-to-
automate-replace-post-trade-processes.
---------------------------------------------------------------------------
Intercontinental Exchange, Inc./ICE Clear Credit LLC
In 2009, ICE launched its CDS clearing business with ICE Clear
Credit LLC's predecessor, ICE Trust U.S., then a New York limited
liability trust company, clearing North American CDS indexes and later
adding liquid single-names and sovereign CDS. In 2011, ICE Trust
converted to a limited liability company, became registered with both
the CFTC and the SEC, and began operating under the name ICE Clear
Credit LLC (ICE Clear Credit). Today, ICE Clear Credit is ICE's largest
wholly owned U.S. based subsidiary by volume and notional value of
cleared trades, clearing a majority of the CDS products in the United
States that are eligible for clearing by a central counterparty,
including the active North American CDS indexes and certain liquid
single names.\372\ ICE Clear Credit was designated as a SIFMU by the
FSOC in 2012.
---------------------------------------------------------------------------
\372\ ICE Clear Credit also clears certain European, Asian-Pacific,
and emerging market CDS.
---------------------------------------------------------------------------
As discussed earlier, the Dodd-Frank clearing mandate applies
directly to clearing for certain CDS indexes.\373\ ICE Clear Credit is
dominant in market share in the U.S. index and single-name CDS cleared
market. ICE Clear Credit handles a large volume of transactions, in
terms of both volume and transaction value, which have markedly
increased since 2010.
---------------------------------------------------------------------------
\373\ U.S. Commodity Futures Trading Commission, Press Release No.
6607-13 (Jun. 10, 2013), available at: http://www.cftc.gov/PressRoom/
PressReleases/pr6607-13; U.S. Commodity Futures Trading Commission,
Press Release No. 7457-16 (Sept. 28, 2016), available at: http://
www.cftc.gov/PressRoom/PressReleases/pr7457-16.
------------------------------------------------------------------------
ICE (Intercontinental Exchange)
Clear Credit 2010 2016
------------------------------------------------------------------------
Annual Volume (# of Contracts 143,653 359,600
Traded)
Annual Volume (Notional Value in $5,452 MM $5,999 MM
USD)
Peak Daily Volume (# of Contracts * 1,428 2,782
Traded)
Peak Daily Value (Notional Value * $43,046 MM $104,053 MM
in USD)
------------------------------------------------------------------------
Data as of year-end 2010 and 2016. Figures include USD index and single-
name credit default swaps.
* These figures are approximate peaks. ICE provided peak weekly
information for 2010, and a daily figure was calculated by dividing
the weekly figure by five.
ICE Clear Credit's ultimate parent is Intercontinental Exchange,
Inc., a publicly traded company that operates a number of futures
exchanges, clearinghouses, and other post-trade services. ICE was
established in 2000 as an OTC energy marketplace listing OTC energy
contracts (oil, natural gas, and power), providing an alternative to
what was then a fragmented and opaque market structure.\374\ ICE
completed its initial public offering in 2005. Today, ICE's exchanges
include futures, cash equities, equity options, and bond exchanges.
ICE's other U.S. clearinghouse is ICE Clear U.S., originally
established in 1915 as the New York Cotton Exchange Clearing
Association. ICE Clear U.S. provides post-trade services across a wide
range of products, including agricultural, currency, metals, credit,
and domestic and equity index futures contracts. ICE also operates OTC
markets for physical energy, swaps and CDS trade execution, and fixed
income, and it offers a range of data services for global financial and
commodity markets.\375\
---------------------------------------------------------------------------
\374\ See biographical background of Jeffrey C. Sprecher describing
the founding and growth of the Intercontinental Exchange, Inc.,
available at: https://www.sec.gov/rules/other/2016/ice-trade-vault/ice-
trade-vault-form-sdr-ex-c.1.pdf.
\375\ For the list of products for which ICE operates OTC Markets,
see: https://www.theice.com/products/OTC.
---------------------------------------------------------------------------
London Stock Exchange Group Plc: LCH, Ltd.
LCH, Ltd. (LCH) is one of three clearinghouses that are part of LCH
Group, a U.K.-based subsidiary of the London Stock Exchange Group
(LSEG). LCH offers clearing services for major exchanges and platforms
and several OTC markets.\376\ LCH clears a variety of products through
a number of clearing services, including LCH SwapClear (interest rate
swaps), LCH RepoClear (repo and cash bond markets), LCH ForEx Clear (FX
nondeliverable forward contracts in emerging market currencies), and
listed derivatives and cash equities (including London Stock Exchange
Derivatives Market, Euronext Derivatives Market, and NASDAQ's NLX). LCH
is a registered derivatives clearing organization since 2001 with the
CFTC but is not an FSOC designated SIFMU.
---------------------------------------------------------------------------
\376\ See http://www.lch.com/documents/731485/762550/
2016_Group_Accounts_for_website.
pdf/4d998b1e-9843-4104-93da-5e52e140e2c6. LCH LLC, established after
Dodd-Frank, is the company's U.S.-based clearinghouse, but it has not
cleared trades since June 2016. See http://www.lch.com/documents/
731485/762550/2016_Group_Accounts_for_website.pdf/4d998b1e-9843-4104-
93da-5e52e140e2c6. LCH SA is the firm's French-based clearinghouse,
which acts as the clearinghouse for markets across Europe in CDS,
equities and bonds, rates and commodity futures, equity and index
futures and options, and OTC bonds and repo. See http://www.lch.com/
documents/731485/762550/2016_Group_Accounts_for_website.pdf/4d998b1e-
9843-4104-93da-5e52e140e2c6.
---------------------------------------------------------------------------
The LCH Group was formed in 2003 following the merger of LCH, which
was established in 1888 in London to clear commodity contracts, and
Clearnet, which was established in 1969 in Paris to clear commodity
contracts, forming LCH.Clearnet.\377\ At the time, it was owned by
clearing members and exchanges. In 2013, LSEG acquired a majority stake
in LCH Group.
---------------------------------------------------------------------------
\377\ See http://www.cftc.gov/files/tm/tmlchappendixa.pdf.
---------------------------------------------------------------------------
The Dodd-Frank clearing mandate applies to certain interest rate
swaps.\378\ LCH, through the SwapClear service, clears more than 90% of
the cleared U.S. dealer market in interest rate swaps and 89% of the
cleared U.S. client market in interest rate swaps (measured by cleared
gross notional).\379\ In swaps denominated in most major currencies,
LCH's SwapClear platform clears more than 75% of the cleared
market.\380\
---------------------------------------------------------------------------
\378\ U.S. Commodity Futures Trading Commission, Press Release No.
6607-13 (Jun. 10, 2013), available at: http://www.cftc.gov/PressRoom/
PressReleases/pr6607-13.
\379\ LSEG, Presentation to U.S. Treasury, LSEG U.S. Operations
(July 2017), at 11.
\380\ See http://www.lch.com/en/asset-classes/swapclear.
------------------------------------------------------------------------
LCH 2010 2016
------------------------------------------------------------------------
Annual Volume (# of Contracts 766,000 4 MM
Traded)
Annual Volume (Notional Value in $185,800 B $666,000 B
USD)
Peak Daily Volume (# of Contracts 7,000 30,000
Traded)
Peak Daily Value (Notional Value $1,400 B $5,600 B
in USD)
------------------------------------------------------------------------
Data as of year-end 2010 and 2016.
LCH Group's majority shareholder, LSEG, is a publicly traded
company with four core divisions, including capital markets, post-trade
services, information services, and technology.
Options Clearing Corporation
Options Clearing Corporation (OCC) was founded in 1973 and is the
largest clearing organization for equity derivatives. It clears U.S.-
listed options and futures on various types of financial assets such as
common stocks, stock indexes, ETFs, certain American Depository
Receipts, and commodities. OCC also serves as the only U.S. central
counterparty for securities lending transactions. OCC's primary
business is clearing; in 2016, 92% of the firm's revenue came from
clearing fees.\381\ OCC was designated by the FSOC as a SIFMU in 2012.
---------------------------------------------------------------------------
\381\ Options Clearing Corporation annual report. The reduction in
clearing fees to total revenue in 2016 was largely due to higher
revenue in the form of investment income in 2016.
---------------------------------------------------------------------------
OCC handles a large volume of transactions, specifically in the
equity options and futures markets. OCC is not active in the OTC
derivatives market, and it has been less affected by the Dodd-Frank
clearing mandate than other CCPs.
------------------------------------------------------------------------
OCC (Options Clearing Corporation) 2010 2016
------------------------------------------------------------------------
Annual Volume (# of Futures 27 MM 105 MM
Contracts Traded)
Annual Volume (# of Options 3,899 MM 4,063 MM
Contracts Traded)
Open Volume as of 12/31/2016 (# of * $15 B
Open Interest Futures Contracts)
Value Exchanged During the Year $1,213 B $1,214 B
(Premium Value from Options in
USD)
Peak Daily Volume (# of Futures * 1MM
Contracts Traded)
Peak Daily Volume (# of Options 31 MM 30 MM
Contracts Traded)
Peak Daily Open Interest Value (# * *
of Open Interest Futures
Contracts)
Peak Daily Premium Value Exchanged * *
(Premium Value of Options in USD)
------------------------------------------------------------------------
Data as of year-end 2010 and 2016.
* Denotes a data point that the OCC was unable to provide.
Central Securities Depository
A central securities depository is a facility or an institution
that holds securities, which enables securities transactions to be
processed by book-entry. Physical securities may be immobilized by the
depository or securities can be dematerialized. In addition to
safekeeping, they may also incorporate comparison, clearing, and
settlement functions.\382\
---------------------------------------------------------------------------
\382\ Assessment of the Compliance of the Fedwire Securities
Service with the Recommendations for Securities Settlement Systems
(Revised August 2009), Glossary of Terms, available at: https://
www.treasury.gov/resource-center/international/standards-codes/
Documents/Securities
%20Settlement%20Self-Assessment%208-09.pdf.
Depository Trust and Clearing Corporation: Depository Trust
---------------------------------------------------------------------------
Corporation
Depository Trust Company (DTC), a subsidiary of DTCC, provides
depository and asset servicing for a wide range of instruments, such as
money market instruments, equities, warrants, rights, corporate debt,
municipal bonds, government securities, asset-backed securities and
mortgage-backed securities. DTC's custodial services include
safekeeping of instruments, record keeping, book entry transfer, and
pledge of securities among DTC's participants. For example, DTC
provides services to securities issuers, such as maintaining current
ownership records and distributing payments to shareholders. DTC
substantially eliminates the physical movement of securities by
providing book-entry delivery of securities, which transfers ownership
electronically among broker-dealers on behalf of beneficial owners of
securities. This process improves the efficiency of post-trade
operations, compared to the previous process of paper certificate
delivery. DTC was established in 1973 as a central securities
depository in response to issues inherent with paper securities
settlement. At its inception, DTC was organized as a limited purpose
trust company in New York.\383\
---------------------------------------------------------------------------
\383\ See http://www.dtcc.com/about/businesses-and-subsidiaries/
dtc.aspx.
---------------------------------------------------------------------------
In 1999, DTC became a wholly owned subsidiary of DTCC, administered
as an industry-owned utility. Before the efficiencies that DTC created,
the New York Stock Exchange had to close each Wednesday to allow for
securities settlement. In addition to its depository and asset
servicing activities, DTC also serves as a swap data repository. DTC
was designated by the FSOC as a SIFMU in 2012.
------------------------------------------------------------------------
DTC (Depository Trust Company) 2010 2016
------------------------------------------------------------------------
Annual Volume (# of Contracts 198 MM 244 MM
Traded)
Annual Volume (Notional Value in $137,248 B $142,227 B
USD)
Peak Daily Volume (# of Contracts 1.3 MM 1.6 MM
Traded)
Peak Daily Volume (Notional Value $716 B $800 B
in USD)
------------------------------------------------------------------------
Data as of year-end 2010 and 2016.
Payment and Settlement Systems
Payment settlement systems communicate information about individual
transfers of funds and settle the actual transfers. Settlement means
the receipt by the payee's depository institution of acceptable final
funds, which irrevocably extinguish the obligation of the payor's
depository institution. Settlement can occur on a gross basis, with
each transfer being settled individually, or periodically on a net
basis, with credits and debits offsetting each other.\384\ Settlement
systems are a critical component of the infrastructure of global
financial markets. Settlement systems broadly include the full set of
institutional arrangements for the confirmation, clearance, and
settlement of trades and safekeeping of securities. The importance of
settlement systems is highlighted by the fact that market liquidity is
critically dependent on confidence in the safety and reliability of the
settlement arrangements. Traders may be reluctant to trade if they have
significant doubts about whether the trade will, in fact, settle.
---------------------------------------------------------------------------
\384\ Comptroller's Handbook: Payment Systems and Funds Transfer
Activities (March 1990), at 1-2, available at: https://
www.occ.treas.gov/publications/publications-by-type/comptrollers-
handbook/payment-sys-funds-transfer-activities/pub-ch-payment-sys-
funds-transfer-activities.pdf.
---------------------------------------------------------------------------
The Clearing House: CHIPS
The Clearing House Interbank Payment System (CHIPS) is one of the
two primary systems for interbank, large-value payment transfers; the
other is Fedwire.\385\ CHIPS is owned and operated by The Clearing
House Payments Company, L.L.C. (TCH) and has 48 participants who, in
turn, have correspondent banking relationships with many banks across
the country and world. In January 2001, CHIPS began functioning as a
real time, prefunded settlement system that takes advantage of a
proprietary multilateral netting algorithm that allows for payments to
be netted and settled more efficiently by tying up less liquidity.
CHIPS accepts payments for 20 hours per day (9 p.m. to 5 p.m. ET). At
the start of each day, CHIPS requires that each bank prefund, via
FedWire, an account at the Federal Reserve Bank of New York before
sending or receiving payments. This account is managed by TCH. Once the
processing day begins, banks begin submitting payments into a central
queue for processing. Using an algorithm, CHIPS matches, nets, and
releases the payments to receiving banks, with approximately 90% of
payments released within 1 minute. At the end of the processing day,
unmatched payments may remain. These unreleased payments are aggregated
and netted to determine a final closing position for each bank. Any
bank that has a closing position requirement must at that time transfer
funds into the CHIPS account via FedWire.\386\ TCH, on the basis of its
role as operator of the CHIPS system, was designated by the FSOC as a
SIFMU in 2012.
---------------------------------------------------------------------------
\385\ See FFIEC: http://ithandbook.ffiec.gov/it-booklets/wholesale-
payment-systems/interbank-payment-and-messaging-systems/fedwire-and-
clearing-house-interbank-payments-system-(chips).
aspx.
\386\ See generally: TCH at https://www.theclearinghouse.org/
payments/chips; and FFIEC IT Examination Handbook (CHIPS) at http://
ithandbook.ffiec.gov/it-booklets/wholesale-payment-systems/interbank-
payment-and-messaging-systems/fedwire-and-clearing-house-interbank-
payments-system-(chips)/chips.aspx.
---------------------------------------------------------------------------
CHIPS and FedWire compete for market share in the USD payments
market, with FedWire representing approximately 60% market share and
CHIPS 40%. While CHIPS uses multilateral netting, FedWire is a real-
time gross settlement system. This means each transaction must be
funded, cleared, and settled individually.
------------------------------------------------------------------------
CHIPS (Clearing House Interbank
Payments System) 2010 2016
------------------------------------------------------------------------
Annual Volume (Total Transaction $365 T $364 T
Value in USD)
Avg Daily Volume (Transaction $1.4 T $1.5 T
Value in USD)
Avg Dollar Amount per Each $4.0 MM $3.3 MM
Transaction
Annual Volume (# of Transactions) 90.9 MM 110.8 MM
Avg Daily Volume (# of 360,805 441,616
Transactions)
\387\ See https://
www.theclearinghouse.org/-/media/
tch/pay%20co/chips/
reports%20and%20 guides/
chips%20volume%20through%20july%2
02017.pdf?la=en.
------------------------------------------------------------------------
Data as of year-end 2010 and 2016.\387\
CHIPS is owned by TCH, which was established as a check
clearinghouse in 1853. TCH operates four distinct payment systems:
CHIPS, a real time payments system that is being launched, a check
image exchange, and an automated clearing house. TCH is mutually owned
by 25 of the largest domestic and international commercial banks.
CLS Bank
CLS Bank International (CLS) focuses on facilitating efficient and
effective settlement in the foreign exchange market and was launched in
2002 to address settlement risk in the FX market.\388\ Settlement risk
in the FX market, where each trade is an exchange of one currency for
another, represents the risk that a counterparty may not deliver the
promised currency per the terms of the trade, on the specified date
(generally 2 or more days after the economic terms of the trade are
agreed). CLS provides trade matching, confirmation, and payment
services that facilitate settlement. CLS's services allow each member
to pay only the net amount it owes in each currency, rather than fund
each trade individually, which makes settlement more efficient. CLS
does not act as a central counterparty, nor does it, except in the most
extreme cases, assume the risks of its members failing to perform. CLS
is an Edge Act corporation based in New York. CLS was designated by the
FSOC as a SIFMU in 2012.
---------------------------------------------------------------------------
\388\ See https://www.cls-group.com/about-us/.
---------------------------------------------------------------------------
CLS handles the equivalent of approximately $1.6 trillion in
transactions every day or the equivalent of more than $403 trillion in
transactions every year.\389\ Transaction volumes handled by CLS grew
significantly from its launch in 2002 until the financial crisis and
have been roughly flat since the passage of Dodd-Frank. CLS handles a
large volume of transactions, in both terms of trade count and
transaction value.
---------------------------------------------------------------------------
\389\ See https://www.cls-group.com/news/cls-fx-trading-activity-
june-2017/.
------------------------------------------------------------------------
CLS 2010 2016
------------------------------------------------------------------------
Annual Volume (Total Transaction $386 T $400 T
Value in USD)
Annual Volume (# of Transactions) 101.2 MM 130.3 MM
Avg Daily Volume (Total $1.5 T $1.5 T
Transaction Value in USD)
Avg Daily Volume (# of 389,000 501,000
Transactions)
Peak Daily Volume (Total $2.2 T $2.1 T
Transaction Value in USD)
Peak Daily Volume (# of 0.8 MM 1.1 MM
Transactions)
------------------------------------------------------------------------
Data as of year-end 2010 and 2016.
Ownership and Governance
Historically, exchanges and clearinghouses were organized as mutual
nonprofit associations.\390\ Demutualization in the industry occurred
in the 2000s, with exchanges transforming from mutual associations of
their members to a for-profit shareholder-owned model. Today, the major
U.S. FMUs are organized either as mutual enterprises that are member-
owned (where participants and shareholders overlap) directly or
indirectly via a parent holding company, or shareholder-owned, (where
the parent is a publicly traded company) with membership and ownership
separate.\391\
---------------------------------------------------------------------------
\390\ See Paolo Saguato, The Ownership of Clearinghouses: When
``Skin in the Game'' Is Not Enough, the Remutualization of
Clearinghouses, 34 Yale Journal on Regulation 601 (2017).
\391\ Id.
---------------------------------------------------------------------------
Participants of the FMUs generally have a voice in the governance
of the FMU through membership on the board of directors and risk
committees of the FMU, although the extent of member participation can
vary between FMUs.
Financial Market Utility (FMU) Ownership And Governance
------------------------------------------------------------------------
Parent Member
FMU Business Ownership Type Company Participation
------------------------------------------------------------------------
CHIPS Payment Member-owned TCH Board of
system (private) Directors,
Supervisory
Boards
CLS Bank Payment Member-owned CLS Group Board of
system Holdings Directors
(private)
CME, CCP Shareholder- CME Group, Multiple Risk
Inc. owned Inc. Committees
(public)
DTC CSD Member-owned DTCC Board of
(private) Directors, Risk
Committee
FICC CCP Member-owned DTCC Board of
(private) Directors, Risk
Committee
ICE CC CCP Shareholder- ICE, Inc. Board of
owned (public) Managers, Risk
(ultimate Committee
parent)
LCH SC CCP Shareholder- LSEG Board of
owned (public) Directors, Risk
(ultimate Committee
parent)
NSCC CCP Member-owned DTCC Board of
(private) Directors, Risk
Committee
OCC CCP Member-owned OCC Board of
(by Directors, Board
exchanges) Committees
------------------------------------------------------------------------
Source: Company filings, and data provided by the firms.
Regulation and Oversight of FMUs
Contagion and panic accelerated during the financial crisis due to
losses connected to derivatives, particularly with respect to certain
types of swaps, and the fear that losses would ripple throughout the
financial system. While financial reforms such as mandatory central
clearing of standardized derivatives were intended to increase
transparency and reduce risk relative to the pre-crisis regime, they
have also concentrated risk and increased the importance of CCPs in the
U.S. financial system.
Problems at one FMU may trigger significant liquidity and credit
disruptions at other FMUs or financial institutions.\392\ As a result
of the actions taken to address underlying causes of the crisis,
clearinghouses assumed an even greater importance to the global
financial system. For example, while approximately 15% of the swaps
market was cleared in 2007, approximately 75% was cleared by 2016.\393\
---------------------------------------------------------------------------
\392\ FSOC FMU Final Rule.
\393\ U.S. Commodity Futures Trading Commission, Press Release No.
7409-16 (July 21, 2016), available at: http://www.cftc.gov/PressRoom/
PressReleases/pr7409-16.
---------------------------------------------------------------------------
Central clearing has long been a feature of risk management in the
U.S. financial system, and strong risk management is key to the
management of CCPs. The statutory framework for CCP regulation has not
adequately addressed the systemic risks previously noted, and instead
mandated that additional products, which CCPs historically had little
expertise in clearing, be centrally cleared. The eight FMUs that are
designated as systemically important are subject to a heightened
regulatory and supervisory regime.\394\ The Federal Reserve, CFTC, and
SEC have prescribed risk management standards governing the operations
related to the payment, clearing, and settlement activities of the
SIFMUs, to promote robust risk management, enhance safety and
soundness, reduce systemic risk, and support the stability of the
broader financial system.\395\ These standards address risk management
policies and procedures, margin and collateral requirements,
participant or counterparty default policies and procedures, the
ability to complete timely clearing and settlement of financial
transactions, and capital and financial resource requirements.\396\
SIFMUs are also required to provide notice of material changes to their
rules, procedures, or operations to regulators for their review.\397\
Despite this acknowledgement of the systemic importance of SIFMUs,
further changes are needed in the statute to establish an appropriate
regulatory environment. In addition, appropriate regulatory resources
need to be dedicated to supervising SIFMUs.
---------------------------------------------------------------------------
\394\ See https://www.treasury.gov/initiatives/fsoc/Documents/
2012%20Appendix%20A%20Des
ignation%20of%20Systemically%20Important%20Market%20Utilities.pdf.
\395\ Dodd-Frank 805(b) [codified at 12 U.S.C. 5464(b)].
\396\ See, e.g., Dodd-Frank 805(c) [codified at 12 U.S.C.
5464(c)], 12 CFR 234.6(c) (Federal Reserve), 17 CFR 40.10 (CFTC),
and 17 CFR 240.19b-4 (SEC).
\397\ Dodd-Frank 806(e) [codified at 12 U.S.C. 5465(e)].
---------------------------------------------------------------------------
It is imperative that our financial regulatory system prevent
taxpayer-funded bailouts and limit moral hazard by addressing the
systemic risks presented by FMUs. Under Dodd-Frank, the Federal Reserve
may authorize a Federal Reserve Bank to establish and maintain an
account for a SIFMU to deposit cash and provide certain additional
services to the SIFMU.\398\ Traditionally, such accounts were available
to depository institutions. Through Title VIII, the authority was
extended to SIFMUs given their importance to the financial system.
While these accounts allow a SIFMU to deposit funds, they do not confer
borrowing privileges and should not be considered implicit backing of
an institution by the Federal Reserve. The Federal Reserve may also
authorize a Federal Reserve Bank to provide a SIFMU with certain
discount and borrowing privileges.\399\ This action may occur only in
``unusual or exigent circumstances,'' on the vote of a majority of the
Board of Governors then serving, after consultation with the Treasury
Secretary, and on a showing by the FMU that it is unable to secure
adequate credit accommodations from other banking institutions.\400\ As
a result, while SIFMUs may be authorized to access the discount window
in unusual or exigent circumstances under Dodd-Frank, a SIFMU shall
exhaust credible private sources of borrowing before turning to the
central bank to borrow in such exigent circumstances.
---------------------------------------------------------------------------
\398\ Dodd-Frank 806(a) [codified at 12 U.S.C. 5465(a)].
\399\ 12 U.S.C. 5465(b).
\400\ Id.
---------------------------------------------------------------------------
FMUs, specifically CCPs, are critical infrastructures in the U.S.
financial system that continue to pose systemic risks, in part due to
the regulatory reforms following the financial crisis, but also other
factors. First, CCPs and other FMUs have been significant market
participants for many years, even before Dodd-Frank, and are uniquely
interconnected with other U.S. financial institutions. Second, while
FMUs have always dealt with high transaction volumes and values, as
depicted above, these have remained high or continued to increase. This
has had the effect of continuing, or increasing, the systemic risk
posed by these institutions. Finally, a number of factors inherent to
the business model of major CCPs contribute to the incentives for
market participants to clear, including mutualization of clearing
members' risk, multilateral netting of exposures, and enhanced
transparencies. However, these same advantages exacerbate the
interconnecting risks these institutions pose.
Issues and Recommendations
`Advance Notice' Review Process
As previously noted, Dodd-Frank mandates that a SIFMU must provide
notice 60 days in advance ``to its Supervisory Agency of any proposed
change to its rules, procedures, or operations that could, as defined
in rules of each Supervisory Agency, materially affect, the nature or
level of risks presented by the designated financial market utility.''
\401\ Under this provision, any objection must be made by the
supervisory agency within 60 days from the later of when the notice was
filed, or when additional information was requested.\402\ If there is
no objection, the change may take effect; however, the supervisory
agency may further extend the review period for an additional 60 days
for novel or complex issues.\403\ The Federal Reserve, CFTC, and SEC
have each promulgated regulations implementing the advance notice
statutory requirements.\404\
---------------------------------------------------------------------------
\401\ Dodd-Frank 806(e).
\402\ Id.
\403\ Id.
\404\ See, e.g., 12 CFR 234.6(c) (Federal Reserve); 17 CFR
40.10 (CFTC); 17 CFR 240.19b-4 (SEC).
---------------------------------------------------------------------------
However, based on feedback from market participants provided during
outreach meetings by Treasury, the process of obtaining Federal
regulatory approval for changes to a SIFMU's rules, procedures, and
operations can take much longer than 60 days. Many changes to firms'
rulebooks, procedures, and operations--even seemingly smaller changes--
are submitted for approval through the advance notice review process,
and the regulators have extended the review period well past the 60 day
period specified in the statute. These review extensions can hamper the
ability of the SIFMUs to bring new innovations to market, leaving the
firms at a competitive disadvantage as they await approval from
regulators.
Recommendations
Given their importance to the financial system and broader economy,
it is important that SIFMUs be subject to heightened regulatory and
supervisory scrutiny, and changes to their rules, operations, and
procedures that may present material risks need to be closely reviewed
by regulators. Accordingly, Treasury recommends that the agencies that
supervise SIFMUs (the Federal Reserve, CFTC, and SEC) bolster resources
devoted to these reviews. In particular, Treasury recommends that
additional resources be allocated to the CFTC to enhance its
supervision of CCPs.
Treasury also recommends that the agencies that supervise SIFMUs
study how they can streamline the existing review process to be more
efficient and appropriately tailored to the risk that a particular
change may pose. This study may result in a number of potential process
improvements that benefit innovation while still protecting financial
stability. For example, the agencies might decide that when extending
the review period because of novel or complex issues to provide, to the
extent possible based on available information, an expected timeline
for completion of their review. The agencies might also more closely
coordinate throughout the review process to ensure one agency does not
lag behind another in their review.
Federal Reserve Bank Account Access
As noted, Dodd-Frank provides that the Federal Reserve may
authorize the Federal Reserve Banks to establish and maintain a central
bank account for, and services to, each SIFMU.\405\ The ability to
deposit client margin at a Federal Reserve Bank is an important
systemic risk mitigation tool. FMUs without such account access rely on
a number of other alternatives for cash management, such as money
market funds, repurchase agreements, and deposits at commercial banks.
These private sources may be less reliable in times of market stress.
Moreover, lack of access to a Federal Reserve Bank account means large
amounts of U.S.-dollar margin may not be maximally safeguarded during
times of market stress. Federal Reserve Bank account access may also
provide an economic advantage to SIFMUs due to the more favorable
interest rate (currently 1.25%) \406\ which the Federal Reserve Banks
may pay \407\ compared to that paid by commercial banks.
---------------------------------------------------------------------------
\405\ Dodd-Frank 806(a).
\406\ See https://www.federalreserve.gov/monetarypolicy/
reqresbalances.htm.
\407\ See Regulation HH, 12 CFR 234.6.
---------------------------------------------------------------------------
Recommendations
It is recommended that the Federal Reserve review: (1) what risks
may be posed to U.S. financial stability by the lack of Federal Reserve
Bank deposit account access for certain FMUs with significant shares of
U.S. clearing business, and an appropriate way to address any such
risks; and (2) whether the rate of interest paid on SIFMUs' deposits at
the Federal Reserve Banks may be adjusted based on a market-based
evaluation of comparable private sector opportunities.
Resilience, Recovery, and Resolution
Resilience refers to the ability of a CCP to withstand clearing
member failures and other market stress events.\408\ Within the
framework of resilience, CCP stress testing involves estimating
potential losses under a variety of extreme but plausible market
conditions, helping firms and regulators determine whether CCPs are
maintaining sufficient financial resources to withstand stress events.
CCPs also use stress tests to calibrate or adjust initial margin and
guaranty fund requirements. If the stress test identifies a potential
shortfall, a reduction in exposure or an increase in financial
resources may be warranted. CFTC regulations require derivatives
clearing organization (DCOs) that are also SIFMUs, or those that
voluntarily comply with the rules for systemically important DCOs and
that clear products with a complex risk profile, to meet the ``Cover
2'' standard, as set out in the Committee on Payments and Market
Infrastructures and the Board of the International Organization of
Securities Commissions (CPMI-IOSCO) Principals for Financial Market
Infrastructures.\409\ The SEC has similar regulations with respect to
clearing agencies. The principals also include minimum standards for
initial margin collected by clearinghouses.\410\ In November 2016, CFTC
staff published a report on its first supervisory stress tests of the
five largest DCOs registered with the CFTC and their largest clearing
members that found the DCOs could withstand extremely stressful market
scenarios and that risk was diversified across clearing members.\411\
---------------------------------------------------------------------------
\408\ See Bank For International Settlements, Committee On Payments
and Market Infrastructures, and Board of the International Organization
of Securities Commission, Final Report : Resilience of Central
Counterparties (CCPs), Further Guidance on the PFMI (July 2017),
available at: http://www.bis.org/cpmi/publ/d163.pdf.
\409\ See, e.g., U.S. Commodity Futures Trading Commission, Press
Release (Feb. 10, 2016), available at: http://www.cftc.gov/PressRoom/
PressReleases/cftc_euapproach021016.
\410\ Committee on Payment and Settlement Systems and Technical
Committee of IOSCO, Principles for Financial Market Infrastructures
(Apr. 2012), available at: http://www.bis.org/cpmi/publ/d101a.pdf.
\411\ Staff of the U.S. Commodity Futures Trading Commission,
Supervisory Stress Test of Clearinghouses (Nov. 2016), available at:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/
cftcstresstest111516.pdf.
---------------------------------------------------------------------------
Recovery refers to the ability of a CCP to continue to provide
services to markets following a stress event without the direct
intervention of a public sector resolution authority.\412\ CFTC
regulations require each DCO to maintain viable plans for: (1) recovery
or orderly wind down necessitated by uncovered credit losses or
liquidity shortfalls; and, separately, (2) recovery or orderly wind
down necessitated by general business risk, operational risk, or any
other risk that threatens the DCO as a going concern. The preparation
of these recovery plans and wind-down plans requires DCOs to ``identify
scenarios that may potentially prevent [the DCO] from being able to
meet its obligations, provide its critical operations and services as a
going concern and assess the effectiveness of a full range of options
for recovery or orderly wind-down.'' \413\
---------------------------------------------------------------------------
\412\ See Committee on Payment and Settlement Systems and Board of
IOSCO, Recovery of Financial Market Infrastructures (Oct. 2014),
available at: http://www.bis.org/cpmi/publ/d121.pdf (``CPSS-IOSCO
Recovery Guidance'').
\413\ 17 CFR 39.39(b)(2)(c)(1).
---------------------------------------------------------------------------
Resolution is the next step when recovery is unachievable.\414\ If
a SIFMU is resolved under Title II of Dodd-Frank, the FDIC would be the
resolution authority. For CCPs, many issues related to the strategy for
addressing CCP failure are still under discussion domestically and
internationally. Cross-border crisis management groups (CMGs), which
are comprised of CCP home and host supervisory and resolution
authorities, have begun meeting to develop resolution planning and
resolvability assessments for CCPs considered to be systemic in more
than one jurisdiction. Earlier this year, the FDIC and CFTC
participated in the first U.S. CMGs for CME, Inc. and ICE, to begin the
resolution planning and information sharing process for these
institutions. They have also participated in CMGs for LCH and its
French affiliate, LCH S.A. Internationally, U.S. regulators, including
the FDIC, CFTC, SEC, and Federal Reserve, have been active in
developing granular guidance on CCP recovery and resolution through
CPMI-IOSCO and Financial Stability Board (FSB) working groups.
---------------------------------------------------------------------------
\414\ See CPSS-IOSCO Recovery Guidance.
---------------------------------------------------------------------------
Recommendations
In the context of resilience, the CFTC's supervisory stress tests
of five registered DCOs was an important first step in promoting
resilience of CCPs. However, that exercise focused only on credit risk
relating to the default of a clearing member. It is recommended that
future exercises incorporate additional products, different stress
scenarios, liquidity risk, and operational and cyber risks, which can
also pose potential risks to U.S. financial stability.
The primary focus of recovery and resolution efforts must be the
recovery of the CCP, such that the CCP can continue to provide critical
services to financial markets, and the matched book of the failing CCP
can be preserved. To this end, Treasury encourages the CFTC and FDIC to
continue to coordinate on the development of viable recovery wind-down
plans for CCPs that are SIFMUs. Furthermore, there have been notable
efforts, both domestically and internationally, by regulators and
market participants to prepare for the default of large clearing
members. However, there may also be instances where a CCP experiences
significant non-default losses, such as operational or business
failures, including cyber, custodial failures, or investment losses.
Accordingly, U.S. regulators, in coordination with their international
counterparts, need to focus additional recovery and resolution planning
efforts on non-default scenarios. In addition, U.S. regulators must
continue to take part in CMGs to share relevant data and consider the
coordination challenges that domestic and foreign regulators may
encounter during cross-border resolution of CCPs. Finally, U.S.
regulators must continue to advance American interests abroad when
engaging with international standards-setting bodies such as CPMI-IOSCO
and FSB.
Regulatory Structure and Process
Overview
The financial regulatory system in the United States consists of
multiple Federal agencies, as well as state regulators and self-
regulatory organizations (SROs). In the Banking Report, Treasury
provided a brief overview of the U.S. financial regulatory structure
and its components. The analysis and recommendations in that report,
however, were focused on banking regulation.
This chapter focuses primarily on the regulatory structure of U.S.
capital markets. U.S. capital markets are distinct from, but
interconnected with, the banking system. These capital markets consist,
broadly speaking, of two segments: (1) the securities markets, which
help foster capital formation by bringing together entities seeking
capital with investors in the equity and fixed income markets, and (2)
the derivatives markets, which facilitate the transfer and management
of financial and commercial business risks through the use of futures,
options, swaps, and other types of derivative instruments, as well as
speculative risk-taking.
The U.S. capital markets regulatory system includes two Federal
regulators, the SEC and the CFTC.\415\ Some industry participants are
subject to regulation by SROs overseen by the SEC or CFTC. State
securities regulators also play an important role in regulating the
securities markets.\416\ In addition, Federal, state, and local
prosecutors may engage in enforcement of criminal laws related to the
capital markets.
---------------------------------------------------------------------------
\415\ Market participants that operate as part of a bank or thrift
holding company may be subject to additional regulation under
consolidated supervision by the Federal Reserve.
\416\ State securities regulators are generally responsible for
regulating investment advisers with less than $100 million in assets
under management. States also may also require the licensing of certain
financial professionals, including registered representatives and
investment adviser representatives, and retain anti-fraud enforcement
authority. States also regulate and require the registration of certain
securities offerings.
---------------------------------------------------------------------------
Securities Laws and the SEC
Securities and Exchange Commission
Established in 1934, the SEC's mission is to protect investors,
maintain fair, orderly, and efficient markets, and facilitate capital
formation. This three-part mission reflects the economic purpose of
securities markets, which is to promote long-term economic development
by bringing together issuers of securities, i.e., borrowers or users of
capital, and those with capital to invest. This transfer of resources
is facilitated in part by requiring that offerings of securities be
registered and that issuers disclose information that is material to
investment decisions. These investor protections are intended to give
investors sufficient insight into the operations of an issuer, and the
risks of the investment, so that investors can make an informed
decision to put their capital at risk in exchange for the opportunity
to share in the borrower's success. The SEC is overseen in Congress by
the House Financial Services and Senate Banking Committees.
In addition to regulating securities offerings, the SEC regulates
market participants, including investment advisers, mutual funds and
exchange-traded funds, broker-dealers, municipal advisors, and transfer
agents. The agency also oversees 21 national securities exchanges, ten
credit rating agencies, and seven active registered clearing agencies,
as well as the Financial Industry Regulatory Authority (FINRA) and the
Municipal Securities Rulemaking Board (MSRB). The SEC is responsible
for selectively reviewing the disclosures and financial statements of
public companies.\417\ Of the top 100 public companies in the world, 77
have reporting requirements to the SEC.\418\
---------------------------------------------------------------------------
\417\ See 15 U.S.C. 7266 (codifying Section 408 of the Sarbanes-
Oxley Act, which mandated that the SEC review reports filed under the
Exchange Act by public companies on no less than a 3 year cycle).
\418\ U.S. Securities and Exchange Commission, Fiscal Year 2018
Congressional Budget Justification and Annual Performance Plan, at 3,
available at: https://www.sec.gov/reports-and-publications/budget-
reports/secfy18congbudgjust(``SEC 2018 Budget Request'').
---------------------------------------------------------------------------
The SEC administers the Federal securities laws, which consist of
several major pieces of legislation and amendments to them that have
been enacted over the last 85 years.
Federal Securities Laws
------------------------------------------------------------------------
------------------------------------------------------------------------
Securities Act of 1933 Requires that issuers provide
financial and other important
information concerning securities
being offered for public sale and
prohibits deceit,
misrepresentations, and other fraud
in the offer and sale of securities.
Offers and sales of securities must
be registered with the SEC unless an
exemption applies.
Securities Exchange Act of 1934 Empowers the SEC with broad authority
over the securities industry,
including the regulation of brokers,
dealers, transfer agents, clearing
agencies, and self-regulatory
organizations. Prohibits fraudulent
and manipulative conduct in
securities markets and provides the
SEC with disciplinary powers over
regulated entities and persons
associated with them. Also empowers
the SEC to require periodic
reporting of information by
companies with publicly traded
securities and to regulate proxy
solicitations and tender offers.
Investment Company Act of 1940 Regulates investment companies (such
as mutual funds that engage
primarily in investing, reinvesting,
and trading of securities) and their
offerings of securities. Addresses
conflicts of interest that arise in
the operations of investment
companies. Requires periodic
investor disclosures by investment
companies.
Investment Advisers Act of 1940 Requires that persons compensated for
advising others about securities
investments must register with the
SEC and conform to regulations
designed to protect investors. Since
the Act was amended in 1996 and
2010, generally only advisers who
have at least $100 million of assets
under management or advise a
registered investment company
register with the SEC.
Sarbanes-Oxley Act of 2002 Mandated reforms to enhance corporate
responsibility, enhance financial
disclosures, and combat corporate
and accounting fraud. Authorized the
Public Company Accounting Oversight
Board to oversee the activities of
auditing firms.
Dodd-Frank Wall Street Reform and Among other provisions, established
Consumer Protection Act of 2010 the Financial Stability Oversight
Council; removed certain exemptions
from registration for advisers to
hedge funds and certain other funds;
regulated the swaps markets; created
the SEC Office of the Investor
Advocate; and amended the securities
laws for enforcement, credit rating
agencies, corporate governance and
executive compensation,
securitization, and municipal
securities.
Jump-start Our Business Startups Created the initial public offering
Act of 2012 on-ramp for emerging growth
companies, removed prohibition on
general solicitation and advertising
for certain private offerings,
permitted crowdfunding, and amended
provisions for Regulation A and
Section 12(g) of the Exchange Act.
------------------------------------------------------------------------
Financial Industry Regulatory Authority
FINRA's mission is to provide investor protection and promote
market integrity through effective and efficient regulation of its
member broker-dealers. FINRA adopts rules and regulations that apply to
its members, including rules for business conduct, supervisory
responsibility, finance and operations, and anti-money laundering.\419\
FINRA administers exams for individuals seeking to work in the industry
as a broker, such as the Series 7 exam to be a licensed general
securities representative. FINRA operates the Central Registration
Depository, which serves as the central licensing and registration
system for broker-dealers and their registered representatives. FINRA
examines its member broker-dealers for compliance with FINRA rules, the
Federal securities laws, and the MSRB rules and engages in surveillance
of market activities to detect suspicious activities such as insider
trading, fraud, and other misconduct. FINRA also operates the Trade
Reporting and Compliance Engine which facilitates mandatory reporting
of over-the-counter secondary market transactions in eligible fixed
income securities.
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\419\ Rules applicable to FINRA members are available at: http://
finra.complinet.com.
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Municipal Securities Rulemaking Board
The mission of the MSRB is to protect investors, state and local
government issuers, other municipal entities and the public interest by
promoting a fair and efficient market for municipal securities, through
(1) the establishment of rules for dealers and municipal advisors; (2)
the collection and dissemination of market information; and (3) market
leadership, outreach, and education.\420\ The MSRB supports market
transparency by making trade data and disclosure documents available
through its Electronic Municipal Market Access program. The MSRB relies
on the SEC, FINRA, and Federal bank regulators to conduct examinations
and enforcement actions with respect to its rules.
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\420\ Municipal Securities Rulemaking Board, Annual Report 2016,
available at: http://www.msrb.org/msrb1/pdfs/MSRB-2016-Annual-
Report.pdf.
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Derivatives Regulation and the CFTC
Commodity Futures Trading Commission
The CFTC's mission is to foster open, transparent, competitive, and
financially sound markets, to avoid systemic risk, and to protect
market users and their funds, consumers, and the public from fraud,
manipulation, and abusive practices related to derivatives and other
products that are subject to the Commodity Exchange Act. The regulation
of futures markets has its origins in 1922, when Congress acted in
response to abuses in grain futures markets. Federal regulation was
carried out by various agencies within the Department of Agriculture
until legislation establishing the CFTC as an independent Federal
regulatory agency was enacted in 1974.
Today, the CFTC oversees the markets for futures, options on
futures, and (since 2010) swaps under the authority of the CEA.\421\
The CFTC's mission is to promote the integrity of these markets to
avoid systemic risk and protect against fraud, manipulation, and
abusive practices. The derivatives markets allow risks to be shifted
from one party to another. Such risks may arise from uncertainty with
regard to the cost or supply of physical commodities, energy, foreign
exchange, interest rates, or other economic factors. Further,
derivatives markets provide a critical price signaling function for
related cash commodity markets. The CFTC is overseen by the House and
Senate Agriculture Committees. The CFTC has exclusive jurisdiction over
the markets for commodity futures and options on futures.
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\421\ Equity options, however, are regulated by the SEC.
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The CFTC oversees derivatives clearinghouses, futures exchanges,
swap dealers, swap data repositories, swap execution facilities,
futures commission merchants, and other intermediaries. To promote
market integrity, the CFTC polices the markets and participants under
its jurisdiction for abuses and brings enforcement actions. The CFTC
oversees industry self-regulatory organizations, including traditional
organized futures exchanges or boards of trade known as designated
contract markets.
By facilitating the hedging of price, supply, and other commercial
risks, derivatives markets help to free up capital for more productive
uses and complement the securities markets in supporting the broader
economy.
National Futures Association
The National Futures Association (NFA) is a self-regulatory
organization whose mission is to provide regulatory programs and
services that ensure futures industry integrity, protect market
participants, and help NFA members meet their regulatory
responsibilities. The NFA establishes and enforces rules governing
member behavior including futures commission merchants, commodity pool
operators, commodity trading advisors, introducing brokers, designated
contract markets, swap execution facilities, commercial firms, and
banks.\422\ NFA's responsibilities include registration of all industry
professionals on behalf of the CFTC, monitoring members for compliance
with its rules, and taking enforcement actions against its members that
violate NFA's rules. NFA also reviews all disclosure documents from
commodity pool operators (CPOs) and commodity trading advisers, annual
commodity pool financial statements, and the policies and procedures
that swap dealers are required to file with the CFTC.
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\422\ See https://www.nfa.futures.org/about/index.html.
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Security Futures, Swaps, and Security-based Swaps
The CFTC and the SEC jointly regulate security futures products,
which generally refer to futures on single securities and narrow-based
security indexes.\423\ Title VII of Dodd-Frank authorized the CFTC to
regulate swaps and the SEC to regulate security-based swaps. The
agencies share authority over mixed swaps. Title VII generally (1)
provides for the registration and regulation of swap dealers and major
swap participants, (2) imposes mandatory clearing requirements on swaps
but exempts certain end-users, (3) requires swaps subject to mandatory
clearing to be executed on an organized exchange or swap execution
facility, and (4) requires all swaps to be reported to a registered
swap data repository and subject to post-trade transparency
requirements.\424\ A report by the Government Accountability Office
found that, while the CFTC and the SEC have worked to harmonize some of
the Title VII rules and related guidance, substantive differences exist
between other rules.\425\ The agencies have issued joint rules
regarding mixed swaps.\426\
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\423\ U.S. Government Accountability Office, Financial Regulation:
Complex and Fragmented Structure Could Be Streamlined to Improve
Effectiveness (Feb. 2016), at 23 (``GAO Report (2016)'').
\424\ Id. at 44.
\425\ U.S. Government Accountability Office, Dodd-Frank
Regulations: Regulators' Analytical and Coordination Efforts (Dec.
2014), at 37-41.
\426\ Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping (July 18, 2012) [77 Fed. Reg. 48208 (Aug. 13,
2012)].
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Regulatory Fragmentation, Overlap, and Duplication
A strong financial regulatory framework is vital to promote
economic growth and financial stability and to protect the safety and
soundness of U.S. financial institutions. Regulatory fragmentation,
overlap, and duplication, however, can lead to ineffective regulatory
oversight and inefficiencies that are costly to the taxpayers,
consumers, and businesses. The convergence of the futures and
securities markets has made coordinated oversight and regulation more
critical.\427\
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\427\ For example, MF Global Holdings Ltd., which had both
commodity and securities brokerage operations, filed for bankruptcy in
2011. The company's collapse resulted in a $1.6 billion shortfall in
customer funds. A Congressional staff investigation found that although
regulated by both the SEC and the CFTC, the agencies failed to share
critical information about MF Global with each other, leaving each
regulator with an incomplete understanding of MF Global's financial
health. See Staff Report Prepared for Rep. Randy Neugebauer, Chairman,
Subcommittee on Oversight & Investigations, Committee on Financial
Services, 112th Congress (Nov. 15, 2012), available at: https://
financialservices.house.gov/uploadedfiles/256882456288524.pdf (``House
Staff Report on MF Global'').
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As more financial products have been developed that contain
elements of both securities and derivatives, it has become increasingly
difficult to distinguish between the two.\428\ In addition, market
participants are increasingly involved in both securities and
derivatives markets. Institutional investors dominate trading in both
markets, and financial intermediaries in the two markets, such as
broker-dealers and futures commission merchants, are often
affiliated.\429\ The growth of the derivatives markets and the
introduction of new derivative instruments further highlight the need
to address gaps and inconsistencies between securities and derivatives
regulation.\430\ On the global regulatory front, having separate
agencies for securities and derivatives regulation complicates
discussions with foreign regulators, because other countries generally
have a single regulator overseeing both markets; it also complicates
discussions within global bodies such as the FSB.\431\
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\428\ See, e.g., GAO Report (2016), at 42.
\429\ See U.S. Department of the Treasury, Blueprint for a
Modernized Financial Regulatory Structure (Mar. 2008), at 106-109,
available at: https://www.treasury.gov/press-center/press-releases/
Documents/Blueprint.pdf (``Treasury Blueprint (2008)'').
\430\ U.S. Department of the Treasury, Financial Regulatory Reform:
A New Foundation (June 17, 2009), at 49-51, available at: https://
www.treasury.gov/press-center/press-releases/Pages/
20096171052487309.aspx (``Treasury Foundation (2009)'').
\431\ Only the SEC is a member of the FSB. The CFTC is not a member
but participates in select FSB activities.
------------------------------------------------------------------------
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SEC and CFTC--Moving Beyond The Merger Debate
The division between the SEC and CFTC, which regulate securities and
derivatives markets, respectively, is a unique feature of the U.S.
financial regulatory system. By contrast, other major market centers
typically have a single markets regulator with jurisdiction over both
securities and derivatives markets. In recent years, regulation of U.S.
securities and derivatives markets has increasingly overlapped as
financial products and the market participants who trade them have
converged. While the SEC and the CFTC have often worked well together,
including engaging in several joint rulemakings required by Dodd-Frank,
they have also been susceptible to jurisdictional disputes, which at
times have prevented the agencies from working together effectively.
Policymakers and other commenters periodically raise the question of
whether there is a continued rationale for maintaining the SEC and the
CFTC as separate market regulators. The issue remains relevant today in
light of the Core Principles, including the need to rationalize the
Federal financial regulatory framework.
The SEC-CFTC merger debate
Principally, this debate centers on the question of whether the SEC
and the CFTC should be merged into a single regulatory agency. In some
cases, proposals to merge the two agencies have been prompted by
specific market events, such as the October 1987 stock market crash
\432\ and the 2011 failure of MF Global.\433\ Congress has also
produced a number of proposals over the years to merge the SEC and
CFTC, in whole or in part. Although Congress occasionally held hearings
on some of these proposals--for example, H.R. 718 during the 104th
Congress--none of the bills ever advanced in committee. Over the years,
Treasury also has considered, and in certain cases published, proposals
to merge the SEC and CFTC, most notably in its 2008 ``Blueprint for A
Modernized Financial Regulatory Structure'' white paper.\434\ Later,
drafters of Dodd-Frank, rather than including a merger, decided to
split jurisdiction over the OTC derivatives markets between the
agencies, including a mandate for the agencies to write joint rules in
certain areas and coordinate on others. The agencies successfully
completed joint rulemakings further defining products and entities
subject to the new OTC derivatives reforms, though there is more work
to be done.
Is there a policy rationale for merging the SEC and CFTC?
The fundamental proposition of combining two separate entities is
that the whole is greater than the sum of its parts. This is
established by identifying sufficient ``efficiencies'' and
``synergies'' arising from the merger, which in turn must outweigh the
costs and other losses that could result from their combination.
\432\ See Report of the Presidential Task Force on Market Mechanisms
(Jan. 1988), at 59, 61-63.
\433\ See House Staff Report on MF Global at 79-81, 83.
\434\ Treasury Blueprint (2008). In the Blueprint, Treasury argued that
combining the SEC and the CFTC into a single agency would ``enhance
investor protection, market integrity, market and product innovation,
industry competitiveness, and international regulatory dialogue.''
Following the financial crisis, however, Treasury stopped short of
recommending a merger of the SEC and the CFTC and instead called on the
two agencies to make recommendations to Congress for changes to
statutes and regulations that would harmonize regulation of futures and
securities. See Treasury Foundation (2009).
What follows is the potential policy rationale for an SEC-CFTC
merger from two viewpoints, operational and budget impacts as well as
impact on markets:
Operational and Budget Impacts. It is likely that efficiencies could
be realized through reduced overhead costs resulting from running a
single entity rather than two separate regulators. For example,
expenses for operating budget items such as rent and utilities,
printing and reproduction, supplies and materials, among other areas,
could be reduced in aggregate. Similarly, certain program and
administrative functions of the SEC and the CFTC could be streamlined
through consolidation of one or more of the offices of the inspector
general, general counsel, legislative affairs, or public affairs. In
addition, synergies could likely be realized in the two agencies'
expenditures on information technology.
Overall efficiencies will be limited, however, because most of the
core mission functions currently carried out by the SEC and the CFTC
would still need to be performed by a combined agency. The SEC, for
instance, considers the adequacy of corporate disclosure, public
accounting, and securities registration--regulatory activities that
have no analogues in the derivatives markets. By contrast, many key
regulatory functions of the CFTC are not performed by the SEC,
including surveillance of underlying commodities markets and regulation
of domestic futures and derivatives clearing organizations at home and
abroad. While some synergies in mission functions could be found,
merging the SEC and the CFTC is unlikely to materially enhance the
efficiency in which their core activities are carried out.
The SEC's budget for fiscal year (FY) 2017 amounted to $1.66 billion
and 4,637 budgeted full-time personnel equivalents (FTEs).\435\ The
CFTC received appropriations for a FY 2017 budget of $250 million, or
about 15% of the SEC's budget, which funds approximately 703 FTEs.\436\
Based on public information on the CFTC's budget, and making some
highly simplified assumptions, a hypothetical outcome from merging the
two agencies can be illustrated. For example, consolidation of physical
space, certain information technology, and inspector general functions
would yield hypothetical savings of roughly 5% of the combined SEC and
CFTC budgets. Viewed in the context of the overall U.S. Federal budget
of roughly $4 trillion, the potential savings are not enough on their
own to justify a merger. The table following this inset summarizes this
discussion.\437\
\435\ SEC 2018 Budget Request. Budget figures are FY 2017 annualized
under continuing resolution.
\436\ U.S. Commodity Futures Trading Commission, Budget Request Fiscal
Year 2018 (May 2017), available at: http://www.cftc.gov/idc/groups/
public/@newsroom/documents/file/cftcbudget2018.pdf. Budget figures are
FY 2017 annualized under continuing resolution.
\437\ It should be noted that this example does not presume to be a
thorough budget analysis but rather a high-level summary. A formal
examination of the agencies' budgets could potentially show greater or
lesser savings from operational efficiencies but even so would likely
not be substantial enough to alter the analysis.
Impact on Markets. Proponents of a merger argue that combining the
agencies would improve regulatory effectiveness and efficiency,
eliminate duplicative regulatory burdens on market participants,
enhance policing of market manipulation, and improve U.S. engagement in
international standard setting bodies. Examples of market overlap
include swaps and security-based swaps,\438\ security futures
products,\439\ and the markets for stocks, stock options, and stock
index futures. Market participants and key market intermediaries in
securities and derivatives also have converged. Indeed, a merger might
eliminate some regulatory gaps, redundancies and conflicts in these
cases. A merger might enhance supervision of key market participants
such as broker-dealers, futures commission merchants, and swap dealers,
while reducing the regulatory burden on regulated entities, though by
how much is hard to quantify. It might also improve access to data to
enhance oversight and surveillance by regulators of linked markets and
activities or help eliminate disparate treatment of economically
similar products, while reducing opportunities for regulatory
arbitrage.
\438\ See the ``Derivatives'' chapter in this report for more detail on
regulation of swaps and security-based swaps.
\439\ Security futures products are regulated as both securities and
futures and include futures on single securities (e.g., single-stock
futures) and narrow-based security indexes.
However, the extent to which these regulatory efficiencies and
synergies can be realized may be limited. The securities and
derivatives markets serve fundamentally different purposes: capital
formation and investment versus hedging and risk transfer. While it may
be appropriate to harmonize differences in approach to regulation of
these markets in some areas, it is far from clear that reconciliation
across all differences--for example, statutory and regulatory
approaches to margin, protection and management of customer funds,
customer suitability, insider trading, short sales, speculative
trading, and product approval processes, among others--would be
practical or advisable without risks to market health.
Although the United States is unique in its separation of securities
and derivatives markets regulation, it also has the largest, deepest,
most liquid financial markets in the world. No other major market
center has securities or derivatives markets of comparable size,
diversity, and sophistication. Our markets are mature and well
established, and while our regulatory system has perhaps evolved by
accident, it is a system that by and large has worked and has served
the American economy well.
Treasury believes that merging the SEC and the CFTC would not
appreciably improve on the current system. Instead, policymakers,
regulators, and other stakeholders should focus on effecting changes
that truly promote efficiency. Indeed, unnecessary supervisory
duplication, jurisdictional conflicts that thwart innovation, and
failures of regulatory accountability stand in contradiction to the
Core Principles, as do developments that risk the competitiveness of
U.S. companies in the financial markets or U.S. interests in
international financial regulatory negotiations. Several of the issues
discussed elsewhere in this report are aimed at prompting the SEC and
the CFTC to take needed steps toward regulatory improvement to address
these concerns. The agencies are encouraged, for instance, to harmonize
their oversight and regulation of the swaps and security-based swaps
markets with each other, as well as with non-U.S. jurisdictions to the
extent feasible and appropriate. The SEC and the CFTC must be
accountable for resolving regulatory differences and avoiding failures
of regulatory coordination.
------------------------------------------------------------------------
Possible Savings from Combined SEC and CFTC
------------------------------------------------------------------------
Assumed
Budget Personnel
FY 2017 Savings from Savings (OIG Combined
IT and Rent and other)
------------------------------------------------------------------------
SEC $1.66 billion -- -- $1.66
billion
CFTC $250 million $72.8 million $18.0 $159.2
million million
---------------------------------------------------------
$1.91 billion Combined potential savings $1.82
<5% billion
------------------------------------------------------------------------
Source: SEC and CFTC FY 2018 budget requests.
Issues and Recommendations
Restoration of Exemptive Authority
Section 4(c) of the CEA provides the CFTC with general authority to
grant exemptions ``to promote responsible economic and financial
innovation and fair competition.'' \440\ Section 36(a) of the Exchange
Act provides the SEC with authority to grant exemptions from the
Exchange Act or any rule thereunder to the extent ``necessary or
appropriate in the public interest'' and ``consistent with the
protection of investors.'' \441\
---------------------------------------------------------------------------
\440\ 7 U.S.C. 6(c).
\441\ 15 U.S.C. 78mm.
---------------------------------------------------------------------------
The CFTC has used its authority judiciously over the years to
accommodate developments and innovations in the markets it oversees,
such as helping to facilitate the emergence of electronic trading of
futures contracts. Similarly, the SEC has used its exemptive authority
to promote development and innovation in the securities markets.
Dodd-Frank amended CEA Section 4(c)(1) and Exchange Act Section
36(c) to limit the agencies' ability to exempt many of the activities
covered under Title VII. Limitations on the exemptive authority with
respect to the swaps requirements of Dodd-Frank was perhaps a measure
to ensure that the agencies, while writing rules and implementing the
new regulatory framework, did not unduly grant exemptions.
However, market participants have suggested that restoring the
exemptive provisions to their original forms could allow the agencies
to evolve with the marketplace and properly tailor their oversight to
those activities posing the highest risk, facilitate emerging and
innovative technologies and products that face high regulatory barriers
to entry, and help both the industry and regulators modernize the
market infrastructure.
For example, restoring Section 4(c) to its original form could help
facilitate the recently announced ``LabCFTC'' initiative, which is
intended to help the CFTC cultivate a regulatory culture of forward
thinking, become more accessible to emerging technology innovators,
discover ways to harness and benefit from financial technology
innovation, and become more responsive to rapidly changing
markets.\442\
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\442\ Acting Chairman J. Christopher Giancarlo, LabCFTC: Engaging
Innovators in Digital Financial Markets, (May 17, 2017), available at:
http://www.cftc.gov/PressRoom/SpeechesTesti
mony/opagiancarlo-23.
---------------------------------------------------------------------------
Recommendations
Both agencies have had an opportunity to observe the swaps markets
and examine the changes in that market that have occurred since the
enactment of Dodd-Frank. The agencies are now in a position to make
appropriate judgments about the advisability, feasibility and necessity
of any exemptions for defined categories of regulated entities or
activities, consistent with the public interest, from the CEA or
Exchange Act, including the requirements added by Dodd-Frank.
Treasury recommends that Congress restore the CFTC's and SEC's full
exemptive authority and remove the restrictions imposed by Dodd-Frank.
Improving Regulatory Policy Decision Making
Treasury believes that there are a number of areas in which the
agencies can improve their processes for making and implementing
regulatory policy decisions. Treasury believes that such changes can be
advanced administratively and could be enhanced through legislative
reform as well.
Economic Analysis in Rulemaking
Economic analysis is widely recognized as a useful rulemaking tool.
An appropriate economic analysis includes at least three basic
elements: (1) identifying the need for the proposed action; (2) an
examination of alternative approaches; and (3) an evaluation of the
benefits and costs, both quantitative and qualitative, of the proposed
action and the main alternatives identified by the analysis.\443\
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\443\ See, e.g., Office of Management and Budget, Circular A-4--
Regulatory Analysis (Sept. 17, 2003).
---------------------------------------------------------------------------
Executive Order 12866 was issued in 1993 with the aim of making the
Federal regulatory process more efficient and reducing the burden of
regulation.\444\ Executive Order 12866 directs Executive Branch
agencies to follow certain principles, including adopting a regulation
only after a reasoned determination that the benefits of the intended
regulation justify its costs. Subsequently, Executive Order 13563 \445\
was issued in 2011 to reaffirm Executive Order 12866 and supplement it
with additional principles, such as retrospective analysis of existing
rules.
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\444\ 58 Fed. Reg. 51735 (Oct. 4, 1993).
\445\ 76 Fed. Reg. 3821 (Jan. 21, 2011).
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As independent regulatory agencies, the CFTC and the SEC are not
subject to Executive Orders 12866 and 13563. However, in July 2011,
President Obama signed Executive Order 13579, which encouraged the
independent regulatory agencies to comply with the provisions in the
previous Executive Orders to the extent permitted by law.\446\
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\446\ 76 Fed. Reg. 41587 (Jul. 14, 2011).
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The CFTC and the SEC are subject to statutory requirements to
conduct some form of economic analysis. Section 15(a) of the CEA
requires the CFTC to consider the costs and benefits before
promulgating a regulation. As part of this process, CFTC must consider
the protection of market participants and the public, efficiency,
competitiveness, and financial integrity of futures markets, price
discovery, sound risk management practices, and other public
interests.\447\ Under the provisions of various securities laws, the
SEC is required to consider efficiency, competition, and capital
formation when engaged in rulemaking.\448\ Both agencies have had rules
challenged in court on the basis of inadequate cost-benefit analysis.
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\447\ 7 U.S.C. 19(a).
\448\ See 15 U.S.C. 77b(b), 78c(f), 80a-2(c), and 80b-2(c).
---------------------------------------------------------------------------
The agencies have undertaken different approaches to implementing
economic analysis. The SEC has published on its website its current
staff guidance for conducting economic analysis in rulemakings.\449\
The CFTC, on the other hand, has not publicly released current guidance
on its economic analysis efforts.\450\
---------------------------------------------------------------------------
\449\ Staff of the U.S. Securities and Exchange Commission, Current
Guidance on Economic Analysis in SEC Rulemakings (Mar. 16, 2012),
available at: https://www.sec.gov/divisions/riskfin/
rsfi_guidance_econ_analy_secrulemaking.pdf.
\450\ A 2011 report by the CFTC inspector general included a 2011
CFTC staff memo on cost-benefit analysis as an appendix. See Office of
the Inspector General, U.S. Commodity Futures Trading Commission, A
Review of Cost-Benefit Analyses Performed by the Commodity Futures
Trading Commission in Connection with Rulemakings Undertaken Pursuant
to the Dodd-Frank Act (June 13, 2011), available at: http://
www.cftc.gov/idc/groups/public/@aboutcftc/documents/file/
oig_investigation_061311.pdf.
---------------------------------------------------------------------------
Recommendations
Treasury reaffirms the recommendations for enhanced use of
regulatory cost-benefit analysis discussed in the Banking Report for
the SEC and the CFTC.\451\ Treasury supports efforts by the CFTC and
SEC to improve their economic analysis processes.\452\ Economic
analysis should not be viewed solely as a legal requirement to be
satisfied nor should the specific provisions of the Federal securities
laws or the CEA be viewed as a limitation on the scope of economic
analysis to be conducted. Economic analysis of proposed regulations,
and their underlying statutes, not only promotes informed decision
making by the agencies but also assists the President, the Congress,
and the public in assessing the effectiveness of regulations.
---------------------------------------------------------------------------
\451\ The Banking Report, at 62-63.
\452\ See Office of the Inspector General, U.S. Commodity Futures
Trading Commission, A Review of the Cost-Benefit Consideration for the
Margin Rule for Uncleared Swaps (Jun. 5, 2017), at 13, available at:
http://www.cftc.gov/idc/groups/public/@aboutcftc/documents/file/oig--
rcbcmrus060517.pdf; Jerry Ellig, Improvements in SEC Economic Analysis
since Business Roundtable, Mercatus working paper (Dec. 2016),
available at: https://www.mercatus.org/system/files/mercatus-ellig-sec-
business-roundtable-v1.pdf.
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Treasury recommends that the CFTC and SEC, when conducting
rulemakings, be guided by the Core Principles for financial regulation
laid out in Executive Order 13772 as well as the principles set forth
in Executive Orders 12866 and 13563, and that they update any existing
guidance as appropriate. Treasury further recommends that the agencies
take steps, as part of their oversight responsibilities, so that SRO
rulemakings take into account, where appropriate, economic analysis
when proposed rules are developed at the SRO level.
Finally, Treasury recommends that the CFTC and SROs issue public
guidance explaining the factors they consider when conducting economic
analysis in the rulemaking process.
Using a Transparent, Common Sense, and Outcomes-Based Approach
As stated in Executive Order 12866, which is still in effect today,
``The American people deserve a regulatory system that works for them,
not against them: a regulatory system that protects and improves their
health, safety, environment, and well-being and improves the
performance of the economy without imposing unacceptable or
unreasonable costs on society; regulatory policies that recognize that
the private sector and private markets are the best engine for economic
growth; regulatory approaches that respect the role of state, local,
and Tribal governments; and regulations that are effective, consistent,
sensible, and understandable.''
To maintain an efficient, effective, and appropriately tailored
regulatory system, it is critical that agencies conduct periodic
reviews of existing regulations. These retrospective reviews should
identify rules that may be outmoded, ineffective, insufficient, or
excessively burdensome, and agencies should move to modify, streamline,
expand, or repeal them in accordance with what has been learned.
Importantly, the retrospective reviews should use data to the maximum
extent possible.
Recommendations
To enhance rulemaking transparency, Treasury encourages the SEC and
the CFTC to make fuller use of their ability to solicit comment and
input from the public, including by increasing their use of advance
notices of proposed rulemaking to better signal to the public what
information may be relevant.
Treasury recommends that the CFTC and the SEC conduct regular,
periodic reviews of agency rules for burden, relevance, and other
factors. Treasury recognizes and supports the efforts undertaken by the
CFTC with Project KISS (for ``Keep it Simple, Stupid'') to conduct an
internal review of rules, regulations, and practices to identify areas
that can be made less burdensome and less costly.\453\
---------------------------------------------------------------------------
\453\ Acting Chairman J. Christopher Giancarlo, CFTC: A New
Direction Forward (Mar. 15, 2017), available at: http://www.cftc.gov/
PressRoom/SpeechesTestimony/opagiancarlo-20.
---------------------------------------------------------------------------
Treasury supports the goals of principles-based regulation and
recommends that the SEC and the CFTC consider using this approach, to
the extent appropriate and consistent with applicable law.
Finally, given the linkages between the derivatives markets and the
capital markets, Treasury believes that the CFTC and the SEC should
continue their joint outcomes-based effort to harmonize their
respective rules and requirements, as well as the cross-border
application of such rules and requirements.
Regulatory Guidance Outside of Rulemaking
In administering their respective laws and regulations, the CFTC
and the SEC may provide regulatory guidance outside of the notice and
comment process conducted pursuant to the Administrative Procedure Act.
For example, staff from the CFTC and the SEC might issue guidance
through an interpretive bulletin or a list of frequently asked
questions after a rulemaking to clarify regulatory expectations or to
ensure the smooth implementation of a rule.
There are other mechanisms through which the CFTC or the SEC may
publicly express new views that have the effect of de facto regulation,
such as:
The preamble of a final rule when such views were not
disclosed at the proposal stage;
Negotiated settlement of an enforcement action;
Court filings in a litigated enforcement action or where the
agency is participating as an amicus curiae;
Commission opinion issued on appeal of an administrative
enforcement action;
No-action letters;
Technical materials and guides;
Comment letters to registrants or regulated entities;
Deficiency letters in connection with examinations;
Policy statements, risk alerts, and legal bulletins;
Speeches and publications;
Publications by international organizations, such as the
Financial Stability Board, the International Organization of
Securities Commissions, and the International Monetary Fund.
Guidance is a valid and useful tool, and there are appropriate
circumstances in which guidance is helpful in assisting regulated
parties in complying with underlying statutes or regulations. However,
there is a serious risk of inappropriate use of guidance as a way to
impose regulatory requirements and burdens outside of notice-and-
comment rulemaking.
Recommendations
Treasury recommends that the CFTC and the SEC avoid imposing new
requirements by no-action letter, interpretation, or other form of
guidance and consider adopting Office of Management and Budget's Final
Bulletin for Agency Good Guidance Practices.\454\ Treasury also
recommends that the CFTC and the SEC take steps to ensure that guidance
is not being used excessively or unjustifiably to make substantive
changes to rules without going through the notice and comment process.
Treasury further recommends that the CFTC and the SEC review existing
guidance and revisit any guidance that has caused market confusion or
compliance challenges.
---------------------------------------------------------------------------
\454\ Final Bulletin for Agency Good Guidance Practices (Jan. 18,
2007) [72 Fed. Reg. 3432 (Jan. 25, 2007)].
---------------------------------------------------------------------------
Update Definitions under the Regulatory Flexibility Act
When engaged in rulemaking, Federal agencies are required to
perform an analysis under the Regulatory Flexibility Act (RFA),\455\
which requires them to consider the impact on small entities.
---------------------------------------------------------------------------
\455\ 5 U.S.C. 601 et seq.
---------------------------------------------------------------------------
Since 1982, the CFTC has excluded any designated contract markets,
FCMs, and CPOs registered with the CFTC from being considered a small
entity under the RFA.\456\ The effect of the CFTC's approach is that
none of these registered entities can ever be a ``small entity'' for
purposes of the RFA analysis. Commodity trading advisors, floor
brokers, and unregistered FCMs are neither automatically included nor
excluded from the definition of ``small entities.'' Instead, the CFTC
has previously stated that, for purposes of RFA analysis, small
entities would be addressed within the context of specific rule
proposals, but without any specified definition.\457\
---------------------------------------------------------------------------
\456\ Policy Statement and Establishment of Definitions of ``Small
Entities'' for Purposes of the Regulatory Flexibility Act [47 Fed. Reg.
18618 (Apr. 30, 1982)].
\457\ Id. Note that individuals are not considered in the RFA
analysis.
---------------------------------------------------------------------------
For the SEC, rules under the Securities Act and the Exchange Act
\458\ generally define an issuer or a person with total assets of $5
million or less as a small business or small organization. This
threshold was last adjusted in 1986. Other small business definitions
under the Exchange Act use monetary thresholds that were set in 1982.
There are other thresholds for small entity definitions under the
Investment Company Act and the Investment Advisers Act that have not
been changed in many years.\459\ The extremely limited scope of these
definitions frequently excludes from the RFA analysis many entities
that should arguably be viewed as a small entity.
---------------------------------------------------------------------------
\458\ 17 CFR 230.157; 17 CFR 240.0-10.
\459\ 17 CFR 270.0-10; 17 CFR 275.0-7.
---------------------------------------------------------------------------
Recommendation
Treasury recommends that the agencies undertake a review and update
the definitions so that the RFA analysis appropriately considers the
impact on persons who should be considered small entities.
Self-regulatory Organizations
Historically, regulation of the U.S. financial markets has entailed
a combination of government regulation and industry self-regulation. In
the derivatives and securities markets, SROs operate under the
regulatory oversight of the CFTC or the SEC. Industry self-regulation
can provide a mutually beneficial balance between the interests of the
public and the regulated industry, particularly if the effects of the
SRO are to strengthen investor protection and promote market integrity.
SROs set standards, conduct examinations, and enforce rules against
their members. SROs can establish conduct standards that may go beyond
those otherwise required by law. For example, FINRA has a requirement
that its members observe high standards of commercial honor and just
and equitable principles of trade.\460\
---------------------------------------------------------------------------
\460\ FINRA Rule 2010.
---------------------------------------------------------------------------
Self-regulation by industry, however, can create a conflict between
regulatory obligations and the interests of an SRO's members, market
operations, or listed issuers, which necessitates appropriate
governmental supervision.\461\ SROs subject to oversight by the CFTC
include the National Futures Association, the commodity exchanges
(designated contract markets), swap execution facilities, derivatives
clearing organizations, and swap data repositories. SROs subject to
oversight by the SEC include FINRA, the registered national securities
exchanges, notice-registered securities future product exchanges (dual
notice-registration with CFTC), registered clearing agencies, and the
MSRB.
---------------------------------------------------------------------------
\461\ The Governance of Self-Regulatory Organizations (June 2,
2004) [69 Fed. Reg. 32326 (Jun. 9, 2004)] (CFTC); Concept Release
Concerning Self-Regulation (Nov. 18, 2004) [69 Fed. Reg. 71256, 71256-
58 (Dec. 8, 2004)] (``SEC SRO Concept Release'').
---------------------------------------------------------------------------
One benefit of SRO regulation is that SROs are more familiar with,
and able to take into account, the complexities of the day-to-day
business operations of regulated entities and the markets.\462\ SROs
engage in market surveillance, trade practice surveillance, and conduct
audits and examinations of members for compliance with various rules,
including financial integrity, financial reporting, sales practices,
and recordkeeping.\463\ SROs can investigate potential violations and
bring disciplinary proceedings against members for violations of SRO
rules. SROs are funded by various fees and assessments, not out of
Federal agency resources.\464\ As an on-the-ground, front-line
regulator, an SRO can be a more efficient and effective mechanism to
protect the public against unlawful market activity.
---------------------------------------------------------------------------
\462\ See, e.g., CFA Institute, Self-Regulation in the Securities
Markets (Aug. 2013), at 2, available at: http://www.cfapubs.org/doi/
pdf/10.2469/ccb.v2013.n11.1 (observing that, although not perfect, the
self-regulatory system is needed ``in today's highly complex and
technologically changing and evolving markets'').
\463\ Self-Regulation and Self-Regulatory Organizations in the
Futures Industry (Nov. 18, 2005) [70 Fed. Reg. 71090 (Nov. 25, 2005)].
\464\ The costs of funding SROs, however, may be borne indirectly
by investors and end-users in the form of higher costs.
---------------------------------------------------------------------------
On the other hand, the SRO model has been called into question by
certain developments and trends. Some SROs, such as the national
securities exchanges and designated contract markets, have transformed
from member-owned, mutual organizations to for-profit, publicly traded
companies. As such, concerns have been raised as to whether their
obligations to their shareholders may conflict with their duties and
powers to regulate public markets and their members. In addition, as a
result of consolidation within the financial services industry, the
economic importance of certain SRO members may create particularly
acute conflicts.\465\
---------------------------------------------------------------------------
\465\ SEC SRO Concept Release at 71259-60.
---------------------------------------------------------------------------
In outreach meetings with Treasury, some member firms stated that
the SROs have gradually become less transparent and more opaque,
arbitrary, and prescriptive in fulfilling their self-regulatory
function, weakening the traditional connection with markets and their
members. The increase in non-member involvement in governance of the
SRO has led to a diminished influence of members, both at the board and
committee levels, in determining SRO regulatory policy.\466\ In this
respect, SROs have become less like an industry-led self-regulator and
more like a government regulator but without due process protections.
---------------------------------------------------------------------------
\466\ But see U.S. Securities and Exchange Commission, Report
Pursuant to Section 21(a) of the Securities Exchange Act of 1934
Regarding the NASD and the NASDAQ Market (Aug. 8, 1996), available at:
https://www.sec.gov/litigation/investreport/nd21a-report.txt (``the
consequences for the Nasdaq market of this failure were exacerbated by
the undue influence exercised by Nasdaq market makers over various
aspects of the NASD's operations and regulatory affairs'').
---------------------------------------------------------------------------
In addition, the increasing number of SRO rules and the potential
for regulatory duplication and overlap with the CFTC or the SEC or with
other SROs, increases operational complexity and costs for market
participants and potentially creates inefficiencies in regulation.
These regulatory costs are ultimately borne by investors and end-users.
Recommendations
Treasury recommends that the CFTC and the SEC conduct comprehensive
reviews of the roles, responsibilities, and capabilities of SROs under
their respective jurisdictions and make recommendations for
operational, structural, and governance improvements of the SRO
framework. Such reviews should consider:
Within specific categories of SROs, how to ensure comparable
compliance by SROs with their self-regulatory obligations to
avoid outlier SROs that do not fully comply with these
obligations;
Appropriate controls on SRO conflicts of interest;
Appropriate composition, roles, and empowerment of SRO
committees;
Appropriate transparency regarding SRO fee structures to
ensure alignment of fees with actual costs of regulation;
Appropriate application and limitations on regulatory
immunity and private liability to SRO regulatory operations as
opposed to general operations, including commercial operations,
of the SRO;
Appropriate limitations on regulatory, surveillance and
enforcement responsibilities entrusted to SROs, including
limitations of regulatory activities to SROs' own markets and
centralization of cross-market regulation within a single SRO
and avoiding duplicative investigations, audits, and
enforcement actions;
Changes to the process for agency review and approval of SRO
rulemakings to manage the volume and priority of such
rulemakings in a manner consistent with applicable laws.\467\
---------------------------------------------------------------------------
\467\ See also Susquehanna Int'l Group v. SEC, No. 16-1061 (D.C.
Cir. Aug. 8, 2017) (finding that SEC approval of a rule change from the
Options Clearing Corporation did ``not represent the kind of reasoned
decisionmaking required by either the Exchange Act or the
Administrative Procedure Act'').
As part of their reviews, Treasury recommends that the agencies
identify any changes to underlying laws or rules needed to enhance
oversight of SROs. Treasury also recommends that each SRO adopt and
publicly release an action plan to review and update its rules,
guidance, and procedures on a periodic basis. In this context, Treasury
supports the current effort by FINRA to conduct a comprehensive,
organization-wide self-assessment and improvement initiative.\468\
Treasury encourages the NFA and other SROs to undertake similar
projects.
---------------------------------------------------------------------------
\468\ See https://www.finra.org/about/finra360.
---------------------------------------------------------------------------
International Aspects of Capital Markets Regulation
Overview
Cross-border financial integration enhances capital markets
efficiency through better allocation of savings while stability is
enhanced through better risk sharing. Because of these economic
benefits, capital markets are increasingly global in nature, becoming
highly integrated and interdependent. However, integration of capital
markets also increases the potential for the cross-border transmission
of shocks. This underscores the need to accompany the increasing role
of nonbank financial intermediation and market-based financing with
adequate regulatory and supervisory frameworks to safeguard financial
stability.
Generally, given the size and global stature of U.S. capital
markets, the U.S. regulatory approach is to provide investors and firms
with a U.S. presence equal access to our markets on national treatment
terms. Cross-border access is allowed to foreign registrants and
financial institutions in a manner consistent with prudential and other
public policy objectives. This provides a level playing field for
market participants wanting to access and be active in our markets, the
largest and most vibrant nonbank financial sector in the world.
Regulatory frameworks that encourage diverse approaches with respect to
products, investment strategies, and investment horizons help create
vibrant markets, and variation across jurisdictions is not only
acceptable but desirable. At the same time, conflicting frameworks,
whether it be within a jurisdiction or between them, can fragment
markets, lead to unnecessary costs, distort price discovery, and reduce
consumers' options. In some cases, regulation can have far reaching and
often unintended consequences for market participants in other
jurisdictions that may have little connection to the jurisdiction
promulgating the regulation or the issue being regulated.
Internationally active financial institutions may be subject to
overlapping, duplicative, and sometimes incompatible national
regulatory regimes. Appropriate regulatory cooperation in bilateral and
multilateral forums can advance U.S. interests by promoting financial
stability, leveling the playing field for U.S. financial institutions,
and reducing market fragmentation.
Since the financial crisis, regulators have worked to address these
shortcomings by agreeing on common standards, where appropriate, and
depending on a jurisdiction's preference, through findings of
substituted compliance and regulatory equivalence. Findings of
substituted compliance and regulatory equivalence are recognitions
(generally unilateral) that foreign regulatory regimes achieve similar
goals and that national regulatory approaches, while differing in
certain respects, were of a high quality. For example, after
consultation with the SEC in 2012 the European Securities and Markets
Authority eventually reported to the European Commission (EC) its
conclusion that the U.S. regulatory regime for credit rating agencies
was equivalent to the EU's own system. Several months later, the EC
formally rendered its equivalency determination for the U.S. credit
rating agency regulatory regime.
------------------------------------------------------------------------
-------------------------------------------------------------------------
Markets in Financial Instruments Directive II
The EU's Markets in Financial Instruments Directive (2004/39/EC,
MiFID) has been applicable across the European Union since November
2007. It is a cornerstone of the EU's regulation of financial markets
seeking to improve the competitiveness of EU financial markets by
improving the single European market for investment services and
activities and to ensure a similarly high degree of protection for
investors in financial instruments. The MiFID II Framework was formally
adopted on June 12, 2014, and many of its key elements will apply
across Europe as of Jan. 3, 2018.\469\
\469\ See https://www.esma.europa.eu/policy-rules/mifid-ii-and-mifir.
One currently contentious cross-border aspect of MiFID II is the
unbundling of financial research services and payments. Currently, fund
managers receive the research at no cost because investment banks and
brokers bundle the costs into the trading fees that are passed onto
investors.\470\ Under MiFID II, European fund managers will be required
to pay investment banks and brokers directly for analyst research via
two options: (1) paying for the research directly from their own
accounts, or (2) creating separate research payment accounts funded by
specific charges billed to clients. Asset managers will likely
significantly reduce the amount of research they pay for, and brokers
are expecting significant decreases in revenue for research services.
MiFID II's research unbundling creates implementation challenges due to
conflicts with U.S. policy on research provision, where U.S. brokers
cannot directly sell research unless they are formally registered as
investment advisers. Under MiFID II, U.S. brokers that are not
registered investment advisers cannot provide research to European
clients since MiFID II would require such clients to make direct
payments for research services. Because many firms operate
internationally, there is uncertainty in the market over how to comply
with MiFID II. There is also confusion on whether U.S. asset managers
can share analyst research freely within their firms if they have
European footprints. The SEC and the European Commission are currently
in discussions to develop solutions to this apparent conflict.
\470\ See 15 U.S.C. 78bb(e).
------------------------------------------------------------------------
Issues and Recommendations
Advancing American Interests
To avoid fragmenting and harming these complex and diverse markets,
U.S. agencies must continue to engage and cooperate bilaterally and
multilaterally with other jurisdictions to work toward coherent
regulation and supervision that protects consumers, manages systemic
risk, and enhances financial stability. U.S. engagement in
international forums should also continue to advance U.S. interests by
enabling U.S. companies to be competitive in domestic and foreign
markets. Additionally, a key objective and consideration of regulation
and regulatory policy both domestically and in the international
context is to maintain the competitiveness of U.S. capital markets.
This means domestic regulation that promotes market efficiency and
cost-effectiveness and international engagement to ensure that U.S.
markets remain attractive to foreign investors and institutions.
Bilateral Regulatory Cooperation
Treasury coordinates a series of productive bilateral policy
dialogues. These include dialogues with the European Union, Mexico, and
Canada within the context of the North American Free Trade Agreement
Financial Services Committee, and India. These discussions have helped
to facilitate cooperation and coherent implementation of financial
regulation.
Recommendations
Treasury recommends that U.S. regulators and Treasury sustain and
develop technical level dialogues with key partners, informed by prior
outreach to industry, to address conflicting or duplicative regulation.
Treasury also recommends that U.S. regulators seek to reach outcomes-
based, non-discriminatory substituted compliance arrangements with
other regulators or supervisors with the goal of mitigating the effects
of regulatory redundancy and conflict when it is justified by the
quality of foreign regulation, supervision, and enforcement regimes,
paying due respect to the U.S. regulatory regime. Treasury also assists
the regulators, when appropriate, in navigating the challenges of
reaching substituted compliance arrangements. Responsible comparisons
of regulatory regimes require sufficient attention to the details and
actual application of rules, and relying on compliance with minimum
international standards is not itself necessarily sufficient. It is the
responsibility of U.S. regulators to determine whether firms operating
in the United States achieve the necessary outcomes for safety,
soundness, and investor protection, as set out in domestic statute and
regulations.
Multilateral Regulatory Cooperation
As noted in the Banking Report, U.S. engagement in international
financial regulatory standard-setting bodies (SSBs) remains important
to promote vibrant financial markets and level playing fields for U.S.
financial institutions, prevent unnecessary regulatory standard-setting
that could stifle financial innovation, and assure the competitiveness
of U.S. companies and markets. Treasury recommends that the U.S.
members of international standard setting organizations should enhance
the efficiency of international standards by reducing conflicting
cross-sectoral standards. To improve transparency and accountability,
the SSBs should appropriately consider and account for the views and
concerns of external stakeholders, including market participants, self-
regulatory organizations, and other interested parties. The current
processes for developing significant standards could be improved, and
Treasury recommends increasing the number and timeliness of external
stakeholder consultation and publicizing the schedule of major
international meetings.
Recommendations
Treasury recommends that the U.S. members of SSBs continue to
advocate for and shape international regulatory standards that are
aligned with domestic financial regulatory objectives.
The American marketplace is like no other, and benefits from a
diversity of providers and consumers of financial intermediation.
Inappropriately applying approaches to regulation in U.S. capital
markets that are ill suited to our jurisdiction or bank-centric would
stifle otherwise vibrant markets while not efficiently enhancing
financial stability or consumer protection. Treasury recommends that
U.S. agencies remain alert to developments abroad and engaged in
international organizations. To promote the effectiveness and
efficiency of regulations, U.S. agencies should continue to regularly
coordinate policy before and after international engagements. Direct
coordination, at all relevant levels of an organization and across all
U.S. agencies, will enhance the substantive basis of advocacy for U.S.
market participants' interests when engaging abroad but also increase
the force of our outreach. We are more effective when we speak with one
voice and the full support of the U.S. regulatory system.
Good policy development should consider the interactions of
regulation and also the proper alignment of incentives. Regulatory
approaches that have worked in one context, such as a country or
sector, should not be inappropriately applied elsewhere. Robust
regulatory impact assessment and stakeholder consultation and input are
key steps in understanding the likely effects of regulation. As a
result, Treasury values the U.S. process of notice and comment under
the Administrative Procedure Act, recommends that other jurisdictions
adopt similarly robust comment procedures, and will work in
international organizations to elevate the quality of stakeholder
consultation globally.
Appendix A
Participants in the Executive Order Engagement Process
------------------------------------------------------------------------
------------------------------------------------------------------------
Academics
------------------------------------------------------------------------
Adi Sunderam, Harvard Business John Taylor, Stanford University
School Hoover Institution
Anat Admati, Stanford Graduate Joseph Grundfest, Stanford Law
School of Business School
Arnold Kling, Independent Scholar Lawrence White, New York University
Stern School of Business
Arthur Wilmarth, Jr., George Mark Willis, New York University
Washington University Law School Furman Center
Darrell Duffie, Stanford Graduate Monika Piazzesi, Stanford
School of Business University
David Skeel, University of Richard Herring, University of
Pennsylvania Law School Pennsylvania, The Wharton School
Jay Rosengard, Harvard Kennedy Roberta Romano, Yale Law School
School
Jim Angel, Georgetown University Robin Greenwood, Harvard Business
McDonough School of Business School
John Cochrane, Stanford University Sanjai Bhagat, University of
Hoover Institution Colorado Leeds School of Business
------------------------------------------------------------------------
Consumer Advocates
------------------------------------------------------------------------
American Association of Retired National Association for the
Persons Advancement of Colored People
Americans for Financial Reform National Community Reinvestment
Coalition
Center for Responsible Lending National Consumer Law Center
Consumer Action National Council of La Raza
Consumer Federation of America National Disability Institute
Consumers Union National Urban League
Leadership Conference on Civil and U.S. Public Interest Research Group
Human Rights
------------------------------------------------------------------------
Regulators and Government Related Entities
------------------------------------------------------------------------
California Public Employees' Independent Member with Insurance
Retirement System Expertise, FSOC
Conference of State Bank Municipal Securities Rulemaking
Supervisors Board
Consumer Financial Protection National Futures Association
Bureau
Delegation of the European Union to New York State Common Fund
the United States of America North American Securities
Federal Deposit Insurance Administrators Association
Corporation
Federal Housing Finance Agency Office of Financial Research
Federal Reserve Bank of New York Office of the Comptroller of the
Currency
Federal Reserve Board Teachers Retirement System of Texas
Federal Reserve Bank of Chicago U.S. Commodity Futures Trading
Commission
Financial Services Agency, Japan U.S. Securities and Exchange
Commission
Financial Industry Regulatory
Authority
------------------------------------------------------------------------
Industry and Trade Groups
------------------------------------------------------------------------
ABN AMRO Clearing The Investors Exchange (IEX)
Aegon N.V. (Transamerica) Janney Montgomery Scott LLC
AFEX/GPS Capital Jones Walker LLP
Aflac Inc. Jordan & Jordan
AllianceBernstein L.P. JP Morgan
Allstate Corporation Katten Muchin Rosenman LLP
American Bankers Association Keefe, Bruyette & Woods
American Council of Life Insurers KKR
American Express KPMG LLP
American Institute of Certified Kroll Bond Rating Agency
Public Accountants
American International Group, Inc. Latham & Watkins LLP
American Investment Council Law Office of William J. Donovan
American Principles Project LCH
Amerifirst Financial, Inc. LCH Clearnet Group Ltd
Andreessen Horowitz Levy Group
Angel Capital Association Liberty Mutual Group, Inc.
Angel Oak Home Loans Lincoln Financial Bancorp, Inc.
AQR Capital Management LivWell
Association for Financial Loan Syndication and Trading
Professionals Association
Association for Enterprise Loomis, Sayles & Co
Opportunity
Association of Institutional LSEG
Investors
Association of Mortgage Investors M&T Bank
Autonomous Research Managed Funds Association
AXA Manulife Financial Corporation
Bank of America Marvin F. Poer and Company
Bank of New York Mellon Massachusetts Mutual Life Insurance
Company
Barclays Mayer Brown, LLP
Bayview Asset Management MB Financial, Inc.
Bernstein McGuireWoods LLP
BGC Partners McKinsey & Company
Biotechnology Innovation MetLife Investors
Organization
BlackRock Mid-Size Bank Coalition of America
Blackstone Modern Markets Initiative
Bloomberg Moody's Corporation
BNP Paribas Moody's Investor Services
BOK Financial Corporation Morgan Stanley
Bond Dealers of America Mortgage Bankers Association
Boston Consulting Group NASDAQ
Bridgewater Associates National Association of Corporate
Treasurers
Business Roundtable National Association of Home
Builders
Cadwalader, Wickersham & Taft, LLP National Bankers Association
Caliber Home Loans National Conference of Insurance
Guaranty Funds
Carlyle Group National Federation of Independent
Business
Carnegie Cyber Policy Initiative National Organization of Life and
Health Guaranty Associations
Center for Capital Markets National Restaurant Association
Competitiveness, U.S. Chamber of National Retail Federation
Commerce
Center for Financial Services National Venture Capital
Innovation Association
Chatham Financial Nationstar Mortgage Holdings Inc.
Chicago Board Options Exchange Nationwide Mutual Insurance Company
Chicago Mercantile Exchange Natixis
Chicago Trading Company Navient
CHIPS NEX Markets
Chubb New York Life Investors, LLC
Citadel Nomura
Citi Northwestern Mutual Life Insurance
Company
Class V Group NYSE
Clayton Holdings, LLC Och-Ziff
Cleary Gottlieb Steen & Hamilton Old National Bancorp
LLP
CLS Oliver Wyman
CMG Financial Inc. Options Clearing Corporation
CNH Industrial Orbital ATK
Coalition for Derivatives End-Users PentAlpha Capital, LLC
Coalition for Small Business Growth PHH Mortgage Corporation
Columbia Investment Management PIMCO
Commercial Real Estate Finance Primary Residential Mortgage, Inc.
Council
Community Bankers Association Progressive Corporation
Community Development Bankers Property Casualty Insurers
Association Association of America
Council of Institutional Investors Prudential Financial, Inc.
Cowen & Co. Pulte Mortgage LLC
Credit Suisse Quantlab Financial, LLC
Crowdfund Capital Advisors Quicken Loans Inc.
Crowdfund Intermediary Regulatory Redwood Trust Inc.
Advocates
Cullen/Frost Bankers, Inc. Risk Management Association
Cypress Group Rock Financial Corporation
D.E. Shaw Roosevelt Management Company
Davidson Kempner Royal Bank of Canada
Davis Polk & Wardwell LLP Runbeck Election Services
DoubleLine Capital Sallie Mae
Depository Trust and Clearing Sandler O'Neill and Partners LP
Corporation (DTCC)
Eby-Brown Sanovas
EKap Strategies LLC Santander
Ellington Management Group, LLC Scale Venture Partners
Elliott Management Corporation Securities Industry and Financial
Markets Association
Emergent Biosolutions Security Traders Association
Equipment Leasing and Finance Small Business & Entrepreneurship
Association Council
Equity Dealers of America Small Business Majority
Equity Markets Association Societe Generale
Equity Prime Mortgage, LLC Standard & Poor's Financial
Services LLC
Fidelity Investments Starwood Mortgage Capital
Financial Executives International State Farm Mutual Automobile
Insurance Company
Financial Information Forum State Street
Financial Services Roundtable Stearns Lending, LLC
Fitch Ratings Inc. Steptoe & Johnson LLP
Flagstar Bank Structured Finance Industry Group
Ford Foundation Sullivan & Cromwell LLP
Francisco Partners SVB Financial Group
Franklin Templeton Investments SWBC Mortgage Corporation
Futures Industry Association Swiss Re Ltd.
GEICO Corporation TCF Financial Corporation
General Electric TD Group US Holdings
Geneva Trading Teachers Insurance and Annuity
Association of America
Gibson, Dunn & Crutcher LLP The Clearing House
Global Financial Markets The Cypress Group
Association
Global Trading Systems Thomson-Reuters
Glycomimetrics TIAA Global Asset Management
Goldman Sachs Tradeweb
Goldstein Policy Tradition
Guaranteed Rate, Inc. Travelers Companies, Inc.
Hancock Whitney Bank Tullet Prebon
HBK Capital Management Two Sigma Investments
Healthy Markets U.S. Chamber of Commerce
Hehmeyer Trading UBS
HomeBridge Financial Services Inc. UMB Financial Corporation
HSBC Union Home Mortgage Corporation
Hudson River Trading United States Automobile
Association
Hunt Consolidated, Inc. Vanguard
ICF International, Inc. VantageScore Solutions, LLC
Independent Community Bankers of Venable LLP
America
Institute of International Bankers Virtu Financial Inc.
Institute of International Finance Waddell & Reed
Intercontinental Exchange (ICE) WeFunder
International Council of Shopping Wellington Management
Centers
International Franchise Association Wells Fargo
International Swaps and Derivatives Wholesale Markets Brokers'
Association Association
Invesco Wilson Sonsini Goodrich & Rosati
Investment Company Institute Wintrust Financial Corporation
------------------------------------------------------------------------
Think Tanks
------------------------------------------------------------------------
American Enterprise Institute Heritage Foundation
Aspen Institute Hoover Institution
Better Markets Mercatus Center at George Mason
University
Bipartisan Policy Center New America
Brookings Institution Pew Charitable Trust
CATO Institute R Street Institute
Committee on Capital Markets Urban Institute
Regulation
Competitive Enterprise Institute
------------------------------------------------------------------------
Appendix B
Table of Recommendations
Access to Capital
------------------------------------------------------------------------
Policy Responsibility
Recommendation ----------------------------- Core
Congress Regulator Principle
------------------------------------------------------------------------
Public Companies and IPOs
------------------------------------------------------------------------
Treasury recommends that Congress SEC D, F
Section 1502 (conflict
minerals), Section 1503
(mine safety), Section 1504
(resource extraction), and
Section 953(b) (pay ratio)
of Dodd-Frank be repealed
and any rules issued
pursuant to such provisions
be withdrawn, as proposed
by H.R. 10, the Financial
CHOICE Act of 2017. In the
absence of legislative
action, Treasury recommends
that the SEC consider
exempting smaller reporting
companies (SRCs) and
emerging growth companies
(EGCs) from these
requirements.
As required by the Fixing SEC F
America's Surface
Transportation Act,
Treasury recommends that
the SEC proceed with a
proposal to amend
Regulation S-K in a manner
consistent with its staff's
recent recommendations.
Treasury recommends that the SEC F
SEC move forward with
finalizing its current
proposal to remove SEC
disclosure requirements
that duplicate financial
statement disclosures
required under generally
accepted accounting
principles by the Financial
Accounting Standards Board.
Treasury recommends that SEC A, D, F
companies other than EGCs
be allowed to ``test the
waters'' with potential
investors who are qualified
institutional buyers (QIBs)
or institutional accredited
investors.
Treasury recommends further SEC A, C, F
study and evaluation of
proxy advisory firms,
including regulatory
responses to promote free
market principles if
appropriate.
Treasury recommends that the SEC D, F, G
$2,000 holding requirement
for shareholder proposals
be substantially revised.
Treasury recommends that the SEC D, F, G
resubmission thresholds for
repeat proposals be
substantially revised from
the current thresholds of
3%, 6%, and 10% to promote
accountability, better
manage costs, and reduce
unnecessary burdens.
Treasury recommends that the SEC, States F
states and the SEC continue
to investigate the various
means to reduce costs of
securities litigation for
issuers in a way that
protects investors' rights
and interests, including
allowing companies and
shareholders to settle
disputes through
arbitration.
Treasury recommends that the SEC A, D, F, G
SEC continue its efforts,
when reviewing company
offering documents, to
comment on whether the
documents provide adequate
disclosure of dual class
stock and its effects on
shareholder voting.
Treasury recommends that the SEC A, D, F, G
SEC revise the securities
offering reform rules to
permit business development
companies (BDCs) to use the
same provisions available
to other issuers that file
Forms 10-K, 10-Q, and 8-K.
------------------------------------------------------------------------
Disproportionate Challenges for Smaller Public Companies
------------------------------------------------------------------------
Treasury supports modifying SEC A, F, G
rules that would broaden
eligibility for status as
an SRC and as a non-
accelerated filer to
include entities with up to
$250 million in public
float as compared to the
current $75 million.
Treasury recommends Congress SEC A, F, G
extending the length of
time a company may be
considered an EGC to up to
10 years, subject to a
revenue and/or public float
threshold.
Treasury recommends that the SEC A, F, G
SEC review its interval
fund rules to determine
whether more flexible
provisions might encourage
creation of registered
closed-end funds that
invest in offerings of
smaller public companies
and private companies whose
shares have limited or no
liquidity.
Treasury recommends a SEC, FINRA A, C, F, G
holistic review of the
Global Settlement and the
research analyst rules to
determine which provisions
should be retained,
amended, or removed, with
the objective of
harmonizing a single set of
rules for financial
institutions.
------------------------------------------------------------------------
Expanding Access to Capital Through Innovative Tools
------------------------------------------------------------------------
Treasury recommends SEC A, F, G
expanding Regulation A
eligibility to include
Exchange Act reporting
companies.
Treasury recommends steps to SEC, States A, F, G
increase liquidity for the
secondary market for Tier 2
securities. Treasury
recommends state securities
regulators promptly update
their regulations to exempt
secondary trading of Tier 2
securities or,
alternatively, the SEC use
its authority to preempt
state registration
requirements for such
transactions.
Treasury recommends that the SEC A, F, G
Tier 2 offering limit be
increased to $75 million.
Treasury recommends allowing SEC A, F, G
single-purpose crowdfunding
vehicles advised by a
registered investment
adviser. Treasury
recommends that any
rulemaking in this area
prioritize alignment of
interests between the lead
investor and the other
investors participating in
the vehicle, regular
dissemination of
information from the
issuer, and minority voting
protections with respect to
significant corporate
actions.
Treasury recommends that the SEC A, F, G
limitations on purchases in
crowdfunding offerings
should be waived for
accredited investors as
defined by Regulation D.
Treasury recommends that the SEC A, F, G
crowdfunding rules be
amended to have investment
limits based on the greater
of annual income or net
worth for the 5% and 10%
tests, rather than the
lesser.
Treasury recommends that the SEC F, G
conditional exemption from
Section 12(g) be modified,
raising the maximum revenue
requirement from $25
million to $100 million.
Treasury recommends SEC A, F, G
increasing the limit on how
much can be raised in a
crowdfunding offering over
a 12 month period from $1
million to $5 million.
------------------------------------------------------------------------
Maintaining the Efficacy of the Private Markets
------------------------------------------------------------------------
Treasury recommends that the SEC, FINRA, A, F, G
SEC, FINRA, and the states States
propose a new regulatory
structure for finders and
other intermediaries in
capital-forming
transactions.
Treasury recommends that SEC A, F, G
amendments to the
accredited investor
definition be undertaken
with the objective of
expanding the eligible pool
of sophisticated investors.
Treasury recommends a review SEC A, F, G
of provisions under the
Securities Act and the
Investment Company Act that
restrict unaccredited
investors from investing in
a private fund containing
Rule 506 offerings.
Treasury recommends that SEC, CFTC, A, G
Federal and state financial FINRA,
regulators, along with States
their counterparts in self-
regulatory organizations,
work to centralize
reporting of individuals
and firms that have been
subject to adjudicated
disciplinary proceedings or
criminal convictions, which
can be searched easily and
efficiently by the
investing public free of
charge.
------------------------------------------------------------------------
Markets Structure and Liquidity
------------------------------------------------------------------------
Policy Responsibility
Recommendation ----------------------------- Core
Congress Regulator Principle
------------------------------------------------------------------------
Equities
------------------------------------------------------------------------
Treasury recommends that the SEC C, F
SEC allow issuers of less
liquid stocks, in
consultation with their
underwriter and listing
exchange, to partially or
fully suspend unlisted
trading privileges for
their securities and select
the exchanges and venues on
which their securities will
trade.
Treasury recommends that the SEC C, F
SEC evaluate whether to
allow issuers to determine
the tick size for trading
of their stock across all
exchanges and whether to
additionally limit
potential tick sizes to a
small number of standard
options to manage
complexity.
Regarding Treasury's concern SEC C, F
that maker-taker markets
and payment for order flow
may create misaligned
incentives for broker-
dealers:
Treasury
recommends the SEC
adopt rules to mitigate
potential conflicts of
interest due to maker-
taker rebates and
payment for order flow
compensation
arrangements.
Treasury
supports a pilot
program to study the
impact reduced access
fees would have on
investors' execution
costs or available
liquidity.
Treasury
recommends that the SEC
exempt less liquid
stocks from the
restrictions on maker-
taker rebates and
payment for order flow
if such exemptions
promote greater market
making.
Regarding market data rules: SEC, FINRA C, F
Treasury
recommends that the SEC
and FINRA issue
guidance clarifying
that broker-dealers may
satisfy their best
execution obligations
by relying on
securities information
processor (SIP) data
rather than proprietary
data feeds if the
broker-dealer does not
otherwise subscribe to
or use those
proprietary data feeds.
Treasury
suggests that the SEC
consider whether
proposed self-
regulatory organization
(SRO) rules
establishing data fees
are ``fair and
reasonable,'' ``not
unreasonably
discriminatory,'' and
an ``equitable
allocation'' of
reasonable fees among
persons who use the
data.
Treasury
recommends that the SEC
consider amending
Regulation NMS as
necessary to enable
competing consolidators
to provide an
alternative to the
SIPs.
Treasury recommends that the SEC C, F
SEC consider amending the
Order Protection Rule to
give protected quote status
only to registered national
securities exchanges that
offer meaningful liquidity
and opportunities for price
improvement. Treasury
recommends that the SEC
consider amending the Order
Protection Rule to withdraw
protected quote status for
orders on any exchange that
do not meet a minimum
liquidity threshold.
Treasury recommends that
the SEC should consider
proposing that any newly
registered national
securities exchange receive
the benefit of protected
order status for some
period of time.
In order to reduce SEC C, F
complexity in equity
markets, Treasury
recommends that the SEC
review whether exchanges
and alternative trading
systems (ATSs) should
harmonize their order types
and make recommendations as
appropriate.
Treasury recommends that the SEC C, F
SEC adopt amendments to
Regulation ATS
substantially as proposed
but revise aspects of the
proposal to: (1) eliminate
unnecessary public
disclosure of confidential
information, (2) require
disclosure of confidential
information only to the SEC
and only if it would
improve the SEC's ability
to oversee the industry,
(3) ensure that disclosures
related to conflicts of
interest are tailored to
provide useful information
to market participants, and
(4) simplify the
disclosures to reduce the
compliance burden and to
increase their readability
and comparability across
competing ATSs.
------------------------------------------------------------------------
Treasuries
------------------------------------------------------------------------
Treasury recommends closing SEC, FINRA C, G
the PTF data granularity
gap by requiring trading
platforms operated by FINRA
member broker-dealers that
facilitate transactions in
Treasury securities to
identify the customers in
reports to TRACE of
Treasury security
transactions.
Treasury supports the FRB C, G
Federal Reserve Board's
efforts to collect Treasury
transaction data from its
bank members.
To further the study and CFTC C, G
monitoring of the Treasury
cash market, Treasury
recommends that the CFTC
share daily its Treasury
futures security
transaction data with
Treasury.
To better understand SEC B, C
clearing and settlement
arrangements in the
Treasury interdealer broker
(IDB) market and the
consequences of reform
options available in the
clearing of Treasury
securities, Treasury
recommends further study of
potential solutions by
regulators and market
participants.
Treasury reiterates its Congress FRB, FDIC, D, F
recommendation from the OCC
Banking Report to amend
regulation to improve the
availability of secured
repurchase agreement (repo)
financing.
------------------------------------------------------------------------
Corporates
------------------------------------------------------------------------
Treasury reiterates its Congress FRB, FDIC, C, F, G
recommendations from the OCC, SEC,
Banking Report to improve CFTC
secondary market liquidity.
------------------------------------------------------------------------
Securitization
------------------------------------------------------------------------
Policy Responsibility
Recommendation ----------------------------- Core
Congress Regulator Principle
------------------------------------------------------------------------
Capital
------------------------------------------------------------------------
Treasury recommends that ............ FRB, FDIC, C, F
banking regulators OCC
rationalize the capital
required for securitized
products with the capital
required to hold the same
disaggregated underlying
assets.
Treasury recommends that FRB, FDIC, C, D, F
U.S. banking regulators OCC
adjust the parameters of
both the simplified
supervisory formula
approach (SSFA) and the
supervisory formula
approach (SFA).
The p factor,
already set at a
punitive level that
assesses a 50%
surcharge on
securitization
exposures, should, at
minimum, not be
increased.
SSFA should
recognize the added
credit enhancement when
a bank purchases a
securitization at a
discount to par value.
Regulators
should align the risk
weight floor for
securitization
exposures with the
Basel recommendation.
Treasury recommends that FRB, FDIC, C, F
bank capital requirements OCC
for securitization
exposures sufficiently
account for the magnitude
of the credit risk sold or
transferred in determining
required capital instead of
tying capital to the amount
of the trust consolidated
for accounting purposes.
Treasury recommends that FRB, FDIC, C, F
regulators consider the OCC
impact that trading book
capital standards, such as
fundamental review of the
trading book (FRTB), would
have on secondary market
activity. Capital
requirements should be
recalibrated to prevent the
required amount of capital
from exceeding the maximum
economic exposure of the
underlying bond.
Treasury recommends that the FRB C, F
Federal Reserve Board
consider adjusting the
global market shock
scenario for stress testing
to more fully consider the
credit quality of the
underlying collateral and
reforms implemented since
the financial crisis.
------------------------------------------------------------------------
Liquidity
------------------------------------------------------------------------
Treasury recommends that FRB, FDIC, C, F
high-quality securitized OCC
obligations with a proven
track record receive
consideration as level 2B
high-quality liquid assets
(HQLA) for purposes of the
liquidity coverage ratio
(LCR) and the net stable
funding ratio (NSFR).
Regulators should consider
applying to these senior
securitized bonds a
prescribed framework,
similar to that used to
determine the eligibility
of corporate debt, to
establish criteria under
which a securitization may
receive HQLA treatment.
------------------------------------------------------------------------
Risk Retention
------------------------------------------------------------------------
Treasury recommends that FRB, FDIC, C, F
banking regulators expand OCC
qualifying underwriting
exemptions across eligible
asset-classes through
notice-and-comment
rulemaking.
Treasury recommends that FRB, FDIC, C, F
collateralized loan OCC
obligation (CLO) managers
who select loans that meet
pre-specified ``qualified''
standards, as established
by the appropriate
rulemaking agencies, should
be exempt from the risk
retention requirement.
Treasury recommends that SEC, FRB, C, F
regulators review the OCC, FDIC,
mandatory 5 year holding FHFA, HUD
period for third-party
purchasers and sponsors
subject to this
requirement. To the extent
regulators determine that
the emergence period for
underwriting-related losses
is shorter than 5 years,
the associated restrictions
on sale or transfer should
be reduced accordingly.
Treasury reiterates its Congress C, F
recommendation that
Congress designate one lead
agency from among the six
that promulgated the Credit
Risk Retention Rulemaking
to be responsible for
future actions related to
the rulemaking.
------------------------------------------------------------------------
Disclosures
------------------------------------------------------------------------
Treasury recommends that the SEC C, F
number of required
reporting fields for
registered securitizations
be reduced. Additionally,
Treasury recommends that
the SEC continue to refine
its definitions to better
standardize the reporting
requirements on the
remaining required fields.
Treasury recommends that the SEC C, F
SEC explore adding
flexibility to the current
asset-level disclosure
requirements by instituting
a ``provide or explain
regime'' for pre-specified
data fields.
Treasury recommends that the SEC C, F
SEC review the 3 day
waiting period for
registered deals and
consider reducing,
dependent on securitized
asset class.
Treasury recommends that the SEC C, F
SEC signal that Reg AB II
asset-level disclosure
requirements will not be
extended to unregistered
144A offerings or to
additional securitized
asset classes.
------------------------------------------------------------------------
Derivatives
------------------------------------------------------------------------
Policy Responsibility
Recommendation ----------------------------- Core
Congress Regulator Principle
------------------------------------------------------------------------
Harmonization Between CFTC and SEC
------------------------------------------------------------------------
Treasury recommends that the Congress CFTC, SEC , F, G
CFTC and the SEC undertake
and give high priority to a
joint effort to review
their respective
rulemakings in each key
Title VII reform area. The
goals of this exercise
should be to harmonize
rules and eliminate
redundancies to the fullest
extent possible and to
minimize imposing
distortive effects on the
markets and duplicative and
inconsistent compliance
burdens on market
participants.
As part of this
review, the SEC should
finalize its Title VII
rules with the goal of
facilitating a well-
harmonized swaps and
security-based swaps
regime.
This effort
should also include
consideration of the
prospects for
alternative compliance
regimes--for example, a
framework of
interagency substituted
compliance or mutual
recognition--for any
areas in which
effective harmonization
is not feasible.
Public comment
should be part of this
process.
Treasury recommends that
Congress consider further
action to achieve maximum
harmonization in the
regulation of swaps and
security-based swaps.
------------------------------------------------------------------------
Margin Requirements for Uncleared Swaps
------------------------------------------------------------------------
Treasury recommends that CFTC, SEC, D, F
U.S. regulators take steps Banking
to harmonize their margin Agencies
requirements for uncleared
swaps domestically and
cooperate with non-U.S.
jurisdictions that have
implemented the Basel
Committee on Banking
Supervision-International
Organization of Securities
Commissions (BCBS-IOSCO)
framework to promote a
level playing field for
U.S. firms.
The U.S.
banking agencies should
consider providing an
exemption from the
initial margin
requirements for
uncleared swaps for
transactions between
affiliates of a bank or
bank holding company in
a manner consistent
with the margin
requirements of the
CFTC and the
corresponding non-U.S.
requirements, subject
to appropriate
conditions.
The CFTC and
U.S. banking regulators
should work with their
international
counterparts to amend
the uncleared margin
framework so it is more
appropriately tailored
to the relevant risks.
Where warranted
based on logistical and
operational
considerations, the
CFTC and the U.S.
banking agencies should
consider amendments to
their rules to allow
for more realistic time
frames for collecting
and posting margin.
The CFTC and
the U.S. banking
regulators should
reconsider the one-size-
fits-all treatment of
financial end-users for
purposes of margin on
uncleared swaps and
tailor their
requirements to focus
on the most significant
source of risk.
Consistent with
these objectives, the
SEC should repropose
and finalize its
proposed margin rule
for uncleared security-
based swaps in a manner
that is aligned with
the margin rules of the
CFTC and the U.S.
banking regulators.
------------------------------------------------------------------------
CFTC Use of No-Action Letters
------------------------------------------------------------------------
Treasury recommends that the CFTC F, G
CFTC take steps to simplify
and formalize all
outstanding staff guidance
and no-action relief that
has been used to smooth the
implementation of the Dodd-
Frank swaps regulatory
framework. This should
include, where necessary
and appropriate, amendments
to any final rules that
have proven to be
infeasible or unworkable,
necessitating broadly
applicable or multiyear no-
action relief.
------------------------------------------------------------------------
Cross-Border Issues
------------------------------------------------------------------------
Cross-border Application and CFTC, SEC D, F
Scope: Treasury recommends
that the CFTC and the SEC
provide clarity around the
cross-border scope of their
regulations and make their
rules compatible with non-
U.S. jurisdictions where
possible to avoid market
fragmentation,
redundancies, undue
complexity, and conflicts
of law. Examples of areas
that merit reconsideration
include:
whether swap
counterparties, trading
platforms, and CCPs in
jurisdictions compliant
with international
standards should be
required to register
with the CFTC or the
SEC as a result of
doing business with a
U.S. firm's foreign
branch or affiliate;
whether swap
dealer registration
should apply to a U.S.
firm's non-U.S.
affiliate on the basis
of trading with non-
U.S. counterparties if
the U.S. firm's non-
U.S. affiliate is
effectively regulated
as part of an
appropriately robust
regulatory regime or
otherwise subject to
Basel-compliant capital
standards, regardless
of whether the
affiliate is guaranteed
by its U.S. parent;
whether U.S.
firms' foreign branches
and affiliates,
guaranteed or not,
should be subject to
Title VII's mandatory
clearing, mandatory
trading, margin, or
reporting rules when
they trade with non-
U.S. firms in
jurisdictions compliant
with international
standards; and
providing
alternative ways for
regulated entities to
comply with
requirements that may
conflict with local
privacy, blocking, and
secrecy laws.
Substituted Compliance: CFTC, SEC D, F
Treasury recommends that
effective cross-border
cooperation include
meaningful substituted
compliance programs to
minimize redundancies and
conflicts.
The CFTC and
SEC should be judicious
when applying their
swaps rules to
activities outside the
United States and
should permit entities,
to the maximum extent
practicable, to comply
with comparable non-
U.S. derivatives
regulations, in lieu of
complying with U.S.
regulations.
The CFTC and
the SEC should adopt
substituted compliance
regimes that consider
the rules of other
jurisdictions, in an
outcomes-based
approach, in their
entirety, rather than
relying on rule-by-rule
analysis. They should
work toward achieving
timely recognition of
their regimes by non-
U.S. regulatory
authorities.
The CFTC should
undertake truly
outcomes-based
comparability
determinations, using
either a category-by-
category comparison or
a comparison of the
CFTC regime to the
foreign regime as a
whole.
Meaningful
substituted compliance
could also include
consideration of
recognition regimes for
non-U.S. CCPs clearing
derivatives for certain
U.S. persons and for
non-U.S. platforms for
swaps trading.
ANE Transactions: Treasury CFTC, SEC D, F
recommends that the CFTC
and the SEC reconsider any
U.S. personnel test for
applying the transaction-
level requirements of their
swaps rules.
The CFTC should
provide certainty to
market participants
regarding the guidance
in the CFTC arrange,
negotiate, execute
(ANE) staff advisory
(CFTC Letter No. 13-
69), which has been
subject to extended no-
action relief, either
by retracting the
advisory or proceeding
with a rulemaking.
In particular,
the CFTC and the SEC
should reconsider the
implications of
applying their Title
VII rules to
transactions between
non-U.S. firms or
between a non-U.S. firm
and a foreign branch or
affiliate of a U.S.
firm merely on the
basis that U.S.-located
personnel arrange,
negotiate, or execute
the swap, especially
for entities in
comparably regulated
jurisdictions.
------------------------------------------------------------------------
Capital Treatment in Support of Central Clearing
------------------------------------------------------------------------
Treasury recommends that Banking D, F
regulators properly balance Agencies,
the post-crisis goal of CFTC, SEC
moving more derivatives
into central clearing with
appropriately tailored and
targeted capital
requirements.
As a near-term
measure, Treasury
reiterates the
recommendation of the
Banking Report and calls
for the deduction of
initial margin for
centrally cleared
derivatives from the SLR
denominator; and
recommends a risk-
adjusted approach for
valuing options for
purposes of the capital
rules to better reflect
the exposure, such as
potentially weighting
options by their delta.
Beyond the near
term, Treasury
recommends that
regulatory capital
requirements transition
from CEM to an adjusted
SA-CCR calculation that
provides an offset for
initial margin and
recognition of
appropriate netting
sets and hedged
positions.
In addition,
Treasury recommends
that U.S. banking
regulators and market
regulators conduct
regular comprehensive
assessments of how the
capital and liquidity
rules impact the
incentives to centrally
clear derivatives and
whether such rules are
properly calibrated.
------------------------------------------------------------------------
Swap Dealer De Minimis Threshold
------------------------------------------------------------------------
Treasury recommends that the CFTC F
CFTC maintain the swap
dealer de minimis
registration threshold at
$8 billion, and establish
that any future changes to
the threshold will be
subject to a formal
rulemaking and public
comment process.
------------------------------------------------------------------------
Definition of Financial Entity
------------------------------------------------------------------------
To provide regulatory Congress CFTC, SEC D, F
certainty and better
facilitate appropriate
exceptions from the swaps
clearing requirement for
commercial end-users
engaged in bona fide
hedging or mitigation of
commercial risks, Treasury
would support a legislative
amendment to CEA Section
2(h)(7) providing the CFTC
with rulemaking authority
to modify and clarify the
scope of the financial
entity definition and the
treatment of affiliates.
Such authority
should include
consideration of non-
prudentially regulated
entities that currently
fall under subclause
VIII of CEA Section
2(h)(7)(c)(i)--i.e.,
entities that are
``predominantly
engaged. in activities
that are financial in
nature''--but which
might warrant exception
from the clearing
requirement if they
engage in swaps
primarily to hedge or
mitigate the business
risks of a commercial
affiliate.
Such authority
should also be flexible
enough to permit, for
example, the CFTC to
formalize its no-action
relief for central
treasury units (CTUs)
in a rulemaking.
Further, any
exceptions provided by
the CFTC under such
authority should be
subject to appropriate
conditions and allow
the CFTC to
appropriately monitor
exempted activity. The
conditions could
include, for example,
making the exception
dependent on the size
and nature of swaps
activities,
demonstration of risk-
management requirements
in lieu of clearing,
and reporting
requirements.
Any legislative amendment
should provide the SEC
analogous rulemaking
authority under Exchange
Act Section 3C(g) with
respect to exceptions from
the clearing requirement
for security-based swaps.
------------------------------------------------------------------------
Position Limits
------------------------------------------------------------------------
Treasury recommends that the CFTC D, F
CFTC complete its position
limits rules, as
contemplated by its
statutory mandate, with a
focus on detecting and
deterring market
manipulation and other
fraudulent behavior. Among
the issues to consider in
completing a final position
limits rule, the CFTC
should:
ensure the
appropriate
availability of bona
fide hedging exemptions
for end-users and
explore whether to
provide a risk
management exemption;
consider
calibrating limits
based on the risk of
manipulation, for
example, by imposing
limits only for spot
months of physical
delivery contracts
where the risk of
potential market
manipulation is
greatest; and
consider the
deliverable supply
holistically when
setting the limits
(e.g., for gold,
consider the global
physical market, not
just U.S. futures).
------------------------------------------------------------------------
SEF Execution Methods and MAT Process
------------------------------------------------------------------------
Treasury recommends that the CFTC D, F
CFTC:
consider rule
changes to permit swap
execution facilities
(SEFs) to use any means
of interstate commerce
to execute swaps
subject to a trade
execution requirement
that are consistent
with the ``multiple-to-
multiple'' element of
the SEF definition (CEA
Section 1a(50)). Such
rule changes should be
undertaken in
recognition of the
statutory goals of
impartial access for
market participants and
promoting pre-trade
price transparency in
the swaps market;
reevaluate the
MAT determination
process to ensure
sufficient liquidity
for swaps to support a
mandatory trading
requirement; and
consider
clarifying or
eliminating footnote 88
in its final SEF rules
to address associated
market fragmentation.
------------------------------------------------------------------------
Swap Data Reporting
------------------------------------------------------------------------
Treasury supports the CFTC's CFTC, SEC F
newly launched ``Roadmap''
effort, as announced in
July 2017, to standardize
reporting fields across
products and SDRs,
harmonize data elements and
technical specifications
with other regulators, and
improve validation and
quality control processes.
Treasury
recommends that the
CFTC secure and commit
adequate resources to
complete the Roadmap
review, undertake
notice and comment
rulemaking, and
implement revised rules
and harmonized
standards within the
timeframe outlined in
the Roadmap.
Treasury
recommends that the
CFTC leverage third-
party and market
participant expertise
to the extent necessary
to develop a coherent,
efficient, and
effective reporting
regime.
------------------------------------------------------------------------
Financial Market Utilities
------------------------------------------------------------------------
Policy Responsibility
Recommendation ----------------------------- Core
Congress Regulator Principle
------------------------------------------------------------------------
Treasury recommends that Congress FRB, CFTC, D, F
U.S. regulators that SEC
supervise systemically
important financial market
utilities (SIFMUs) bolster
resources for their
supervision and regulation,
and that the CFTC be
allocated greater resources
for its review of CCPs.
Treasury also recommends
that the agencies study how
they can streamline the
existing advance notice
review process to be more
efficient and appropriately
tailored to the risk that a
particular change presented
by a SIFMU may pose.
Treasury recommends that the FRB B
Federal Reserve review: (1)
what risks are posed to
U.S. financial stability by
the lack of Federal Reserve
Bank deposit account access
for financial market
utilities (FMUs) with
significant shares of U.S.
clearing business and an
appropriate way to address
such risks; and (2) whether
the rate of interest paid
on SIFMUs' deposits at the
Federal Reserve Banks
should be adjusted based on
market-based evaluation of
comparable private sector
opportunities.
Treasury recommends that CFTC B
future central counterparty
(CCP) stress testing
exercises by the CFTC
incorporate additional
products, different stress
scenarios, liquidity risk,
and operational and cyber
risks, which can also pose
potential risks to U.S.
financial stability.
Treasury recommends that CFTC, FDIC, B, E
U.S. regulators continue to SEC
take part in crisis
management groups (CMGs) to
share relevant data and
consider the coordination
challenges that domestic
and foreign regulators and
resolution authorities may
encounter during cross-
border resolution of CCPs.
Treasury recommends that CFTC, SEC, E
U.S. regulators continue to FRB, FDIC
advance American interests
abroad when engaging with
international standard
setting bodies such as The
Committee on Payments and
Market Infrastructures of
the International
Organization of Securities
Commissions (CPMI-IOSCO)
and Financial Stability
Board's (FSB's) work
streams.
------------------------------------------------------------------------
Regulatory Structure and Processes
------------------------------------------------------------------------
Policy Responsibility
Recommendation ----------------------------- Core
Congress Regulator Principle
------------------------------------------------------------------------
Restoration of Exemptive Authority
------------------------------------------------------------------------
Treasury recommends that Congress F, G
Congress restore the CFTC's
and SEC's full exemptive
authority and remove the
restrictions imposed by
Dodd-Frank.
------------------------------------------------------------------------
Improving Regulatory Policy Decision Making
------------------------------------------------------------------------
Treasury reaffirms the CFTC, SEC C, F, G
recommendations for
enhanced use of regulatory
cost-benefit analysis
discussed in the Banking
Report for the SEC and the
CFTC.
Treasury recommends that the CFTC, SEC C, F, G
CFTC and the SEC, when
conducting rulemakings, be
guided by the Core
Principles for financial
regulation laid out in
Executive Order 13772, as
well as the principles set
forth in Executive Orders
12866 and 13563, and that
they update any existing
guidance as appropriate.
Treasury recommends that the CFTC, SEC C, F, G
agencies take steps, as
part of their oversight
responsibilities, so that
self-regulatory
organization (SRO)
rulemaking take into
account, where appropriate,
economic analysis when
proposed rules are
developed at the SRO level.
Treasury recommends that the CFTC, SROs C, F, G
CFTC and the SROs issue
public guidance explaining
the factors they consider
when conducting economic
analysis in the rulemaking
process.
Treasury encourages the CFTC CFTC, SEC C, F, G
and the SEC to make fuller
use of their ability to
solicit comment and input
from the public, including
by increasing their use of
advance notices of proposed
rulemaking to better signal
to the public what
information may be
relevant.
Treasury recommends that the CFTC, SEC C, F, G
CFTC and the SEC conduct
regular, periodic reviews
of agency rules for burden,
relevance, and other
factors.
Treasury supports the goals CFTC, SEC F, G
of principles-based
regulation and recommends
that the SEC and the CFTC
consider using this
approach, to the extent
appropriate and consistent
with applicable law.
Treasury believes that the CFTC, SEC D, E, F, G
CFTC and the SEC should
continue their joint
outcomes-based effort to
harmonize their respective
rules and requirements, as
well as cross-border
application of such rules
and requirements.
Treasury recommends that the CFTC, SEC C, F, G
CFTC and the SEC avoid
imposing new requirements
by no-action letter,
interpretation, or other
form of guidance and
consider adopting Office of
Management and Budget's
Final Bulletin for Agency
Good Guidance Practices.
------------------------------------------------------------------------
Improving Regulatory Policy Decision Making
------------------------------------------------------------------------
Treasury recommends that the CFTC, SEC C, F, G
CFTC and the SEC take steps
to ensure that guidance is
not being used excessively
or unjustifiably to make
substantive changes to
rules without going through
the notice and comment
process.
Treasury recommends that the CFTC, SEC C, F, G
CFTC and the SEC review
existing guidance and
revisit any guidance that
has caused market confusion
and compliance challenges.
Treasury recommends that the CFTC, SEC C, F, G
agencies undertake a review
and update the definitions
so that the Regulatory
Flexibility Act analysis
appropriately considers the
impact on persons who
should be considered small
entities.
------------------------------------------------------------------------
Self-Regulatory Organizations
------------------------------------------------------------------------
Treasury recommends that the CFTC, SEC C, F, G
CFTC and the SEC conduct
comprehensive reviews of
the roles,
responsibilities, and
capabilities of the SROs
under their respective
jurisdictions and make
recommendations for
operational, structural,
and governance improvements
of the SRO framework.
Treasury recommends that the CFTC, SEC C, F, G
agencies identify any
changes to underlying laws
or rules that are needed to
enhance oversight of SROs.
Treasury recommends that SROs C, F, G
each SRO adopt and publicly
release an action plan to
review and update its
rules, guidance, and
procedures on a periodic
basis.
------------------------------------------------------------------------
International Aspects of Capital Market Regulation
------------------------------------------------------------------------
Policy Responsibility
Recommendation ----------------------------- Core
Congress Regulator Principle
------------------------------------------------------------------------
Treasury recommends that CFTC, FDIC, D, E
U.S. regulators and FRB, OCC,
Treasury sustain and SEC,
develop technical level Treasury
dialogues with key
partners, informed by
previous outreach to
industry, to address
conflicting or duplicative
regulation.
Treasury recommends that CFTC, SEC D
U.S. regulators seek to
reach outcomes-based, non-
discriminatory substituted
compliance arrangements
with other regulators or
supervisors with the goal
of mitigating the effects
of regulatory redundancy
and conflict when it is
justified by the quality of
foreign regulation,
supervision, and
enforcement regimes, paying
due respect to the U.S.
regulatory regime.
Treasury recommends that CFTC, FDIC, E
U.S. members of standard- FRB, OCC,
setting bodies (SSBs) SEC,
continue to advocate for Treasury
and shape international
regulatory standards
aligned with domestic
financial regulatory
objectives.
Treasury recommends that CFTC, FDIC, E
U.S. agencies should FRB, OCC,
continue to regularly SEC,
coordinate policy before as Treasury
well as after international
engagements.
Treasury recommends that CFTC, FDIC, D, E
U.S. agencies to work in FRB, OCC,
international organizations SEC,
to elevate the quality of Treasury
stakeholder consultation
globally.
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2017-04856 (Rev. 1) Department of the Treasury
Departmental Offices www.treasury.gov
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