CFTC Commissioner Giancarlo Releases Swaps Trading Rules White Paper

CFTC Commissioner J. Christopher Giancarlo released a white paper titled “Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank” (the “White Paper”), which proposes an alternative to the CFTC’s swaps trading framework.

The White Paper is critical of the implementation of the swaps trading framework, asserting that there is a “fundamental mismatch” between the CFTC’s framework and the “distinct liquidity and trading dynamics of the global swaps market.” According to the White Paper, the CFTC framework is “highly over-engineered, disproportionately modeled on the U.S. futures market and biased against both human discretion and technological innovation.” 

The White Paper identifies a number of adverse consequences of the “flawed” swaps trading rules, and proposes an alternative swaps trading framework that “better aligns with swaps market dynamics and is more true to congressional intent.” The alternative framework is built upon five tenets:

  • “comprehensiveness,” by subjecting the broadest range of U.S. swaps trading activity to CFTC oversight;
  • “cohesiveness,” by removing “artificial segmentation” of swaps trading and regulating all CFTC swaps trading in a holistic fashion;
  • “flexibility,” by permitting trade execution through “any means of interstate commerce” and allowing “organic development of swaps products and market structure”;
  • “professionalism,” by establishing requirements for product and market knowledge through requiring, for example, swaps broker testing, as well as requirements for professionalism and ethical behavior for swaps market personnel; and
  • increased transparency.

See: Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank” by Commissioner Giancarlo; Commissioner Giancarlo’s TabbFORUM Speech; CFTC Press Release.


Senators Ask SEC to Extend Duration of Tick Size Pilot Program

U.S. Senators Pat Toomey (R-PA) and Mark Warner (D-VA) (the “Senators”) sent a letter to SEC Chair Mary Jo White in which they urged the SEC to lengthen the time period of the Tick Size Pilot Program (the “Pilot”).

The Pilot would change the minimum price increments at which certain small capitalization stocks are traded on U.S. exchanges in an attempt to encourage research on and investment in these stocks, as well as ensure adequate liquidity in secondary trading.

The Senators applauded the SEC for its “proactive work” on the Pilot, stating that it “has the potential to create new opportunities for small businesses to grow and succeed.” However, they added, the one-year duration specified in the current proposal may be too short to attract the attention needed from market participants to gauge the effectiveness of the Pilot.

The Senators explained that changing various systems and the infrastructure to make markets trade at wide spreads “requires both time and financial investments, which are less likely to make sense for market participants if the Pilot runs for too short a duration.” According to the Senators, even if participation in the Pilot were high, the data collected from the one-year program would be at “significant risk” of being distorted by short-term market fluctuations. For those reasons, the Senators urged the SEC to lengthen the time period of the Pilot to ensure that adequate data would be collected.

Lofchie Comment: It is good to see bipartisan support for a rule change that is intended to help business. A better approach might be for the SEC to run pilot programs under a comprehensive plan for testing a number of different trading rules.

As for helping small businesses, certain measures might provide more direct benefits than an increase in tick size (where the benefit is fairly indirect). The SEC should develop new rules that might encourage the production of research on small companies, since investors would be more likely to trust such companies if there were more information and opinions about them from third parties. The research rules that were developed in response to overly enthusiastic reports by investment banks on internet companies likely had the negative consequence of reducing the incentive for investment banks to write research about companies that are not the subject of wide investor interest.

See: The Senators’ Letter.

IOSCO Issues Final Report on Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives

IOSCO published a final report, titled “Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives,” which outlines standards that are intended to reduce risk in the non-centrally cleared OTC derivatives markets.

The risk mitigation standards in the report were developed in consultation with the Basel Committee on Banking Supervision and the Committee on Payments and Market Infrastructures. They stem from a proposed standards report that was published in September 2014.

The final report focuses on a number of ways in which risk standards can be applied in key areas to reduce risks in the non-centrally cleared OTC derivatives market. These include:

  • financial entities and systemically important non-financial entities’ employing risk mitigation techniques;
  • executing written trading relationship documentation prior to a trade;
  • sending trade confirmations as soon as practicable after execution;
  • agreeing on the valuation process with counterparties;
  • ensuring portfolio reconciliation;
  • agreeing on policies and procedures for assessing and engaging in compression; and
  • agreeing to dispute resolution procedures with counterparties.

In addition, the report recommends that regulators implement rules that require the above procedures as soon as possible, and that regulatory regimes be harmonized to facilitate cross-border transactions.

See: Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives.
Related news: IOSCO Publishes Consultation Report on Risk Mitigation for Non-Centrally Cleared OTC Derivatives (September 18, 2014).

SEC to Hold Roundtable on Proxy Voting

The SEC announced that it will hold a roundtable on February 19, 2015 to explore ways to improve the proxy voting process.

The roundtable will be divided into two panel discussions:

  • the first panel will focus on (i) the state of contested director elections, and whether changes should be made to the federal proxy rules to facilitate the use of universal proxy ballots by management and proxy contestants, and (ii) state law, logistical and disclosure issues presented by a possible universal proxy ballot process; 
  • the second panel will focus on (i) strategies for increasing retail shareholder participation in the proxy process, (ii) how technology might affect retail participation, and (ii) whether the format of disclosure could be improved to increase the engagement of shareholders and how the mechanics of voting could be improved to affect retail shareholder participation.

Lofchie Comment: Retail investors comprise a very small portion of ownership in the stock market. It is doubtful that an increase in their participation would affect voting rates meaningfully. Further, retail voters are unlikely to bring some special knowledge to the proxy process that makes a good result more likely. Even if, in theory (and it is difficult to identify one) a retail investor might make a better voting decision than an institutional investor, it is hard to imagine why it is worth the retail investor’s evenings poring over competing proxies. Better they should spend that time in more worthwhile pursuits like reading (1984, an appropriate classic), seeing a movie (perhaps A Most Violent Year), watching a dance concert (anything by Ohad Naharin) or getting geared up for the Super Bowl (go Patriots!).

See: SEC Press Release.

CFTC Commissioner Giancarlo Discusses “End-User Collateral Damage” Stemming from Dodd-Frank

CFTC Commissioner J. Christopher Giancarlo delivered a speech before the Commodity Markets Council titled, “End-Users Were Not the Source of the Financial Crisis: Stop Treating Them Like They Were.”

Commissioner Giancarlo said he is a proponent of what he considers to be the three “key pillars” of Dodd-Frank: (i) central counterparty clearing; (ii) swap data reporting; and (iii) regulated swaps execution. He stated that his opinions are founded on the view that well-regulated markets are good for business and job creation. He explained, however, that end-users, unfortunately, have become collateral damage of certain Dodd-Frank reforms, even though they “were not the source of the financial crisis.”

One rule Commissioner Giancarlo identified as burdensome to end-users is revised CFTC Rule 1.35 (“Records of Commodity Interest and Related Cash or Forward Transactions”), which requires the keeping of oral and written records. Commissioner Giancarlo explained that it is simply not “feasible technologically” to keep pre-trade text messages in a form that the rule requires. Therefore, the rule misses the intended benefit and instead imposes “senseless costs that fall especially hard” on among others, U.S. futures markets.

Commissioner Giancarlo also criticized the CFTC’s process regarding the final rule defining a “swap dealer.” He noted that the final rule could cause “many non-financial companies to curtail or terminate risk hedging activities with their customers, limiting risk management options for end-users, and ultimately consolidating marketplace risk in only a few large swap dealers,” running counter to the goals of Dodd-Frank to reduce systemic risk in the marketplace.

Commissioner Giancarlo additionally expressed his concern that the bona fide hedging framework in the CFTC’s position limits proposal imposes a “federal regulatory edict,” rather than allowing market participants to assess the risk of hedging activity. He encouraged the CFTC to “carefully consider” concerns raised by market participants regarding the position limits proposal, including:

  • updating and modernizing deliverable supply estimates;
  • carving out ERISA plans;
  • modifying or eliminating the limitations on cross-commodity hedging;
  • restoring bona fide hedging status to anticipatory merchandising hedges; and
  • creating an aggregation policy that focuses on effective control over trading decisions, rather than primarily on ownership.

Lofchie Comment: As the Commissioner points out, Dodd-Frank is having numerous “undesirable” consequences, including materially raising costs for end-users and exacerbating whatever the consequences of “too big to fail” may be by creating a costly regulatory structure that drives medium-sized firms out of regulated activities. (We use the term “undesirable” rather than “unintended” because, even if these consequences are not intended, they were so predictable that “unintended” seems too generous a word choice, as it carries some implication of “unforeseeable.”)

The Commissioner had pointed remarks on how the CFTC is imposing a “federal regulatory edict” in its position limits proposal. We have long questioned the CFTC process. In the absence of presenting convincing economic studies, the CFTC asserted that its rules could be justified by referencing the supposed wrongdoings of oil hoarders who were manipulating prices upward. As energy prices have recently crashed driven by world events, it behooves the CFTC to re-examine what now seems to be a weak intellectual foundation to impose such limits. In retrospect, it now seems likely that the prior increases in oil prices were also driven by world events (such as threats of war and the booming Asian economies), and not merely by the trading of oil speculators.

See: Commissioner Giancarlo’s Speech.

CFTC Chair Massad Continues Urging Cross-Border Harmonization of Swaps Rules

In the keynote address before the Monetary Authority of Singapore, CFTC Chair Massad continued to advocate for cross-border harmonization.

Chair Massad reiterated his belief that the G-20’s agreements to reform the swaps market can only go so far, explaining that it is incumbent upon regulators to develop rules that implement the G-20’s commitments. He also stated that the best way to continue to grow domestic and international financial markets is to create a sound regulatory framework, which must “bring transparency, integrity, and oversight, but, at the same time, provide predictability to market participants, and encourage innovation and competition.”

Chair Massad explained that clearing is “perhaps the most important reform in terms of reducing systemic risk,” but noted that central clearing does and will not eliminate risk. While the CFTC is working with European regulators to harmonize rules, he commented, the CFTC does not take the view that every clearinghouse must register with it. 

He identified margin standards and stress testing as two areas that are “critical pieces of this discussion” of harmonizing clearinghouse supervision. Chair Massad further stated that setting margin requirements for uncleared swaps is an opportunity for global regulators to make the rules in the U.S., Asia and Europe “substantially similar” from the outset.

Chair Massad called on regulators in Asia to become even more involved in the process of establishing swap data and trade repositories. Additionally, he mentioned the recent CFTC approvals of Bursa Malaysia and SGX as foreign boards of trade, stating that the approvals show “the increasing interconnectedness of the global derivatives markets and the importance of Asia in that development.” With this increasing interconnectedness, Chair Massad reiterated that the CFTC is committed to a coordinated regulatory approach.

Lofchie Comment: The CFTC is substantially improved under the leadership of CFTC Chairman Massad. His efforts to reach out to international regulators to urge the development of a common approach is a significant step-up from the CFTC previously asserting that it would go it alone.

That said, there is still an inherent weakness to Chairman Massad’s approach. The major problems that he inherited were not just ones resulting from the CFTC’s interaction with other regulators. The more fundamental problems are with the CFTC’s rules themselves: they were rushed through, with little consideration of their economic effect, based upon a statute (Dodd-Frank) that was likewise rushed through. The Chairman should not try to convince the Asian regulators to adopt a similar set of flawed rules. The Asian regulators are not under reciprocal political pressure to copycat our rules. Chairman Massad might want to consider using the reluctance of the Asian regulators to follow the U.S. “model” as a reason to rethink our own rules.

Lofchie Wikipedia Selection.

See: Chair Massad’s Remarks.
Related news: In Japan, CFTC Chair Massad Discusses Cross-Border Harmonization (January 22, 2015); CFTC Chair Massad Discusses Cross-Border Harmonization (January 21, 2015); Chair Massad Announces Trip to Asia to Discuss Swaps Market Reform (January 14, 2015).


FIA and FIA Europe Issue Their Second Report in a Series Covering ESMA MiFID II Regulations

The Futures Industry Association (“FIA”) and FIA Europe issued their second special report in a series that covers technical advice and consultation documents by the European Securities Markets Authorities (“ESMA”) on MiFID II regulations.

The special report provides an overview of ESMA’s proposals in its Consultation Paper, including the draft Regulatory Technical Standards on the trading obligation for derivatives, as well as ESMA’s proposals concerning the definition of “liquid market” in relation to the transparency requirements for derivatives.

The MiFID II regulations will become effective on January 3, 2017.

See: Second Special Series Report.
Related news: FIA and FIA Europe Issue First in a Series of Special Reports Regarding Summaries of ESMA MiFID II Regulations (January 16, 2015).

FSOC to Change SIFI Designation Process

At a recent open session meeting, members of the Financial Stability Oversight Council (“FSOC”) announced that they would change the selection process for identifying systemically important financial institutions (“SIFIs”).

At the meeting, the Department of Justice delivered a presentation to FSOC regarding the lawsuit brought by MetLife, Inc. The presentation challenged FSOC’s determination that the company would be subject to supervision by the Board of Governors of the Federal Reserve System and to enhanced prudential standards. FSOC members promised to provide earlier notification than in the past to firms under scrutiny, make more information about their decisions publicly available and conduct more in-depth reviews of their decisions each year.

FSOC has yet to release a written copy of the changes on which they will vote at a future meeting.

Lofchie YouTube Selection regarding the Designation Process: A Call for Volunteers.

Lofchie Comment: It does not speak well of FSOC’s process that, over the past several years, it ignored numerous public suggestions to create a more open and transparent methodology for designating SIFIs, only to concede that the designation process required improvement as soon as it was challenged in court by a designee. FSOC’s retreat raises questions about the fairness of the process by which prior firms were designated. Given the costs imposed on a designated firm, FSOC should consider suspending its prior designations until it has put an improved review process in place and any prior designees are permitted to engage in that improved process. 

Whatever improvements may be made
eventually, we continue to believe that the substance of the law is flawed. If Congress concludes that the Federal Reserve Board ought to oversee large insurance companies or clearing corporations, then Congress should adopt legislation containing objective measures to determine what firms would be regulated, and should likewise provide at least some guidance on the types of regulation to which firms in each industry would be subject. The notion of adopting a system of substantive regulation that applies to all insurance companies, clearing corporations and perhaps investment advisers is inherently flawed. There are simply no improvements to be made to FSOC’s process that would rescue the underlying substance of the SIFI designation (though greater transparency and more objectivity would still be helpful).

See: FSOC Meeting Press Release for January 21, 2015.
See also: Article in the Wall Street Journal.


NFA Announces Increases to Minimum Security Deposits Required for FDMs

In response to recent events involving the Swiss franc, the NFA announced that its Executive Committee will increase the minimum security deposits required to be collected and maintained by forex dealer members (“FDMs”) under NFA Financial Requirements Section 12.

Section 12 requires FDMs to collect and maintain a minimum security deposit of two percent of the notional value of transactions in ten listed major foreign currencies, and five percent of the notional value of other transactions. Section 12 also permits NFA’s Executive Committee to temporarily increase these requirements under “extraordinary market conditions.” Therefore, the NFA is increasing the minimum security deposits required to be collected and maintained as follows:

  • Swiss franc: 5 percent;
  • Swedish krona: 3 percent; and
  • Norwegian krone: 3 percent.

These increases are effective as of 5 p.m. Central Standard Time, on January 22, 2015 and will remain effective until further notice.

See: NFA Notice I-15-04.


In Japan, CFTC Chair Massad Discusses Cross-Border Harmonization

Speaking before the Futures Industry Association in Japan, CFTC Chair Massad reiterated various cross-border initiatives that he had discussed in a previous speech in Hong Kong.

Chair Massad identified the clearinghouse initiative as important, explaining that, as regulators require more firms to engage in clearing financial products, steps must be taken to ensure that clearinghouses do not pose a systemic risk.

According to Chair Massad, regulators should not require all swaps to be cleared and, therefore, should set margin requirements for certain uncleared swaps. He stated that he is pleased about the recently proposed rules regarding margin rules from regulators in Europe and Japan, and commented that they are “substantially similar and reflect internationally agreed standards.”

Chair Massad explained further that cybersecurity is “the single most important new risk to financial stability.” He called on G-20 countries to prioritize cybersecurity in similar ways to those of the CFTC, which include requiring clearinghouses, exchanges and other market infrastructures to implement safeguards, as well as focusing on this issue in CFTC examinations.

See: Chair Massad’s Speech.
Related news: CFTC Chair Massad Discusses Cross-Border Harmonization (January 21, 2015); Chair Massad Announces Trip to Asia to Discuss Swaps Market Reform (January 14, 2015).