UK and U.S. Swaps Regulators Agree to Maintain Existing Arrangements Post-Brexit

In a Joint Statement, the Bank of England (“BoE”), the Financial Conduct Authority (“FCA”) and the CFTC said that the United Kingdom’s withdrawal from the European Union would not serve to disrupt existing agreements as to the regulation, or exemptions from regulation, of firms engaged in the trading or clearing of derivatives.

The parties said that:

  • by the end of March 2019, the BoE, FCA and CFTC will put in place “information-sharing and cooperative arrangements to support the effective cross-border oversight of derivatives markets and participants and to promote market orderliness, confidence and financial stability”;
  • post-Brexit, U.S. trading venues, firms and central counterparties may continue to operate in the United Kingdom on the same basis that they do today; and
  • post-Brexit, the CFTC intends to issue new no-action letters and orders to permit UK firms to continue to operate in the United States on the same basis that they do today.

The notes to the document provide a “non-exhaustive list” of existing cooperation documents among the BoE, FCA and CFTC that will require amendment or reaffirmation post-Brexit.

 

CFTC Commissioners Urge Bank Regulators to Change to Leverage Ratio Treatment of Cleared Derivatives

Four Commissioners of the CFTC urged U.S. banking regulators to amend the calculation of the supplementary leverage ratio in order to recognize client-posted initial margin in cleared derivatives. The Commissioners’ comments came in response to a rule proposal by the banking regulators to update the calculation of derivative contract exposure amounts under the regulatory capital rules, previously covered here.

In a comment letter, CFTC Commissioners Dan Berkovitz, Rostin Behnam and Brian Quintenz said that the banking regulators (the Federal Reserve Board, the FDIC and the Office of the Comptroller of the Currency) neglected to acknowledge the “risk-reducing impact” of client initial margin that the clearing member banking organization holds on behalf of clients. The Commissioners contended that a supplementary leverage ratio (“SLR”) calculation that permits initial margin to offset potential future exposures would eliminate an unnecessary impediment to banks offering client clearing services.

According to the Commissioners, the adoption of the standardized approach for counterparty credit risk (SA-CCR) without offset will:

  • “maintain or increase the clearing members’ SLRs by more than 30 basis points on average”;
  • continue to “disincentivize clearing members” from supplying clearing services; and
  • limit access to clearing in “contravention of G20 mandates and Dodd-Frank.”

Commissioner Dawn Stump recused herself from providing commentary on the proposed rule.

Federal Register: Banking Agencies Propose Updating Calculation of Derivative Contract Exposure Amounts

The Comptroller of the Currency, Federal Reserve Board and FDIC proposal allowing “advanced-approaches” banking organizations (i.e., those with $250 billion or more in total consolidated assets, or $10 billion or more in on-balance sheet foreign exposure) to use an alternative approach for calculating derivative exposures under regulatory capital rules was published in the Federal Register. Comments must be received before February 15, 2019.

As previously covered, the proposed approach – the standardized approach for counterparty credit risk (“SA-CCR”) – would replace the current exposure methodology (“CEM”). If adopted, the proposal would (i) require advanced-approaches banking organizations to use SA-CCR to calculate their standardized total risk-weighted assets by July 1, 2020 and (ii) allow non-advanced-approaches banking organizations to use either CEM or SA-CCR when calculating standardized total risk-weighted assets.

CFTC Commissioner Quintenz Encourages China to Adopt U.S. Approach to Derivatives Markets

CFTC Commissioner Brian Quintenz described the role of derivatives in supporting economic growth, the advantages of the “principles-based” regulatory model of the U.S. derivatives markets and concrete steps China has taken to liberalize its financial markets.

In remarks at the 14th Annual China International Derivatives Forum, Mr. Quintenz disagreed with the label that derivatives are “risky,” stating that the derivatives present tools to manage and efficiently transfer risk to market participants who have the ability to bear it. He described derivatives as being vital to the “health and growth of a country’s real economy” and said that, as China’s derivatives markets grow, it should adopt an approach to futures market regulation akin to that taken by the CFTC.

He stated that participant diversity, customer protection, and market integrity promoted by principles-based regulation are three characteristics of the U.S. futures market that have contributed to “resiliency, vitality, and efficiency.” In particular, Mr. Quintenz added that:

  • the policy of open participation helped increase liquidity, which enables companies to engage with the market even during times of instability;
  • the legal regime supporting the U.S. futures markets leads to strong customer protections (i.e., the CFTC and exchanges “police the markets for fraud, abuse and manipulation”); and
  • a “principles-based approach” has numerous advantages over a “prescriptive approach” (i.e., principles-based regulation enables market participants to be “individually responsive to market dynamics”).

Mr. Quintenz explained that the growth of China’s futures markets has been critical to its economic rise. In particular, he cited recent incremental steps that have lowered barriers on the ability of non-Chinese entities to access Chinese financial markets.

 

Banking Agencies Propose Updating Calculation of Derivative Contract Exposure Amounts

The Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation proposed allowing “advanced-approaches” banking organizations (i.e., those with $250 billion or more in total consolidated assets, or $10 billion or more in on-balance sheet foreign exposure) to use an alternative approach for calculating derivative exposures under regulatory capital rules.

The proposed approach – the standardized approach for counterparty credit risk (“SA-CCR”) – would replace the current exposure methodology (“CEM”). If adopted, the proposal would (i) require advanced-approaches banking organizations to use SA-CCR to calculate their standardized total risk-weighted assets by July 1, 2020 and (ii) allow non-advanced-approaches banking organizations to use either CEM or SA-CCR when calculating standardized total risk-weighted assets.

In addition, the proposal would require advanced-approaches banking organizations to use SA-CCR to determine the exposure amount of derivative contracts for calculating total leverage exposure and would amend the cleared transactions framework to include SA-CCR.

Comments on the proposal must be submitted within 60 days from the date of publication in the Federal Register.

SEC Commissioner Offers Recommendations on Implementing G20 Swaps Reforms

SEC Commissioner Hester M. Peirce offered recommendations to regulators on implementing G20 swaps reforms. Ms. Peirce said that the G20 reforms were not foolproof and encouraged regulators to exercise “healthy skepticism” when implementing them.

In remarks before the International Regulators Conference, Ms. Peirce said that “poorly designed regulations” played a role in the 2007-2009 financial crisis. She cited the “favorable regulatory treatment given to highly rated securitization tranches.” She stated that, among other things:

  • “central clearing is not a panacea” and brings its own risks;
  • regulators should attend to market feedback and market professionals’ knowledge when considering rulemaking; and
  • regulators must consider more flexible regulation rather than a one-size-fits-all approach.

In implementing the regulatory framework for security-based swaps, Ms. Peirce advised, the SEC should:

  • reexamine proposed and final regulations to ensure that the regulatory framework serves its intended purpose;
  • devise clear rules and provide guidance instead of relying on staff no-action letters;
  • streamline regulatory processes so that the agency can promptly respond when implementation issues arise;
  • ensure that the compliance periods for rules provide the market with sufficient time to prepare for and then comply with requirements; and
  • provide that multiple rule sets do not overly burden market participants.

In addition, Ms. Peirce advocated for regulatory cross-border deference as international regulators develop their framework for security-based swaps. According to Ms. Peirce, regulatory cross-border deference will ensure that the global over-the-counter derivatives market can serve the risk management needs of companies throughout economies.

Lofchie Comment: Commissioner Peirce’s call for the regulators to be self-critical is welcome. Likewise are her suggestions that both the causes of the financial crisis and the regulatory responses to it be critically re-examined.

There are, however, important challenges to her stated goals. Is it possible to have multiple regulators both be open to ongoing regulatory review and revision and, at the same time, to conform their own rules? It is certainly good news that the CFTC and the SEC are cooperating now; but will the agencies be able to sustain such cooperation over the long term?

CFTC Commissioner Advocates for International Regulatory Cooperation

CFTC Commissioner Rostin Behnam advocated for international regulatory cooperation to address the risks posed by benchmark reforms, margin, Brexit, cross-border regulation and FinTech. In a speech at the 2018 ISDA Annual Japan Conference, Mr. Benham weighed in on the following:

  • Benchmark Reforms. Mr. Behnam emphasized the importance for global regulatory authorities to work with one another as well as private sector entities to facilitate the transition away from various inter-bank offer rates. He praised the work being done by, among others, the UK FCA, Japanese regulators, and, in the United States, the public-private partnership of the Alternative Reference Rates Committee (“ARRC”). Mr. Behnam encouraged market participants to examine LIBOR-fallback language in existing contracts and highlighted the work of market participants and regulators to develop alternative contract language to facilitate this approach. He also broadly encouraged participants to transact in SOFR-referenced derivatives markets, noting that a move to SOFR could help avoid the consequences of “zombie LIBOR.” Mr. Behnam noted that, while he is aware of “some preference” for continuing with LIBOR, regulators are generally “anticipating a clear and certain break from LIBOR.” He also highlighted the work of the CFTC Market Risk Advisory Committee, in particular its Interest Rate Benchmark Reform Subcommittee. He expressed his hope that the subcommittee would “complement” the work of the ARRC.
  • Initial Margin. Mr. Behnam stated that the full phase-in of initial margin requirements in 2020 raises “a number of potential challenges for the marketplace.” He stressed that the CFTC and U.S. bank regulators are listening to concerns of market participants about 2020 implementation and are gathering information to understand the situation to “avoid catastrophe.” He highlighted the work and recommendations of, among others, ISDA and SIFMA, and while not committing to their suggested approach, said that the CFTC and other regulators would “bundle” efforts toward “appropriate recommendations and guidance.”
  • Cross-Border Regulation. Mr. Behnam said that CFTC Chair J. Christopher Giancarlo’s recent whitepaper announcing his vision of the agency’s approach to applying its statutory authority over swaps activities to cross-border activities merely reflected his ambitions and views. Mr. Behnam distanced himself from the white paper, stating that he thinks the CFTC should build its internal consensus in accordance with formal, statutory procedures while considering the needs of and affording deference towards global regulators. He noted that the timing for turning the white paper proposals into formal rulemaking is “unclear,” and noted that Mr. Giancarlo had suggested that it would be “several quarters” for such a sea change to progress. Mr. Behnam said that the sufficient time was needed, expressing his view that aspects of Mr. Giancarlo’s proposals would depart from CFTC policy and “may even conflict with our governing statute and prior [CFTC] interpretations thereof or lead to gaps in certain protections afforded to U.S. persons transacting overseas.”
  • FinTech. Mr. Behnam urged regulators to approach FinTech with “an open mind and a healthy respect for [regulators’] role in the markets.”

Lofchie Comment: Commissioner Benham’s remarks included some pointed criticisms of CFTC Chair Giancarlo. In reference to the White Paper that Chair Giancarlo published on cross-border regulation, Mr. Benham asserted that CFTC commissioners ought to act only through formal commission action, such as the issuance of concept releases or formal rule makings.

There is nothing in the law that limits the ability of CFTC commissioners to take individual public stands on regulatory issues. If it were improper for a CFTC Commissioner to express a personal view, then it would be not only improper to publish a White Paper, but also improper for a commissioner to deliver a speech or other public statement that has not been ratified by the entire commission. Both Commissioner Benham’s speech and Chair Giancarlo’s White Paper present the standard disclaimer that the views expressed are those of the author and not the views of the Commission or staff.

Financial regulation benefits tremendously from debates about policy that are backed by views as to market behavior and facts. Commissioner Benham’s disagreement with Chair Giancarlo approach ought to focus on the substance of the Chair’s well considered views, and not with its existence.

SEC Director of Investment Management Outlines Policy Initiatives

In testimony before the U.S. House Committee on Financial Services, SEC Division of Investment Management (the “Division”) Director Dalia Blass outlined the following underlying aims of the Division: (i) improve the retail investor experience; (ii) modernize the regulatory framework and engagement; and (iii) utilize resources efficiently. The Division is working on the following rule proposals or potential rulemaking areas:

  • propose Regulation Best Interest;
  • modernize fund disclosure both by reviewing the content of disclosures and by allowing funds to provide shareholder reports online;
  • improve disclosure as to variable annuities;
  • finalize a rule for the issuance of exchange-traded funds (“ETFs”), so that the SEC exemptive process can more efficiently process exemptive relief requests for ETFs not within the scope of the rule;
  • reduce obstacles to publishing research on investment funds in compliance with the Fair Access to Investment Research Act of 2017;
  • harmonize and improve registration and reporting requirements for business development companies and closed-end registered investment companies (“RICs”);
  • regulate the use of derivatives by RICs;
  • publish guidance regarding valuation procedures;
  • update investment adviser marketing rules;
  • improve investment company liquidity disclosures;
  • support fund innovation as to cryptocurrency-related holdings; and
  • review the proxy process.

Lofchie Comment: While the SEC talks the talk as to facilitating innovation, walking the walk is far more difficult. ETFs, for example, have become a significant product in the financial markets, and yet the SEC is only now considering a rule to routinize their issuance. As to cryptocurrency funds, one really has to question whether the SEC wants them to go forward, or is hoping that interest in the product is a bubble that will pop before the SEC is pushed to act. Compare SEC Rejects Another Nine Proposed Bitcoin ETFs with SEC Commissioner Peirce Calls on SEC to Embrace Innovation and Allow Cryptocurrency Risk-Taking.

Federal Register: CFTC Proposes to Simplify Exemptive Process for Foreign Clearing Organizations

The CFTC proposed amendments to codify policies and procedures for a non-U.S. clearing organization to obtain an exemption from registration as a derivatives clearing organization (“DCO”). The amendments were published in the Federal Register. Comments must be received on or before October 12, 2018.

As previously covered, the proposal would amend CFTC Parts 39 and 140, which address procedures for registration as a DCO. The proposal would (i) establish a new rule, CFTC Rule 39.6, that would create a regulatory framework for exempting non-U.S. clearing organizations from DCO registration with the CFTC, (ii) mandate clearing organizations to “observe the principles for financial market infrastructures in all material respects and be in good regulatory standing in its home country” under proposed regulation 39.6(a)(1)(ii), and (iii) obligate that a memorandum of understanding satisfactory to the CFTC be in effect between the agency and the clearing organization’s home country regulator.

CFTC Chair Evaluates Challenges Facing Derivatives Market

CFTC Chair J. Christopher Giancarlo assessed the challenges facing the CFTC and the United States in the global competition as a center for the derivatives markets. In an address at the West Texas Legislative Summit, Mr. Giancarlo warned that the CFTC must be proactive if the United States is to retain its preeminent position in the global financial markets.

Mr. Giancarlo described the significance of the commodity derivatives market and its impact on pricing. He pointed out that even those who do not participate in such markets are still affected and that 90 percent of companies in the Fortune 500 use derivatives to hedge. He highlighted the challenge of global competition, particularly China’s domestic futures market, specifically alluding to the country’s recent opening to international participation, which has “competitive implications” for the United States. To maintain “world leadership,” he said, it is urgent that derivatives markets in the United States maintain “openness, orderliness, and liquidity” to sustain global economic leadership.

Mr. Giancarlo emphasized the importance of establishing a regulatory framework that is “ahead of the curve,” and advocated for the “SMART-REG” approach he first outlined in 2014. This approach, he said, is intended to “solve problems – real problems, not invented ones.”

Mr. Giancarlo asserted that under his leadership, the CFTC has “emphasized greater care and precision in rule drafting, more thorough econometric analysis, and a reduced docket of new rules and regulations to be absorbed by market participants.”

Lofchie Comment: Chairman Giancarlo went beyond a discussion of the derivatives markets to discuss the underlying commodities markets. In explaining the success of the shale revolution in the United States, he described a “combination of American technological innovation, North American geology, U.S. property law, the skilled and entrepreneurial American workforce and our dynamic capitalist economy.” Chairman Giancarlo continues to be a voice of clarity and an educator in an often confused debate about the value of markets and the limits of governments as providers of services and products.

It is not so long ago that the Union of Soviet Socialist Republics collapsed in economic failure. That collapse seemed as if it would put an end to any debate as to the benefits of government ownership of the means of production. But today that debate is revived, or at least there are new advocates for it. To the extent that these advocates are taken seriously, it is important that advocates for private enterprise and for market competition not be shy to point out successes, face criticisms and to make comparisons as to the successes of different systems.