Acting Chair Giancarlo Asserts “New Direction Forward” for CFTC

CFTC Acting Chair J. Christopher Giancarlo called for the CFTC to “reinterpret its regulatory mission” by (i) fostering economic growth, (ii) enhancing U.S. financial markets, and (iii) “right-sizing its regulatory footprint.” Acting Chair Giancarlo delivered his remarks before the 42nd Annual International Futures Industry Conference, on the day after President Donald J. Trump announced his intention to nominate Mr. Giancarlo as CFTC Chair (see previous coverage).

In his speech, Mr. Giancarlo called for an end to the “overly prescriptive regulation of the American derivatives markets,” which he asserted are now “more fragmented, more concentrated, less liquid, and less supportive of economic growth and renewal than in the past.” Mr. Giancarlo noted that he is not opposed to Title VII of Dodd-Frank (in which, he maintained, “Congress got much right”), but rather with the CFTC’s implementation of the market reforms.

Acting Chair Giancarlo stated that the CFTC should foster economic growth by:

  • reducing regulatory burdens through initiatives like “Project KISS” (“Keep It Simple, Stupid”), designating his chief of staff as the CFTC Regulatory Reform Officer, and reviewing all CFTC rules in order to reduce regulatory burdens and costs for participants in markets under CFTC oversight;
  • becoming a “smarter regulator” by restructuring agency surveillance organizations and appointing a Chief Market Intelligence Officer who will report directly to the CFTC Chair; and
  • embracing financial technology (“fintech”) by adopting a “do-no-harm” approach and reviewing agency treatment of fintech innovation.

Acting Chair Giancarlo also asserted that the CFTC should enhance financial markets by:

  • “calibrating bank capital charges for economic growth” as a voting member of the Financial Stability Oversight Committee;
  • reforming the CFTC’s “flawed swaps trading implementation” with a “better regulatory framework for swaps trading” that allows market participants to select the manner of trade execution best suited to their needs, rather than having specific types “chosen for them by the federal government”; and
  • improving coordination with global regulators through measures while “fully embrac[ing] the Trump Administration’s Executive Order to advance American interests in international financial regulatory negotiations and meetings.”

Lastly, Mr. Giancarlo suggested that the CFTC should obtain a “right-size regulatory footprint” by:

  • “normaliz[ing] CFTC operations” after the “era of Dodd-Frank implementation” by decreasing regulatory burdens and attending to “longer range goals,” such as leveraging diversity;
  • “eschew[ing] empire building” at the CFTC by “resetting its focus on its core mission” and streamlining the work of various divisions; and
  • “run[ning] a tighter ship” in the wake of recent reductions in the agency budget and appropriations.

Acting Chair Giancarlo concluded:

“The time has come to reduce regulatory barriers to economic growth. The American people have elected President Trump to turn the tide of over-regulation. Financial market regulators, like the CFTC, must pursue their missions to foster open, transparent, competitive and financially sound markets in ways that best foster American prosperity.”

CFTC Chair Timothy Massad Resigns

CFTC Chair Timothy G. Massad tendered his resignation to President Obama. He will leave the CFTC on January 20, 2017. In a statement, which was accompanied by a 16-page summary of the CFTC’s accomplishments during his two-and-a-half-year tenure, Chair Massad asserted that the Commission had realized his agenda:

“I came to the CFTC with a number of priorities, and I am proud we have made significant progress in every area.”

Chair Massad highlighted accomplishments during his tenure. The CFTC:

  • ensured that “commercial businesses [could] continue using the derivatives markets efficiently and effectively to hedge routine commercial risk and engage in price discovery”;
  • “worked to ensure clearinghouses are stronger and more resilient through enhanced risk surveillance, new supervisory stress testing, and the development and completion of recovery and wind down plans and rules”;
  • “largely finished implementing the regulatory framework for swaps”;
  • “improved international coordination”;
  • “engaged in robust enforcement efforts”; and
  • took action to “address the new challenges and opportunities in the derivatives markets, particularly cyber threats, clearinghouse resilience, and the increased use of automated trading.”

Chair Massad emphasized that he “worked to make sure the rules focus on where the greatest risk exists, in transactions between large financial institutions,” and to ensure they were “largely harmonized with other domestic and international requirements.” He also noted that the clearinghouses are “stronger and more resilient,” through enhanced risk surveillance, new supervisory stress testing, and the development and completion of recovery wind down plans and rules.

SEC Chair White Presses Ahead with New Regulations

SEC Chair Mary Jo White issued a response to the Senate Banking Committee’s November 30 letter cautioning federal agencies not to finalize pending rules during the departing administration’s last days. According to Chair White, many of the SEC’s planned initiatives are “ready for Commission consideration.” She stated her intention to move forward with them before the change in administrations.

Chair White referred to comparable post-election periods in the past. She noted that the SEC enacted a number of substantive rules during transition periods after the 2000 and 2008 elections. The SEC should not “deviate from its historical practice of independently carrying out its duties,” she said.

Chair White listed several items that were ready for an SEC vote, including the following:

  • the adoption of rules to establish capital, margin and segregation requirements for security-based swap dealers and major security-based swap participants;
  • the adoption of rules regarding recordkeeping, reporting and notification requirements for security-based swap dealers and major security-based swap participants;
  • the adoption of rules regarding the orderly liquidation of certain broker dealers; and
  • the adoption of Investment Company Act Rule 30e-3, which concerns an optional method for investment companies to use to transmit shareholder reports by web posting.

Lofchie Comment: How much of the letter is devoted to formalities and how much concerns important issues is difficult to say, since some of the proposed rules are not significant to market participants; e.g. the rules on orderly liquidation and shareholder reports. At least three new Commissioners will be joining the SEC in the next few months. Surely, it is appropriate to allow those Commissioners to decide for themselves whether to proceed with the swap dealer rules as proposed or to amend them. In other words, given that these rules have been years in the making, is there an urgent reason to adopt them before the new Commissioners are seated?

Chair Massad Describes the CFTC’s Efforts on Behalf of Commercial End-Users

CFTC Chair Timothy Massad detailed the agency’s past efforts and his remaining agenda on behalf of commercial end-users. In an address at the American Gas Association 9th Annual Energy Market Regulation Conference, Chair Massad outlined actions the CFTC undertook in support of commercial end-users:

  • the exemption of commercial end-users from the CFTC’s rule on margin for uncleared swaps;
  • clarifying when commonly used agreements that include volumetric optionality provisions are forward contracts, and not subject to swaps rules;
  • eliminating certain reporting and recordkeeping obligations and announcing that trade options would not be subject to position limits;
  • customer protection improvements regarding collection of margin;
  • simplifying recordkeeping requirements;
  • granting delayed reporting for contracts in illiquid markets;
  • amending CFTC swap dealer rules so that “local, publicly-owned utility companies can continue to effectively hedge their risks in the energy swaps market”;
  • the exemption of certain transactions in the regional transmission organization and independent system operator markets from most provisions of CFTC rules other than the authority to pursue fraud and manipulations in these markets;
  • clarifying that community development financial institutions and small banks may choose not to clear a swap subject to the CFTC’s clearing requirement; and
  • ensuring that end-users can use the Congressional exemptions given to them regarding clearing and swap trading even if they enter into swaps through a treasury affiliate.

He then described several pending actions (position limits, capital requirements for swaps dealers and major swap participants, the de minimis threshold, and the modernization of recordkeeping requirements), as well as new challenges (cybersecurity, automated trading and the changing nature of liquidity and clearinghouse resilience).

On the issue of recently reproposed rules for limiting speculative futures and swaps positions, Chair Massad stated that the CFTC has a responsibility to “implement a balanced rule that achieves the objectives Congress has established,” and that he hopes the reproposal can be finalized in the near future.

Chair Massad asserted that end-users were “not the cause of the crisis.” He stated that there is a need to make sure that implementing reforms do not create undue burdens on these businesses. In a look back on his legacy at the CFTC, Chair Massad stated:

“We worked to keep the focus of regulation on those who create the most risk, and made rules less prescriptive in some areas. And we have worked to strengthen relationships with international regulators and harmonize regulations across borders.”


Lofchie Comment: In his remarks, Chair Massad stated:

“When I and my fellow Commissioners, Sharon Bowen and Chris Giancarlo, joined the CFTC together in June of 2014, it already had written most of the rules required by the Dodd-Frank Act. However, there were many criticisms and concerns. We inherited the task of finishing and improving this framework.” [Emphasis supplied.]

In many ways, Chair Massad’s freedom to re-examine and re-think the regulations adopted under former Chair Gensler was limited. That is, Chair Massad was limited to working at the edges, always declaring that any amendments made under his stewardship were merely “fine-tuning,” finishing a “framework” that he had inherited. See, e.g.Chair Massad Updates CFTC Priorities (need to fine-tune swap regulations); CFTC Chair Massad Discusses CFTC Rulemaking in an International Context (with Lofchie Comment) (fine tuning of cross-border regulations); Chair Massad Discusses CFTC’s Market Risk Strategy and Priorities for “Fine-Tuning” Flawed Rules (with Zwirb Comment). It is quite clear, however, that the CFTC’s rules were (and are) in need of an entirely fresh eye. This requires more of a Zen mindset than the one he brought to the task. See, e.g.Zen Mind, Beginner’s Mind by Shunryu Suzuki. The next CFTC administration should be better positioned in this regard.

CFTC Proposes Capital, Liquidity and Related Requirements for Swap Dealers

The CFTC approved proposed rules establishing minimum capital, liquidity, financial reporting and related requirements for CFTC-registered swap dealers (“SDs”) and major swap participants (“MSPs”). The proposed rules are a reproposal of rules previously proposed in 2011.

The proposed rules cover the follow areas related to SDs and MSPs:

  • capital requirements;
  • liquidity requirements;
  • financial recordkeeping and financial reporting;
  • obligation to notify regulators if a firm’s capital drops below certain levels; and
  • limitations on the withdrawal of capital and liquid assets.

The CFTC identified three approaches to allow firms to meet capital requirements:

  • an approach based on bank capital requirements that would be available to SDs that are subsidiaries of a bank holding company and thus subject to BHC capital requirements;
  • an approach modeled after the SEC’s capital requirements; and
  • a “tangible” net capital approach intended for a commercial enterprise, but that is also required to register as a swap dealer with the CFTC.

The proposal would establish certain liquidity, reporting and notification requirements, and would obligate entities covered by the proposal to keep current books and records in accordance with U.S. Generally Accepted Accounting Principles. Firms would be able to use models, although the models would have to be approved by the regulators. In addition, the rules provide for a “comparability” determination that will allow non-U.S. swap dealers that are not subject to regulation by the Federal Reserve Board to be subject to their home country capital rules.

There are currently 104 provisionally-registered swaps dealers (no registered major swap participants). Of those, 51 are not subject to the CFTC’s capital requirements because they are subject to U.S. bank requirements (including 36 which are non-U.S. banks having branches in the United States). Eight of the remaining swap dealers are already capital-regulated by the CFTC because they are FCMs, some of which are also SEC-registered broker-dealers. Of the remaining firms, some are subsidiaries of U.S. or non-U.S. bank holding companies or other entities subject to Basel-capital requirements that have sufficient capital to sustain their activities. Currently, there are no registered major swap participant and there is only one primarily commercial firm (Cargill) provisionally registered as a swap dealer with the CFTC.

In statements issued in connection with the reproposal, Chair Timothy Massad emphasized that the proposed requirements should avoid requiring all such firms to follow one approach. “Requiring all firms to follow one approach could favor one business model over another, and cause even greater concentration in the industry,” he said.

Commissioner J. Christopher Giancarlo expressed concerns regarding (i) the rule’s effect on smaller swap dealers and how much additional capital they may have to raise; (ii) the especially broad scope of the proposal; and (iii) the proposed capital model review and approval process.

Lofchie Comment: In terms of the substance of the rule requirements, the CFTC largely punted responsibility (and appropriately so) either to the banking regulators or to the SEC, both of which have significantly more expertise and staff to deal with these matters. It would have been messy for the CFTC and the SEC to take different approaches to capital requirements. Firms subject to regulation by both regulators would have been forced to comply with the more conservative set of rules in any case. In terms of process, the CFTC will wait and see what capital rules are eventually adopted by the SEC and then piggyback on them. For the CFTC, this is an entirely sensible way to go.  For firms that have an interest in the CFTC Rules, and will be subject to the “SEC version of the SEC rules, this means that they should concentrate on commenting on the actual SEC Rules, as the CFTC will likely follow along with whatever the SEC does.

In the Appendix, the CFTC reports the number of registered swap dealers and major swap participants. The numbers are revealing.

  • The CFTC stated that it had expected 300 swap dealers to register. Only 104 firms have done so. The costs associated with registration have likely caused numerous firms either to abandon dealing in swaps or to reduce their level of business below the de minimis level so as to not become subject to registration. Put differently, the regulations have led to a significant increase in the concentration of the swaps-dealing business. If the CFTC determines to reduce the level of business at which swap dealers are required to register, virtually all of the small unregistered swap dealers will further reduce their level of business or drop out of swaps dealing entirely. In short, Dodd-Frank has led to a significant accelerated concentration of swaps exposure.
  • There are no firms registered as a major swap participant. Not one. The registration requirements, applicable to large users of swaps that are not dealers, are absurd; it would be impossible for any non-dealer to comply with them. These provisions should be dropped from Dodd-Frank and the regulators should no longer waste time coming up with rules for registration categories that will apply to no one.
  • Congress gave no instruction as to how capital requirements could possibly be applied to a commercial entity that is a swap dealer. It simply does not work to have regulatory capital requirements (which largely require that a firm hold liquid financial assets) for commercial enterprises that own oil wells, related buildings and refineries. After years of struggling with how to make this round peg fit into a square hole, the CFTC essentially gave up (which was the rational thing to do). It set a low tangible capital requirement, which serves as an irrelevant fig leaf: a rule that the CFTC proposed merely because Congress required it to do so.

Currently, the CFTC does not have the expertise to supervise a models-based capital regime. Greater consideration should be given as to how this will work in practice.

SEC Explains Methodology for Analyzing Comments on Proposal to Restrict Derivatives Use

The SEC Division of Economic and Risk Analysis (“DERA”) set forth the methodology it used to analyze comments received on a proposal for the use of derivatives by registered funds and business development companies.

According to DERA, most commenters proposed that Investment Company Act Rule 18f-4 should measure a fund’s derivatives exposure using notional amounts adjusted to reflect the risks of the underlying reference assets. These SEC-adopted risk-based adjustments would be derived from standardized schedules used for other regulatory purposes.

DERA evaluated aspects of the proposal that included (i) the internal consistency of using risk-adjustment and haircut schedules across asset classes, and (ii) categories created for the purposes of risk adjustment and risk weighting with respect to the rule.

Lofchie Comment: In its analysis, DERA seemed not to differentiate between the use of derivatives for speculation and for hedging. Apparently, DERA assumed that the derivatives would be used only for speculation.


IOSCO Reports on Implementation of Post-Crisis Recommendations for Securities Markets

The IOSCO Board reported on the implementation of the G20/Financial Stability Board’s (“FSB”) post-crisis recommendations to strengthen securities markets. The Board report includes insight and analysis on the implementation of recent reforms and is based on self-reporting by national authorities in FSB jurisdictions. The report focused on (i) hedge funds; (ii) structured products and securitization; (iii) oversight of credit rating agencies; (iv) measures to safeguard the efficiency and integrity of markets; and (v) supervision and regulation of commodity derivative markets.

Highlights of the report:

  • hedge funds – all responding jurisdictions which permit or have hedge funds reported implementation of the G20 and IOSCO recommendations relating to registration, disclosure and oversight of hedge funds. Almost all reported implementation of recommendations in relation to international information and enhancing counterparty risk management;
  • structured products and securitization – most responding jurisdictions reported the introduction of measures to strengthen supervisory requirements or best practices for investment in structured products, and to enhance disclosure of securitized products as recommended by the Financial Stability Forum (now the FSB) in 2008 and IOSCO in a number of reports from 2009 onwards; and
  • oversight of credit rating agencies – all responding jurisdictions implemented G20/FSB recommendations to require registration and provide appropriate oversight of FSB jurisdictions in line with IOSCO’s Code of Conduct Fundamentals for Credit Ratings Agencies.

In addition, the report stated that the implementation of G20/FSB recommendations “is still progressing” in the areas of (i) measures to safeguard the integrity and efficiency of financial markets, and (ii) the supervision and regulation of commodity derivatives markets.

ISDA Analyzes Key Trends in Clearing

In its latest Research Note, ISDA examined recent trends in the clearing business in the United States and the European Union.

The ISDA Research Note found, among other things, that:

  • shifts occurring in the business models of futures commission merchants (“FCMs”) due to the impact of new capital requirements and rising operational costs have led to significant changes in the market share of top FCMs in the United States;
  • some derivatives users were dislocated from their existing FCMs and needed to establish relationships with new FCMs in order to continue using swaps mandated for clearing;
  • FCMs are imposing increased costs on smaller derivatives users (survey results in the United States estimated fees from $60 to $150K over the life of a cleared swap); and
  • monthly mandatory minimum clearing fees and minimum revenue thresholds among larger clearing members in the European Union could range from $100,000 to $280,000 per year, and that range of costs is becoming increasingly common in the United States.

In conclusion, ISDA noted, one of the main effects of the increased cost of cleared swaps is this: end users are being pushed to choose alternative hedging measures and/or accept greater risks by either not hedging or using imperfect hedges.

Lofchie Comment: The bottom line of ISDA’s analysis is that, (i) despite all of the outcry about too-big-to-fail, regulatory costs weigh most heavily on smaller institutions, whether buy-side or sell-side, and (ii) increasing the costs of entering into derivatives transactions makes hedging more expensive, which increases risk in the economy generally, even if the risk of derivatives specifically is decreased. To put this in practical terms, if a small firm is prevented from hedging with derivatives in a way that would reduce that firm’s risk, then (a) the risk of derivatives seems to be reduced (since you can’t default on a derivative into which you can enter), but (b) the actual risk to the business (and to the economy generally) is increased because the small firm can’t hedge.

Streetwise Professor Examines “Fundamental Tension” Underlying CCP Resolution Authority

In response to reports that the European Commission (“EC”) is finalizing legislation on Central Counterparty (“CCP”) recovery, University of Houston Finance Professor Craig Pirrong outlined the sources of “fundamental tension” that underlie the final resolution authority. Citing a statement in the EC’s Executive Summary Sheet that the contemplated framework is likely to involve “a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders” (emphasis supplied), Professor Pirrong concluded that the prospect of trampled rights “calls into question the prudence of creating and supersizing entities with such latent destructive potential.”

Professor Pirrong argued that the resolution authority potentially will “impose large costs on members of CCPs, and even their customers, [which] raises the burden of being a member, or trading cleared products,” and consequently, disincentivizes membership. He also asserted that “[t]he prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that push[] it over the edge.” According to Professor Pirrong, the irony is that these measures to protect CCPs will lead to a “reduced supply of clearing services, and reduced supply of the credit, liquidity and capital that [such CCPs] need to function.”

In addition, Professor Pirrong cautioned that with discretionary power comes “inefficient selective intervention” and the potential to influence costs. “[T]his makes it inevitable,” he warned, that the body will be subjected to intense rent-seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens.”

SEC Adopts Enhanced Regulatory Framework for Securities Clearing Agencies

The SEC voted to adopt final rules to require securities clearing agencies that are deemed systemically important or that are involved in complex transactions (“covered clearing agencies”) to “establish, implement, maintain, and enforce policies and procedures reasonably designed to address all major aspects of [their] operations, including [their] governance, risk management (including financial, business, and operational risks), access requirements, and settlement and depository systems.” In addition, the SEC voted to propose the application of these enhanced standards to all SEC-registered central counterparties.

The adopted rules apply to SEC-registered securities clearing agencies that have been designated as systemically important by the Financial Stability Oversight Council (“FSOC”). The rules require a covered clearing agency to have policies and procedures that, among other things:

  • establish the qualifications of members of boards of directors and the senior management of covered clearing agencies, specify clear and direct lines of responsibility, and consider the interests of relevant stakeholders in covered clearing agencies;
  • address recovery and wind-down planning;
  • address daily stress testing, monthly reviews and annual validation of credit risk models;
  • set and enforce appropriately conservative haircuts and concentration limits, and subject them to review annually at the very least;
  • mark positions to market, collect margin at least daily, and conduct daily backtesting and monthly sensitivity analyses, and perform model validation at least annually;
  • address holding “qualifying liquid resources” that are sufficient to withstand the default of the participant family that would generate the largest aggregate payment obligation in extreme but plausible market conditions;
  • test the sufficiency of their liquidity providers;
  • provide for holding liquid net assets funded by equity equal to at least six months of current operating expenses in order to allow covered clearing agencies to continue operations during a recovery or wind-down; and
  • maintain a viable plan, which must be approved by boards of directors and updated at least annually, for raising additional equity should that of covered clearing agencies fall close to or below the required amount.

In his statement at the open meeting, SEC Commissioner Michael S. Piwowar emphasized that he voted for the final rule and proposal, but expressed his misgivings:

I support today’s adopting and proposing releases as the best approach we currently have at setting heightened standards for the clearing agencies we regulate. However, this entire effort has the eerie feeling of re-arranging deck chairs on the Titanic. I hope that history will prove me wrong, but I fear that the Dodd-Frank Act has created too many icebergs for our financial system to safely navigate.

SEC Commissioner Kara M. Stein expressed reservations about the laxity of the final rules, which she said only “marginally decrease the risk posed by systemically important clearing agencies.”

Comments on the final rules must be submitted within 60 days after their publication in the Federal Register. If adopted, the final rules also will become effective 60 days after their publication in the Federal Register. Covered clearing agencies will be required to comply with the final rules no later than 120 days after the effective date.

Lofchie Comment: In statements that might have sounded familiar to Goldilocks, the three SEC commissioners voiced three different views on the final rules: Commissioner Stein said that they do too little, but are better than nothing, Commissioner Piwowar complained that they comprise a part of an ill-conceived scheme of regulation that exacerbates the problem of too-big-to-fail, while Chair Mary Jo White declared that the rules are just right.