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.

CFTC Leaders Respond to Criticisms Raised in Vatican Document

CFTC Chair J. Christopher Giancarlo and CFTC Chief Economist Bruce Tuckman responded to criticisms outlined in the Bollettino, a document released by the Vatican that “lays out ethical foundations to govern economic and financial systems.” The CFTC leaders defended derivatives and credit default swaps (“CDS”), which were subject to particular scrutiny in the document.

Mr. Giancarlo and Mr. Tuckman emphasized that it is important to recognize the “social utility” of derivatives. They asserted that derivatives products help to “moderate price, supply and other commercial risks” which can facilitate economic growth and prosperity. Additionally, they highlighted that derivatives can be tools for risk transfer and mitigation, particularly in agricultural communities.

Notably, Mr. Giancarlo and Mr. Tuckman argued that in order for agricultural exporting nations to help “feed the world’s growing population,” they must have support from derivatives markets. They added that derivatives markets play a significant role in aiding return on capital, which they said supports investments in various farming technologies that are necessary to meet the global food demand.

Mr. Giancarlo and Mr. Tuckman focused on three specific issues related to CDS: (i) information asymmetries, (ii) speculation and (iii) profiting from the suffering of others. They argued that information asymmetry is an inherent aspect of a healthy financial system and that speculation contributes to the “generation of information and the dissemination of that information to the public at large.” They stated that proper uses of CDS “require a counterparty on the other side of the trade,” and speculators fulfill this role. Mr. Giancarlo and Mr. Tuckman further asserted that research shows that CDS trading on sovereign bonds (i) “lowers countries’ cost of debt and increases the information efficiency of their bond markets” and (ii) acts as “an important check on poor fiscal management.”

Mr. Giancarlo and Mr. Tuckman concluded that derivatives “help stabilize the price of global commodities and financial rates in a manner that is particularly beneficial to the world’s poor.”

Lofchie Comment: It is important that participants in our capitalist system be willing to step up to its defense, educate as to its social benefits and engage with its well-intentioned critics.

CFTC Issues Guidance to Exchanges and Clearinghouses on Virtual Currency Derivative Product Listings

The CFTC issued staff guidance to exchanges and clearinghouses to “ensure proper surveillance and oversight of the trading and clearing of virtual currency contracts.”

The CFTC stated that virtual currencies “are unlike any commodity that the CFTC has dealt with in the past.” The CFTC cited heightened risks and a lack of transparency and susceptibility to market manipulation as causes for concern about how virtual currency derivative products may impact the commodities markets. As a result of these risks, the CFTC identified several areas that demand greater attention from designated contract markets (“DCMs”), swap execution facilities (“SEFs”) and derivatives clearing organizations (“DCOs”). As described in the advisory, the CFTC set the following expectations:

  • Enhanced Market Surveillance. The CFTC expects exchanges to enter into information-sharing agreements with spot markets for virtual currency products in order to facilitate access to trade data. The CFTC heightened its expectations for the monitoring of “relevant data feeds” from the underlying spot markets. The CFTC expects that exchange-listed virtual currency contracts should be based on spot markets that adhere to federal anti-money laundering regulations.
  • Close Coordination with the CFTC Surveillance Group. The CFTC expects exchanges to regularly coordinate with CFTC staff regarding the surveillance of virtual currency derivative contracts, provide certain trade data to CFTC staff upon request, and coordinate with staff regarding the timing of new virtual currency derivative listings.
  • Large Trader Reporting. The CFTC recommends that exchanges implement a large trader reporting threshold for virtual currency derivative contracts at “five bitcoin” or the “equivalent for other virtual currencies.” This threshold could help to better identify traders who are engaging in virtual currency-related market manipulation.
  • Outreach to Members and Market Participants. The CFTC expects exchanges to “meaningfully” engage with stakeholders in the lead-up to new virtual currency derivative product listings. This includes the expectation that exchanges will solicit comments from stakeholders not only on contract terms and vulnerability to market manipulation, but also on the impact on clearing members and futures commission merchants. The CFTC also expects exchanges to share feedback from market participants with CFTC staff.
  • DCO Risk Management. The CFTC expects a DCO to submit to CFTC staff proposed initial margin requirements and other relevant information concerning a proposed virtual currency derivative contracts. CFTC staff also expects DCOs to explain their consideration of stakeholders’ views in approving proposed contracts.

The CFTC explained that in the event that a self-certified virtual currency derivative contract raises concerns, the CFTC will provide a notice to the exchanges regarding its concerns as to compliance with the CEA and CFTC rules.

CFTC Commissioners Have Different Wish Lists

In separate remarks at the FIA 40th Annual Law and Compliance Conference, CFTC Commissioners Brian Quintenz and Rostin Behnam described their respective regulatory priorities in contrasting terms.

Commissioner Quintenz advocated for concerted efforts to accomplish harmonization between SEC and CFTC swap regulation. According to Mr. Quintenz, firms that register as both swap dealers and securities-based swap dealers with the CFTC and the SEC, respectively, should be subject to different regulatory requirements only when there are “irreconcilable difference[s] between the securities and derivatives markets.” Further, Mr. Quintenz emphasized the importance of pushing for full harmonization where possible, noting that small differences often lead to a large cost for compliance. As to CPO/CTA registration for registered investment advisers, SEFs and data reporting, Mr. Quintenz argued that deference to the rules of the other agency may be appropriate. A firm engaged in trading and reporting swaps and security-based swaps should follow “one set of rules, instead of two,” he argued.

While Commissioner Behnam also spoke about SEC/CFTC harmonization, he emphasized more broadly that CFTC Chair J. Christopher Giancarlo’s agenda for regulatory change was overly ambitious. In Mr. Behnam’s words:

We’ve been waiting for deliverables in terms of Project KISS, Reg. Reform 2.0, and CFTC and SEC harmonization, and anticipating resolution of unfinished business in terms of the de Minimis exception, position limits, capital, and Regulation Automated Trading (Reg. AT). Since that time, we’ve received the Chairman’s white paper on “Swaps Regulation Version 2.0,” which purports to set the agenda for Reg. Reform 2.0. While I appreciate the Chairman’s transparency in setting forth his vision and, in his words, starting a dialogue, I can’t help but note that there is already a process for dialogue with market participants regarding potential rule changes – the notice and comment process for proposed rules under the Administrative Procedure Act. Adding another white paper just pushes back the timeline for getting to actual deliverables. It adds another step to the process. It also takes a lot of staff time when budgets are tight.

Commissioner Behnam went on to say: “If [CFTC] staff is directed to focus on reworking the broader framework for the swaps market in lieu of fine-tuning and building on the progress we’ve made since 2008, we risk creating greater uncertainty and impracticability at increased costs to market participants.”

Lofchie Comment: While one can be sympathetic to Commissioner Behnam’s skepticism of the need for regulatory change, and that such change itself can be costly, sufficient time has now passed since Dodd-Frank was adopted to evaluate many of the rule changes. Many of the rule changes have not only not produced the suggested benefits, but have had a negative impact on liquidity, have increased market fragmentation, and have materially increased costs to end users. Particularly given the tremendous speed with which the swap rules were adopted, and given that there is now sufficient data to evaluate at least some of the results that they have produced, there seems a great benefit in the rethinking suggested by Chair Giancarlo and CFTC Chief Economist Bruce Tuckman. It should also be noted that many of the observations made by Chair Giancarlo had also been raised by him when he was a Commissioner, but had not received the attention that they merited or the discussion that they deserved and now hopefully will receive.

CFTC Chair Unveils New Measure of Swaps Market Size and Risk

CFTC Chair J. Christopher Giancarlo introduced a new measure for the size of the rates segment of the swaps markets and called for a new “paradigm” in describing that market.

In remarks delivered at Derivcon 2018 in New York, Mr. Giancarlo characterized notional value as a highly flawed metric for the size and risk of the swap market, and emphasized that reliance on the metric for regulatory purposes leads to poor allocation of public resources. In particular, he noted that the common use of notional amounts in public discourse without normalizing for duration or offsetting positions creates an impression that the market is much larger than it is in actual risk terms, and has led to misguided policy decisions.

Mr. Giancarlo unveiled a new metric for measuring the size of the rate swap markets developed by CFTC Chief Economist Bruce Tuckman. This measure would evaluate market size based on entity-netted notionals (“ENNs”), which are produced by converting notional amounts for rate swaps of all durations into five-year risk equivalents, and then netting long and short exposures in the same currency between pairs of market participants. Mr. Giancarlo explained that ENNs are designed to describe the amount of market risk transfer in the interest rate swaps markets. Using this method of calculating risk, the aggregate risk transfer amount is sized much more consistently with other major markets, such as the debt market, and can be evaluated accordingly.

Mr. Giancarlo encouraged consideration of the ENN including its potential uses for regulation, but noted that his intention was not to come up with a specific alternative to the current swap dealer de minimis calculation methodology. He also emphasized that ENNs are not intended to quantify credit or operational risk.

Lofchie Comment: Query whether the new measure will be adopted by those who believe that there is a political advantage in exaggerating the size of the swaps market? It sounds a lot more ominous to describe a swap as having a billion dollar notional than it does to describe it as having a four dollars and thirty-seven cents market value.

 

European Commission Recognizes U.S. DCMs and SEFs as “Equivalent”

The European Commission (“EC”) announced a decision recognizing certain CFTC-regulated DCMs and SEFs as “eligible for compliance” with EU trading obligations for certain derivatives. CFTC staff recommended that the CFTC adopt a similar order exempting EU-authorized trading facilities from U.S. registration requirements. The decisions follow the recent agreement between the CFTC and EC to adopt a “common approach” to derivatives trading on certain platforms.

According to the EC, this recognition will allow for EU counterparties to trade derivatives on CFTC-authorized designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) based in the United States. In accordance with the decision, traders will be able to use U.S. trading platforms for such transactions even as MiFID II (and its derivatives trading obligation) becomes applicable on January 3, 2018. The trading obligation will require certain derivatives transactions to be executed on EU venues or venues designated as equivalent by the EC. The European Commission noted that its decision does not affect the ability of EU counterparties to trade on CFTC-regulated DCMs and SEFs with respect to derivatives that are not subject to the EU trading obligation.

CFTC Chair J. Christopher Giancarlo urged his fellow commissioners to “act expeditiously in approving” an exemptive order for EU trading facilities. CFTC Director of the Division of Market Oversight Amir Zaidi added that the CFTC is “close behind” with its own order.

Lofchie Comment: This is a significant success. CFTC Chair Giancarlo had, at once, both reached out to the Europeans in regard to the mutual acceptance of “comparable regulations” and cautioned the Europeans against imposing regulatory requirements that would disadvantage U.S. financial intermediaries.  See CFTC Chair J. Christopher Giancarlo Criticizes “EU Plan to Invade U.S. Markets.”

CFTC Commissioner Behnam Evaluates Implementation of Derivatives Reforms

Commissioner Rostin Behnam identified four key reform priorities: mandatory clearing, exchange trading of standardized swaps, swap data reporting, and capital and margin requirements for non-centrally cleared swaps.

In remarks at the Georgetown Center for Financial Markets and Policy, Commissioner Behnam expressed support for the “broad policy objectives” in Title VII of Dodd-Frank and said that the CFTC acted as a “leader” in implementing over-the-counter derivatives reforms in the wake of the 2008 financial crisis. He acknowledged that these changes have come with “costs and unintended consequences,” and expressed support for ongoing regulatory adjustments.

Commissioner Behnam identified four key reform priorities:

  • Mandatory clearing of swaps: Commissioner Behnam said that the clearing mandate has been largely successful, but questioned the size and interconnectedness of clearinghouses, and whether the clearing mandate and higher capital and margin requirements for uncleared swaps have “disincentivized risk management.” He said that the CFTC will evaluate the potential systemic effects of the clearing mandate, and that he will seek to bolster regulations to promote a safer clearing ecosystem.
  • Exchange trading of standardized swaps: Mr. Behnam noted the unintended consequences of the CFTC’s trading rules that have caused concerns as to market fragmentation and liquidity.
  • Swap data reporting: Mr. Behnam argued that the CFTC needs to develop requirements that establish “clear parameters” for data collection and submission, including when data must be submitted, as well as what form the data must take. He stressed the need for data set uniformity, both across the CFTC and with international regulators.
  • Capital and margin requirements for non-centrally cleared swaps: Noting that the CFTC has yet to adopt capital requirements for swap dealers, Mr. Behnam urged the CFTC to develop tools to monitor market resiliency, safety and liquidity in times of stress.

Mr. Behnam also highlighted three ongoing issues at the CFTC: enforcement, international cooperation and technology. In each case, he expressed general support for ongoing initiatives. As sponsor of the Market Risk Advisory Committee, Commissioner Behnam said he will engage in a “listening tour” to hear perspectives on risk management from market participants, regulators and other interested parties.

Lofchie Comment: Commissioner Behnam’s first published speech covers a lot of ground, but does not suggest that there are new initiatives that he will spearhead or that there are current initiatives that he opposes. Instead, Mr. Behnam indicates he will be in observation mode for the first part of his tenure.

In many ways, Mr. Behnam’s speech is similar to the speech given by CFTC Chair J. Christopher Giancarlo on Monday. Both Mr. Giancarlo and Mr. Behnam expressed broad support for the policy aims of Title VII of Dodd-Frank while noting a number of ways in which the current derivatives regulatory framework can be upgraded (including a handful of shared takes). One important difference may be that Chair Giancarlo believes that there were substantial problems with the CFTC’s prior rulemakings. Commissioner Benham’s remarks seem to suggest a position closer to those of former CFTC Chair Timothy Massad, who referenced the need only to “fine tune” the CFTC Title VII rules. Chair Massad never conceded the existence of material issues or attempted any significant revisions to existing rules. Given that Commissioner Benham was last in the office of Senator Stabenow (D. from Michigan), it is reasonable to expect that Chair Giancarlo intends a more ambitious clean-up of the CFTC’s rules than former Chair Massad attempted or than Commissioner Benham may be willing to support.

MFA Recommends Greater Harmonization of CFTC/EU Swaps Trading Rules

The Managed Funds Association (“MFA”) published a comparative analysis of U.S. and European Union (“EU”) derivatives trading regimes, and made recommendations for further cross-border harmonization. The MFA found the two regimes to be aligned in many important areas. The MFA identified two areas where harmonization could be improved: (1) the calibration of the transparency regime in the EU, and (2) whether prearranged trading is permitted for instruments subject to the trading obligation in the EU.

The MFA made the following observations and recommendations:

  • Pre-trade transparency/modes of execution: evaluate European Securities and Markets Authority (“ESMA”) “transitional transparency calculations” to ensure that liquidity classifications are appropriate and market participants receive adequate liquidity. The CFTC should consider allowing greater flexibility for execution on swap execution facilities.
  • Prohibition on prearranged trading: ensure that prearranged trading is prohibited by ESMA except for block trades.
  • Post-trade transparency: the length of public reporting delays differs between EU and U.S. regimes; ESMA should continue to evaluate transitional transparency calculations and should consider limitations on the use of the extended deferral program of four weeks.
  • Straight-through processing: given that U.S. and EU rules are substantially similar, monitor to ensure that rules are faithfully implemented by trading venues.
  • Impartial/non-discriminatory access to trading venues: given that U.S. and EU rules are substantially similar, monitor to ensure that rules are faithfully implemented by trading venues.
  • Process for determining the derivatives subject to a trading obligation: the CFTC should consider undertaking greater oversight of the “made-available-to-trade” process.
  • Scope of instruments covered by a trading obligation: instruments subject to regulation under both U.S. and EU regimes are substantially similar.
  • Access to trading venue rulebooks: EU regulators should encourage trading facilities to disclose their rulebooks to market participants.

Lofchie Comment: CFTC Chair Giancarlo favors greater flexibility as to the means by which swaps are executed. Having a buy-side group support this direction should be further proof that the Chair is going in the right direction.

Another recommendation by MFA that is worth strong support (and Congressional amendment of Dodd-Frank) is the “made available to trade” process under which an exchange can effectively force a particular type of swap to be traded on exchange (if that type of swap is centrally cleared). Giving an exchange this type of power, where the exchange may be completely self-interested in its use of this authority, is, to put it politely, a very bad idea. Only the CFTC should have the authority to force any particular type of swap to be traded only on-exchange.

CFTC, EU Make Comparability Determinations on Margin Requirements for Uncleared Swaps

The CFTC approved a comparability determination that European Union (“EU”) margin requirements for uncleared swaps are comparable in outcome to relevant CFTC Regulations. The European Commission announced a similar equivalence decision that the CFTC uncleared margin rules are comparable to the EU’s requirements.

The CFTC determination generally allows swap dealers that comply with the EU margin requirements, in circumstances enumerated in the CFTC Regulation 23.160, to be deemed to be in compliance with CFTC requirements. Such swap dealers would remain subject to CFTC examination and enforcement authority. CFTC Letter 17-22, which extended exemptive relief to certain swap dealers that are subject to both U.S. and European margin requirements for uncleared swaps, is no longer applicable.

In addition, the CFTC announced that the CFTC and the EC have agreed to a “common approach” for certain authorized trading venues. Under the common approach, the CFTC plans to grant relief to certain EU trading venues from the swap execution facility (“SEF”) registration requirement, provided they satisfy the “comparable and comprehensive” standard for exemptive relief under CEA Section 5h(g). The EU would propose a corresponding equivalence decision recognizing CFTC-authorized SEFs and designated contract markets as eligible venues.

CFTC Chair J. Christopher Giancarlo characterized the cooperative efforts as an important step in cross-border harmonization:

“These cross-border measures will provide certainty to market participants. It will ensure that our global markets are not stifled by fragmentation, inefficiencies, and higher costs. Indeed these measures are critical to maintaining the integrity of our swaps markets.”

 

Lofchie Comment: This is a significant step by the CFTC both in improving relationships with the Europeans and in accomplishing Chair Giancarlo’s goals of facilitating the ability of firms to transact globally and undoing the geographic market fragmentation that had resulted from the post Dodd-Frank regulatory regime.  One can guess that the Chair will next turn attention to improving the rules for trading on U.S. swap execution facilities, which will benefit the competitiveness of the United States as a financial center.