FROM: U.S. SECURITIES EXCHANGE COMMISSION
Keynote Address by Commissioner Scott D. O’Malia at the Quadrilateral Meeting of the European Financial Markets Lawyers Group, Financial Law Board, Financial Markets Law Committee, and Financial Markets Lawyers Group at the Federal Reserve Bank of New York
Regulators Must First Do No Harm
July 15, 2014
Good afternoon. Thank you very much for the kind introduction and invitation to speak here today. I am pleased that there are international forums like the Quadrilateral Meeting where regulatory developments in the financial markets are shared and discussed. The importance of international comity in ensuring that our modern, global markets are healthy and well-functioning cannot be overstated.
Next week marks the fourth anniversary of the signing of the Dodd-Frank Act, and this September will be the fifth anniversary of the 2009 Pittsburgh G20 Leaders Summit that committed to international reform of the over-the-counter (OTC) derivatives markets.1
World leaders pledged to strengthen the international financial regulatory system by working together under common principles. The G20 principles include four areas of reform: (1) exchange or electronic platform trading for standardized contracts; (2) clearing through central counterparties (CCPs) for standardized contracts; (3) transaction reporting to trade repositories; and (4) higher capital and margin requirements for non-centrally cleared transactions.
I believe, however, that there is an even more fundamental principle that should underlie reform of the global derivatives markets—regulators must first do no harm.
Doctors safeguard their patients’ health and pledge to do no harm. So, too, should financial regulators ensure that markets are healthy and well-functioning and that regulation does not impair market resiliency or robustness.
I am deeply concerned by continuing reports of market fragmentation and fracturing of liquidity between U.S. and non-U.S. markets as a result of diverging regulatory approaches to implementation of the G20 principles.2
We have seen that lack of international harmonization results in regulatory arbitrage. When this artificial incentive causes market structures to evolve and global business to shift, we must ask ourselves: Are regulators doing more harm than good?
My answer is that I do not believe this is what the G20 envisioned when it set forth a cooperative and coordinated response to the financial crisis.
I am also concerned that CFTC regulations are negatively impacting liquidity for end-users and making hedging too costly.3 These increased costs will ultimately trickle down to consumers through higher prices for commodities.
Good regulation is balanced. The Commission must not lose sight of our twofold mission to both protect market participants and the public while also fostering transparent, open, competitive and financially sound markets.
Today, I would like to outline how we can reverse this trend and promote competitive markets that serve to best provide liquidity, price discovery, and transfer of risk. These characteristics of healthy and well-functioning markets drive economic growth and are essential to efficient markets. This will, in turn, speed recovery and fuel job creation.
First, the Commission must maintain its progress in reexamining rules that have negatively impacted the market by generating market inefficiencies, distorting market behavior, or constraining market access by end-users and other market participants.
Where our rules have proven unworkable, it is incumbent upon us to fix them. And if we don’t, we shouldn’t be surprised when Congress gets involved.
I support the Commodity Exchange Act reauthorization bill recently passed by the U.S. House of Representatives that took the initiative to make customer protection and other reforms, and give end-users relief.4
Second, it is critically important that international regulators continue to work together to harmonize swap data reporting, exchange trading, and CCP clearing before market fragmentation and contraction of liquidity hardens and becomes permanent.
I believe this is best achieved through an outcomes-based approach premised on substituted compliance and mutual recognition.
Third, it is imperative that the Commission make the necessary investments in technology to transform the CFTC into a 21st-century regulator.
Only by leveraging technology can we efficiently and cost-effectively oversee the derivatives markets under our expanded mission mandated by Dodd-Frank. The CFTC must be innovative in its adoption and use of big data and market analytics in order to keep pace with today’s electronic and increasingly automated financial markets.
The Cure Should Not Be Worse than the Disease: Fixing Unworkable Rules
As you know, the Commission once again has a full complement of five Commissioners to undertake the important mission entrusted to us by Congress and the public. I would like to congratulate and welcome Chairman Timothy Massad, Commissioner Sharon Bowen, and Commissioner Christopher Giancarlo to the CFTC.
I look forward to working together collegially with them on the remaining Dodd-Frank rulemakings and implementation, including corrections to the rules when necessary. I am encouraged by the progress the Commission and CFTC staff have made so far in thoughtfully reexamining our rules in response to press reports and dialogue with market participants.
Under the leadership of then-Acting Chairman Mark Wetjen, CFTC staff held a number of roundtables to hear from the public on the impact of our Dodd-Frank rulemakings. The topics included mandatory trade execution of package transactions5; end-user issues such as Rule 1.35 recordkeeping, forward contracts with embedded volumetric optionality, and the $25 million (special entity) de minimis threshold for swap dealing to public power utilities6; and position limits and aggregation7. I would like to thank the staff for the hard work they put into these roundtables.
I believe the Commission must make it a priority to address the concerns of end-users and market participants. Where our rules have been shown to be unworkable, we must find a better solution.
Doctors calibrate the right dosage of medicine for a sick patient. The Commission should calibrate its rules to minimize the side effects while we try to get it right.
As I noted earlier, we shouldn’t be surprised when Congress begins to revisit our regulation in response to public demand. When the Commission is too slow or unwilling to act, I welcome Congressional solutions.
I applaud the work of the U.S. House of Representatives Committee on Agriculture in putting together comprehensive legislation (H.R. 4413) that not only reauthorizes the CFTC, but also provides important market structure and Commission reforms. In recognition of the real problems we have been seeing in the markets, this legislation convincingly passed the House with a bipartisan vote of 265-144 and will now go to the U.S. Senate.
H.R. 4413 provides additional protections for customers and their funds in the event of another MF Global travesty. It also would fine-tune the Commission’s unworkable rules that make it too costly and burdensome for ordinary American companies—the engine of the U.S. economy—to comply with the letter of the law and still stay in business. Finally, the legislation would reform the internal operations of the Commission to ensure that it regulates in a manner that is open and transparent to the public.
I testified on many of these issues last year before the House Agriculture Subcommittee on General Farm Commodities and Risk Management hearing on the Commission’s implementation of the Dodd-Frank Act and oversight of the futures and swaps markets.8
I think it is important to discuss the reforms in H.R. 4413 because the bill addresses critical areas where CFTC oversight requires additional improvements. These areas are customer protection, end-user relief, cost-benefit analysis, and further enhancements to the Commission’s internal operations.
I have strongly advocated for increased customer protection in the wake of the blatant misappropriation of customer funds—totaling over $1 billion—by CFTC registrants like MF Global and Peregrine Financial Group.
I am pleased that H.R. 4413 includes provisions to require enhanced risk controls over segregated customer funds, as well as electronic fund verification and funds deficiency notices to the CFTC and the National Futures Association (NFA).
These requirements will make it harder for offenders to misuse customer funds. H.R. 4413 also includes data privacy provisions that are important to both customers and other market participants.
I have also called for a careful review of the Commission’s rules implementing Dodd-Frank to ensure that they best serve the needs of end-users who use the markets to help run their businesses.
End-users are the foundation of our markets because they use futures and swaps to hedge risks and perform price discovery, like a farmer trying to bring his crop to market.
The legitimate hedging and risk mitigation activities of commercial businesses like end-users were not supposed to be impacted by the OTC derivatives reforms in Dodd-Frank because they did not contribute to the financial crisis.9
But instead of recognizing this distinction, the Commission’s 68 final and proposed rules, 206 no-action letters, 40 exemptive orders or letters, and 36 staff interpretive letters, guidance, advisories, and other written materials have made hedging more complicated and expensive for end-users.
One example of the Commission’s unworkable rules is the swap dealer definition. The Commission failed to faithfully interpret Dodd-Frank by broadly applying the swap dealer definition to all market participants and ignored the express statutory mandate to exclude end-users from its reach.
Accordingly, I am pleased that H.R. 4413 provides relief to end-users by creating a new “commercial market participant” definition. It makes it clear that end-users who use swaps to hedge and mitigate risk are not treated like banks by excluding end-users from the financial entity definition.
In addition, H.R. 4413 responds to concerns from the public power and energy sectors that the Commission’s rules did not take into account the realities of their operations and were driving up costs by treating certain contracts as swaps. These costs would have been passed on to customers through increased rates. H.R. 4413 would solve this problem by explicitly excluding forward contracts with volumetric optionality (which have built-in flexibility that is used to meet customer demand) from the swap definition.
H.R. 4413 would also exclude transactions with “utility special entities” (such as public power companies) from being counted towards the special entity de minimis threshold for purposes of registration as a swap dealer, similar to the Commission’s proposed rule.10 This will encourage more non-bank market participants to trade with municipal utilities, without having to worry that they will be forced to register as a swap dealer.
These critical reforms will provide end-users the certainty they need in order to comply with CFTC regulations in a way that does not harm American businesses.
Importantly, H.R. 4413 provides necessary legislative reform to require the Commission to perform appropriate quantitative and qualitative analysis for rulemakings. I have always advocated that the Commission’s rulemaking must include a thorough cost-benefit analysis to ensure that new rules do not impose unreasonable costs on the public.
Cost-benefit analysis is simply a common-sense tool designed to ensure that the benefits of any regulation exceed its costs and that regulators adopt the least burdensome approach to achieve the desired regulatory outcome.
This legislative reform builds on President Bill Clinton’s Executive Order No. 1286611, President Barack Obama’s Executive Orders Nos. 1356312 and 1357913, and Office of Management and Budget (OMB) Circular A-414 on best practices for regulatory analysis.
These initiatives for better regulation have earned bipartisan support and improve the regulatory process. All executive branch administrative agencies must comply with these executive orders—the CFTC should be held to the same standard and no less.
Increased Public Participation in Commission Business
Finally, H.R. 4413 reauthorizes the Commodity Exchange Act (CEA) and makes specific improvements to the Commission’s internal operations to make our rulemaking process and procedures for granting “no-action” relief more transparent, as well as involving the full Commission in critical management decisions.
The public will be better served because these reforms will help improve the Commission’s procedures to maintain consistency, ensure that public participation is a core component in our deliberations, and that decisions that significantly impact market participants happen in an open and transparent manner.
I am also pleased that H.R. 4413 recognizes the importance of technology to conducting surveillance of electronic markets by requiring the Commission to provide a strategic technology plan to Congress and requiring a Government Accountability Office (GAO) study of CFTC resources. This strong oversight of the Commission by the Congress will increase our accountability and ensure that scarce taxpayer resources are being used wisely.
A Holistic Approach: Substituted Compliance and Mutual Recognition
My second topic recognizes, however, that because the derivatives markets are global in nature, it is not enough to simply look at issues domestically.
Comprehensive solutions to the negative impact on liquidity and market structure must be addressed through a holistic approach that focuses on international harmonization through substituted compliance and mutual recognition of other jurisdictions. If systemic risk is a cancer of the global financial system, then the whole body must be treated to prevent its spread.
One area where I am concerned that an uncoordinated approach to regulation would lead to greater systemic risk is clearing. As you know, the CPSS-IOSCO Principles for Financial Market Infrastructures (PFMIs) set forth international standards for CCPs. The CFTC finished adopting the PFMIs last year.15
Because of the G20 commitment to CCP clearing for standardized contracts and the higher margin requirements for uncleared swaps under Basel III, CCPs have more recently expanded to serve multiple markets across national borders. The interest of traders in more efficient use of collateral reinforces this trend and adds to the impetus for a coordinated approach to CCP regulation.
To that end, I hope that the European Commission (EC) will continue to work with the CFTC to find the U.S. regulatory regime equivalent under the European Market Infrastructure Regulation (EMIR) so that the European Securities Market Authority (ESMA) may proceed with the recognition of U.S. CCPs by the December 15, 2014 deadline under the Capital Requirements Directive (CRD IV).16
Without recognition, third country CCPs will not qualify as Qualifying CCPs (QCCPs) for purposes of the Basel III risk-weighting approach for banking institutions.
If this happens, it would be cost-prohibitive for EU banks to clear through third country CCPs. U.S. CCPs will be unable to maintain direct clearing member relationships with EU firms and would be ineligible to clear contracts subject to the EU clearing mandate next year.
This outcome would be detrimental to both U.S. and European interests because it will lead to market fragmentation and contraction of liquidity, as well as market disruption and dislocation due to the international nature of the swaps market.
I am encouraged by the recent U.S.-EU Financial Markets Regulatory Dialogue Joint Statement17 that reaffirmed regulators’ commitment to principles of international comity and working together to implement OTC derivatives reforms. I look forward to continued engagement by the EC with the CFTC to turn these aspirational words into action.
Decoding the Data
But as important as the cross-border CCP recognition is, we can’t lose sight of another critical area of cross-border cooperation: data sharing and harmonization.
Both the U.S. and EU should continue to engage in discussions to recognize each other’s swap trade repositories and develop a means to share the data, as well as collaborate to harmonize both the form and format of the data being reported.
The ability to compare and aggregate data across U.S. swap data repositories (SDRs) and EU trade repositories (TRs) is critical to the analysis and monitoring of threats to financial stability. Mutual recognition of SDRs and TRs would also eliminate the need for duplicative reporting.
As I have stated before, it is my firm belief that the key to effective and efficient cross-border regulation of the swaps market is through an outcomes-based approach where regulators would defer to the other jurisdiction when it is justified by the quality of their respective regulation and enforcement regimes.
All members of the G20 should strive to implement the G20 principles for OTC derivatives reform while avoiding conflicts of law, inconsistencies, and legal uncertainty. By adhering to a policy of substituted compliance or mutual recognition, market regulators can prevent artificial incentives like regulatory arbitrage from disrupting the global financial markets.
Finding the Silver Bullet: Investing in Technology
Now, let me turn to my third topic—technology.
We all would like to find a silver bullet to prevent the next financial crisis. I believe that the closest we will get to that is through the application of technology to the massive amounts of data available to the CFTC.
I am pleased that the House Appropriations Subcommittee on Agriculture provided the CFTC with $52.6 million for technology investments for Fiscal Year (FY) 2015.18 Such an investment would allow the CFTC to begin making the necessary investments to keep up with technological innovation in today’s electronic and highly automated markets.
Only by establishing a 21st-century surveillance system can the CFTC effectively monitor the health of the markets we supervise and ensure that they are well-functioning. No doctor would try to diagnose a patient and prescribe treatment without performing tests and gathering sufficient data. The CFTC must do the same.
For many years now, the Commission has pointed to budget restraints and insufficient human capital as the reasons for the lack of investment in technology. Funding for the Office of Data and Technology has grown only 6.8 percent from FY 2011 to FY 2014, while the CFTC’s overall funding has grown 11.7 percent during this same period.
The Commission’s inadequate support for technology has left the CFTC with diminished automated surveillance capacity and an inability to manage the regulatory data stored in SDRs.
It is time for the CFTC to start making serious technology investments in order to meet its mission objectives of ensuring market integrity and protecting market participants. We must make automated surveillance the foundation of our oversight and compliance program.
The Commission must also fund an order message data collection and analysis system, a key tool for surveillance. Futures exchanges receive millions of order messages on a minute-by-minute basis, but according to CFTC staff, only 8 percent of all order messages result in completed trades.
The CFTC receives transaction data on a daily basis and doesn’t collect roughly 90 percent of all market activity. It is crucial to perform market surveillance at the order message level to understand the behavior of automated trading systems and identify possible violations.
If the CFTC does not act now, it will fall behind other agencies and regulators in understanding the impact of automated trading on the market.
The CFTC must also deploy cross-product and cross-market surveillance and analytical tools in order to facilitate detection of improper market conduct and systemic risks. Cross-market surveillance was recognized at the last Technology Advisory Committee (TAC) meeting as vitally important to the oversight of today’s complex markets.
In addition, the CFTC must improve its automated risk management surveillance of both clearing houses and swap dealers. This will enable the CFTC to efficiently oversee the highest risk firms, saving both time and money. Dodd-Frank clearly directed regulators to increase their ability to monitor risk in banks, intermediaries, and clearing houses.
As chair of the TAC, I have made it a priority to find the next best thing to a silver bullet for systemic risk and fraud, manipulation, and abuse in our markets. At the last TAC meeting held on June 3, 2014, we held a panel on developing a 21st-century surveillance program and heard various proposals from panelists on what such a system should include.
I have called on the public to also submit their ideas to take our surveillance program to the next level.19 Comments are due by August 4, 2014, and I hope to discuss them at a future TAC meeting.
It is the Commission’s responsibility to restore balance to the markets we regulate and ensure that our markets are healthy and well-functioning. We must take the time to thoughtfully reexamine our rules and mission objectives to make sure that we get it right and first do no harm.
I have now identified three critical areas where the new Commission should be focusing its energy.
First, we need to fix broken rules to ensure that they are workable and that we aren’t creating unnecessary and costly regulatory burdens for end-users. The futures and swaps markets provide two essential functions for end-users and market participants: to manage their commercial and operational risks through hedging, and to provide price discovery on the commodities that are their business inputs. We have to make sure the markets can still function the way they are supposed to.
Second, we need to resolve the regulatory differences among foreign jurisdictions in a manner that is consistent with the G20 principles. I believe this is best achieved through an outcomes-based approach. Those areas demanding immediate attention are CCP recognition and data sharing and harmonization.
Third, we need to develop a plan to maintain sustained focus on the implementation and integration of technology to support our expanded oversight mission to spot and perform systemic risk analysis, and to develop a 21st-century surveillance program.
Thank you for providing me with the opportunity to share with you my priorities and concerns facing the Commission, four years after the President signed the Dodd-Frank Act into law.
I am happy to answer any questions you might have. Thank you.
1 G20 Leaders’ Statement, The Pittsburgh Summit (Sept. 24-25, 2009), available at https://www.g20.org/sites/default/files/g20_resources/library/Pittsburgh_Declaration_0.pdf.
2 Tom Osborn, Transatlantic swap liquidity split persists, Risk.net, June 3, 2014.
3 Lananh Nguyen, Oil Hedging Seen in Decline as Banks Exit Commodities, Bloomberg, July 10, 2014.
4 Customer Protection and End-User Relief Act, H.R. 4413, 113th Cong. (2014), available at https://beta.congress.gov/113/bills/hr4413/BILLS-113hr4413eh.pdf.
5 CFTC Public Roundtable Regarding the Trade Execution Requirement and Package Transactions (Feb. 12, 2014), http://www.cftc.gov/PressRoom/Events/opaevent_cftcstaff021214.
6 CFTC Public Roundtable to Discuss Dodd-Frank End-User Issues (Apr. 3, 2014), http://www.cftc.gov/PressRoom/Events/opaevent_cftcstaff040314.
7 CFTC Public Roundtable to Discuss Position Limits for Physical Commodity Derivatives (June 19, 2014), http://www.cftc.gov/PressRoom/Events/opaevent_cftcstaff061914.
8 Testimony of Hon. Scott D. O’Malia, Commissioner, Commodity Futures Trading Commission, Before the Subcommittee on General Farm Commodities and Risk Management, House Committee on Agriculture, “The Future of the CFTC: Commission Perspectives” (July 23, 2013), available at https://agriculture.house.gov/sites/republicans.agriculture.house.gov/files/pdf/hearings/OMalia130723.pdf.
9 Letter from U.S. Senators Christopher Dodd and Blanche Lincoln to U.S. Representatives Barney Frank and Collin Peterson (June 30, 2010).
10 Exclusion of Utility Operations-Related Swaps With Utility Special Entities From De Minimis Threshold for Swaps With Special Entities; Proposed Rule, 79 Fed. Reg. 31,238 (June 2, 2014), available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2014-12469a.pdf.
11 Exec. Order No. 12,866, Regulatory Planning and Review (Sept. 30, 1993).
12 Exec. Order No. 13,563, Improving Regulation and Regulatory Overview (Jan. 18, 2011).
13 Exec. Order No. 13,579, Regulation and Independent Regulatory Agencies (Jul. 14, 2011).
14 Office of Management and Budget, Circular A-4: Regulatory Analysis (Sept. 17, 2003), available at http://www.whitehouse.gov/omb/circulars_a004_a-4.
15 CFTC regulations have fully implemented the PFMIs. See Derivatives Clearing Organization General Provisions and Core Principles, 76 Fed. Reg. 69,334 (Nov. 8, 2011); Enhanced Risk Management Standards for Systemically Important Derivatives Clearing Organizations, 78 Fed. Reg. 49,663 (Aug. 15, 2013); Derivatives Clearing Organizations and International Standards, 78 Fed. Reg. 72,476 (Dec. 2, 2013).
16 Letter from Commissioner Scott D. O’Malia, CFTC, to Commissioner Michel Barnier, European Commission (May 6, 2014), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/omailalettertobarnier050614.pdf.
17 U.S.-EU Financial Markets Regulatory Dialogue Joint Statement (July 11, 2014), available at http://www.treasury.gov/press-center/press-releases/Pages/jl2564.aspx.
18 H.R. 4800, 113th Cong. (2014).
19 The comment file is available on the CFTC Technology Advisory Committee website at http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/index.htm.
Last Updated: July 15, 2014