CFTC COMMISSIONER O'MALIA'S ADDRESS ON DERIVATIVES MARKET

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Keynote Address by Commissioner Scott D. O’Malia, Derivatives 2014: A Market in Transition – A TabbForum Event

We Have the Power to Reverse the Negative Impacts of the Commission’s Rules on Market Structure

May 6, 2014

Thank you for the kind introduction and for the opportunity to serve as your closing keynote speaker. It is my pleasure to engage with you here today and discuss market structure changes. Also, thank you to Larry Tabb and his great staff who contribute to this debate with opinions and research on a daily basis. It is my pleasure to have Larry Tabb contribute to the Technology Advisory Committee (“TAC”) work and in particular the high-frequency trading (“HFT”) discussion. I would also like to remind everyone that today is the fourth anniversary of the Flash Crash so it is particularly apt that we discuss evolving market structure at this conference.

Now that the final framework for derivatives regulation in the United States (“U.S.”) is largely in place, we have been witnessing some negative impacts on market structure of the Commission’s rules. Some people criticize the Commission for promulgating rules too fast and without taking the time to anticipate the impacts of its rules. I do not disagree with this assessment and, in fact, have made the same argument. As evidence, in the past three years, the Commission has finalized 68 rules and has issued 188 – that’s right 188 – staff no-action letters, staff guidance, and advisories to correct unintended consequences of its rules.

Last week, there was a funny headline in Risk.net that read “Scott O’Malia, It’s Your Fault.”1 This eye-catching story builds on some thorough reporting by Risk.net reporter Peter Madigan, who found that the Commission’s cross-border guidance has led to serious liquidity fragmentation between U.S. and European traders, who are doing everything possible to avoid getting caught up in the jurisdictional web of the Commission’s guidance.2 The story quotes me as saying that if the Commission’s rules contributed to such fracturing of liquidity, “…it means we have screwed up in the regulation somewhere.”3 While I did not vote for the onerous cross-border guidance, I am committed to fixing the guidance and every other rule that has cast the regulatory net too broadly or resulted in an outcome that has missed the mark.

In keeping with the spirit of today’s conference, I will focus on three topics that have contributed to changes in the derivatives market structure and discuss ways for the Commission to fix the negative impacts of its rules. First, I will address the recent HFT debate and provide a preview of the next TAC meeting, which will take this debate head-on as it relates to the derivatives market. Next, I will discuss the importance for regulators to refocus our efforts on outstanding cross-border harmonization issues so that liquidity fragmentation in the swaps market does not become permanent. Finally, I will discuss the Commission’s regulatory path forward, including the necessity to fix unworkable rules that have negatively impacted market structure.

High-Frequency Trading: The Next TAC Meeting Will Answer the Charges in Lewis’s Book Flash Boys

Michael Lewis’s book Flash Boys has stirred up quite a debate about HFT and market structure over the last month. The book claims that the stock market is “rigged” by HFTs that are front-running other traders’ orders. The book raises other concerning issues, such as HFTs having faster data feeds than other traders, exchanges paying brokers to take or provide liquidity, and HFTs co-locating within the exchanges. Although Flash Boys focuses on the equity market, several charges in the book could apply to the derivatives market. By CME Group’s own admission, HFTs account for about 30 percent of its trading volumes.4

HFT and automated trading is not a new topic for the TAC. The TAC has focused on this issue since I reconstituted it in July 2010, and since then, 9 out of 11 TAC meetings have focused on some element of automated trading. As Chairman of the TAC, I also established the Subcommittee on Automated and High Frequency Trading in 2012. The TAC has committed significant time and resources to better understand automated markets and their evolving structures. We will do so again at the next TAC meeting.

TAC Panel I: Answering the Charges Against HFT

As Securities and Exchange Commission (“SEC”) Chair Mary Jo White said about the equities market, I do not believe that our markets are rigged.5 At the next TAC meeting on June 3rd, I plan to have the first panel focus on HFT and respond to the charges in Lewis’s book from a derivatives market perspective to validate my belief. We will have an in depth discussion of data feeds, pricing, co-location, direct market access, order cancellation policies, among other issues and ask whether the right protections are in place. We will also discuss how these issues may impact the swaps market with its horizontally-integrated nascent swap execution facilities (“SEFs”). HFTs and non-HFTs will also provide their perspectives. I expect a robust discussion of these issues given the fire that Flash Boys has reignited around HFT.

I am committed to using TAC resources to continue examining the issues surrounding automated trading so that the Commission has all the facts and information before taking regulatory action to improve market structure, if necessary. The TAC first discussed risk controls and system safeguards back in 2010, and has continued to discuss these issues in subsequent meetings. These discussions directly contributed to the Commission’s Concept Release on Risk Controls and System Safeguards for Automated Trading Environments that was published last September.6 The concept release is a good start and asked over 120 questions in an attempt to further benefit from industry knowledge about automated trading.

I understand that Commission staff is starting to work on a proposed rule. I hope that Commission staff is carefully considering the comments and the previous TAC discussions, which, by the way, are all available on the Commission’s website,7 when formulating this proposal. I also hope that Commission staff is researching and analyzing the current market structure and anticipating the impact of any rules in order to avoid negative consequences.

TAC Panel II: Designing a Twenty-First Century Surveillance System

After we address the charges in the Lewis book, the second panel will address the Commission’s own market surveillance capability. I do not believe that the Commission’s systems are adequate to oversee today’s fast and complex derivatives markets. Previously, I have expressed my frustration with the lack of a strategic technology plan. It is more than a little ironic that the Commission has been so thorough in dictating the regulatory requirements under Dodd-Frank, but is unwilling to set its priorities for technology upgrades. The Commission will continue to have an incomplete picture of today’s highly automated markets, thus hampering its ability to make well-informed regulatory decisions and surveil the markets, unless the Commission invests in a strategic technology plan.

Frankly, I am tired of asking the Commission for its preferred strategy so I am instead going to seek input from the exchanges, other self-regulatory organizations, and HFTs, who have invested millions of dollars in their own technology, for their thoughts on how the Commission should design the twenty-first century mouse trap to spot disruptive and manipulative trading practices – at any speed. I think it is important to recall that an HFT firm designed the SEC’s Midas surveillance platform.

Mr. Lewis’s book highlighted the rapid cancellation of orders by HFTs. Currently, the Commission does not have an order message data collection and analysis system. Without such a system, the Commission does not have access to the millions of order messages that inundate the exchanges on a minute-by-minute basis. How can the Commission understand and make decisions about today’s automated trading strategies without this system? With the high trade-to-cancel ratios, I would like to understand how the Commission can develop systems that are able to identify spoofing and momentum ignition strategies.

In addition, Flash Boys highlighted the interconnectedness of today’s markets. The Commission does not have cross-product and cross-market analytical tools. The Commission must develop a database to link the futures, swaps, and options markets to perform this cross-market analysis and surveillance. Again, without such tools, the Commission cannot effectively oversee today’s automated markets.

These are just two examples of the surveillance capabilities that we will discuss at the next TAC meeting. I also want to hear from market participants, exchanges, vendors, and other interested parties beyond the TAC meeting about their specific ideas regarding the Commission’s development of a twenty-first century surveillance system. So, after the June 3rd TAC meeting, I plan to put a link on the TAC website so that parties can submit their proposals or ideas about how the Commission should develop such a surveillance system. I hope that many interested parties will submit comprehensive plans and that the Commission will seriously review these proposals in developing its technology strategy.

TAC Panel III: Increasing Buy Side Participation on SEFs

Moving away from HFT, the final TAC topic will discuss buy side participation on SEFs. I have been a little concerned that the buy side has been slow to get involved in SEF trading. I am also concerned about the decline in SEF trading over the last month and would like to better understand the cause.8 We will hear from the buy side about any remaining obstacles for them to actively trade on SEFs and discuss potential solutions. I would also like to hear about any lingering problems with the SEF rules.

We will have a busy TAC agenda with these three very important and timely topics so I hope that you will tune in to the discussion.

Cross-Border: Let’s Close the Deal on International Harmonization

My second topic is cross-border harmonization – or the lack thereof.

Of course the swaps market is a global market and shifts in its market structure are also happening outside of the U.S. Last December when the Commission made its extremely narrow substituted compliance determinations, I advocated for a much more expansive effort to recognize the on-going international efforts by regulatory colleagues.9 That approach would minimize disruption in the changing landscape and alleviate the burden of regulatory uncertainty and duplicative compliance with both U.S. and foreign regulations. I also advocated for a flexible, outcomes-based approach to the substituted compliance process, consistent with the agreement of the Over-the-Counter (“OTC”) Derivatives Regulators Group (“ODRG”).10

The Commission has not made any additional substituted compliance determinations since last December, which is having the tangible and negative effect of fragmenting liquidity in the swaps market.11 Unless the Commission and foreign regulators undertake serious efforts to recognize each other’s regulatory regimes on data, clearing, and execution based on a flexible, outcomes-based approach, we risk developing micro-solutions that highlight our differences rather than our commonality. I urge the Commission and foreign regulators to demonstrate our commitment to G20 principles by quickly “closing the deal” on data and clearing recognition and solving for the difference in timing on exchange trading.

Data: It’s Time for “Project Harmonization”

European Union (“EU”) reporting rules under the European Market Infrastructure Regulation (“EMIR”) became effective almost three months ago, but there is still no international data sharing agreement between the U.S. and EU and no mutual recognition of swap data repositories and EU trade repositories. These agreements are crucial so regulators can compare and aggregate data in order to monitor and analyze risks in the global financial system. It is also important so that market participants are not burdened by duplicative reporting requirements.

I am pleased that the Commission and other regulators have been working diligently on the data challenges here in the U.S. I thank U.S. Treasury Acting Deputy Secretary and Under Secretary for Domestic Finance Mary Miller for her support for improving swaps data reporting, standardization, and sharing. I also thank the U.S. Treasury’s Office of Financial Research for their assistance in working with the Commission to improve its swaps data quality.

Regulators have devoted much work to the swaps data challenges; now it is time to quickly resolve the outstanding issues. Both the Dodd-Frank Act and EMIR12 included provisions for international data sharing so that our two jurisdictions could cooperate in carrying out the G20 OTC derivatives reform mandates. In keeping with these provisions and the ODRG agreement, I call on the Commission and the EU to sign an international data sharing agreement, collaborate to harmonize both the form and format of data being reported, and recognize each other’s swap trade repositories. We must get back to the substituted compliance process and follow a flexible, outcomes-based approach.

Qualifying Multilateral Trading Facilities: Is This the Right Solution?

Last month, Commission staff issued a clarification to its conditional relief for Qualifying Multilateral Trading Facilities (“Qualifying MTFs”).13 In order for an MTF to qualify for this relief from the SEF registration requirement, it basically has to look like a SEF and comply with the Commission’s reporting and clearing requirements. In addition, Commission staff may pull the relief if a significant proportion of the participants are U.S. persons and a significant proportion of the growth in trading is attributable to U.S. persons.

Given the detailed conditions in the relief and the possibility of having the relief pulled, it is not surprising that MTFs are not signing up for such recognition. Once again, the Commission will not be able to achieve mutual recognition with foreign regulators if it continues to impose the SEF regime on foreign execution platforms. The Commission’s approach thus far also does not bode well for any future exempt SEF rulemaking.

There is recent evidence that the lack of substituted compliance is bifurcating liquidity into U.S. and non-U.S. pools, with U.S. persons suffering the consequences.14 An article last week by Risk.net provided a good analysis of the issue, noting that non-U.S. persons are refusing to trade with U.S. persons, and instead, insisting on trading with U.S. banks’ non-guaranteed affiliates to avoid the Commission’s regulations.15 This means U.S. persons cannot directly access non-U.S. pools of liquidity and must instead trade through the banks.16 The story also points out that the Qualifying MTF relief has not helped because it basically provides for a SEF regime and the only way to reverse the fragmentation is through mutual recognition.17

The Commission and foreign regulators have the power to reverse this liquidity fragmentation before it becomes permanent. However, the Commission must work with foreign regulators and follow a flexible, outcomes-based substituted compliance approach to do so.

Let’s Declare Victory on Clearing and Move to Implementation

Another area that is ripe for substituted compliance is clearing. Thanks to the good work of the International Organization of Securities Commissions (“IOSCO”), regulators have established international standards for central counterparties (“CCPs”) known as the Principles for Financial Market Infrastructures (“PFMIs”).18

Today, I am sending a letter to European Commissioner for Internal Market and Services Michel Barnier that is in the same spirit of the “Path Forward Statement,”19 asking him to move forward with U.S. equivalence and CCP recognition under EMIR. In this letter, I offer my assistance to make this happen by the June 15th deadline under the Capital Requirements Directive (“CRD IV”). I am concerned that further delay by the European Commission (“EC”) in making an equivalence decision for the U.S. derivatives regulatory regime will impede the European Securities Market Authority from recognizing U.S. CCPs by this deadline.

Last year, the Commission finished adopting the PFMIs. Without recognition, U.S. CCPs will not qualify as Qualifying CCPs (“QCCPs”) for purposes of the Basel III risk-weighting approach for banking institutions. U.S. CCPs will also be unable to maintain direct clearing member relationships with EU firms and will be ineligible to clear contracts subject to the EU clearing mandate next year. These scenarios would be detrimental to both U.S. and EU interests by leading to market fragmentation and contraction of liquidity, as well as market disruption and dislocation.

In the spirit of international harmonization, I urge the EC to quickly resolve any outstanding issues so that equivalence and CCP recognition is achieved by June 15th.

I fear that without tangible evidence of flexible, outcomes-based recognition, regulators may be left with one-off rule based solutions. It is time we bring G20 members back to the table to: 1) sign an agreement on data and work to harmonize data to enable sharing, 2) begin discussions on exchange trading standards so that we can stop implementing solutions that fracture liquidity, and 3) provide mutual recognition for those entities that meet the PFMIs so that the market can move forward on mandatory clearing.

Regulatory Path Forward: Let’s Fix What’s Broken

Now, let me turn to my last topic — the Commission’s regulatory path forward. The Commission is moving forward on a number of issues that impact market structure, but the Commission must also spend the time to fix unworkable rules in order to alleviate the negative impacts on the market.

Package Transactions

Last week, Commission staff issued a no-action letter phasing-in package trades.20 As of May 16, 2014, all package transactions where each component of the transaction is subject to the trade execution mandate are required to be executed on a SEF through either the order book or the request-for-quote to 2 or on a designated contract market (“DCM”). Commission staff provided further relief for other types of package trades, such as those involving a future, an uncleared swap, or a swap that is not within the Commission’s exclusive jurisdiction.

I believe that the no-action letter strikes an appropriate balance between promoting trading on SEFs and the need to preserve orderly markets. Deriving a workable solution for these complex transactions is essential to ensuring a level, competitive playing field, and preserving orderly markets so I hope that Commission staff will continue to work on solutions for package transactions that received further relief.

Clearing Mandate for Non-Deliverable Forwards

Commission staff is finalizing a proposal to establish a clearing requirement for certain non-deliverable forwards (“NDFs”). Market interest in clearing NDFs is driven by forthcoming requirements to hold additional capital and post initial margin against non-centrally cleared derivatives. Similar to the clearing mandates for interest rate and credit default swaps, the NDF proposal will allow for phased-in compliance and will set in motion a shift from OTC trading to a more transparent trading environment. I understand that the workflow to achieve clearing and straight-through-processing for NDFs is more complicated than for interest rate and credit default swaps so I hope that Commission staff highlights these issues in its future proposal.

It is also important to note that NDF participants should prepare for a quick transition to mandatory SEF trading after the clearing requirement takes effect because the Commission does not have much say in made available-to-trade determinations. I hope that the proposed NDF rule will ask questions about any SEF trading issues so that the Commission can provide market participants with sufficient time to ensure that they have the necessary technology in place to trade NDFs on SEFs. I encourage commenters to opine on these and other issues when the Commission publishes the proposal.

Other Rules

Several other rulemakings are forthcoming, but it is not clear whether they will wait until after the full Commission is seated. The Commission has been considering for some time a futures block rule proposal that will limit the availability of block trades. Exchanges have facilitated the transition from swaps to futures by establishing low threshold sizes for block trades in futures contracts. It remains to be seen how Commission rules would affect this transition.21

Additionally, all of the Commission nominees have committed to finalizing the position limits rule. Setting position limits is not an easy task. The Commission is supposed to stop excessive speculation and manipulation, but must also protect the essential price discovery process and hedging function in the markets. The new commissioners will have their work cut out for them on this rule.

In addition to promulgating rules, the Commission must take a closer look at its rule implementation process, re-visit unworkable rules, and articulate a roadmap for market participants so that they can comply with our new rules. Unfortunately, the Commission has not always been up to par on these responsibilities.

Recordkeeping Rule 1.35(a)

The recordkeeping rule 1.35(a) provides a good example.22 In general, the rule requires Futures Commission Merchants, Introducing Brokers, and members of DCMs and SEFs that are registered or required to be registered with the Commission to record all oral communications as part of a trade record, including preliminary conversations that occur over cell phones if they lead to the execution of a transaction.23

One adverse impact of the rule is the increased recordkeeping requirements for SEF members. Until the SEF rule became final, Commodity Trading Advisors (“CTAs”) operated under the assumption that asset managers and their clients would not be “members” of SEFs, but simply participants using a SEF platform as an execution venue for their trades. However, the term “member” is unclear and thus CTAs have been dragged into the scope of rule 1.35(a). I am pleased that Commission staff hosted a roundtable on this issue to obtain feedback from market participants and provided relief from compliance with the oral recording requirement for CTAs until the end of this year.24

But entities that do not qualify for the exemption will need to purchase expensive recording technology to comply with the requirements of the rule. While large banking institutions will have the means to find a compliance solution, smaller institutions will take the heavy brunt of regulatory compliance.

I hope that the Commission will implement a workable rule amendment that strikes an appropriate balance between the Commission’s interest in preserving its enforcement authority and imposing on market participants workable and cost-effective requirements.

Forward Contracts with Volumetric Optionality

Speaking of workable solutions, as you all know, end-users have been raising concerns about the definition of a volumetric option. According to the Commission’s rules, contracts with embedded volumetric optionality may qualify for the forward contract exclusion only if exercise of the optionality is based on physical factors that are outside the control of the parties.25 This logic contradicts how market participants have traditionally used volumetric options. Commission staff’s recent roundtable discussed this issue so I now encourage the Commission to implement a workable solution through a rule amendment.

Conclusion

Although shifts in market structure are inevitable, regulators should ensure a smooth transition for the market. Before promulgating rules, the Commission must research and analyze current market structure and anticipate the impact of any rule changes.

I understand that it is impossible to anticipate all of the negative impacts of all of the Commission’s complex rules. However, once the Commission discovers a negative impact, it must re-visit unworkable rules and quickly identify solutions through a rule amendment.

Finally, the Commission and foreign regulators must work together to harmonize their regulatory regimes so that swaps market trading remains global. Fragmented swaps liquidity in today’s market is a reminder of the negative effect of the regulators’ failure to harmonize our regimes. The best way for regulators to reverse this market fragmentation is to adopt a flexible, outcomes-based substituted compliance approach.

Thank you very much for your time.

1 Duncan Wood, Scott O’Malia, It’s Your Fault, Risk.net, May 1, 2014, available at http://www.risk.net/risk-magazine/opinion/2342391/scott-omalia-its-your-fault.

2 Peter Madigan, US end-users are losers in swaps liquidity split, Risk.net, Apr. 28, 2014, available at http://www.risk.net/risk-magazine/feature/2340854/us-end-users-are-the-losers-in-swaps-liquidity-split.

3 Id.

4 Neil Munshi, CME says high-frequency trading outcry should not hit futures, Financial Times, May 1, 2014, available at http://www.ft.com/intl/cms/s/0/df5e54ea-d126-11e3-bdbb-00144feabdc0.html#axzz30aT9KqtU.

5 Sarah N. Lynch, SEC chair to Congress: ‘The markets are not rigged’, Reuters, Apr. 29, 2014, available at http://www.reuters.com/article/2014/04/29/us-sec-highspeed-trading-idUSBREA3S0OO20140429.

6 Concept Release on Risk Controls and System Safeguards for Automated Trading Environments, 78 FR 56542 (Sep. 12, 2013).

7 TAC meeting transcripts and presentations are available at http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.

8 The Clarus blog shows declining SEF volumes since March, available at http://www.clarusft.com/sef-week-30/.

9 Statement of Dissent by Commissioner Scott D. O’Malia, Comparability Determinations for Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland: Certain Entity and Transaction-Level Requirements (Dec. 20, 2013), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement122013.

10 ODRG report to the G20, available at http://www.cftc.gov/PressRoom/PressReleases/pr6678-13.

11 Peter Madigan, US end-users are losers in swaps liquidity split, Risk.net, Apr. 28, 2014.

12 European Market Infrastructure Regulation, Regulation (EU) 648/2012, of the European Parliament and of the Council of 4 July 2012 on OTC Derivatives, Central Counterparties and Trade Repositories, available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2012:201:0001:0059:EN:PDF.

13 CFTC Letter No. 14-46 (Apr. 9, 2014), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-46.pdf.

14 Peter Madigan, US end-users are losers in swaps liquidity split, Risk.net, Apr. 28, 2014.

15 Id.

16 Id.

17 Id.

18 Derivatives Clearing Organizations and International Standards, 78 FR 72476 (Dec. 2, 2013).

19 The European Commission and the CFTC reach a Common Path Forward on Derivatives, available at http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.

20 CFTC Letter No. 14-62 (May 1, 2014), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-62.pdf.

21 Keynote Address by Commissioner Scott D. O’Malia, New Risk in Energy 2014: Energy Trading Risk and the Policy that Drives It, available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/omaliapresentation040714.pdf. See Futures block data on pages 6-8 of the presentation.

22 17 CFR 1.35(a).

23 Id.

24 CFTC Letter No. 14-60 (Apr. 25, 2014), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-60.pdf.

25 Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 FR 48208 (Aug. 13, 2012).

Last Updated: May 6, 2014

CFTC O'MALIA'S STATEMENT AT TECHNOLOGY ADVISORY COMMITTEE MEETING

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Opening Statement of Commissioner Scott D. O’Malia, 11th Meeting of the Technology Advisory Committee

February 10, 2014

I am pleased to call the 11th TAC meeting to order since we reconstituted it in July 2010. I thank all of our TAC participants for joining us here today after the January 21 meeting was snowed out. I appreciate everyone’s willingness to accommodate the change in date.

I would like to acknowledge that our new Acting Chairman Mark Wetjen is here with us today. Chairman Wetjen has shown a great interest in our technology issues and a real willingness to ensure that the data we are collecting will be used in a thorough and automated manner. I was pleased to join with Chairman Wetjen and Commissioner Chilton a few weeks ago to announce that the Commission is taking concrete steps to address the challenges we face in optimizing our data.1

Specifically, on January 21, the Commission announced the formation of a cross-divisional data team that will focus on identifying problems faced by each division and developing solutions to resolve problems with the Commission’s regulatory data. The data team will also solicit comments from market participants on recommended rule changes to the Commission’s data rules. Based on this input, the data team will make written recommendations on a corrective path forward. Until now, no one in the Commission has taken ownership to fix the problems. This has now changed.

Enhancing the Commission’s swaps reporting rules will improve data quality, minimize confusion regarding reporting workflows, and increase standardization.

In addition, the Commission staff will continue to work on the data standardization effort, led by the Office of Data and Technology. The first phase of this work has been reported to TAC,2 but much work remains to harmonize many more fields and asset classes.

Agenda

Today’s TAC agenda is packed with three very important and timely topics that are also at the top of the Commission’s policy agenda.

Panel I -- Data: Where Does the Commission Stand and How Do We Fix What’s Broken?

First, we will hear from a collection of the Commission’s division directors who have critical market oversight responsibilities, as well as our Office of Data and Technology and our new Chief Economist. They will discuss where the Commission has been successful in utilizing swap data repository data, identify areas that are not working, and explain where changes must be made.

In thinking about our goals, I reviewed the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions (CPSS / IOSCO) Final Report issued in January 2012 entitled, “Report on OTC derivatives data reporting and aggregation requirements.”3 Significantly, the report identifies key reporting standards and goals for data reporting, aggregation, and sharing among regulators.

The report also establishes several high level objectives for data utilization that the Commission should be able to achieve. These objectives include:

1. Assessing systemic risk and financial stability

2. Conducting market surveillance and enforcement

3. Supervising market participants

4. Conducting resolution activities

5. Bringing greater transparency to OTC markets

While it is clear we have achieved objective 5 with a partially complete swaps data report and a real-time swaps data ticker, I believe we have a long way to go on the other fundamental data objectives.

Working hand-in-hand with the division directors, I want to better understand how we will tackle these key objectives, and further learn about the data priorities of each division and the progress being made to achieve these priorities.

Panel II -- Concept Release on Automated Trading

Our second panel will focus on a question that TAC has extensively discussed over the past three and a half years: What is the appropriate level of pre-trade functionality deployed by traders, futures commission merchants, and exchanges to protect market integrity against rouge trades which can cause market disruption?

The first TAC meeting4 addressed this topic and by the third TAC meeting,5 there were recommendations for minimum standards.6 Subsequently, we established a Subcommittee on Automated and High Frequency Trading to define high frequency trading and explore other policy questions related to automated trading.7

Today, we will discuss the Concept Release on Risk Controls and Systems Safeguards for Automated Trading Environments.8 The comment period closed on December 11, 2013,9 but my colleagues have generously agreed to reopen the comment period until February 14, 2014 to include this panel discussion and any additional comments. We have received a variety of comments and ideas regarding these standards, and I have asked four witnesses and Commission staff to participate on this panel. I also encourage our TAC members, many who submitted comments on the concept release, to share their views on this matter.

I recognize that there are very strong opinions regarding automated trading and I believe that we will have a robust discussion.

Panel III – Made Available-to-Trade Determination

Finally, the third panel will address swap execution facilities (SEFs) and the recent Made Available-to-Trade (MAT) determinations.

The Division of Market Oversight (DMO) has deemed certified several MAT submissions for standard interest rate benchmark swaps and credit default swaps. While I am supportive of the MAT determinations for the benchmark contracts, I do not believe that the appropriate research and consideration has been given to package transactions tied to benchmark contracts. I believe that we can transition many of these contracts to mandatory trading in the near future, but we must first complete some additional analysis.

As part of our research and analysis, we are focusing panel III’s discussion on package transactions and the Commission staff will hold a roundtable on February 12.

While I am pleased that the Commission staff is working to provide relief from the mandatory trading requirement for package transactions, I did raise serious concerns with the MAT process in my January 16 statement that was tied to DMO’s announcement that it deemed certified Javelin’s MAT determination.10 My concerns have nothing to do with Javelin as a company or with their offering. They just happened to be the first mover to submit an application, which exposed the flaws in the MAT process. In many respects, it is appropriate for a company called Javelin to be the first mover, or rather the “tip of the spear.”

DMO’s memo to the Commission on the MAT determinations did not include any discussion of the types of package transactions that would be impacted by the MAT determination, nor did it address the concerns regarding technical or operational readiness or the jurisdictional issues involving these transactions.

The only insight provided in the staff memo regarding commenters’ requests for temporary relief for package transactions was the following statement: “[S]uch requests are not appropriate for consideration within the scope of the Commission’s process for reviewing a MAT determination.” (emphasis added).

Thankfully, the memo went on to say, “[t]herefore, the Division is taking these comments into consideration and may provide a future response or guidance as appropriate.” However, that was the extent of the discussion.

While I am frustrated that we are conducting the analysis on package transactions after making the MAT determinations, I am pleased that this TAC meeting will initiate the process for identifying and resolving the issues associated with such transactions.

I would like to see the market continue to benefit from the efficiency of package transactions and encourage the trading of such products on exchange. So, let's begin the process to figure out how to make that happen.

1 Press Release PR6873-14, CFTC to Form an Interdivisional Working Group to Review Regulatory Reporting, January 21, 2014, available at http://www.cftc.gov/PressRoom/PressReleases/pr6837-14.

2 This report is available at http://www.cftc.gov/ucm/groups/public/documents/file/dataharmonization.pdf.

3 The final report is available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD366.pdf.

4 July 14, 2010 TAC meeting.

5 March 1, 2011 TAC meeting.

6 These recommendations are available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/tacpresentation030111_ptfs2.pdf.

7 The subcommittee presentations regarding high frequency trading and automated trading from the October 30, 2012 TAC meeting are available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/tac103012_wg1.pdf;

http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/tac103012_wg2.pdf;

http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/tac103012_wg3.pdf;

http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/tac103012_wg4.pdf.

8 78 FR 56542 (proposed Sep. 12, 2013).

9 All comment letters on the concept release are available through the Commission’s website at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1402.

10 The statement is available at http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement011614

CFTC COMMISSIONER O'MALIA'S DISSENTING STATEMENT ON CUSTOMER PROTECTION ENHANCEMENTS IN DERIVATIVES MARKET

FROM:  U.S. COMMODITY FUTURES TRADING COMMISSION 
Dissenting Statement of Commissioner Scott D. O’Malia, Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations1

October 30, 2013

I respectfully dissent from the Commission’s approval today of the final Customer Protection Rules.

I supported the proposed rules because I wanted to solicit public comment and engage market participants in an open discussion about how the Commission should improve its customer protection regulatory oversight.

In the wake of the global financial crisis, it is extremely important to intensify regulatory efforts to strengthen customer protection policies in order to promote the financial stability of the derivatives markets. There is no dispute customer protection must be the cornerstone of the Commission’s oversight. Sound customer protection policies and measures, such as the electronic customer verification confirmation services will improve the efficiency and transparency of financial markets.2

The Commission must promulgate workable regulations that provide clear guidance to industry participants and ensure cost-effective access to markets. Such regulations must be designed to address real weaknesses in the current regulatory regime and allow industry participants to continue with well-established industry practices that had nothing to do with the financial crisis or the recent bankruptcies of MF Global and Peregrine Financial.

Unfortunately, the Commission’s customer protection rules fall short of these objectives. Instead of mitigating customer risk, the rules create a false sense of security by imposing broad and ambiguous requirements and introducing another layer of governmental oversight. Even worse, they force a change in a longstanding and generally accepted industry practice that will likely result in seriously harmful consequences for small FCMs and their end-user customers.

I do support several provisions that allow customers greater insight into the operations of an FCM. These provisions include: an improved FCM disclosure regime that will give customers new and critical information about their FCM exposures, elimination of the alternative method of calculating segregation requirements for §30.7 funds (treatment of foreign futures or foreign options), improved reporting of segregated fund balances, and enhancements to risk management procedures. However, I am unable to support the final rule for the reasons stated below.

Reinterpretation of the residual interest deadline will result in costly prefunding of margin payments.

My main concern with the final rules is their radical reinterpretation of the longstanding residual interest deadline. This reinterpretation decreases the time in which customers’ margin calls must arrive to their FCM from the current three days to just one day.

Such a change would mean a drastic increase in pre-funding of margin, perhaps nearly double the amounts currently required. As a result, many small agribusiness hedgers will have to consider alternative risk management tools or, even worse, will be forced out of the market.3 I am disappointed that yet again the Commission has rushed to implement a rule that disregards the express Congressional directive to protect end-users.

I recognize that the Commodity Exchange Act (CEA) does not permit an FCM to use the money or property of one customer to margin the futures or option positions of another customer.4 Despite this fact, it has been the prevailing industry practice authorized by the Commission for decades.

To the extent that the Commission must reinterpret this statutory provision, I believe this reinterpretation must be based on the thorough analysis of the market data and the full evaluation of the costs of strict compliance with the statute before implementing policy changes, and not after as is the case with the residual interest deadline.

The residual interest deadline rule makes no effort to respond to the commenters’ concerns that the residual interest deadline would be especially costly for smaller FCMs and end-users.5 Given the express Congressional directive to protect end-users, I would have expected the Commission to conduct meaningful cost-benefit analysis to justify the costs when compared to the actual risk to customer accounts and the derivatives markets and to explain why the Commission could not have adopted an alternative approach. Regrettably, the Commission has failed to do so.

Even the Commission’s own cost benefit analysis points out, while significantly understating the impact, that:

“Smaller FCMs may have more difficulty than large FCMs in absorbing the additional cost created by the requirements of the rules (particularly §1.22). It is possible that some smaller FCMs may elect to stop operating as FCMs as a result of these costs.”6

I cannot support a rule that will impose such onerous costs and compliance burdens on the smallest FCMs and small, non-systemically relevant customers.

Finally, although I support a phase-in compliance schedule for the residual interest deadline, I am disappointed that the Commission, in deciding whether to change the deadline at a future time, is not required to make such a decision based on data. Instead, the Commission will simply come up with another arbitrary residual interest deadline that has nothing to do with customer or FCM risk exposure.

Yet again, the Commission has chosen to avoid fact-based analysis. I strongly believe that the Commission should utilize facts and data to make an informed decision about the appropriate time for the residual interest deadline.

The rules fail to provide a clear standard for compliance.

In addition to my serious concerns about the final rules’ treatment of the residual interest deadline, I am concerned that the rules unreasonably expand the scope of the new regulatory compliance regime without providing a clear regulatory objective.

For example, the rules require that a Self-Regulatory Organization (SRO) supervisory program “address all areas of risk to which [FCMs] can reasonably be foreseen to be subject (emphasis added).”7 This broad language requires the SRO to guess at what criteria the programs would be measured against, and under what framework the SRO would make this determination. In short, the new language does nothing but adds more ambiguity to the SRO’s customer protection program and increases the cost of compliance with vague requirements.

Examination experts do not add value to the customer protection regime.

I also have concerns about the requirement that each SRO supervisory program of its member FCMs be reviewed by an “examinations expert.”8 I question the benefit of this requirement given the fact that the Joint Audit Committee (JAC) currently performs this function. The JAC’s primary responsibility is to oversee the practices and procedures that each SRO must follow when it conducts audits and financial reviews of FCMs. This regulatory task is already in place and implemented in a less costly and more efficient manner than set forth in the final rules.

Moreover, in light of the Commission’s regulatory oversight of all SROs and the Commission’s review of all JAC examination programs, this additional layer of review does not provide any benefit except for isolating the Commission from its primary responsibility to oversee customer protection programs.

Customers deserve better protections in bankruptcy proceedings

Going forward, the Commission should address key customer protections in the areas of bankruptcy. Congress should make changes to the Bankruptcy Code to ensure that certain bankruptcy protections are afforded to FCM customers. Specifically, Congress should amend the pro-rata distribution rules in bankruptcy. Despite the Commission’s customer segregation requirements, individual customer accounts are still subject to a pro-rata distribution in bankruptcy. In addition to these changes to the Bankruptcy Code, the Commission should amend its rules to allow the Commission to appoint a trustee to oversee derivatives customers’ accounts in the bankruptcy of a broker-dealer FCM.

Conclusion

I support implementation of a rigorous customer protection program that provides clear and meaningful mechanisms for mitigating customer risks. However, the customer protection rules approved today have missed the mark.

In sum, many of the new rules impose overly broad and nonsensical regulatory requirements and, in doing so, impede the industry’s ability to operate in an efficient manner. Regrettably, the negative effects will be felt most by farmers and other end-users, whose ability to hedge risk in a cost-effective manner will be hampered if not eliminated altogether. This is contrary to the Congressional directive, and I cannot support rules that result in such an outcome.

1 “Customer Protection Rules”

2 In this regard, I applaud the efforts of the Chicago Mercantile Exchange Inc. (CME) and the National Futures Association (NFA) to protect customer accounts by introducing daily electronic confirmation services. This new technology allows CME and NFA to review balances held at bank depositories and compare the balances with customer account information provide by futures commission merchants (FCMs).

3 See e.g.; National Grain and Feed Association Comment Letter at 2 (Dec. 28, 2012) (stating that the Commission’s proposed changes “could have the unintended impact of disadvantaging smaller and mid-size FCMs that provide ‘hands-on’ service to many of the relatively smaller hedgers in agribusiness”); Texas Cattle Feeders Association Comment Letter (Jan. 14, 2013) (warning that such changes “could have the potential to cause unintended consequences such as added costs eventually borne by customers”); Iowa Cattlemen’s Association Comment Letter (Feb. 15, 2013) (“it is imperative that the CFTC understand all sizes of businesses . . . [in order to have] . . . a better opportunity to write rules that provide a logical fit. Our fear is that if this rule is put in place, we will have members who will not take advantage of the risk management tools . . ..”).

4 CEA § 4d(a)(2).

5 Futures Industry Association Comment Letter at 16 (Feb. 15, 2013).

6 Customer Protection Rules at 313.

7 § 1.52 (c)(2).

8 § 1.52.

CFTC COMMISSIONER O'MALIA'S STATEMENT ON CUSTOMER FUND PROTECTIONS IN DERIVATIVES MARKETS

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Opening Statement, Commissioner Scott D. O’Malia, Open Meeting On Rules Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations

October 30, 2013

Mr. Chairman,

I would like to thank staff for their hard work on the customer protection rules. I appreciate the hard work of the staff of DSIO, DCR and OGC who have contributed to this rulemaking.

In the wake of the global financial crisis, it is extremely important to intensify regulatory efforts to strengthen customer protection policies in order to promote the financial stability of the derivatives markets. There is no dispute customer protection must be the cornerstone of the Commission’s oversight. Sound customer protection policies and measures will improve the efficiency and transparency of financial markets.

I do support several provisions of the rules that allow customers greater insight into the operations of an FCM. These provisions include: an improved FCM disclosure regime that will give customers new and critical information about their FCM exposures, elimination of the alternative method of calculating segregation requirements for §30.7 funds (treatment of foreign futures or foreign options), improved reporting of segregated fund balances, and enhancements to risk management procedures.

However, my main concern with the draft final rules is their radical reinterpretation of the longstanding residual interest deadline. This reinterpretation decreases the time in which customers’ margin calls must arrive to their FCM from the current three days to just one day.

Such a change would mean a drastic increase in pre-funding of margin, perhaps nearly double the amounts currently required. As a result, many small agribusiness hedgers will have to consider alternative risk management tools or, even worse, will be forced out of the market.

I recognize that the Commodity Exchange Act (CEA) does not permit an FCM to use the money of one customer to margin the futures or option positions of another customer.1 However, I believe that the Commission, in deciding whether to reinterpret this provision, must make such a decision based on data.

Therefore, I am proposing my amendment that would continue to make progress to accelerate the collection of margin of customers from 3 days after the settlement date to 1 day after settlement at 6 pm EST. Just like the draft final rule, the amendment would be phased in one year following the date of publication of the rules in the Federal Register; and just like the draft final rule, the amendment will also require a study to determine the feasibility of changing the collection date and the costs associated with such a move.

The main difference between my amendment and the draft final rule is that my amendment doesn’t mandate that in 5 years’ time, customers will need to meet their margin obligations by the end of the settlement cycle. The amendment simply lets a future Commission make a determination about the best way to proceed after it has collected all the evidence.

In other words, the amendment does not bias the study with an outcome that has been previously determined. Instead, my amendment will task a future Commission to perform the analysis and decide at that point, analyzing against future technology and payment methodologies what the best course of action should be. This way, the future Commission can make an informed and unbiased decision.

If the Commission votes for my amendment, I will be able to support this rule.

Again, I want to express my thanks to the Commission staff for their efforts on this rule.

Let me close by also thanking so many staff from the Division of Enforcement, who devoted their efforts and long hours bringing the recent charges against Rabobank and all of the other LIBOR settlements. Their work must be recognized by the Commission as well as the work from staff from OCE and DMO. We couldn’t do it without their hard work.

Anne M. Termine
Stephen T. Tsai
Maura M. Viehmeyer
Philip P. Tumminio
Timothy Kirby
Jonathan Huth
Brian Mulherin
Rishi Gupta
Aimée Katimer-Zayets
Jason Wright
Elizabeth Padgett
Terry Mayo

Mr. Chairman, thank you for you indulgence to all us to recognize all of their hard work.

1 CEA § 4d(a)(2).

CFTC COMMISSIONER O'MALIA'S DISSENT FROM SETTLEMENT ORDER REGARDING JPMORGAN'S "LONDON WHALE" TRADES

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Statement of Commissioner Scott D. O'Malia Regarding JPMorgan's Use of Manipulative Device
October 15, 2013

I respectfully dissent from the settlement Order with JPMorgan Chase Bank (JPMorgan) resolving charges against JPMorgan for use of a manipulative device with respect to the so called "London Whale" trades in violation of Section 6(c)(1)1 of the Commodity Exchange Act (CEA) and Regulation 180.1.2

As I explain in more detail below, I would prefer a twofold approach. First, the Commission should have taken more time to investigate whether the company is liable for a more serious violation, namely price manipulation. Second, since the "manipulative device" charge has not been tested before, I strongly believe that the courts must decide this case of first impression in order to set precedent and to guide both the Commission and market participants.

As a threshold issue, I question whether it is in the·public interest to settle with JPMorgan on a lesser "manipulative device" charge. I am concerned that in a rush to join in on a settlement brokered by other regulators, the Commission may be missing the opportunity to pursue allegations of greater wrongdoing—price manipulation.

In other words, the Commission's abbreviated investigation has failed to determine whether JPMorgan intentionally or recklessly manipulated the price of a particular type of credit default swap index known as "CDX."

Remarkably, the Order discusses the Commission's broad manipulation authority at length, but still does not conclude whether JPMorgan's aggressive trading strategy resulted in price manipulation. Failure to do so undermines the Commission's integrity and its enforcement powers in favor of taking shortcut's to achieve high-profile settlements.

I am also concerned that by accepting this settlement, the Commission may be missing the opportunity to establish a legal standard for a "manipulative device."

Because the settlement Order does not allege that JPMorgan engaged in manipulative or fraudulent conduct, I believe the Commission needs to do a better job of explaining why the company's aggressive trading strategy constitutes a "manipulative device."

Regrettably, neither the CEA nor Commission regulations define a "manipulative device." This lack of a legal standard makes it even more difficult to determine whether JPMorgan engaged in a reckless behavior that put the company at risk or whether such behavior constitutes a "manipulative device."

Although, some case law supports the Commission's conclusion that any device that is intentionally employed to distort a pricing relationship may be manipulative, the Commission has failed to produce data or conduct a more careful evaluation of the actual price to determine whether JPMorgan's conduct distorted the price of certain CDX indices.

This problem is compounded even more by the fact that the allegations in the settlement Order center on bilateral or over-the-counter trading. Given this trading environment, I am not clear how the Commission can distinguish between "real" and "distorted" prices if the trades were executed through bilateral negotiations.3

To reiterate, a better approach would have been for the Commission to fully utilize its expanded enforcement authority and conduct a more comprehensive investigation to establish whether there was price manipulation, rather than rush to settlement. As to the manipulative device charge, a better course would have been to have a federal court take a fresh look at this case to clarify the ambiguity in the Commission's new authority.

1 7 u.s.c. § 9 (2012)

2 17 C.F.R. § 180.1 (2012)

3 The Commission alluded to the issue of "real" versus "distorted" pricing in OTC trading when it promulgated Regulation 180.1. In the rule preamble, the Commission stated that "the failure to disclose ... information [about market conditions] prior to entering into a transaction, either in an anonymous market setting or in bilateral negotiations, will not. by itself, constitute a violation of final Rule 180.1" (emphasis added). 76 FR41398 at41402 (July 14, 2011).

CFTC COMMISSIONER O'MALIA SPEAKS ON 'GOOD GOVERNMENT' REGULATION

FROM: COMMODITY FUTURES TRADING COMMISSION
Commissioner Scott D. O’Malia Before Mercatus Center, George Mason University
November 13, 2012
Jim, thanks for that kind introduction.

I am happy to be here and pleased to see the Mercatus Center, as it often does, putting the spotlight today on an issue that is near and dear to my heart: how government regulation affects the real world. That’s right: government regulation has real-world consequences. What a revolutionary concept. You may take this concept for granted, but too often government regulators fail to understand, or take into account, the effect that regulations will have on markets and market participants. And this problem has been especially true in the past two plus years, as government agencies have rushed to promulgate rules under the Dodd-Frank Act. As you know, we at the CFTC have been in the trenches of Dodd-Frank implementation. I would like to take this opportunity now to provide you with some of my thoughts on this implementation process.

Don’t worry – I won’t take you through an exhaustive review of the Commission’s work because at 39 final Dodd-Frank rules and counting we would be here until tomorrow. Instead, what I would like to do is talk to you about good government. You see, I am the government employee who believes that government doesn’t have all the answers and that it must do a better job of developing "good government" solutions.

What Is Good Government?

You may ask: what do I mean by good government? In a nutshell, good government regulation strikes the right balance in order to develop beneficial rules of the road and to implement them according to a measured and reasonable timeline. This approach requires fact-based analysis in order to come up with cost-effective solutions based on a range of policy options.

So, what does it mean specifically in the context of the Commission’s rulemaking process? For rules that have not yet been proposed, good government means faithful adherence to the statutory authority and a strong understanding of the markets that will be affected by the envisioned regulation. For rules that have not yet been finalized, it means understanding and addressing the concerns of market participants and adopting final rules that are clear, consistent and create a level playing field. For rules that have already been finalized, it means providing transparent implementation guidance that is consistent with the final rules. In addition, good government means being aware of the consequences of Commission regulations on market activity and maintaining the flexibility to reassess and revise such regulations where appropriate.

If we apply this framework of good government regulation to what the Commission has done in the past two plus years, we can see many places where we have fallen short of the standard. One example is the position limits rule, which a federal court recently struck down.<sup>1 The Commission will file an appeal, which I don’t support because I agree with the judge’s ruling that the Commission failed to justify its establishment of limits as required by the statute. I would like to point out that the Commission has now been sued three times within the past year on its rulemakings.2

Today I want to focus on three areas in particular of the Commission’s implementation of Dodd-Frank. These are: the October 12 effective date for swap regulations and the resulting ‘futurization’ of the swaps world, the Commission’s final rules for swap execution facilities (SEFs), and the Commission’s guidance on cross-border issues.

The Nightmare of Friday the 12th

I would like to start with the significant date on the Dodd-Frank implementation calendar that we passed last month. On October 12, the joint CFTC-SEC definition of the term swap became effective. This triggered compliance dates for a number of other Commission swaps regulations.

As it turned out, Friday, October 12 was a day of great drama, but certainly not in a good way and certainly not by design. Friday the 13th may have been more appropriate, given the nightmare scenario the Commission was trying to avoid at the absolute last minute. In truth, the nightmare was the fact that we had reached such a point in the first place.

By that evening, the Commission had rushed out 18 no-action letters and guidance documents in a last-minute attempt to mitigate the chaotic impact of all the rules that were to take effect the following Monday. Think about that for a second: 18 relief documents issued on the day before the compliance deadline. We don’t need a study by the Mercatus Center to tell us that this last-minute flurry fell embarrassingly short of the goal of regulatory certainty and the principles of good government regulation.

Good government should take a measured, well-thought out approach to developing a new regulatory regime. To that end, I have repeatedly asked the Commission to publish a clear and specific rulemaking timeline and implementation schedule. Frustratingly, my calls have gone unheeded. A clear and well-reasoned implementation schedule would have allowed the Commission to avoid the hurried, ad-hoc process of temporary relief and interpretations that we witnessed and would have done much to put the Commission’s rulemaking process in the good government category.

Even now, we are not out of the woods yet. The temporary relief provided expires on December 31, and we can’t risk keeping the markets in the dark until the eleventh hour again. The Commission needs to take action by mid-December in order to provide adequate clarity to the markets through the new year. Think of this as the Dodd-Frank Regulatory Cliff.

Let me go back for a minute to October 12. The big storyline is the migration of cleared energy products to the futures markets. In response to regulatory uncertainty in the swaps market, energy customers of both CME and ICE demanded that the markets move to listed futures, instead of swaps. There are good reasons to stay away from the swaps market, including the expansive and ill-defined swap dealer definition and the regulatory consequences of becoming designated as well as uncertainty as to what will be permitted to trade on SEFs. In addition, the capital efficiency of margining all trades in one account is also a powerful financial incentive.

On October 15, the day the new swap rules took effect, the entire market had shifted from a swaps market to the futures market. Liquidity simply dried up in the OTC space. To me, this is evidence of the Commission’s struggle to get swap regulations right.

This futurization of the cleared energy swap market may result in reduced flexibility for some firms because futures contracts, unlike swaps, can’t be individually tailored to meet specific risk needs. However, futures markets offer greater regulatory certainty and provide high liquidity to allow for the efficient hedging of commercial risk.

It was surely not the Commission’s intention to draft rules that would send market participants fleeing from the swaps market. But good government requires more than good intent; it requires good execution of that intent as well. Instead, the Commission has created such a regulatory nightmare that the energy markets have sought cover in the relative safe haven of the futures markets.

And we may very well be at just the start of the futurization of our markets. Again, it’s hard to believe that this brave new world of futurization is what the Commission envisioned would be the end result of its new swaps regulatory regime.

Learning Lessons and Moving Forward

But I bring up these examples not simply to say that the Commission should have done better. Rather, I raise them because learning from mistakes is the crucial first step toward getting us back on the road of good government regulation. And luckily for us, there are several significant rules on the horizon that will give us that opportunity. For example, the Commission has yet to consider final rules on capital and margin requirements. The Volcker rule, which will clarify and distinguish market-making trades from proprietary trading, is also in this category.

These rules will put a final price tag on over-the-counter trades and will have broad and significant consequences for the swaps markets, so it is very important that we get them right. If we make sure to identify concerns raised by market participants and properly address them in the final rules, and then implement the rules in a measured and consistent manner, I am confident that we can get them right.

In any case, those rules are still a bit further down the road. Of more immediate interest are two areas that the Commission will likely consider before the end of the year. These are trade execution, including SEF final rules, and the cross-border guidance.

Swap Execution Facilities

Let me address the SEF rules. This is an area that I am excited about. There are new trading models that offer exciting innovations and ideas that will make the swaps market more transparent and well as more competitive.

As you know, the concept of SEFs was heavily negotiated in Congress as well as at the Commission. SEFs represent a monumental shift away from the current bilateral swap trading model to a centrally regulated trading model. Centralized swap execution should offer market participants greater price transparency, increased access to larger pools of liquidity, and improved operational efficiency. Congress envisioned that SEFs would promote price discovery and competitive trade execution in all asset classes.

The Commission published the proposed SEF rules last January. While the proposal was a good start, a broad array of market participants – from buy-side asset managers, pension funds, commercial end users, farm credit banks and rural power cooperatives to sell-side dealers and even prospective SEFs – expressed concern that if the final rules are adopted as proposed, less liquid swaps will not be able to be executed on the SEF platforms because the proposed SEF rules would limit their choice of execution.

While I am supportive of the overarching objective of promoting pre-trade price transparency, I believe that the SEF final rules should allow for flexible methods of execution including request for quote systems (RFQs). These features will protect the confidential trading strategies of asset managers, pension funds, insurance companies, and farm credit banks and will provide commercial end users access to the swap market to fund their long-term capital and infrastructure projects.

Finally, I hope that the final SEF rules will provide a clear interpretation of the "by any means of interstate commerce" clause contained in the SEF definition. Dodd-Frank defines a SEF as a platform on which multiple participants have the ability to trade swaps by accepting bids and offers made by multiple participants, through any means of interstate commerce.
3 Instead of providing further meaning to the "any means of interstate commerce" clause, the proposal focused on two methods of execution on a SEF: an electronic platform and an RFQ.

Currently, the Commission is considering the suite of related execution rules that determine the viability of SEFs and the overall OTC market going forward. These include mandatory clearing, Core Principle 9, and the block and made available for trading rules in addition to the SEF rules. These rules must work together and reflect the new realities of the evolving market in reaction to the Commission’s already finalized rules.

I remain optimistic that we can develop rules that will encourage a competitive and innovative market in swap trading as envisioned by Congress and something the market has been developing over the past decade. It would be a shame if government rules stood in the way of this opportunity.

Regulatory Overreach: The Commission’s Cross-Border Guidance

Moving now to the third topic I want to discuss: the Commission’s Cross-Border Guidance.

Last week the Commission held a public meeting with regulators representing most of the largest markets across the globe, and their criticism of the Commission’s overreaching cross-border Guidance was consistent and firm. I certainly don’t want to see this draft proposal result in a regulatory tit-for-tat that would create an environment where U.S. financial institutions and market participants are put at a competitive disadvantage based on competing regulatory regimes. I am committed to resolving this regulatory matter to the satisfaction of all regulators and minimizing regulatory overlap and confusion so that market participants have a clear understanding of the new global regulatory paradigm. As such, it means we must redraft our cross-border Guidance.

Let me give you some background. The Commission published its proposed Guidance as well as a related exemptive order in July of this year. The objectives of the Guidance were to (1) clearly define the scope of the extra-territorial reach of Title VII of Dodd-Frank and (2) reinforce the Commission’s commitment to the goals of the G-20 summit by providing a harmonized approach to derivatives regulation.
4

These are sound objectives. However, the proposed Guidance missed the mark in several respects. Start with the fact that it was issued as guidance and not as a formal rulemaking, which would have required the Commission to conduct a cost-benefit analysis. As proposed, market participants will be deprived of an opportunity to review and comment on a cost-benefit assessment despite the significant costs that the Guidance will impose on them.

More fundamentally, the proposed Guidance exceeded the scope of the Commission’s statutory mandate. The statute provides that Dodd-Frank swaps regulations shall not apply to activities outside of the United States unless those activities have a direct and significant connection with activities in the United States.
5 This provision was drafted by Congress as a limitation on our authority, yet the proposed Guidance has interpreted it as the opposite.

As a result, the proposal empowers the Commission to find virtually any swap to have a direct and significant impact on our economy and imposes U.S. rules and obligations, including requirements on transactions, on non-U.S. entities. This has set off alarm bells in foreign capitals across the globe, and the Commission received an unprecedented number of letters from foreign regulators.
6 Just a few weeks ago, a strongly worded joint letter from the top finance officials of the UK, France, EU and Japan again urged the Commission to reconsider its approach and engage much more actively with them to coordinate regulatory efforts across borders. And as I mentioned earlier, these views were strongly echoed by representatives of several foreign regulators at a meeting last week of the Commission’s Global Markets Advisory Committee.

The Commission’s statutory overreach is reflected throughout the proposed Guidance. A prime example is the definition of U.S. person, which as drafted in the proposed Guidance sweeps numerous entities that are outside the U.S. into the Commission’s jurisdiction. The proposal requires non-U.S. counterparties to treat overseas branches of U.S. banks, unlike affiliates of U.S. banks, as U.S. persons. If these foreign companies do enough business with foreign-based U.S. banks, they will be subject to U.S. regulation.

The Commission has heard concerns from a number of U.S. banks that foreign competitors are trying to tempt clients away by pointing to the potential increased costs of doing business with U.S. banks as a result of the Commission’s proposed Guidance. Even more disturbing, the Commission has received more recent indications that many foreign firms are no longer doing business with U.S. banks. I’ve said it before and I’ll say it again: I cannot support a Commission proposal that puts U.S. firms at a competitive disadvantage to foreign banks, especially those that operate in the United States.

As I mentioned earlier, good government regulations address the concerns of market participants in drafting a final Commission document. In this case, both the market and foreign regulators have spoken loudly.

So here is what the Commission should do. First, the entire Guidance should be scrapped and the document should be re-drafted as a formal rulemaking that provides an opportunity for public comment and includes a cost-benefit assessment.

Second, the proposal should provide a clear, consistent interpretation of the "direct and significant" connection with a sufficient rationale for the extent of the Commission’s extraterritorial reach. Identifying more accurately those activities that could pose a risk to the U.S. will allow the Commission to assess how such risk could be mitigated through clearing and to determine whether other transaction rules must be applied.

Third, the definition of U.S. person should be narrowed to include only those entities that are residents of the U.S., are organized or have a principle place of business in the U.S., or have majority U.S. ownership. It should exclude a foreign affiliate or subsidiary of a U.S. end user that is guaranteed by that end user. This more reasonable definition is similar to the definition articulated by Commission staff in one of the flurry of no-action letters issued on October 12.

Finally, the rule must clearly interpret the concept of "substituted compliance." The proposal indicates that the Commission will review the comparability of non-U.S. regulations with Commission rules. This review should be a broad, big-picture assessment of comparability, not a rule-by-rule analysis. A rule-by-rule comparison could result in a hodgepodge of disparate regulatory requirements that would be a compliance nightmare for market participants. It would also undermine the coordinated regulatory effort that G-20 members have agreed to support.

The bottom line is that today’s swaps markets are global in nature and interconnected. Given this reality, the Commission needs to engage much more actively and meaningfully with foreign regulators and develop a more harmonized approach in order to eliminate redundancy and inconsistency among the respective regulatory regimes.

Conclusion

To conclude, I want to emphasize how important it is for the Commission to be mindful of the real and significant impact that its regulations have on market activity. Anyone who doubted this reality needs look no further than October 12, the new world of futurization that we are seeing in our industry and the mounting lawsuits that the Commission is facing.

Therefore, it is crucial that we apply the principles of good government so that our regulations are clear, consistent and not overly burdensome to market participants. As I’ve noted, we have at times failed to live up to these standards. But if we are willing to learn from these lessons, we can do better with the rules we have before us and on the horizon.

Thank you very much for your time.</sup>