CFTC COMMISSIONER GIANCARLO MAKES STATEMENT ON GOVERNMENT POLICIES AND FUTURES COMMISSION MERCHANTS

FROM:  U.S. COMMODITY FUTURES TRADING COMMISSION 

Statement of Commissioner J. Christopher Giancarlo for the Market Risk Advisory Committee Meeting

June 1, 2015

Federal government policies are making America’s Futures Commission Merchants (FCMs) an endangered species. The most recent example is the storied commodities firm, Bache, founded in 1879, that is now being dismembered. A French bank is acquiring a portion of it, while thousands of its clients are being told to find new FCMs to serve their business needs.1

While not a household term, “FCMs” are the futures markets equivalent of stock brokers providing critical services for businesses that need to hedge against business and production risks. Today, because of a combination of mismanagement by a few, U.S. monetary policy and over-regulation, FCMs are consolidating at an alarming rate with dire consequences for America’s farmers, ranchers and manufacturers. Tomorrow, the Commodity Futures Trading Commission’s (CFTC) Market Risk Advisory Committee (MRAC), under the sponsorship of Commissioner Sharon Bowen, will hold a hearing to discuss the plight of American FCMs.

That hearing will undoubtedly recognize that there are far fewer FCMs than there used to be. The number of FCMs has dramatically fallen in the past 40 years: from over 400 in the late 1970s, to 154 before the 2008 financial crisis,2 and down to just 72 today.3 Of the 72 FCMs registered with the CFTC as of March 2015, 15 firms were dormant, leaving only 57 active firms serving customers.4 As the number of FCMs has dwindled, systemic risk has increased with the five largest firms accounting for more than 70 percent of the market.5 Meanwhile, customer assets held by all FCMs have grown from $169.5 billion in December 2007 to $245.7 billion in March 2015.6

Industry consolidation derives from several factors. Fraud and mismanagement caused spectacular failures of firms like Refco, MF Global and Peregrine Financial. The prolonged U.S. monetary policy of near zero percent interest rates has eliminated a key source of income for FCMs through reinvestment of customer money.7

Another threat to FCM survival comes from burdensome new regulations. The collapse of MF Global and Peregrine Financial prompted a series of new customer protection rules,8 some of which were undoubtedly needed. However, these new rules have impacted small FCMs more harshly than large ones. In addition, the CFTC’s new rules on ownership and control reporting greatly increased compliance and paperwork burdens for FCMs.9 The CFTC also further expanded FCM recordkeeping obligations to include the recording of all oral and written communications leading up to the execution of a transaction.10 The supplementary leverage ratio (SLR) rule issued last year by U.S. prudential regulators will make it more expensive for bank-owned FCMs to clear customer trades. That is because the SLR requires banks to hold more capital for every asset on their books, even margin held for clients on cleared trades of commodity futures, leading to diminished FCM income and increased client costs.

FCMs as an industry are spending millions of dollars for infrastructure, technology and compliance personnel to implement these complex regulations. Smaller FCMs that traditionally serve agricultural and small manufacturing interests must devote precious resources to comply with cumbersome rules more easily handled by large bank-affiliated competitors. FCMs are also overwhelmed by significantly increased demands for information from self-regulatory organizations and the CFTC. One FCM told me that it receives around 9,000 regulatory requests per year!

While many new rules contain plausible protections, regulators have lost sight of the increased costs for FCMs. Most of the rules have been imposed without a true analysis of the effect on FCMs and end-users.11 As a result, many small to medium-sized FCMs providing specialized services to everyday businesses are charging higher fees or leaving the industry because they cannot afford the additional infrastructure, technology and compliance costs imposed by the swelling regulations. Still, others have stopped clearing swaps for customers, which has the perverse effect of concentrating risk in fewer and fewer firms, a dangerous proposition in light of Dodd-Frank’s clearing mandate.

The Dodd-Frank Act was ostensibly about reforming “Wall Street.” Yet, again, the increased costs and burdens that directly or indirectly flow from the law have negatively impacted Main Street and America’s farmers, ranchers and manufacturers who need the services of the remaining small and medium-sized FCMs. Rules born out of the law are forcing America’s farmers, ranchers and manufacturers to pay higher fees for less choice in FCM services. With fewer firms serving a bigger market, risk is being more concentrated in large bank-affiliated firms, increasing the systemic risk that Dodd-Frank promised to reduce. Undoubtedly, heightened systemic risk arising from FCM consolidation is appropriate for consideration and analysis by MRAC.

If we are not careful, America’s rural producers will soon be left with few places to protect against business risk. The Midwest farmer who plants 1,000 acres of corn may have no choice but to go unhedged against market volatility. Sadly, it appears that the markets where “derivatives” were born are quickly losing their core service providers, possibly forever.

1 Christian Berthelsen and Tatyana Shumsky, SocGen Deal for Bache Illustrates Commodity-Trading Woe, The Wall Street Journal, May 26, 2015, available at http://www.wsj.com/articles/socgen-deal-for-bache-illustrates-commodity-trading-woe-1432681628.

2 CFTC, Selected FCM Financial Data as of December 31, 2007, http://www.cftc.gov/files/tm/fcm/fcmdata1207.pdf (last visited May 26, 2015) (excludes firms registered solely as retail foreign exchange dealers).

3 CFTC, Selected FCM Financial Data as of March 31, 2015, http://www.cftc.gov/ucm/groups/public/@financialdataforfcms/documents/file/fcmdata0315.pdf (last visited May 26, 2015) (excludes firms registered solely as retail foreign exchange dealers).

4 Id.

5 Joe Rennison, Nomura Exits Swaps Clearing for US and European Customers, Financial Times, May 12, 2015, available at http://www.ft.com/intl/cms/s/0/e1883676-f896-11e4-be00-00144feab7de.html#axzz3bSYWViZ4 (based on amount of customer collateral required according to CFTC data).

6 The March 2015 number includes $53.1 billion in cleared swaps customer assets that was not included in the December 2007 number. See supra note 2 and 3.

7 17 C.F.R. 1.25.

8 Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations, 78 FR 68506, 68510-12 (Nov. 14, 2013) (discussing recent customer protection initiatives).

9 Ownership and Control Reports, Forms 102/102S, 40/40S, and 71, 78 FR 69178 (Nov. 18, 2013).

10 17 C.F.R. 1.35. The rule applies to transactions in a commodity interest and related cash or forward transactions. Oral communications that lead solely to the execution of a related cash or forward transaction are excluded.

11 7 U.S.C. 19(1), CEA 15(a). Given the CFTC’s lax cost-benefit consideration requirements.

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).