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Showing posts with label OVERSIGHT. Show all posts
Showing posts with label OVERSIGHT. Show all posts

Saturday, June 20, 2015

SEC CHARGES MUTUAL FUND ADVISER'S BOARD MEMBERS WITH FAILING TO HAVE PROPER OVERSIGHT

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION
06/17/2015 12:55 PM EDT

The Securities and Exchange Commission charged a mutual fund adviser, its principal, and three mutual fund board members with failing to satisfy their statutory obligations in connection with the evaluation and approval of mutual fund advisory contracts.

Richmond, Va.-based advisory firm Commonwealth Capital Management was charged with violating Section 15(c) of the Investment Company Act of 1940 for providing incomplete or inaccurate information to two mutual fund boards, and the firm’s majority owner John Pasco III was charged with causing the violations.  They and former trustees J. Gordon McKinley III, Robert R. Burke, and Franklin A. Trice III have agreed to settle the SEC’s charges.

Commonwealth Capital Management acted as the investment adviser to various mutual funds within World Funds Trust (WFT) and World Funds Inc. (WFI).  Commonwealth Capital Management was part of a turnkey mutual fund platform that provided various services to small to mid-size mutual funds.  An SEC investigation found that as part of what’s known as the 15(c) process, the WFT board of trustees requested that Commonwealth Capital Management and Pasco provide certain information regarding advisory fees paid by comparable funds as well as the nature and quality of the firm’s services.  There was no documentary evidence that Commonwealth Capital Management provided or that the trustees evaluated fees paid by comparable funds.  Commonwealth Capital Management also provided incomplete responses about the nature and quality of services provided by Commonwealth Capital Management versus services provided by the funds’ sub-adviser and administrator, and the trustees did not request or receive additional materials.  Nevertheless, the trustees approved the advisory contracts without having all of the information they requested as reasonably necessary to evaluate the contracts.

“As the first line of defense in protecting mutual fund shareholders, board members must be vigilant,” said Andrew J. Ceresney, Director of the SEC Enforcement Division.  “These trustees failed to fully discharge their fund governance responsibilities on behalf of fund shareholders.”

Julie M. Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, added, “The advisory fee typically is the largest expense reducing investor returns.  The WFT trustees fell short as the shareholders’ watchdog by essentially rubber-stamping the adviser’s contract and related fee.”

According to the SEC’s order instituting a settled administrative proceeding, Commonwealth Capital Management also omitted or provided inaccurate information requested by independent directors in the WFI series of mutual funds in connection with board meetings to approve the firm’s advisory contract.  Commonwealth Capital Management supplied a fee chart containing inapt comparisons and erroneous information while omitting other details.  The firm additionally failed to provide certain information about profitability and an expense limitation agreement that had been in place to limit the relevant fund’s expenses.  Commonwealth Capital Management also informed the WFI independent directors that the fund had appropriate breakpoints when, in fact, breakpoints were omitted from the advisory contract.

The SEC’s order finds that Commonwealth Capital Management, McKinley, Burke, and Trice violated Section 15(c) of the Investment Company Act, and Pasco caused the firm’s violations.  The order finds that Commonwealth Capital Management’s affiliated administrator Commonwealth Shareholder Services was contractually responsible for preparing the shareholder reports on behalf of the WFI funds, and failed to include required information concerning the 15(c) process in one fund’s 2010 shareholder report in violation of Section 30(e) of the Investment Company Act and Rule 30e-1.  Without admitting or denying the findings, they each consented to the order and agreed to cease and desist from committing or causing any such violations.  Pasco and the firms agreed to jointly and severally pay a $50,000 penalty, and the trustees each agreed to pay $3,250 penalties.

The SEC’s investigation was conducted by Jacob Krawitz, Brian Privor, and John Farinacci, and the case was supervised by Anthony Kelly of the Asset Management Unit.  Christian Schultz assisted with the investigation.  The SEC examination that led to the investigation was conducted by Miguel A. Torres, Andrew B. Green, Cormac J. Logue, and Tamara D. Young, and managed by Margaret Jackson.

Thursday, March 12, 2015

CFTC CHAIRMAN MASSAD'S ADDRESS TO FUTURES INDUSTRY ASSOCIATION BOCA CONFERENCE

FROM:  U.S. COMMODITY FUTURES TRADING COMMISSION
Keynote Address of Chairman Timothy G. Massad before the Futures Industry Association Boca Conference
March 11 2015
As Prepared For Delivery

Thank you for inviting me today, and I thank Walt for that kind introduction. It is a pleasure to be here. This is my first time to the International FIA Conference here, an event that I have heard a lot about. And, of course, with the winter we have been having in Washington, being here is a real treat.

Let me begin by acknowledging the work that the Futures Industry Association and its members do. Your commitment to improving the industry, and your participation in the work of the Commission, is very important.

I want to also acknowledge and thank the CFTC staff. What this agency has accomplished, not only since my arrival, but well before that, is a credit to their hard work. We have an incredibly dedicated and talented team. I also thank my fellow commissioners for their efforts, particularly their willingness to work constructively together. We may not always agree, but I believe all of us are working in good faith to carry out the CFTC’s responsibilities.

Everyone here appreciates the importance of the derivatives markets. They enable businesses of all types to manage risk, and in so doing, are engines of economic growth. The success of these markets depends on many factors, and a key one is having a strong and sensible regulatory framework.

We knew that before the global financial crisis, but the crisis certainly drove that lesson home. The absence of regulation allowed the build-up of excessive risk in the over-the-counter swaps market. That risk intensified the crisis and the damage it caused. We must never forget the true costs of the crisis: millions of jobs lost, homes foreclosed and dreams shattered.

As a result of the financial crisis our country took action to address those risks. We are implementing a new regulatory framework for swaps, one that mandates central clearing and brings greater transparency, reporting and oversight. The CFTC’s responsibility today is to regulate the derivatives markets in a manner that not only prevents the build-up of excessive risk, but also creates a foundation on which the derivatives markets can continue to thrive and work for the many businesses that rely on them.

So today I would like first to review briefly some of the things we have done recently, and some of the things we will be doing in the months ahead. And then I want to discuss a key aspect of that new framework, which is the role of clearinghouses. In particular, I want to discuss the issue of clearinghouse resiliency, because this is an issue that has been a priority for us and has received increased public attention lately.

Current Priorities

We have been very busy since two of my fellow commissioners and I took office last summer. Our agenda today reflects several priorities.

First, the agency has largely finished an intensive rule-writing phase to create the new regulatory framework for swaps. We are now focused on implementation of that framework. One of our priorities has therefore been to focus on fine-tuning our rules, in particular to make sure that the commercial businesses, consistent with the Congressional mandate, that depend on these markets to hedge risk can continue to use the markets effectively. We have made a number of changes to address concerns of commercial end-users. This has included amending our rules to enable publicly-owned utilities to continue to be able to hedge their risks effectively in the energy swaps market. We have proposed revisions regarding the posting of residual interest which is related to the posting of collateral with clearing members. We have proposed exemptions for commercial end-users from certain recordkeeping requirements and clarifications to give the market greater certainty with regard to the treatment of contracts with embedded volumetric optionality.

In addition, the Commission staff has taken action to make sure that end-users can use the Congressional exemption regarding clearing and swap trading, including when they enter into swaps through a treasury affiliate. The staff also recently granted relief from the real-time reporting requirements for certain less liquid, long-dated swap contracts, recognizing that immediate reporting can sometimes undermine a company’s ability to hedge.

We have also extended relief with respect to the treatment of package trades on swap execution facilities to avoid unnecessary disruptions in the marketplace. There may be additional measures, such as today we are looking at trade option reporting rules and the rules on trading of swaps on swap execution facilities.

Finishing the Dodd Frank Rules. We are also working to finish the few remaining rules mandated by Congress, including our proposed rule on margin for uncleared swaps. This rule plays a key role in the new regulatory framework, because uncleared transactions will always be an important part of the market. Certain products will not be suitable for central clearing because of their lack of sufficient liquidity or other risk characteristics. In these cases, margin will continue to be a significant tool to mitigate the risk of default from those transactions and, therefore, the potential risk to the financial system as a whole.

We are currently working with the bank regulators to finalize these proposed rules. These rules exempt commercial end-users from the margin requirements, consistent with Congressional intent. I am hopeful that we can finalize these rules by the summer.

We are also working on the rules on position limits and capital for swap dealers.

Cross-Border Harmonization. We are also focused on addressing cross border issues related to the new framework. We have had productive discussions with the Europeans to facilitate their recognition of U.S. based clearinghouses, and I would hope that we could reach agreement soon. Another important area for cross-border harmonization is the proposed rule I just mentioned, concerning margin for uncleared swaps. We have been working with our counterparts in Europe and Japan, and I am hopeful that our respective final rules will be substantially similar, even though they are not likely to be identical.

Data. We have also made enhancing our ability to use market data effectively a key priority. We continue to focus on data harmonization, including by helping to lead the international work in this area. We are also looking at clarifications to our own rules to improve data collection and usage. We have a lot of work to do in the area of data generally, but we have come a long way since 2008, when we knew very little about the swaps market. Today, there is real time price and volume information and we have much better insight into participant activity.

New Challenges and Risks. We are also looking at new challenges and risks in our markets. We have been very focused on the increased use of automated trading strategies, for example, and their impact on the derivatives markets. We issued a concept release last year and we received a lot of very useful input. We are also keenly focused on cybersecurity, which is perhaps the single most important new risk to market integrity and financial stability. We have incorporated cyber concerns into our core principles and made it a priority in our examinations. Our challenge is to leverage our limited resources as effectively as possible. Many major financial institutions are spending far more on cybersecurity than our entire budget. We do not have, for example, the resources to do independent testing. So one of the things we are looking at is whether the private companies that run the core infrastructure under our jurisdiction – the major exchanges and clearinghouses for example – are doing adequate testing themselves of their cyber protections. We are holding a public staff roundtable to discuss this issue next week.

Enforcement and Compliance. We also remain committed to a robust surveillance and enforcement program to prevent fraud and manipulation. We have held some of the world’s largest banks accountable for attempting to manipulate key benchmarks. We have brought successful cases against those who would attempt to manipulate our markets through sophisticated spoofing strategies. And we have also stopped crooks trying to defraud seniors through precious metal scams and Ponzi schemes. In all these efforts, our goal is to make sure that the markets we oversee operate with fairness for all participants regardless of their size or sophistication.

Ensuring the Strength and Stability of Clearinghouses in the New Regulatory Framework

Let me turn now to discuss clearinghouses. In just about every speech I have given since taking office, I have talked about our progress in implementing the mandate to clear standardized swaps. In our markets, the percentage of swaps cleared has increased from 15% in December 2007 to about 75% today. At the same time, I have talked about the importance of clearinghouse stability and oversight. As we make clearinghouses even more important in the global financial system, we must pay attention to the risks that they can pose.

Lately, there has been increased discussion of this, with many views put forward in papers and speeches, on issues like clearinghouse resiliency, recovery, and resolution. Questions are being asked in particular about the adequacy of recovery plans, about whether clearinghouses have enough capital or “skin in the game,” and whether the potential liability of clearing members is properly sized or capped. This is a good and healthy debate. Today, I would like to discuss how we at the CFTC think about some of these issues. Let me do so by first talking about the work that has taken place in this area, both by us and internationally, then discuss the need to look at issues in context, and then discuss the work that lies ahead.

First, a great deal of work has already taken place to consider these issues, here and internationally. The CFTC has had a regulatory framework in place to oversee clearinghouses since well before the passage of Dodd-Frank. Dodd-Frank amended the agency’s core principles for clearinghouses, with the goal of reducing risk, increasing transparency, and promoting market integrity within the financial system. In 2011, the agency adopted detailed regulations to implement the revised core principles. These regulations provide a regulatory framework designed to strengthen the risk management practices of DCOs, promote financial integrity for swaps and futures markets, and enhance legal certainty for DCOs, clearing members, and market participants.

In 2013, we also supplemented these regulations by adopting additional requirements for systemically important clearinghouses. Thus, our clearinghouse regulations are now consistent with the Principles for Financial Market Infrastructures, or PFMIs, published in 2012 by CPMI-IOSCO.

The work of CPMI-IOSCO with respect to clearinghouses has been an important international effort, and the CFTC has played an active role. The PFMIs set comprehensive principles and key considerations for the design and operation of financial market infrastructures, including clearinghouses, to enhance their safety and efficiency, to limit systemic risk, and to foster transparency and financial stability. This same group also published a Disclosure Framework and Assessment Methodology and last month published quantitative disclosure standards, to further increase transparency of clearinghouses.

The Basel Committee on Banking Supervision has provided strong incentives for clearinghouses to meet these standards, because bank exposures to such “qualifying CCPs” are subject to capital treatment that is significantly more favorable than that afforded to exposures to clearinghouses that do not meet these standards. CPMI-IOSCO has also undertaken a rigorous process to assess the completeness of the regulatory framework in several jurisdictions. The Financial Stability Board has also contributed through the publication of the Key Attributes of Effective Resolution Regimes, which includes an annex on financial market infrastructures.

Writing standards that clearinghouses must follow, however, is of course not enough. That is why the CFTC also engages in extensive oversight activities. Our program includes daily risk surveillance, analysis of margin models, stress testing, back testing, and in-depth compliance examinations. We engage in ongoing review of clearinghouse rules and practices, and we review what products should be mandated for clearing. We require a variety of periodic reporting including some on a daily basis as well as event-specific reporting.

In addition to supervision of clearinghouses, we look at risk at the clearing member and large trader levels. We conduct daily stress tests to identify traders who pose risks to clearing members and clearing members who pose risks to clearinghouses. We require clearinghouses to oversee the risk management policies and practices of their members. We require FCMs, whether clearing members or not, to meet risk management and minimum capital standards. And we have a rigorous compliance examination process.

There is also public transparency on these matters. You can go to our website and see each FCM’s net capital requirement and the amounts of adjusted capital and customer segregated assets they hold.

This oversight and reporting framework is intended to enable us to take proactive measures to promote the financial integrity of the clearing process.

So as we engage in this public discussion about clearinghouse risk, we should always remember to look at the full picture – that is, to look at all the regulatory policies, the clearinghouse practices, the oversight, and the sum of activities that contribute to rigorous risk mitigation. We should not focus on one particular issue without considering how it connects to other issues.

An example of the importance of looking at the full picture is when we consider issues pertaining to risk mitigation through the collection of initial margin. Although there are many aspects to consider, there has been some focus on one issue in particular, which is the liquidation period – that is, whether a clearinghouse should assume a 1 day, 2 day, 5 day, or other minimum time horizon for its ability to liquidate a particular product. This is an important issue. Indeed, our regulations require that the time period must be appropriate based on the characteristics of a particular product or portfolio. But the minimum liquidation period is only one of the many issues that affect how much initial margin is posted with the clearinghouse.

The amount of margin a clearinghouse holds will also depend on whether clearing members post margin on a gross or net basis. “Net” means a clearing member can net customers’ positions to the extent they offset one another, which reduces the amount of margin that must be sent to the clearinghouse for the overall portfolio. By contrast, “gross” posting means the clearing member must post for each customer, without any offsets across customers, which means the clearinghouse receives more – in many cases, much more – collateral than under net posting.

A further difference in regulatory regimes is whether the clearing member is even obligated to collect a minimum amount of margin from each customer, sufficient to cover that customer’s position, or whether the clearing member can negotiate different deals with different customers. Our rules, for example, require that the clearinghouse must require each clearing member to collect from each customer, more than 100% of the clearinghouse’s initial margin requirements with respect to each product and swap portfolio.

Another example of the importance of context is with regard to the issue of whether clearinghouses have enough capital or “skin in the game.” There has obviously been a lot of public and regulatory attention in the last few years on how much capital banks should hold. When it comes to clearinghouses, it’s important to remember that there are significant differences between the business models of clearinghouses and banks, and therefore, in the role that capital plays. A banking institution needs capital to offset losses that may arise frequently. Those losses can be as varied as the many lines of businesses in which a bank engages.

By contrast, when people talk about a clearinghouse drawing on its capital, they are usually talking about a very unusual event: there has been a default of a clearing member, and the resources of the defaulter held by the clearinghouse – both initial margin and default fund contribution – are not enough to cover the loss. The clearinghouse has sought to transfer the defaulting member’s positions to one or more other clearing members, and the success of that auction has affected the size of the loss. The clearinghouse is now looking at covering that loss through the waterfall of resources available to it for recovery – that is, the clearinghouse’s capital, the other clearing members’ prefunded contributions to the default fund, and potential assessments on clearing members.

This would be a very serious event. Historically, however, the use of other clearing members’ resources to meet a default is exceedingly rare worldwide. To my knowledge, it has never happened here in the United States.

That does not mean we should not think about it or plan for it. Post financial crisis, we are and should be doing many things to increase the resiliency of our financial system in the event of unusual situations. The issue of capital needs to be considered in the context of a clearinghouse’s overall financial resources. That is, what are the resources to deal with a loss if initial margin is not adequate? Under CFTC requirements, each of our systemically important clearinghouses must maintain sufficient financial resources to meets its financial obligations to its clearing members notwithstanding the default by the two clearing members creating the largest combined loss to the clearinghouse in extreme but plausible market conditions – the standard known as “Cover 2.” These requirements are consistent with the PFMIs.

To meet these requirements, a clearinghouse may use initial margin payments, its own capital dedicated to this purpose, and default fund contributions. The allocation or the balance between these financial resources may vary, such that the more margin paid up front, the less default fund contributions the clearinghouse will collect and vice versa.

I should note that a clearinghouse faces risks outside of a default by a member, and we are looking at those as well. These can include operational or technological issues, such as the cybersecurity concerns I noted earlier. And we separately require clearinghouses to have capital, or other resources acceptable to us, to cover operating costs for one year. This capital is not fungible with the Cover 2 resources.

We are currently considering the issues pertaining to the resources available to deal with a default in the context of reviewing clearinghouse recovery plans. We are trying to make sure that these plans are “viable” – that is, that they are designed to maximize the probability of a successful clearinghouse recovery, while mitigating the risk that recovery actions could result in contagion to other parts of the financial system. And we will be holding a public staff roundtable on these issues next week – unless Washington gets another snowstorm. The agenda will include discussion of what tools a clearinghouse may use in these situations.

Let me suggest a few questions that may be useful to think about in considering clearinghouse capital in this context: first, is capital primarily about alignment of incentives – that is, alignment of incentives between the clearinghouse and its clearing members – rather than the quantitative increase to the waterfall? In an era when the equity of clearinghouses is held by persons other than the clearing members, this may be particularly important. As the CPMI-IOSCO Recovery Report notes, “[e]xposing owners to losses … provides appropriate incentives for them to ensure that the [clearinghouse] is properly risk-managed.”

Second, when we think about capital in the context of recovery plans, should we also think about issues of governance and process? That is, whose interests should be taken into account when a clearinghouse designs its recovery plan and when a clearinghouse faces a default? If the waterfall of resources is not sufficient to cover a default, then how does the clearinghouse decide what happens next, and who should participate in or have input into that decision? How do we ensure there is adequate time for that decision-making process to take place?

In outlining the things the CFTC has done and is doing, as well as the international work that has taken place, let me note a couple of caveats. While I believe the agency has developed very good policies and practices, there is more we should be doing, particularly with respect to the frequency of examinations. Unfortunately, we are limited by our resources. In addition, to state the obvious, no matter how good the regulatory framework, no regulator can ever guarantee that there won’t be problems.

Finally, I want to underscore that this work is ongoing, and there are many aspects of these issues that I have not touched on today given time limitations. We will be continuing to look at the full range of issues pertaining to clearinghouse risk, resiliency, recovery, and resolution. We will also be participating in further international work on these issues. I note that CPMI-IOSCO will be continuing to look at stress testing – are clearinghouse stress testing programs adequate and should we develop standards, for example – and they will also be looking at recovery issues, and we will be helping to lead that process. I also expect the FSB’s Resolution Steering Group to look further at the resolution issues, and we will work with our colleagues on that as well. While no one wants to get to resolution, it is important that we explore how this would be done as well, without a government bailout and without creating contagion. This is very useful, and it reflects the very good international dialogue that has taken place already in this area. In addition, this work can help us balance the multiple regulatory objectives that come into play in considering these issues, so that regulators with different responsibilities do not work at cross purposes.

As we engage in this work, and as the public discussion about clearinghouse resilience continues, I would just encourage all of us to keep in mind the full picture. We should always take a comprehensive approach to these issues, one that is based on a clear understanding of risk, that enhances transparency and market integrity, and that is backed up by rigorous, ongoing oversight. Effective risk mitigation and resiliency require a broad range of policies and procedures.

Central clearing is fundamental to the health and vibrancy of our markets. We must make sure that clearing firms, as well as clearinghouses, can continue to operate successfully. It is only in this way that the businesses which depend on these markets can continue to use them effectively.

Conclusion

That brings me back to where I started, which is the importance of these markets to the many businesses that rely on them, and to our economy generally. All of you who participate in these markets understand that. And that is what guides us at the Commission. I know I speak for all the Commissioners in saying it is a privilege for us to work on these issues of importance to these markets and our economy. I look forward to working with you to make sure these markets continue to thrive in the years ahead.

Thank you for inviting me.

Last Updated: March 11, 2015

Tuesday, October 22, 2013

CFTC CHAIRMAN GENSLER'S REMARKS BEFORE AMERICANS FOR FINANCIAL REFORM

FROM: U.S. COMMODITY FUTURES EXCHANGE COMMISSION 
Keynote Remarks of Chairman Gary Gensler before the Americans for Financial Reform and Georgetown University Law Center’s Financial Transparency Symposium

Note: this transcript was edited and abbreviated for clarity

October 11, 2013

I want to thank the Americans for Financial Reform and Georgetown Law Center for this invitation. We’re in the midst of a government shutdown so I’m going to give a presentation from some notes, not the usual prepared text speech.

Five years ago, the U.S. economy was in free fall.

Five years ago the swaps market was at the center of this crisis. It cost middle class Americans – and hardworking people around the globe – their jobs, their pensions and their homes.

President Obama and Congress came together and they responded with historic reforms to bring the swaps market into the light through transparency and oversight.

And now, with the Commodity Futures Trading Commission’s (CFTC) near completion of these reforms, a true paradigm shift has resulted.

A paradigm shift to a transparent, regulated marketplace that benefits investors, consumers and businesses in this country and around the globe.

The CFTC, through 61 final rules, orders, and guidances, has brought traffic lights, stop signs, and speed limits to this once dark and unregulated market.

Through these reforms, we have stood up an entire comprehensive regime covering:

Transparency and access – which helps promote greater competition and market efficiency;
Clearing – promoting access and lowering risk;
Oversight of intermediaries and customer protection – to better protect the public;
Registration requirements – ensuring there is actual compliance with the reforms; and
New enforcement tools – to guard against market abuses.
These completed reforms have resulted from an active public debate –

First in Congress and the Administration, and then
Subsequently through our public rule making. We have received nearly 40,000 comment letters on these various rules – and that’s not even counting the 19,000 comments on the Volcker Rule. We’ve conducted 2,200 plus meetings that we’ve put on our website.
I thought I would review where we stand today in this critical reform in the context of a dozen debates that have gone on around this reform.

The first three debates relate to the scope of reform.

First, which products should be covered?

Congress and the Administration chose not to limit regulatory reform only to those products or entities that received the most attention during the financial crisis, which were credit derivatives. The comprehensive regulatory framework now covers the full suite of swaps products. This includes interest rate swaps, currency swaps, commodity swaps, equity swaps, credit default swaps – the center of the crisis – as well as derivative products that may be developed in the future.

Credit default swaps may have been the leading culprit in the crisis, but omitting the markets for interest rate, currency swaps and commodity swaps would have left, the market still opaque and inefficient. And we needed to shine the same light and lower risk in all of the OTC derivatives markets, not just credit derivatives.

Now there was some debate about foreign currency forwards and swaps. Though they are exempted from clearing and the trade execution mandate, Congress and the CFTC worked to ensure that they have to be reported into trade repositories, and also that they come under business conduct standards. We’ve worked closely with the foreign currency community, and they have changed their back office documentation as of June of this year.

Second, which participants should be covered through reforms?

Congress and our rules ended up with a three-tiered system of participant reforms: swap dealers at the center; then financial institutions; and finally, non-financial institutions, or so-called end-users.

It is only with comprehensive regulation of the dealers at the center of this market that we can really oversee and regulate the entire derivatives markets. This was one of the key reforms that we laid out with Secretary Geithner and Mary Schapiro during the presidential transition five years ago. Subsequently, we worked with then Chairman Harkin of the Senate Agriculture Committee and others to ensure that there would be oversight of the dealers themselves.

Through regulating the dealers, we ensure that reform applies to both standardized and customized products.

You might remember the debate. Would there be an allowance for a bilateral or customized swap, ensuring the economy could get the benefit of all these hedging products? The answer was yes. Customized products would continue, but we would need to oversee the dealers that are offering those swaps.

By giving the CFTC clear authority to set business conduct standards, swap dealers and their nearly 10,000 counterparties around the globe have changed their swap documentation, lowering risk.

Today, we have 86 registered swap dealers and two major swap participants. This group includes the world’s 16 largest financial institutions in the global swaps market or what’s called the G16. It also includes a number of energy swap dealers.

The second group of market participants was financial institutions. There was a debate four years ago as to whether financial institutions were to be covered by reform. Our thinking was that if we didn’t include hedge funds, insurance companies, mortgage companies and the like, we would leave a significant part of the interconnected financial system outside of reform. Though not required to register as dealers, they came under two of the very critical reforms – the required clearing and the required trade execution. Congress did that, and we’ve executed on that plan.

The third group of market participants is the non-financial participants – the so-called “end-users.” It’s really the end-users, the non-financial side of our economy, that provide 94 percent of private-sector jobs in America. They only make up a small, single-digit percent of the swaps market. End-users were exempted from clearing and many other rules. For instance, the Commission’s proposed rule on margin provides that end-users do not have to post margin. They do have some responsibilities for recordkeeping and reporting.

Third, what would be the cross-border scope of reform?

Would reform just be territorial, such that only that which happened within the borders of the United States were covered? Or would it extend further?

Congress recognized that risk knows no geographic border. Look at AIG – it nearly brought down the economy – its operations were in London. It was actually registered as a French bank with a branch in London.

AIG wasn’t the only one. Lehman Brothers, Citigroup, Bear Stearns – Bear Stearns hedge funds, by the way, were incorporated in the Cayman Islands, as well as Citigroup’s off-balance-sheet Structured Investment Vehicles (SIVs). Ten years earlier, there was Long-Term Capital Management, a hedge fund operated out of Connecticut. You would have thought, as I did on a certain Sunday in September of 1998 when I visited it, that it was a U.S. person, even though it was booking its $1.2 trillion derivatives book in its Cayman Island affiliate.

Congress knew that the nature of modern finance is that financial institutions commonly set up hundreds, even thousands of institutions around the globe. When Lehman Brothers went down, it had 3,300 legal entities. When a run starts at any part of an overseas affiliate or branch in modern financial institution days, risk knows no geographic boundary. It comes right back here, just as our housing risk went offshore to other countries.

What Congress made clear in reform was that the far-flung operations of U.S. enterprises are to be covered. Congress said this in key words. We really need to thank Chairman Frank because he reached out to our agency and asked how to deal with what he called “risk importation?”

Our remarkable staff at the CFTC worked with his staff on the key words in the statute that say if it has “a direct and significant connection with activities in or effect on Commerce of the United States” it’s covered by reform. We were not going to just take a territorial approach. That’s really because Chairman Frank had the vision and foresight, asked for advice, got advice, and included, in a bipartisan way at the time, these key words in the statute.

The CFTC, coordinating closely with global regulators, completed cross-border guidance in July. Swaps market reform would cover transactions between non-U.S. dealers and guaranteed affiliates of U.S. persons. Why guaranteed affiliates? Because their risk can come right back here. Reforms also cover swaps entered into between two guaranteed affiliates or with the offshore branches of U.S. banks. Another more recent lesson comes from the events surrounding JPMorgan Chase’s Chief Investment Office, which booked their credit index swap trades through their London branch, which was fully part of the bank.

After allowing time for market participants to phase in compliance, this week, much of our cross-border guidance became effective. Yesterday, the final U.S. person guidance became effective. Based on that, hedge funds and other funds whose principal place of business is in the U.S. or majority owned by U.S. persons will clear and come into many other reforms.

Hedge funds like Long-Term Capital Management today would now clear standardized swaps. So no longer would a P.O. Box in the Cayman Islands or another nice vacation holiday spot be good enough to get out of reform.

Further, yesterday foreign branches of U.S. persons, that means branches of big U.S. banks, and guaranteed affiliates of U.S. financial institutions now have to comply with the clearing requirement.

Now, let me turn to the big decisions on substance.

Let me start with transparency.

Key to promoting efficiency in markets is transparency and access. Adam Smith in the Wealth of Nations wrote about this over 200 years ago. He contended that if the price of information is lowered or you make information free, in promoting such transparency, the economy benefits. Similarly, if access to the market is free, everybody gets to compete.

Transparency and access was not the swaps market as we knew it in 2008. It was opaque. Most people in the market couldn’t see the pricing, and access was really dominated by large dealers with trillion dollar plus balance sheets.

In bringing forward reform, there was a debate about whether transparency to regulators was enough or if we also needed public market transparency. Congress and the Administration determined that regulatory transparency wasn’t enough. We have put in place swap data repositories (SDRs) to provide transparency to regulators, and as of two weeks ago, there was $400 trillion notional of swaps in the data repositories (market facing and single counted swaps).

But that’s not enough. Adam Smith was about promoting transparency to the public, and that’s what Congress believed as well.

First, Congress responded that we need post-trade transparency. As of December 31 of this past year, we started putting it in place, and as of September 30, the last compliance date, the public and end-users can see the price and volume of each transaction as it occurs on a website, like a modern-day ticker tape.

Due to an amendment sponsored by Sen. Jack Reed during the conference, this post-trade transparency covers not only those transactions on an exchange or on a registered platform, it covers the entire marketplace – including customized swaps and off-exchange swaps.

Also Congress adopted an initiative to make sure there is transparency before the transaction. This covers the portion of the market for swap dealers and financial institutions trading swaps that are required to be cleared and made available for trading on a platform.

Starting this past week, on October 2, the public began to benefit as swap trading platforms, called swap execution facilities (SEFs), came under common-sense rules of the road. SEFs will require that the dealers and non-dealers alike are able to get impartial access -- another part of Adam Smith’s writings from 200 years ago.

Seventeen SEFS are currently registered and operating. It is truly a paradigm shift. It’s still early, but just to give you a few numbers, the first day there was about 1,200 trades on this collection of SEFS. Two or three days ago, it was 1,800 trades.

We do understand that there are going to be issues that arise. Just as we have for other reforms, we are going to try to work with market participants to smooth the transition. But let there not be any doubt – over time, market participants will benefit from enhanced pre-trade transparency because it brings competition into the marketplace.

A fifth key decision was regarding requiring central clearing.

Clearing has existed since the 1890s. It lowers risk to the market. The debate was not whether there was going to be clearing. It was who was going to be covered by it. Where Congress came out is that financial actors would be covered as well as the dealers.

The dealers in 2009 came together, and it’s been well reported, and said they could live with clearing, but they were contending it should be mandated only for between dealers. That was because they wanted to lower their risk between themselves. Congress responded and said no, it needs to cover 90-plus percent of the market. It has to cover financial enterprises as well to lower the risk of that interconnected market.

This month, with the completion of phased implementation, mandatory clearing of interest rate and credit index swaps is a reality for dealers, hedge funds, and other financial institutions. And with yesterday’s phase-in, it’s now also a reality for these P.O. Box hedge funds as well, and for the branches and guaranteed affiliates around the globe. In mid-September, 72 percent of new interest rate swaps were being cleared.

In the data repositories, there are currently $330 trillion of interest rate swaps, and $182 trillion, or 54 percent, were cleared.

The sixth key debate was regarding access.

Back to Adam Smith’s writings, how do you make a market competitive? You make information free, and you make access free. Congress got this right. It required, and the CFTC has followed, impartial access to trading venues. As these 17 SEFs have gone live, we are looking at each of their rulebooks to ensure they really provide impartial access -- that it’s not just a dealer-dominated platform, but other financial institutions and market participants can have access and compete in the marketplace.

When we come out of the shutdown, we’ll be calling up a few of these platforms and saying “I don’t think that’s consistent with the spirit of what Congress put in place.” Impartial access really means that the non-dealers as well as the dealers, the non-clearing members as well as the clearing members, have access. All of these parties can make bids and offers on a central-limit order book. All can respond as well as request quotes in an RFQ system. There’s not supposed to be two rooms in a swap execution facility, one for the insiders and one for the less dealer-oriented group.

Open access to clearing was a key piece that Congress included in reform as well. That means that the clearinghouses have to take swaps trades even if it’s not from their sister or affiliated trading platform. Of the 17 registered SEFs, only one of them is affiliated directly with a clearinghouse, and the other 16 are not. They all actually do have access to the main clearinghouses. This is significant.

We also put in place something called straight-through processing. It’s highly technical, but it was significantly debated. What it comes down to is – will there be real-time processing of a trade to a clearinghouse. Why is it critical? Because it creates great access when everybody knows that if they intend to clear a trade, they don’t have to worry about their counterparty’s credit risk. In the 1980s and 1990s and into the next decade, swaps became centered and concentrated with the bank sector because the banks are in the business of extending credit, and they have very large balance sheets. To bring access to everybody else, you need this highly technical, specialized thing called straight-through processing or real-time processing.

With regard to SEFs, we put out guidance on September 26 to ensure that straight-through processing is a reality, that it’s not just something in the CFTC rulebooks. That’s what we do, every step of the way. We’re trying to ensure that the vision of Congress, the vision of the Administration happens.

A seventh key decision related to intermediaries.

Were we going to register them or not? Registration or licensing means if you go on the roads, you have passed some test. You also are consenting in various states to the jurisdiction or the authority of the police. Registration is a critical part of reform – for dealers as well as to many others. I see Pat McCarty back there who worked for Sen. Blanche Lincoln. He ensured the word “swap” was put into each and every statutory definition for intermediaries – commodity pool operators, futures commission merchants, introducing brokers, every spot. The registration regime had to include swaps, not just futures.

An eighth key decision was on customer protection. This was not so much a decision Congress had – that was straightforward at the time. But after Dodd-Frank passed, we had to go back and ask -- what do we do to better protect customers? There were a lot of debates. We decided to reverse the loosening made in 2003-2005 on the investment of customer funds, in Rule 1.25. We required clearinghouses to move to something called gross margining -- they can no longer net two customers’ positions against each other. But there’s more that we need to do on customer protection when you look at the events in the last two years and the failings of a couple of big firms in that area.

A ninth key decision that Congress made was repealing what was called the “Enron loophole.”

You might remember that a law passed in 2000, the Commodity Futures Modernization Act, which included provisions that various trading platforms didn’t have to register with the CFTC. They didn’t have to have that driver’s license to be a trading platform. These platforms, whether they were for energy, foreign currency or interest rates, they didn’t have any oversight at all. Congress debated it, and it was a long debate. It reached its crescendo in the summer of 2008. There was a farm bill that passed that year that moved to close the “Enron loophole” that was partially successful. I’d even note that in June of 2008, then Senator Obama put out a release calling for fully closing the “Enron loophole.”

Why do I focus on this? Because it spilled over into the debate about SEFs. A footnote in the SEF rule, Footnote 88, has gotten much attention, both by the media and market participants. This Footnote 88 is just confirming what Congress did -- Congress closed the “Enron loophole.” I don’t see what the discussion is here. We put a footnote in confirming that Congress had closed this loophole. What it means is that all the platforms as of October 2 needed to register.

Now there are some questions that have come up about jurisdiction. What will trigger this registration? Which platforms will trigger it? I think that if anybody is asking the question, they may want to read the guidance we did on cross-border in July.

My own conservative advice is that if a multilateral trading platform itself is a U.S. person, they probably ought to register. If a platform itself is operating in New York or Chicago or elsewhere in the U.S., you’ve got to think that you’ve got a connection to activities or commerce in the U.S.

I would also say that if you permit U.S. persons or persons located in the U.S. – you’ve got a lot of folks located in New York or Connecticut or Chicago that are using your platform – you’d think that the platform has a direct and significant connection to the activities in the U.S., whether you’ve given direct or indirect access. My conservative advice would be that you would want to register.

I recognize that this approach would trigger some SEF registrations for foreign-based platforms that are already registered with their home country. We’ve had one such platform actually reach out to us from Australia. It’s going to register with us, and we’re working with the Australian home country regulators. We’re prepared to figure out where we might defer to those home country regulators. But the registration itself is important so that we have some oversight, some licensing if I can use that analogy.

We also along the way registered many commodity pools that had previously not registered with the CFTC because of exemptions from 2003. The repeal of these exemptions was actually the case that went to the DC Circuit.

A tenth key decision was on enforcement tools.

Prior to Dodd-Frank, our enforcement authority was more narrow. In particular, our anti-manipulation rules required us to prove that someone intentionally created an artificial price. Dodd-Frank filled gaps in our authority. As a result of Senator Cantwell’s amendment and our new rules, we have broad powers to prohibit reckless, fraud-based and other manipulative conduct. We also can use this new broad provision against any deceptive conduct in connection with futures and swaps. These authorities bring us in line with some similar authorities the SEC has had for years, as well as the Federal Energy Regulatory Commission. These authorities expand our arsenal of enforcement tools and strengthen the Commission’s ability to effectively deal with threats to market integrity. We will use these tools to be a more effective cop on the beat to promote market integrity and protect market participants.

An eleventh decision was about compliance dates, phased compliance.

We as an agency were given by Congress one year to get everything done. We didn’t quite make that. We basically did it in three years – these 61 completed rules, orders and guidances. Congress also gave us another authority. They said nothing we put in place could be effective shorter than, I think it is 60 days after we have a completed rule. We chose to use the congressional authority to give more time. Sometimes we’d give a year. Sometimes we’d only give the two months. But we also sought public input on phased compliance to lower the costs of this change but also to make it work.

Phased compliance started with the anti-manipulation rules that went into effect in 2011. The next piece was that swap data repositories had to register with us. The big compliance date was one year ago, October 12 of 2012, when the whole reform went live, the definitions were in place. Dealers then registered in December. We started with 66. We have had 20 more -- 86 dealers have registered. Clearing was phased through this whole year. Real-time reporting was phased through this whole year. Now swap execution facilities are in place. We very much believe phased compliance smoothes this through because it is a monumental change.

Lastly, decision twelve, which was not directly in Dodd-Frank. A number of years ago, we decided to focus on reforms on the benchmarks that underlie the vast majority of the swaps market.

There are interest rate benchmarks called LIBOR, Euribor and others, if I can just call them the “ibors,” that are critical reference rates for our markets. In the U.S., LIBOR is the reference rate for 70 percent of the futures market and more than half of the swaps market. Thus, it is the most significant reference rate for the swaps market, which we’ve brought under reform.

A benchmark that is an underlying reference to a market, like these interest rate benchmarks, can only have market integrity if it is based on fact, not fiction. Unfortunately, what we have found with regard to LIBOR and Euribor is the underlying market, the so-called interbank market for unsecured lending between banks, has essentially dried up and no longer exists. Why is that? Well why does a bank really want to lend to another bank with an open line of credit, like a credit card loan? They only want to lend to each other like an auto loan or a mortgage. They want collateral to back that loan up. That market has shifted dramatically over the last ten or so years.

We’ve brought four big enforcement cases with regard to this, along with the Justice Department and international regulators. We’ve worked with international standard setters called International Organization of Securities Commissions to put in place a new paradigm for how benchmarks should be based on observable transactions – they need to be anchored in observable transactions. There needs to be a there, there. These benchmarks need better governance to ensure against conflicts of interest.

The Financial Stability Oversight Council, a reform out of Dodd-Frank, has spoken to need for benchmark reform and recommended that U.S. regulators work with foreign regulators and international bodies and market participants to really address two questions:

To promptly identify interest rate benchmarks anchored in observable transactions and supported by appropriate governance; and
To develop a plan to accomplish a transition.
It’s not going to be without challenges. These are the underlying benchmarks of $300 trillion plus in derivatives. But we have the ingenuity and the human spirit that we can make change. We cannot leave the system so frail that it has an underlying benchmark that is essentially fiction, not fact.

Those are the 12 big decisions that we’ve made along the way.

The government shutdown and resources are a challenge. Looking forward, our greatest challenge at the agency is not the shutdown. We’ll get through that. It is surreal having only 30 or so people at the agency, but we’ll get through the shutdown. We are a skeletal crew right now and at best we have a cursory oversight of the markets. Though we are dark, we have brought additional lightness to the markets with these new swap execution facilities and the cross-border guidance going into effect yesterday.

Looking past the shutdown, we’re only an agency of about 680 people. Far too small to oversee the markets that we’ve been tasked with from Congress. I think that’s a significant challenge for reform going forward.

I think the other significant challenge going forward is that as market participants look to maximize their revenues and customer support, as they should, they, at times, may look to arbitrage our rules versus other rules around the globe, or just arbitrage our rules against our rules, if they can.

I think that we’re in very firm setting on clearing, on data reporting, on real-time reporting, on some of the business conduct areas, reforms that all have been implemented. Right now, with this week’s implementation of cross-border and last week’s standing up of SEFs and, there’s bound to be challenges with regard to these reforms and we’ll get through them as they arise.

Lastly, just as Congress came together on new reforms in 2010, our regulations will need to evolve. They will need to evolve to stay abreast of market participants’ practice. We are hopeful that we got things right, but I think we always need to stay open that there may be things down the road that need to change.

Thank you. I’m pleased to take questions.

Sunday, September 22, 2013

CFTC COMMISSIONER CHILTON'S ASSESSMENT OF LOOMING GOVERNMENT SHUTDOWN

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Boom, Boom, Out Go the Lights

Statement of CFTC Commissioner Bart Chilton

September 20, 2013

On September 30th, at the stroke of midnight, our country will face a government shutdown unless a continuing resolution to fund it is adopted.  That would be grave news for consumers.

Under a shutdown scenario, government regulators will be handcuffed in our ability to go after crooks who are trying to evade our oversight and protection of markets.  You can bet the “do-badders” are licking their chops.

The dark markets that Dodd-Frank brought into the light of day will go dark again.  The lights will go out.  Given the huge growth in the derivatives industry and our new oversight of swaps, CFTC’s market oversight functions are more important than ever.  Taking our cops off the beat for even a few days could have disastrous impacts on these markets that consumers depend upon.

In the longer term, I remain concerned about the stagnant budgetary circumstances and am convinced that a targeted transaction fee on trading, like the one the President has proposed to Congress, is needed to fund the agency and keep the markets safe.  But for now, let’s avoid a “Boom, Boom, Out Go the Lights” debacle, and hope a deal can be reached to keep the lights on.