CFTC Is Kicking the Extra Point
By Sol Steinberg, OTC Partners
Originally published on TABB Forum
Recent rule changes by the CFTC indicate that the Commission has largely crossed the goal line with respect to OTC reform and is now in the process of ‘fine-tuning’ regulatory requirements in the US. Cross-border harmonization, however, remains a critical challenge.
With ESMA recently taking significant steps to catch up with the financial market reforms that have been implemented by U.S regulators, it’s a good time to stop and reflect on where we are, where we’ve been, and all that’s been accomplished since the financial crisis.
Here in the U.S., the last significant regulatory moves were the changes to the rules governing Residual Interest, Recordkeeping Requirements, and Forwards With Volumetric Optionality, which were proposed by the CFTC in November 2014. Given that this is Super Bowl week, I liken these moves — all of which were approved by the Commission — to setting up for the extra point after the game-winning scoring drive. The strategies of Bill Belichick and Pete Carroll have all come down to this, and now we’re just waiting for Gostowski or Hauschka to end the game.
The odds-makers say it’s going to be Hauschka; but for the purpose of this analogy it really doesn’t matter. The point is, the game is almost over. That latest round of proposed rules changes, which are detailed below, fall into the realm of “fine-tuning.” That’s how they were characterized by CFTC Chairman Timothy Massad, and he was right.
The Commission’s actions between 2010 and 2013 were highly effective and cannot be overstated. Four years ago, the $700 trillion OTC derivatives market was largely unregulated, but now most of the truly hard work is complete. Thanks to former Commissioners Gary Gensler, Bart Chilton, and Scott O’Malia (the longest-serving commissioner in CFTC history), we’ve crossed the goal-line of regulation.
However, the credit cannot go to the regulators alone. Industry figures such as Dan Maguire, Jeff Sprecher, and Sean Tully deserve great appreciation for their efforts in helping create a realistic regulatory framework to govern the massive and unwieldy OTC derivatives space.
Now that we’ve made it into the end-zone, so to speak, rules changes like those proposed in November are akin to kicking the extra point. The only difference is that we are likely to see several more extra points as we move forward and continue dealing at the edges of regulation.
That’s not to say these recent adjustments are insignificant. In fact, they are quite important.
New Rules Changes
Residual Interest Deadline
The first change affects Rule 1.22, which was created to help ensure that the funds deposited by customers with Futures Commission Merchants (FCMs) remain safe by prohibiting FCMs from using the funds of one customer for the benefit of another customer. Pursuant to the rule, FCMs are obliged to maintain their own capital when customers are required to post additional margin but have not yet done so. The FCM must now deposit those additional funds by close of business (6:00 pm Eastern Time) the next day following a trade.
The rule also stipulated that, on Dec. 31, 2018, the deadline would automatically move to start of business (9:00 am Eastern Time) the day after a trade if the Commission failed to take any action beforehand. That automatic termination of the phase-in compliance period has now been removed, and the Commission may only revise the Residual Interest Deadline through a separate rulemaking.
I strongly support this change. Moving the deadline to the start of business — thus requiring customers, mainly farmers, to pre-fund margin accounts — has the potential to create larger losses in the event of another failure along the lines of MF Global or Peregrine Financial.
This situation, however, illustrates how important it is to ensure that policy properly balances the Commission’s intentions. I speak specifically about the goal of strengthening FCM risk-management requirements while guaranteeing adequate accessibility to the derivatives marketplace and continued market liquidity. Under certain circumstances, these goals can be at odds with each other. Each one must, therefore, be approached with a conscious understanding of how it affects the other.
This rule change was unanimously approved by the four members of the Commission, each of whom commented to varying degrees:
Massad:
“An earlier residual interest deadline better protects customers from one another, in line with the statute, but we want to make sure we move deliberately so that the model works best for customers in light of all of their interests, since the deadline will affect how much margin customers have to post and when.”
Wetjen:
“This has the effect of increasing certainty to FCMs that any further change to the deadline would occur only following the robust procedures associated with a rulemaking, in addition to the already required study and roundtable, which is an outcome I support.
“The resulting certainty provided to the FCM community outweighs the potential value of incentivizing FCMs to improve their margin-collection practices to comply with a future, time-of–settlement deadline.”
Giancarlo:
“Without [this change], the so-called and, perhaps, misnamed ‘customer protection’ rule finalized in October 2013 would likely result in significant harm to the core constituents of this Commission: the American agriculture producers who use futures to manage the everyday risk associated with farming and ranching.
“As it stands, the rule will cause farmers and ranchers to prefund their futures margin accounts due to onerous requirements forcing FCMs to hold large amounts of cash in order to pay clearinghouses at the start of trading on the next business day. Without revision, the increased costs of pre-funding accounts will likely drive many small and medium-sized agricultural producers out of the marketplace. It would likely force a further reduction in the already strained FCM community that serves the agricultural community.”
Recordkeeping Requirements
The second rule change approved by the Commission clarifies the definition of how transaction records must be “identifiable.” Under the latest proposal, members of DCMs and SEFs that are not registered with the Commission do not have to keep text messages or store their other records in a manner that is identifiable and searchable by transaction. Additionally, CTAs do not have to record oral communications regarding their swap transactions.
This is another small but extremely important move by the Commission. I applaud the CFTC for recognizing that the costs of complying with certain aspects of the rule as it is currently written might exceed the potential benefits for certain market participants. The important thing to consider here is that the costs of maintaining those records would ultimately be passed along, via transaction fees, to those whom the rule seeks to protect: the customers.
However, the changes provide an incomplete sense of accomplishment. Yes, they achieve an important element of clarity; but they do not address concerns that the rule may be needlessly onerous and may hurt small FCMs, which are already burdened by low interest rates and increasing regulatory requirements. We see this painfully illustrated in the fact that there are currently about half as many FCMs serving our nation’s farmers as there were a few years ago.
The amendments to Regulation 1.35 were approved three to one, with Giancarlo opposed.
Giancarlo:
“The revisions to Rule 1.35 that the Commission is proposing today go a long way towards addressing the Rule’s difficulties. Unfortunately, they do not go far enough. The proposed Rule text raises unanswered questions. It continues to contain provisions that may be difficult or overly burdensome in practice for certain covered entities. In my opinion, many of the problems stem from imprecise construction and definition in the legal drafting.
“Without healthy FCMs serving their customers, the everyday costs of groceries and winter heating fuel will rise for American families… In implementing the Dodd Frank Act, I am conscious that the stated purpose, and indeed its official title purports to reform ‘Wall Street.’ Instead, we are harming ‘Main Street’ by forcing burdensome new compliance costs onto our country grain elevators, farmers, and small FCMs.
“Rather than facilitating the collection of useful records to use in investigations and enforcement actions, the underlying rule and the lack of sufficient relief provided in today’s proposal will instead result in senseless cost increases. Increased costs may even curtail the use of sound risk management tools needed to help farmers hedge the risks — and there are many — of growing the crops that feed and fuel our nation.”
Forwards With Embedded Optionality
The third and final rule change approved by the CFTC clarifies its interpretation of the seven-part test that is used to determine if an agreement, contract or transaction with embedded volumetric optionality would be considered a forward contract. The clarifications are designed to address concerns raised by utilities and other commercials as to whether these contracts should be treated as physical forwards or as swaps. This is a key distinction, as physical forwards are not subject to CFTC jurisdiction, while swaps are.
The clarifications spelled out in this rule change were essential. Over the past year, it appears that a number of participants have withdrawn from the market because of the ambiguities in the rule as it is currently written. This resulted in inferior execution for commercial firms and seems to have had a negative impact on electricity and gas consumers.
The proposed rule changes were approved unanimously by the four Commissioners:
Bowen:
“I appreciate that a number of market participants and end-users want clarity regarding which volumetric options qualify as forwards and, therefore, are excluded from our jurisdiction. I am sympathetic to these concerns and agree we should try to make our guidance on this point clearer.
“Yet, I worry that the current proposal as written goes too far and will cause too many options to be incorrectly regarded as forwards. I think the trade option exemption provides a much clearer and cleaner approach to address the issues raised regarding volumetric optionality. I hope the Commission can consider revising our trade option regulations soon.”
Wetjen:
“The bottom line is that such uncertainty in the seven-part test increased transaction costs for commercial firms and limited their access to an effective risk-management tool.
“Today’s proposal should go a long way towards providing commercial firms adequate guidance.”
Giancarlo:
“Without [this change], the so-called and, perhaps, misnamed ‘customer protection’ rule finalized in October 2013 would likely result in significant harm to the core constituents of this Commission: the American agriculture producers who use futures to manage the everyday risk associated with farming and ranching.
“As it stands, the rule will cause farmers and ranchers to prefund their futures margin accounts due to onerous requirements forcing FCMs to hold large amounts of cash in order to pay clearinghouses at the start of trading on the next business day. Without revision, the increased costs of pre-funding accounts will likely drive many small and medium-sized agricultural producers out of the marketplace. It would likely force a further reduction in the already strained FCM community that serves the agricultural community.”
The Road Ahead
Now that most of the difficult regulatory work is finished (see Appendix A for a full list of CFTC rulemakings), the Commission will have a much simpler job in 2015. I don’t foresee any major changes in the near future; just more “fine-tuning” to keep everything running smoothly.
I see proof of this in the fact that only one of the Commissioners who had a hand in the major regulatory initiatives of 2010 through 2013 — J. Christopher Giancarlo — remains in place. All the other key figures have moved on.
We can expect to see more amendments to rules that have automatic deadlines for implementation of higher standards, such as the Residual Interest Rule discussed above. In particular, I anticipate that the threshold for determining when a firm must register as a swap dealer, which will automatically drop from $8 billion to $3 billion in 2017, will be one of the areas that are fine-tuned in the coming months. We should also expect to see more amendments to the rules governing package transactions and position limits.
The biggest task I foresee for the CFTC over the next few years is to increase cooperation with other regulatory bodies around the world. Chairman Massad echoed this sentiment earlier this month when he said, “We have agreed to consider changes that would further harmonize our rules with European rules governing these clearinghouses. This would in turn facilitate their recognition of our U.S. clearinghouses.”
At the moment, the CFTC is continuing to consider how to apply its rules to swaps trades between non-U.S. entities that are arranged, negotiated, or executed in the U.S. While I’m glad to see the Commission taking steps toward global cooperation, I question whether we have the right people in place to accomplish this in the most efficient manner. None of the current Commissioners have substantial experience dealing with international regulatory agencies.
As a result, I would advise the Commission to rely on industry ambassadors, such as the ones acknowledge above, to help push the new global market initiative. With more and more new requirements going into effect, this will be the key regulatory issue in the months and years ahead, so its importance cannot be overstated.
We’re already seeing increased emphasis in this area, as exemplified by Federal Reserve Governor Jerome Powell’s recent call for more coordinated global regulation of derivatives clearinghouses. Specifically, Powell said, “We need transparent, actionable and effective plans for dealing with financial shocks that do not leave either an explicit or implicit role for the government.”
I fully agree. Over the past few years, central clearing of standardized derivatives has brought more transparency to the market. However, it has also increased the damage that could be caused by the failure of a large clearinghouse. In order to ensure that clearinghouses do not become the new “too-big-to-fail” entities, they must increase their liquidity, transparency and ability to withstand shocks without government bailouts.
Consequently, global regulators should consider establishing coordinated, standardized stress tests for clearers, and the results of those tests should be made public.
Appendix A