CFTC Floats Swaps Reform
The Commodity Futures Trading Commission (CFTC) Chairman J. Christopher Giancarlo has released a white paper, Swaps Regulation Version 2.0: An Assessment of the Current Implementation of Reform and Proposals for Next Steps, co-authored with CFTC Chief Economist Bruce Tuckman.
Giancarlo unveiled the white paper at the International Swaps and Derivatives Association (ISDA) annual meeting, in an interview with ISDA CEO Scott O’Malia.
“This white paper is economy-focused,” said Giancarlo. “And our role at the CFTC is to bring a market-focused approach. Our focus is what’s in the best interest of the markets. Our mission is market integrity and market health.”
In response to questions about the timeline of implementation of the ideas in the paper, Giancarlo said, “I’m committed to a process in rule writing which is ‘ready, aim, fire.’ I think sometimes, regulators can use the ‘ready, fire, aim’ approach. I’m committed to a deliberative process and getting back to regular order at the agency. We’re not in the wake of a crisis right now – we need to take the time to get this right. We have an ambitious timetable, and we will get this done, but we will do this right. We will move forward in regular order and in good order – we will get this done.”
The white paper utilizes a range of academic research, market activity and the agency’s regulatory experience with implementing current swaps reform, to assess the agency’s implementation of swaps reform, determine its strengths and deficiencies and recommend improvements to the current swaps market reform framework.
In this paper, Giancarlo and Tuckman seek to optimize the CFTC’s implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) so as to strike a balance between systemic safety and stability and market vibrancy and economic growth. Giancarlo and Tuckman explain that financial regulators have a duty to apply the policy prescriptions in ways that enhance markets and their underlying vibrancy, diversity and resiliency. That duty also includes the responsibility to review past policy applications continuously to confirm they remain improved for the purposes intended. It further includes anticipating changing market dynamics and the impact of technological innovation.
The paper takes a comprehensive look at five key areas:
Swaps Central Counterparties (CCPs)
- Swaps clearing is probably the most far-reaching and consequential of the swaps reforms adopted under Title VII of Dodd-Frank.
- CFTC implementation of Dodd-Frank’s clearing mandate has been highly successful, significantly increasing the volume of swaps cleared by CCPs.
- CCPs and the CFTC have made substantial progress to ensure that CCPs are safe and sound under extreme but plausible scenarios and have credible recovery plans to remain viable without government assistance.
- Continued vigilance and improvement are essential with respect to ensuring the liquidity of pre-funded resources; understanding network effects; estimating the liquidation costs of defaulted positions; and enhancing the transparency and predictability of recovery plans.
- The FDIC and CFTC have much to do in formulating resolution plans, which would guide government intervention in the most dire of eventualities.
Swaps Reporting Rules
- Swaps data reporting was an important mandate to assist regulators in measuring the counterparty credit risk of swaps by large financial institutions.
- Yet, ten years after the crisis, the reporting structure is still incomplete.
The initial implementation was flawed and ineffective, providing insufficient technical specificity.
Since then, CFTC has laid out a more detailed and clear path forward under its July 2017 “Roadmap to Achieve High Quality Swaps Data.”
- Meanwhile, the CFTC continues global leadership in swaps reporting by co-chairing CPMI-IOSCO Harmonization Group that issued final guidance regarding unique transaction identifiers (UTIs) and unique product identifiers (UPIs)
- Real-time reporting requirements should be tailored to the liquidity profiles of the associated swaps products in order to yield value of transparency to market (e.g. price discovery, confidence) without introducing trading risk.
- The CFTC should look to collaborate with other authorities to cultivate the development of “regulator nodes” on distributed ledgers.
Swaps Execution Rules
- Congress enacted the G-20 swaps execution reforms by requiring that swaps transactions be traded on regulated platforms called swap execution facilities (SEFs) and executed by “any means of interstate commerce.”
- The CFTC incorrectly implemented the execution mandate by arbitrarily confining swaps execution to two methodologies and adopting trading rules from highly liquid futures markets, the wrong model for swaps that trade in more episodically liquid markets.
- The adverse consequences of restrictive execution methods has been global fragmentation of swaps markets and pushing swaps liquidity formation and price discovery away from the SEF platforms, contrary to Congressional intent.
- The CFTC could encourage a greater amount of swaps trades to take place on regulated SEFs by making the “Made Available to Trade” requirement synonymous with the clearing requirement.
- Instead of trying to determine SEFs’ swaps execution business model, the CFTC should focus on raising standards of conduct for swaps trading.
Swap Dealer Capital
- Several components of today’s bank capital regime overestimate the risks of swaps.
- The conceptual problems are relying on swap notional amount to measure risk; failing to sufficiently recognize offsetting swap positions; and failing to sufficiently acknowledge the risk mitigation of posted margin.
- These problems can be addressed by iterating and likely complicating, prescriptive models. Alternatively, regulators might focus on how to rely more heavily but confidently on the internal risk models used by banks and their swap affiliates.
End User Exception
- Dodd-Frank intended a robust end-user exception from clearing and margin requirements and did not intend margin rules to favor cleared products.
- To reduce the burdens on end users that are not sources of systemic risk, and, in some cases, to reduce their liquidity risk, material swaps exposure thresholds should be established, below which entities would be excepted from clearing and margin requirements.
- Rules governing uncleared initial margin should be reworked to be less prescriptive and to be unbiased with respect to cleared and uncleared products.
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