[House Hearing, 112 Congress]
[From the U.S. Government Publishing Office]
HEARING TO REVIEW IMPLEMENTATION OF TITLE VII OF THE DODD-FRANK WALL
STREET REFORM AND CONSUMER PROTECTION ACT
=======================================================================
HEARINGS
BEFORE THE
COMMITTEE ON AGRICULTURE
AND THE
SUBCOMMITTEE ON
GENERAL FARM COMMODITIES
AND RISK MANAGEMENT
HOUSE OF REPRESENTATIVES
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
__________
FEBRUARY 10, 15, 2011
__________
Serial No. 112-1
Printed for the use of the Committee on Agriculture
agriculture.house.gov
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COMMITTEE ON AGRICULTURE
FRANK D. LUCAS, Oklahoma, Chairman
BOB GOODLATTE, Virginia, COLLIN C. PETERSON, Minnesota,
Vice Chairman Ranking Minority Member
TIMOTHY V. JOHNSON, Illinois TIM HOLDEN, Pennsylvania
STEVE KING, Iowa MIKE McINTYRE, North Carolina
RANDY NEUGEBAUER, Texas LEONARD L. BOSWELL, Iowa
K. MICHAEL CONAWAY, Texas JOE BACA, California
JEFF FORTENBERRY, Nebraska DENNIS A. CARDOZA, California
JEAN SCHMIDT, Ohio DAVID SCOTT, Georgia
GLENN THOMPSON, Pennsylvania HENRY CUELLAR, Texas
THOMAS J. ROONEY, Florida JIM COSTA, California
MARLIN A. STUTZMAN, Indiana TIMOTHY J. WALZ, Minnesota
BOB GIBBS, Ohio KURT SCHRADER, Oregon
AUSTIN SCOTT, Georgia LARRY KISSELL, North Carolina
STEPHEN LEE FINCHER, Tennessee WILLIAM L. OWENS, New York
SCOTT R. TIPTON, Colorado CHELLIE PINGREE, Maine
STEVE SOUTHERLAND II, Florida JOE COURTNEY, Connecticut
ERIC A. ``RICK'' CRAWFORD, Arkansas PETER WELCH, Vermont
MARTHA ROBY, Alabama MARCIA L. FUDGE, Ohio
TIM HUELSKAMP, Kansas GREGORIO KILILI CAMACHO SABLAN,
SCOTT DesJARLAIS, Tennessee Northern Mariana Islands
RENEE L. ELLMERS, North Carolina TERRI A. SEWELL, Alabama
CHRISTOPHER P. GIBSON, New York JAMES P. McGOVERN, Massachusetts
RANDY HULTGREN, Illinois
VICKY HARTZLER, Missouri
ROBERT T. SCHILLING, Illinois
REID J. RIBBLE, Wisconsin
______
Professional Staff
Nicole Scott, Staff Director
Kevin J. Kramp, Chief Counsel
Tamara Hinton, Communications Director
Robert L. Larew, Minority Staff Director
______
Subcommittee on General Farm Commodities and Risk Management
K. MICHAEL CONAWAY, Texas, Chairman
STEVE KING, Iowa LEONARD L. BOSWELL, Iowa, Ranking
RANDY NEUGEBAUER, Texas Minority Member
JEAN SCHMIDT, Ohio MIKE McINTYRE, North Carolina
BOB GIBBS, Ohio TIMOTHY J. WALZ, Minnesota
AUSTIN SCOTT, Georgia LARRY KISSELL, North Carolina
ERIC A. ``RICK'' CRAWFORD, Arkansas JAMES P. McGOVERN, Massachusetts
MARTHA ROBY, Alabama DENNIS A. CARDOZA, California
TIM HUELSKAMP, Kansas DAVID SCOTT, Georgia
RENEE L. ELLMERS, North Carolina JOE COURTNEY, Connecticut
CHRISTOPHER P. GIBSON, New York PETER WELCH, Vermont
RANDY HULTGREN, Illinois TERRI A. SEWELL, Alabama
VICKY HARTZLER, Missouri
ROBERT T. SCHILLING, Illinois
Matt Schertz, Subcommittee Staff Director
(ii)
C O N T E N T S
----------
Page
Full Committee, Thursday, February 10, 2011
Lucas, Hon. Frank D., a Representative in Congress from Oklahoma,
opening statement.............................................. 1
Prepared statement........................................... 2
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 3
Prepared statement........................................... 4
Tipton, Hon. Scott R., a Representative in Congress from
Colorado, prepared statement...................................
Prepared statement........................................... 5
Witnesses
Gensler, Hon. Gary, Chairman, Commodity Futures Trading
Commission, Washington, D.C.................................... 6
Prepared statement........................................... 7
Submitted questions.......................................... 95
Gallagher, Edward W., President, Dairy Risk Management Services,
Dairy Farmers of America; Vice President, Risk Management,
Dairylea Cooperative, Washington, D.C.; on behalf of National
Council of Farmer Cooperatives................................. 37
Prepared statement........................................... 39
Duffy, Terrance A., Executive Chairman, CME Group, Inc., Chicago,
IL............................................................. 42
Prepared statement........................................... 44
Pickel, Robert G., Executive Vice Chairman, International Swaps
and Derivatives Association, Inc., New York, NY................ 54
Prepared statement........................................... 55
Morrison, Scott C., Senior Vice President and CFO, Ball
Corporation; Chairman, National Association of Corporate
Treasurers, Broomfield, CO; on behalf of Coalition for
Derivatives End-Users.......................................... 71
Prepared statement........................................... 73
Olesky, Lee, Chief Executive Officer, Tradeweb, New York, NY..... 75
Prepared statement........................................... 76
Subcommittee on General Farm Commodities and Risk Management, Tuesday,
February 15, 2011
Boswell, Hon. Leonard L., a Representative in Congress from Iowa,
opening statement.............................................. 99
Prepared statement........................................... 100
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, opening statement....................................... 97
Submitted letters on behalf of:
Donald, Bill, President, National Cattlemen's Beef
Association............................................ 196
National Corn Growers Association and Natural Gas Supply
Association............................................ 196
Submitted statement on behalf of:
English, Hon. Glenn, CEO, National Rural Electric
Cooperatives Association............................... 193
Boswell, Hon. Leonard L., a Representative in Congress from Iowa,
opening statement.............................................. 97
Witnesses
Bernardo, Shawn, Senior Managing Director, Americas Head of
Electronic Broking, Tullett Prebon; Vice Chairman Wholesale
Markets Brokers Association, Americas, Jersey City, NJ......... 101
Prepared statement........................................... 102
Bullard, Jr., William T., Chief Executive Officer, R-CALF USA,
Billings, MT................................................... 132
Prepared statement........................................... 134
Kaswell, Stuart J., Executive Vice President, Managing Director,
and General Counsel, Managed Funds Association, Washington,
D.C............................................................ 147
Prepared statement........................................... 148
Damgard, John M., President, Futures Industry Association,
Washington, D.C................................................ 153
Prepared statement........................................... 156
Submitted questions.......................................... 199
McMahon, Jr., Richard F., Vice President of Energy Supply and
Finance, Edison Electric Institute, Washington, D.C.; on behalf
of American Public Power Association; Electric Power Supply
Association.................................................... 161
Prepared statement........................................... 163
Sanevich, Bella L.F., General Counsel, NISA Investment Advisors,
L.L.C., St. Louis, MO; on behalf of American Benefits Council;
Committee on Investment of Employee Benefit Assets............. 169
Prepared statement........................................... 170
HEARING TO REVIEW IMPLEMENTATION OF TITLE VII OF THE DODD-FRANK WALL
STREET REFORM AND CONSUMER PROTECTION ACT
----------
THURSDAY, FEBRUARY 10, 2011
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 10:10 a.m., in Room
1300 of the Longworth House Office Building, Hon. Frank D.
Lucas [Chairman of the Committee] presiding.
Members present: Representatives Lucas, Johnson, Conaway,
Fortenberry, Stutzman, Austin Scott of Georgia, Fincher,
Crawford, Huelskamp, Gibson, Hultgren, Hartzler, Schilling,
Peterson, Holden, Boswell, David Scott of Georgia, Costa,
Kissell, Welch, and McGovern.
Staff present: John Goldberg, John Konya, Kevin J. Kramp,
Joshua Mathis, Ryan McKee, Debbie Smith, Pelham Straughn, Liz
Friedlander, Clark Ogilvie, and Jamie W. Mitchell.
OPENING STATEMENT OF HON. FRANK D. LUCAS, A REPRESENTATIVE IN
CONGRESS FROM OKLAHOMA
The Chairman. This hearing of the Committee on Agriculture
to review the implementation of Title VII of the Dodd-Frank
Wall Street Reform and Consumer Protection Act will come to
order. With that, today this Committee begins what will be a
long series of hearings to review the implementation of the
derivatives provisions included in the Dodd-Frank Wall Street
Reform Act.
This Committee first considered legislation to reform the
derivatives legislation. The Ranking Member and I worked hard
to reach bipartisan consensus around the legislation we
believed would bring needed reforms to the derivatives markets,
also maintaining robust and liquid markets to allow farmers,
ranchers, and commercial end-users to manage risk and discover
market-driven prices. While it was not ultimately the
legislation that became law, I believe the same principles
should be applied as we exercise our oversight responsibilities
on implementation of Dodd-Frank.
The complexity of Title VII shouldn't be underestimated,
but neither should the far-reaching impact it will have on our
economy. Title VII isn't just about financial firms; it has the
potential to impact every segment of our economy, from farmers
and ranchers to manufacturers, energy companies, to healthcare
and technology. That is why we must ensure that we get it
right. As we work to revive the economy and create new jobs, we
simply cannot afford sweeping new regulations that are poorly
vetted that impose substantial costs that outweigh the benefits
for our financial system and our economy, or that are crafted
in the interest of speed rather than sound policy.
In addition, I am concerned that the regulators may be
considering rules at odds with the statute, or with
Congressional intent. Although it may not have been perfect,
Congress included an exemption in Dodd-Frank for end-users from
the margin, clearing and exchange trading requirements. Yet,
there are growing concerns among end-users that they may be
subject to margin requirements for their over-the-counter
trades, an outcome that is clearly inconsistent with
Congressional intent. A margin requirement imposed upon end-
users would subject them to significant cash burdens, cash that
might otherwise be used to put to work in the economy. And at
the same time, such a requirement would create a significant
disincentive to responsible risk-managing practices that
provide price stability and certainty, and allow companies to
remain focused on their core businesses.
Today and through the coming months, we will focus our
oversight on the following important areas: to ensure that in
meeting regulatory objectives, there are not undue or misguided
regulations that will impede well-functioning markets, economic
growth and the global competitiveness of U.S. firms; to ensure
the process by which the CFTC and other Federal financial
regulators implement the rules is fair, transparent, rationally
sequenced to support public comment, and in line with
meaningful and deliberate cost-benefit analysis; to ensure new
rules are consistent with the statutory language and
Congressional intent of Dodd-Frank, particularly with regard to
the end-users exemptions; and as a part of this review, we will
examine the feasibility of the statutory time tables and any
other provisions of Dodd-Frank that may be impediments to
meeting these objectives.
[The prepared statement of Mr. Lucas follows:]
Prepared Statement of Hon. Frank D. Lucas, a Representative in Congress
from Oklahoma
Today, this Committee begins what will be a long series of hearings
to review the implementation of the derivatives provisions included in
the Dodd-Frank Wall Street Reform Act.
When this Committee first considered legislation to reform
derivatives regulation, the Ranking Member and I worked hard to reach
bipartisan consensus around legislation we believed would bring needed
reforms to the derivatives markets, while also maintaining robust and
liquid markets to allow farmers, ranchers and commercial end-users to
manage risk and discover market driven prices. While it was not
ultimately the legislation that became law, I believe the same
principles should be applied as we exercise our oversight
responsibilities over implementation of Dodd-Frank.
The complexity of Title VII shouldn't be underestimated, but
neither should the far-reaching impact it will have on our economy.
Title VII isn't just about financial firms--it has the potential to
impact every segment of our economy, from farmers and ranchers, to
manufacturers and energy companies, to health care and technology.
And that is why we must ensure we get it right. As we work to
revive the economy and create new jobs, we simply can't afford sweeping
new regulations that are poorly vetted, that impose substantial costs
that outweigh the benefits for our financial system and our economy, or
that are crafted in the interest of speed--rather than in sound policy.
In addition, I am concerned that the regulators may be considering
rules at odds with the statute or with Congressional intent. Although
it may not have been perfect, Congress included an exemption in Dodd-
Frank for end-users from the margin, clearing and exchange trading
requirements. Yet, there are growing concerns among end-users that they
may be subject to margin requirements for their over-the-counter
trades--an outcome that is clearly inconsistent with Congressional
intent. A margin requirement imposed upon end-users would subject them
to significant cash burdens, cash that would otherwise be put to work
in the economy. At the same time, such a requirement will create a
significant disincentive to responsible risk management practices that
provide price certainty and stability, and allow companies to remain
focused on their core businesses.
Today, and through the coming months, we will focus our oversight
in the following important areas:
To ensure that in meeting regulatory objectives, there are
not undue or misguided regulations that will impede well-
functioning markets, economic growth and the global
competitiveness of U.S. firms;
To ensure the process by which the CFTC and other Federal
financial regulators implement the rules is fair, transparent,
rationally sequenced to support public comment, and in line
with meaningful and deliberate cost-benefit analysis; and
To ensure new rules are consistent with the statutory
language and Congressional intent of Dodd-Frank, particularly
with regard to the end-user exemption.
And, as part of this review, we will examine the feasibility of the
statutory timetables, and any other provisions of Dodd-Frank, that may
be impediments to meeting these objectives.
I look forward to hearing from our witnesses today.
The Chairman. I very much look forward to our witness's
testimony today, and with that, I turn to the Ranking Member
for his opening statement.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
Mr. Peterson. Good morning, and thank you, Mr. Chairman,
for holding today's hearing. I welcome Chairman Gensler back to
the Committee, we appreciate you being with us.
Today we are discussing the implementation of Title VII of
the Dodd-Frank Wall Street Reform and Consumer Protection Act.
It is important that Dodd-Frank is the topic of the Committee's
first oversight hearing of the new Congress, and I anticipate
that there will be several more. It is also important that we
get this right, and that the CFTC remain on track to implement
the law in a responsible manner and as Congress intended.
Derivatives played a key role in the collapse of our
financial markets. We had over $600 trillion over-the-counter
derivatives market with no oversight, no transparency, no
regulation. As a consequence of this and many other factors,
the American taxpayer ended up having to bail out large
financial institutions, like AIG, when the financial system
fell apart.
Even before the financial crisis, nearly 3 years ago this
Committee was looking into these markets, and we tried to
address some of these issues in early 2009. Many of the
provisions this Committee adopted with bipartisan support were
ultimately included in the Dodd-Frank Act. Mandatory clearing
of the over-the-counter swaps and requiring major swap
participants and swap dealers to back up their deals with
additional capital should help ensure that taxpayer dollars
will not be needed to rescue these large financial firms again,
and hopefully bring greater stability to the swaps marketplace.
The Committee focused closely on ensuring that under these
new rules, end-users could continue using derivatives to hedge
risks associated with their underlying business, whether it is
energy exploration, manufacturing, commercial activities,
agriculture. End-users did not cause this financial crisis, and
frankly, they were the victim of it.
We worked to see that mandatory clearing, mandatory
training, new capital margin requirements, and other
obligations fell upon the financial players responsible for
this crisis, and not upon the commercial end-users. Proper
oversight by this Committee will ensure that our efforts are
implemented by the regulators.
The provisions of Dodd-Frank will also increase
transparency to better arm end-users with negotiating with the
big banks. Commercial end-users generally get the worst end of
any swap deal because they simply do not have the same level of
information on swap prices and terms as do their dealer
counterparties. By requiring the big dealers to report and
clear more of their swaps and move into more transparent
marketplaces, commercial end-users will be able to get a better
picture of the swaps market and be better armed in the
negotiations with these dealers.
Unfortunately, there is still a lot of confusion and
misinformation out there with regard to commercial end-users. I
don't know exactly who is ginning this all up, but you know, at
the end of the day, my opinion is if we bring transparency to
this market, these end-users are going to get a better deal
than they are getting now. This is actually going to cost them
less money in the long run than they are paying now.
So we are looking forward to working with you, Mr.
Chairman, and being involved in this process and working with
the CFTC and Chairman Gensler to make sure that we get this
right and we don't have another financial boondoggle like we
had here a couple years ago.
Thank you.
[The prepared statement of Mr. Peterson follows:]
Prepared Statement of Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Good morning. Thank you Chairman Lucas for holding today's hearing
and welcome, Chairman Gensler, to the Committee. Today we are
discussing the implementation of Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act.
It is appropriate that Dodd-Frank is the topic of the Committee's
first oversight hearing of the new Congress, and I would anticipate
there will be several more. It is important that we get this right and
that the CFTC remain on track to implement the law in a responsible
manner and as Congress intended.
Derivatives played a key role in the collapse of our financial
markets. We had an over $600 trillion OTC derivatives market with no
oversight, no transparency, and with no regulation. As a consequence of
this and many other factors, the American taxpayer ended up having to
bail out large financial institutions like AIG when the financial
system fell apart.
Even before the financial crisis, nearly 3 years ago, this
Committee was looking into these markets and we tried to address some
of these issues in early 2009. Many of the provisions this Committee
adopted with bipartisan support were ultimately included in the Dodd-
Frank Act.
Mandatory clearing of over-the-counter swaps and requiring major
swap participants and swap dealers to back up their swap deals with
additional capital should help ensure that taxpayer dollars will not be
needed to rescue these large financial firms again and bring greater
stability to the swaps marketplace.
The Committee focused closely on ensuring that under these new
rules end-users could continue using derivatives to hedge the risks
associated with their underlying business, whether it is energy
exploration, manufacturing or other commercial activities. End-users
did not cause the financial crisis; they were the victims of it.
We worked to see that mandatory clearing, mandatory trading, new
capital and margin requirements, and other obligations fell upon the
financial players responsible for the crisis and not upon commercial
end-users. Proper oversight by this Committee will ensure that our
efforts are implemented by the regulators.
The provisions of Dodd-Frank will also increase transparency to
better arm end-users when negotiating with the big banks. Commercial
end-users generally get the worse end of any swap deal because they
simply do not have the same level of information on swap prices and
terms as do their dealer counterparties. By requiring the big dealers
to report and clear more of their swaps and move into more transparent
marketplaces, commercial end-users will be able to get a better picture
of the swaps market and be better armed in their negotiations with
these dealers.
Unfortunately, there is still a lot of confusion and misinformation
out there with regard to commercial end-users. I hope this hearing
gives us an opportunity to clear some of that up. Because if
implemented properly, the derivative title of Dodd-Frank could prove to
be a major benefit to commercial end-users.
Again, I thank the Chairman for holding today's hearing and look
forward to hearing from our witnesses.
The Chairman. That is absolutely correct, Ranking Member,
and as our witness is preparing to offer his opening comments,
do you have any inquiries you would like to make of the under
classmen?
Mr. Peterson. No, I will----
The Chairman. Save that for later? Fair enough.
The chair would request that other Members submit their
opening statements for the record so the witnesses might begin
their testimony to ensure there is ample time.
[The prepared statement of Mr. Tipton follows:]
Prepared Statement of Hon. Scott R. Tipton, a Representative in
Congress from Colorado
Thank you, Chairman Lucas, for convening today's hearing, and thank
you to all of you here today. It is an honor to serve on this
committee, and I welcome today's discussion of derivatives. I also want
to give a special welcome to Mr. Scott Morrison, Senior Vice President
and Chief Financial Officer of Ball Corporation, which is headquartered
in Broomfield, Colorado. Mr. Morrison is on our panel today to share
his concerns about the rulemaking.
As a small business owner, I understand the risks inherent in doing
business, and I recognize the role derivatives play in helping farmers,
manufacturers and other end-users manage risks. Agriculture is an
important part of Colorado's economy, and we have many farmers who use
derivatives to hedge against price swings in the crops they produce and
in the fertilizer, fuel, and other supplies they rely on. We also have
manufacturing companies like Ball Corporation who use derivatives as a
prudent risk-management tool.
It is important to reduce systemic risk and improve market
transparency. There are important provisions within Dodd-Frank for
which the CFTC is currently drafting rules. As the rulemaking process
progresses however, we must be watchful that the regulations being
implemented do not unduly hamper private investment. End users like
farmers and manufacturers did not cause the financial crisis, and that
is why they were given an exemption within Title VII. Forcing them to
comply with onerous rules will not help us achieve market transparency
and risk reduction.
I have particular concerns about the margin requirement, and how
this one regulation, if applied to end users, could tie up capital,
hinder job creation, and further stall economic recovery while not
doing anything to prevent another financial crisis. As a Member of the
Small Business Committee, one of my priorities is regulatory reform; I
oppose excessive government regulation that unduly impedes private
sector job creation.
We have not yet seen rules from the CFTC concerning this capital
and margin issue, but we must be watchful that the CFTC promulgates
rules in line with the intent of the Dodd-Frank legislation. I have
here a letter from Chairman Dodd and Chairman Lincoln and a colloquy
from Chairman Frank and Chairman Peterson, and they could not have been
clearer in expressing their intent that capital and margin requirements
should not apply to end users of derivatives. I hope that CFTC
regulators are mindful of this, and they do not attempt to go beyond
the scope of their authority and place capital requirements on end
users that force them out of the derivatives market.
Thank you again, Mr. Chairman, for holding today's hearing. Today's
discussion is important, and it is something we must continue as the
rulemaking process moves forward. We will likely request further
information from Mr. Gensler and the CFTC, and we will continue to
exercise oversight over the rulemaking.
We would like to welcome our first panel to the table, the
Honorable Gary Gensler, Chairman of the Commodity Futures
Trading Commission, Washington, D.C. Mr. Gensler, Chairman,
please begin when you are ready.
STATEMENT OF HON. GARY GENSLER, CHAIRMAN,
COMMODITY FUTURES TRADING COMMISSION,
WASHINGTON, D.C.
Mr. Gensler. Chairman Lucas, Ranking Member Peterson,
Members of this Committee, I thank you for inviting me here
today to this hearing, as I understand it, your first oversight
hearing, so it is quite an honor to be here in front of this
new chair and this new Congress.
I am pleased to testify on behalf of the Commodity Futures
Trading Commission. I also want to thank each of my fellow
Commissioners for their hard work, their thoroughness, and
commitment on implementing the legislation that was passed last
year.
Markets work best when they are transparent, open, and
competitive. The American public has benefited from these
attributes in the futures market that you help oversee through
overseeing us, and the securities markets, those markets that
were regulated after the great regulatory reforms after an
earlier crisis in the 1930s. Congress directed the CFTC and the
SEC after this generation's crisis to try to bring similar
features to what is called the swaps market, or over-the-
counter derivatives market. The reforms that Congress enacted
last summer will bring transparency and better pricing for
corporations throughout America that use derivatives to hedge
their risk. This is a significant change in the marketplace.
Currently when a corporation or other end-users want to hedge a
risk through the use of a swap, they don't benefit from a
centralized marketplace as they might in a futures marketplace,
and have that pricing in a transparent exchange or trading
platform. So bringing transparency to these markets will
improve information for end-users and other entities, provide
greater competition in the marketplace, and yes, greater
liquidity. Such transparency is also critical to lowering risk
for the clearinghouses and risk in the large financial
institutions that unfortunately 2 years ago the taxpayers stood
behind.
The CFTC is engaged in an open consultative process to
complete implementation of Dodd-Frank. We are grateful for the
public's input on the CFTC's rulemakings. In the summer, we
identified 30 topic areas from the bill itself where rulemaking
would be necessary. So far, we have proposed rules in 26 of
those 30 areas. We have done so using significant input from
the public prior to our proposing of rules, and during the
official public comment periods. Importantly, commenters inform
the Commission's consideration of costs and benefits associated
with the rules. We also have coordinated closely with other
domestic regulators and international counterparts. As part of
seeking public comment on each of these individual rules, we
have asked a question related to the timing of implementation,
and we do have latitude, and I thank you for the latitude about
implementation dates. We have asked the public, looking at the
entire set of rules, the entire mosaic of rules, to please
inform the Commission as to what requirements can be met sooner
and which ones will take a bit more time, given the cumulative
effect of the rules and the potential costs of those rules.
One of the areas where we have yet to propose rules is in
capital and margin, where we are working very closely in
coordination with the banking regulators and the SEC. As it
relates to margin, Congress recognized the different levels of
risk posed by transactions between financial entities, a bank
and an insurance company or hedge fund, and those involving
non-financial end-users. This is reflected in the non-financial
end-user exception to clearing. Transactions involving non-
financial entities do not present the same risk to the
financial system as those between two financial entities.
Why is this? In our opinion, and I think what is probably
behind what Congress did, the risk of crisis spreading through
the financial system is far greater the more interconnected
financial companies are with other financial companies. This
interconnectedness among financial entities can spread during a
crisis--and then create economic harm to the public.
So consistent with what the Congress did with regard to
clearing, the proposed rules, as we move forward at the CFTC, I
believe margin requirements should only focus on transactions
between the financial entities. Thus, we would not have or
involve the non-financial end-users, consistent with what this
Congress did.
Before I close, I will just briefly address one thing on
resources. The futures marketplace that we oversee right now is
$40 trillion in size. The swaps marketplace here in the U.S.
that we are asked to oversee is about $300 trillion, half of
what Chairman Lucas talked about. So thus, about seven times
the size of the futures marketplace that we oversee, and it is
far more complex. The CFTC's current funding is far less than
what we would require to fulfill the mandate to oversee the
swaps market that is seven times the size.
We look forward to working with this Congress on securing
the adequate resources. I thank you and I look forward to
questions.
[The prepared statement of Mr. Gensler follows:]
Prepared Statement of Hon. Gary Gensler, Chairman, Commodity Futures
Trading Commission, Washington, D.C.
Good morning, Chairman Lucas, Ranking Member Peterson and Members
of the Committee. I thank you for inviting me to today's hearing on
implementing the Wall Street Reform and Consumer Protection Act. I am
pleased to testify on behalf of the Commodity Futures Trading
Commission (CFTC). I also thank my fellow Commissioners for their hard
work and commitment on implementing the legislation.
Before I move into the testimony, I want to congratulate Chairman
Lucas on becoming Chairman of this Committee that is so critical to
both the economy and American agriculture. I also want to thank
Chairman Lucas, Ranking Member Peterson and this Committee for leading
the effort to bring regulatory reform to the over-the-counter
derivatives--or ``swaps''--markets. This Committee passed the first
bill during the last Congress--the bipartisan H.R. 977--that included
comprehensive reform of derivatives. The joint framework for
derivatives legislation that was released later by this Committee's
leadership also helped frame the debate on how to best protect the
American public through regulatory reform of swaps. H.R. 977 and the
joint framework formed the basis of the derivatives title of the Wall
Street Reform and Consumer Protection Act.
The Wall Street Reform and Consumer Protection Act
On July 21, 2010, President Obama signed the Wall Street Reform and
Consumer Protection Act (the Act). Title VII of the Act, entitled ``The
Wall Street Transparency and Accountability Act,'' amended the
Commodity Exchange Act (CEA) to establish a comprehensive new
regulatory framework for swaps and security-based swaps. The
legislation was enacted to reduce risk, increase transparency and
promote market integrity within the financial system by, among other
things:
1. Providing for the registration and comprehensive regulation of
swap dealers and major swap participants;
2. Imposing clearing and trade execution requirements on
standardized derivatives products;
3. Creating robust record-keeping and real-time reporting regimes;
and
4. Enhancing the Commission's rulemaking and enforcement
authorities with respect to, among others, all registered
entities and intermediaries subject to the Commission's
oversight.
The reforms mandated by Congress will reduce systemic risk to our
financial system and bring sunshine and competition to the swaps
markets. Markets work best when they are transparent, open and
competitive. The American public has benefited from these attributes in
the futures and securities markets since the great regulatory reforms
of the 1930s. The reforms of Title VII will bring similar features to
the swaps markets. Lowering risk and improving transparency will make
the swaps markets safer and improve pricing for end-users.
Implementing the Wall Street Reform and Consumer Protection Act
The Wall Street Reform and Consumer Protection Act is very
detailed, addressing all of the key policy issues regarding regulation
of the swaps marketplace. To implement these regulations, the Act
requires the CFTC and Securities and Exchange Commission (SEC), working
with our fellow regulators, to write rules generally within 360 days.
At the CFTC, we initially organized our effort around 30 teams who have
been actively at work. We have recently added another team. We had our
first meeting with the 30 team leads the day before the President
signed the law.
The CFTC is working deliberatively and efficiently to promulgate
rules required by Congress. The talented and dedicated staff of the
CFTC has stepped up to the challenge and has recommended thoughtful
rules--with a great deal of input from each of the five Commissioners--
that would implement the Act. Thus far, the CFTC has approved 39
notices of proposed rulemaking, two interim final rules, four advanced
notices of proposed rulemaking and one final rule.
The CFTC's process to implement the rulemakings required by the Act
includes enhancements over the agency's prior practices in five
important areas. Our goal was to provide the public with additional
opportunities to inform the Commission on rulemakings, even before
official public comment periods. I will expand on each of these five
points in my testimony.
1. We began soliciting views from the public immediately after the
Act was signed and prior to approving proposed rulemakings.
This allowed the agency to receive input before the pens hit
the paper.
2. We hosted a series of public, staff-led roundtables to hear
ideas from the public prior to considering proposed
rulemakings.
3. We engaged in significant outreach with other regulators--both
foreign and domestic--to seek input on each rulemaking.
4. Information on both staff's and Commissioners' meetings with
members of the public to hear their views on rulemakings has
been made publicly available at cftc.gov.
5. The Commission held public meetings to consider proposed
rulemakings. The meetings were webcast so that the Commission's
deliberations were available to the public. Archive webcasts
are available on our website as well.
Two principles are guiding us throughout the rule-writing process.
First is the statute itself. We intend to comply fully with the
statute's provisions and Congressional intent to lower risk and bring
transparency to these markets.
Second, we are consulting heavily with both other regulators and
the broader public. We are working very closely with the SEC, the
Federal Reserve, the Federal Deposit Insurance Corporation, the Office
of the Comptroller of the Currency and other prudential regulators,
which includes sharing many of our memos, term sheets and draft work
product. CFTC staff has had 376 meetings with other regulators on
implementation of the Act.
Specifically, our rule-writing teams are working with the Federal
Reserve in several critical areas: swap dealer regulation,
clearinghouse regulation and swap data repositories, though we are
consulting with them on a number of other areas as well. With the SEC,
we are working on the entire range of rule-writing, including those
previously mentioned as well as trading requirements, real time
reporting and key definitions. So far, we have proposed two joint rules
with the SEC as required by Congress.
In addition to working with our American counterparts, we have
reached out to and are actively consulting with international
regulators to harmonize our approach to swaps oversight. As we are with
domestic regulators, we are sharing many of our memos, term sheets and
draft work product with international regulators as well. Our
discussions have focused on clearing and trading requirements,
clearinghouses more generally and swaps data reporting issues, among
many other topics.
We also are soliciting broad public input into the rules. On July
21st, we listed the 30 rule-writing teams and set up mailboxes for the
public to comment directly. We determined it would be best to engage
the public as broadly as possible even before publishing proposed
rules. We have received 2,851 submissions from the public through the
e-mail in-boxes as well as 1,111 official comments in response to
notices of proposed rulemaking.
We also have organized nine roundtables to hear specifically on
particular subjects. We have coordinated the majority of our
roundtables with the SEC. These meetings have allowed us to hear
directly from investors, market participants, end-users, academics,
exchanges and clearinghouses on key topics including governance and
conflicts of interest, real time reporting, swap data record-keeping
and swap execution facilities, among others. The roundtables have been
open to the public, and we have established call-in numbers for each of
them so that anyone can listen in.
Additionally, many individuals have asked for meetings with either
our staff or Commissioners to discuss swaps regulation. To date, we
have had more than 500 such meetings. We are now posting on our website
a list of all of the meetings CFTC staff, my fellow Commissioners and I
have with outside organizations, as well as the participants, issues
discussed and all materials given to us.
We began publishing proposed rulemakings at our first public
meeting to implement the Act on October 1, 2010. We have sequenced our
proposed rulemakings over 11 public meetings thus far. Our next meeting
is scheduled for February 24.
Public meetings have allowed us to discuss proposed rules in the
open. For the vast majority of proposed rulemakings, we have solicited
public comments for a period of 60 days. On a few occasions, the public
comment period lasted 30 days. As part of seeking public comment on
each of the individual rules, we also have asked a question within many
of the proposed rulemakings relating to the timing for the
implementation of various requirements under these rules. In looking
across the entire set of rules and taking into consideration the costs
of cumulative regulations, public comments will help inform the
Commission as to what requirements can be met sooner and which ones
will take a bit more time.
We have thus far proposed rulemakings in 26 of the 30 areas
established last July. We still must propose rules on capital and
margin requirements, product definitions (jointly with the SEC) and the
Volcker Rule. We also are considering comments received in response to
advanced notices of proposed rulemaking with regard to disruptive
trading practices and segregation of funds for cleared swaps.
A number of months ago we also set up a 31st rulemaking team tasked
with developing conforming rules to update the CFTC's existing
regulations to take into account the provisions of the Act. This is
consistent with one of the requirements included in the recent
Executive Order issued by the President, entitled ``Improving
Regulation and Regulatory Review.''
In reviewing the Executive Order more broadly, the CFTC's practices
are consistent with the Executive Order's principles. The CFTC has a
robust process to involve and ensure public participation in the
rulemaking process. The CFTC also consults broadly with other
regulators to coordinate, harmonize and simplify regulations. We work
to identify and consider regulatory approaches that reduce burdens and
maintain flexibility and freedom of choice for the public. Further, the
CFTC routinely seeks public comment on technical information and data
considered during the regulatory process. Last, the CFTC conducts cost-
benefit analyses in its rulemakings as prescribed by Congress in Sec.
15(a) of the CEA rather than as prescribed in Section 1 of the
Executive Order. The statute includes particularized factors to inform
cost-benefit analyses that are specific to the markets regulated by the
CFTC. Thus, we will continue to fulfill the CEA's statutory
requirements. Even though the statute dictates different cost-benefit
analysis methodology, the CFTC's practices are consistent with the
executive order's principles.
In addition to considering conforming amendments to update the
CFTC's existing regulations, we also will examine the remainder of our
rule book consistent with the executive order's principles to review
existing significant regulations. We intend to develop and make public
a preliminary plan for the periodic review of significant regulations
within the 120 day timeframe outlined in the Executive Order.
End-User Margin
One of the rules that the CFTC will consider pertains to capital
and margin requirements. As it relates to margin, the Act states that,
``to offset the greater risk to the swap dealer . . . and the financial
system from the use of swaps that are not cleared,'' regulators shall
``help ensure the safety and soundness of the swap dealer'' and set
margin requirements that are ``appropriate for the risk associated with
the non-cleared swaps.''
Congress recognized the different levels of risk posed by
transactions between financial entities and those that involve non-
financial entities, as reflected in the non-financial end-user
exception to clearing. Transactions involving non-financial entities do
not present the same risk to the financial system as those solely
between financial entities. The risk of a crisis spreading throughout
the financial system is greater the more interconnected financial
companies are to each other. Interconnectedness among financial
entities allows one entity's failure to cause uncertainty and possible
runs on the funding of other financial entities, which can spread risk
and economic harm throughout the economy. Consistent with this,
proposed rules on margin requirements should focus only on transactions
between financial entities rather than those transactions that involve
non-financial end-users.
Conclusion
Before I close, I will briefly address the resource needs of the
CFTC. The futures marketplace that the CFTC currently oversees is
approximately $40 trillion in notional amount. The swaps market that
the Act tasks the CFTC with regulating has a notional amount roughly
seven times the size of that of the futures market and is significantly
more complex. Based upon figures compiled by the Office of the
Comptroller of the Currency, the largest 25 bank holding companies
currently have $277 trillion notional amount of swaps.
The CFTC's current funding is far less than what is required to
properly fulfill our significantly expanded mission. Though we have an
excellent, hardworking and talented staff, we just this past year got
back to the staff levels that we had in the 1990s. To take on the
challenges of our expanded mission, we will need significantly more
staff resources and--very importantly--significantly more resources for
technology. Technology is critical so that we can be as efficient as an
agency as possible in overseeing these vast markets.
The CFTC currently is operating under a continuing resolution that
provides funding at an annualized level of $169 million. The President
requested $261 million for the CFTC in his proposed Fiscal Year (FY)
2011 budget. This included $216 million and 745 full-time employees for
pre-reform authorities and $45 million to provide half of the staff
estimated at that time needed to implement the Act. The President is
scheduled to release his FY 2012 budget request soon.
Given the resource needs of the CFTC, we are working very closely
with self regulatory organizations, including the National Futures
Association, to determine what duties and roles they can take on in the
swaps markets. Nevertheless, the CFTC has the ultimate statutory
authority and responsibility for overseeing these markets. Therefore,
it is essential that the CFTC have additional resources to reduce risk
and promote transparency in the swaps markets.
Thank you, and I'd be happy to take questions.
The Chairman. Thank you, Chairman. I will begin the
questioning.
We are hearing from companies across the country that the
rulemaking process that CFTC may very well just simply be
moving too quickly, and that the sequence of the rules is
precluding them from commenting in a meaningful way. You have
to figure out the chain of flow before you can offer comments.
The proposed rules reflect what some are concerned might be
rushed policies that potentially jeopardize the viability of
the derivatives market, which ultimately would be to the
impediment of the economy.
You have acknowledged, Chairman, that it may be necessary
to phase in compliance with the new rules, and we certainly
commend you for those efforts and comments. But Chairman, the
concerns about the rulemaking process are shared by market
participants, not in any one particular part of the economy,
but in a broad cross section. Despite statutory directives,
CFTC and the SEC are not only moving in different directions,
but the rules you are proposing on critical issues are
inconsistent, including real-time reporting, the swap execution
facility rules, the ownership and governance rules. In
addition, you will need to build consensus, I would think,
among your Commissioners, in line with the bipartisan tradition
of this Committee, I strongly urge you to work to minimize
those divided votes among your Commissioners and build
consensus.
So I guess that said, Mr. Gensler, does the Commission need
more time to vet the rules, to collect the data, to build a
consensus, to do all the things that are important so that we
can minimize the adversarial consequences to the--adverse
consequences to the market and our economy? Do you need more
time, Chairman?
Mr. Gensler. I think that the Congress laid out this 1 year
timeframe, and that the Commission--I commend all of my fellow
Commissioners and the excellent staff at the CFTC has reached
out to the public. I commend the public. There has been
enormous input. We have had well over 500 meetings with the
public. I think we have had thousands of comments.
We do, right now, have a natural pause. Though we have a
couple of rules still--important rules to propose, we are where
the public can now start to see the entire rule set, and in
fact, one of the rules that has been raised is the entity
definition rule whose closing period is in a couple of weeks,
February 22. I would certainly encourage everybody in the
public, if you have a comment on any of the rules that are out
there, because there is this interplay that the Chairman talks
about between the rules. Please submit it. Let us know in this
period of time, and we will make sure that our Commissioners
and the staff know all the comments and all the rules, even if
a comment period is closed. We do have the discretion to
continue to consider that, look at the whole mosaic.
I don't envision us taking up final rules, really, until
this spring, so there is a natural pause right now where we can
hear from the public, hear from Congress, and consider this in
the whole mosaic as we move forward. We are human. Some of
these rules will be put in place after July. There is no doubt
that some will be after July, but I think that we did have a
significant crisis 2 years ago, and we are trying to address
that crisis, and also lower regulatory uncertainty by finishing
these rules.
The Chairman. Chairman, we are very sensitive to the
effects on the economy of these decisions. Can you assert that
under the current statutory timeframes that the cost-benefit
analysis that the CFTC has performed are related to each rule,
and the rules imposed in a comprehensive fashion? Can you
assert to me that they would stand up to an independent
evaluation?
Mr. Gensler. Well, we have actually direction from Congress
in statute on how to comply with cost-benefit analyses. This
agency, with this Committee's direction 11 years ago, has
something called Section 15(a) of our statute that says how to
do it, and to take into consideration many of the factors you
talked about.
So yes, Mr. Chairman, we--and all of our rules comply with
the very directed, specific, cost-benefit analysis that
Congress has laid out for us to consider factors like lowering
risk, promoting price discovery, and the integrity of markets.
By their nature, they are very important factors for this
market.
The Chairman. Can you commit to this Committee, Chairman,
that without an extension of the statutory deadline, these
rules will not impose undue costs on end-users or cause the
distortion to the market by adversely impacting liquidity?
Mr. Gensler. We are very sensitive to end-users. End-
users--the corporations, tens of thousands of them,
municipalities, hospitals, small real estate developers, need
these products to hedge their risk, and that is absolutely
critical. That is why Congress left that--you can do customized
bilateral swaps that are not going to be in the clearinghouses.
I believe we are going to address the margin issue forthwith in
March, very directly.
So yes, sir, I believe that end-users will benefit,
actually, from greater liquidity because there will be greater
transparency in the marketplaces, but at the same time, not be
brought into clearing or margining.
The Chairman. Thank you, Mr. Chairman. My time has expired
and I turn to the Ranking Member for his questions.
Mr. Peterson. Thank you, Mr. Chairman.
You know, one of the reasons we gave the CFTC the latitude
here, we were looking at doing this ourselves. The more I dug
into it, the more I realized it was pretty complicated stuff
and we were probably going to screw it up. I think they are
working through this and I believe that they are sensitive to
this.
I guess the question I have, it seems to me that these end-
users are actually going to have--lower their costs. If you get
this information available, they are going to be able to go to
more than one swap dealer and basically play them off against
each other and get a better deal, right?
Mr. Gensler. I think that they will have greater
transparency, even if they don't have to come into the clearing
or trading. In essence, they get the benefit because all their
financial firms' transactions have to be in the clearing, so
they get to see that pricing.
Mr. Peterson. Do these end--have you looked into this? Do
these end-users now do business with more than one entity, or
are they basically always doing their swaps with one bank? You
know, is there a way for them to actually go out to five banks
and get the best deal? I mean, how does that work?
Mr. Gensler. Congressman, they can----
Mr. Peterson. I mean, there is no information----
Mr. Gensler. Many end-users spend a significant amount of
time in their treasury function, working with multiple banks,
three to five, six. Sometimes they do put them in competition.
But what a central exchange does is put them more naturally in
competition, and they get the benefit of seeing that price.
Mr. Peterson. I understand that, but I guess the stuff that
can't be cleared or that is not enough for a clearinghouse. So
we are going to make that information available and you are
going to try to get that more out there in real time.
So these customized trades, right now there is no
information, nobody knows what is going on. So it almost seems
like, with those kinds of things they are probably just dealing
with, it is one bank in the dark in terms of what the pricing
is.
Mr. Gensler. You are absolutely right. The more customized,
the more particular usually it is one bank. That still would be
allowed, but you could also have the benefit of seeing where
the standard transactions were priced, and you would say, ``Ah-
ha, it is over here, it is priced this way, I can get a better-
informed negotiation.''
Mr. Peterson. Well, I personally think that what this fight
is about is that this is actually going to reduce the spreads
and reduce the profits of these Wall Street guys, and that is
what is stirring all this up. That is what I think, but what do
I know? I am just a dirt farmer from Minnesota.
One of the other issues, there is this story about these
banking elite getting together and trying to corner this market
and keep this under control. We gave you guys some authority to
try and go in there and try to put some rules on in terms of--
so that can't happen, so that we have--so we don't have the big
Wall Street guys controlling these clearinghouses, which I
think they have been trying to do. So where is that all in the
process?
Mr. Gensler. I think Congress recognized markets work best
when not only are they transparent, but open and competitive,
and you included that the clearinghouses have to have what is
called open access, and the trading platforms have to have
something called impartial access. So our proposed rules--and
we look forward to the public comment on it--say on both of
those that they really do have to be open. The clearinghouse's
membership have to be far more open than currently exists. The
clearinghouses have to manage their risk, but they can scale
that risk. A smaller member would only have smaller
participation, and then a bigger member, bigger participation.
Mr. Peterson. Well, I heard some discussion that apparently
some of the big financials have been resisting getting involved
in some of these clearing entities because they--apparently
because they can't control it or something. Is that--have you
looked into that, or--I mean, has there been a reluctance to
join some of the clearing folks that have been--that clearly
know what they are doing and they have been operating and it is
working, but because they can't--apparently because they can't
control it, I guess.
Mr. Gensler. Historically I think there is some truth to
that. Clearinghouses, though, under the new Dodd-Frank would be
far more open, because that is what Congress directed. There
would be more competition amongst the dealers, and the public
would benefit, I think from that competition, while we still
will have the risk reduction of clearinghouses.
Mr. Peterson. That is probably not going to happen until
you actually get these rules in place that force this to
happen, right?
Mr. Gensler. I think that some of it will happen beforehand
because they will see what is coming, and we will get very good
comments and we will change some of the rules based on those
comments, but openness and competitiveness was at the core of
what Congress asked us to do in these rules.
Mr. Peterson. Thank you. Thank you, Mr. Chairman.
The Chairman. The gentleman's time has expired. We turn to
the gentleman from Illinois, Mr. Johnson.
Mr. Johnson. Thank you, Mr. Chairman.
Let me address my comments or I guess my questions, Mr.
Gensler, specifically to your--to the definition of a swap
dealer under the Act.
According to the rules that you promulgated in December,
and be as specific as you can with this, how many entities do
you think will be required to register as swap dealers under
those rules, specifically? I know you can't tell me or I assume
you can't tell me exactly, but as best you can.
Mr. Gensler. That is an excellent question. We have
estimated about 200. We looked at the ISDA website. They have
over 800 members, and approximately--well, there are some that
are called primary members----
Mr. Johnson. So you are saying about 200?
Mr. Gensler. About 200.
Mr. Johnson. Okay.
Mr. Gensler. Some of those I would say would be multiple
dealers. Some of the big dealers have said they were going to
register four or five or six legal entities, so that 200
actually is fewer companies.
Mr. Johnson. Do you recall--I am assuming you recall in
February of 2009 at your confirmation hearing where you
addressed that issue?
Mr. Gensler. You could help remind me.
Mr. Johnson. Yes, let me help remind you. Do you recall at
your testimony before the Senate Banking Committee that you
estimated between 15 and 20 entities would qualify for
virtually the entire regulatory scheme? Do you recall that
comment and that answer?
Mr. Gensler. And that----
Mr. Johnson. I am just asking you if you recall that. You
do? You recall having given that response?
Mr. Gensler. You have helped me recall that.
Mr. Johnson. Okay. I guess what I am asking you is there is
a pretty significant difference between 15 and 20 and 200. I am
just wondering whether your viewpoint has changed in the last
several years, or whether that is an evolutionary process as
well.
Mr. Gensler. Most of those 15 have told us they will
register multiple legal entities. Some have said they were
going to register six or seven, some have said four or five. So
without naming the largest banks, but most of the largest banks
have said they have several legal entities. So that----
Mr. Johnson. Okay. I am assuming the answer is your
viewpoint has changed.
In terms of the de minimis exception, the definition under
the Act, can you tell this Committee now specifically companies
that would qualify for that exemption?
Mr. Gensler. I don't----
Mr. Johnson. I assume you are aware specifically explicitly
included a de minimis exception under the definition of swap
dealers. My question is, what entities exist now that you
believe qualify for that exception?
Mr. Gensler. Well, I think that many companies will not be
swap dealers. Tens of thousands of companies will not be swap
dealers because they are end-users. The de minimis exemption is
also likely to include certain small banks, certain companies
that from time-to-time might offer risk management services to
others, but as a small number----
Mr. Johnson. Can you give the Committee the names--
specifically the names of companies who qualify for that
exemption?
Mr. Gensler. I do not have names. They would come in and
talk to us, and we are looking forward to the public comment to
see whether we need to adjust that de minimis number, as well.
Mr. Johnson. In terms of cooperatives, and I guess I am
addressing my comments not only to the dairy co-ops that will
have the opportunity to testify here--or at least on their
behalf later, but also rural electric co-ops which play a huge
role in many of our districts.
What do you think--what is your viewpoint about the
impact--let me rephrase that. Do you believe that those
cooperatives, the dairy co-ops, let us even take the rural
electric co-ops, will have to register as swap dealers, or do
you think they will be exempt?
Mr. Gensler. Let me take them one at a time. I am not
familiar with any rural electric cooperative that has--and we
have talked to them, has raised this issue, but we are looking
forward to their public comment. I don't want to preclude--they
might somehow raise a comment. On the dairy cooperatives, we
have had a lot of very good dialogue, and I think it is wrapped
into something, if I might say, related to how they do their
business. Most of what they do, as I understand it, actually
are not swaps, they are forwards. If there is an intent to
deliver dairy product or cattle product or grain wheats, it is
actually exempted. We are going to take--and I know that
Congressman Peterson had a colloquy----
Mr. Johnson. My time is coming to a close. I am not trying
to cut you off, but I would like to get a specific answer, as
best you can, as to whether you believe those cooperatives are
going to be----
Mr. Gensler. As best I can, I think most of what they do
aren't even swaps, that they are forwards or forwards with
embedded options. But again, we look forward to their comments.
We are working very closely with the dairy cooperatives.
Mr. Johnson. And I guess my concluding question in those
cooperatives--because my time is coming to a close--what do you
believe--I do--whether you believe that there will be a
specific impact on the members of those cooperatives who are
also obviously the farmers and otherwise, if they are subjected
to regulation of this Act. I am assuming you think there will
be an impact?
Mr. Gensler. I think that they will benefit from the
transparency from the marketplace, and we have put out a
proposed rule that ag swaps should be treated similarly and
they get the benefit of that, of other swaps.
Mr. Johnson. Thank you for your comments.
The Chairman. The gentleman's time has expired. We now turn
to the gentleman from Pennsylvania for his 5 minutes.
Mr. Holden. Thank you, Mr. Chairman.
Chairman Gensler, I believe you tried to reference a
colloquy that I think then-Chairman Peterson and I had on the
floor during a debate where we talked about Farm Credit
institutions and credit unions and small banks and thrifts
being exempt because they did not cause the problem and they
should not be subject to regulations. Is that what you were
just attempting to say to Mr. Johnson?
Mr. Gensler. It may have been part of that colloquy. I was
referencing a forwards exemption colloquy, so it may have been
part of that colloquy.
Mr. Holden. Yes, because that was the intention of the
legislation, that these institutions that did not cause the
problem not be subject to it. And some of these institutions do
have assets greater than $10 billion, particularly the big Farm
Credit System. Are you considering exemptions there?
Mr. Gensler. We have asked the public for comment in--I
think it was in December--if I recall, to help us with regard
to this. Congress gave us the authority under the clearing
exemption to extend that to certain--I think the words in the
statute was small banks, farm credit, and--I'm sorry, there was
a third category--credit unions.
Mr. Holden. Right, thank you.
The Commission's proposed rule requires such reporting as
soon as technologically possible and for lock trades a
reporting delay of 15 minutes is permitted. From your
discussions within the industry, what is technologically
possible with regard to real-time reporting?
Mr. Gensler. If it is traded on a platform, if it is traded
on an exchange, as soon as technologically practical is within
seconds. If it is bilateral, we recognize that in some
circumstances that might take some time. But these are for the
smaller transactions. The bigger trades, what are called
blocks, there would be a delay and that is what Congress has
asked us to do, and we have asked a lot of questions of the
public about that delay.
Mr. Holden. I had a public utility in to see me yesterday
about this issue, and they thought 15 minutes was not
reasonable. We had a meeting yesterday with Ranking Member
Peterson and we seem to think--what is your opinion on what--if
you had up to 24 hours as opposed to 15 minutes? What is the
difference?
Mr. Gensler. Well, I think then the market loses
transparency. The market greatly benefits from real-time
reporting. Now, in terms of that utility, that utility would
not have to do a transaction on an exchange because they have
an exemption from Congress to be out of it. So on the bilateral
transactions, we have not suggested the 15 minutes. We have
actually asked a whole series of questions as to what would be
appropriate, and we put it in three categories. On an exchange,
it is as soon as technologically practical, if it is small. If
it is a block and it is on an exchange, it is a 15 minute
delay, and the third category are these bilaterals where we
just ask, frankly, a lot of questions.
Mr. Holden. Thank you. Thank you, Mr. Chairman.
The Chairman. The gentleman yields back his time. The chair
now recognizes the gentleman from Texas, Mr. Conaway, for 5
minutes.
Mr. Conaway. Thank you, Mr. Chairman. Mr. Chairman, thank
you, very good to be here.
I am going to play off the Chairman's question in reference
to cost-benefit analysis. The President sent out a letter a
couple of weeks ago that directed Executive Branch agencies,
which you didn't necessarily come under, that had a sentence in
it that required cost-benefit analysis in the quantitative and
qualitative natures must be considered. But in your testimony,
you said that you are in principle going to put your agency
under his letter, but then page seven and eight you say
specifically that you are not going to use the definition in
his paragraph, but instead, are going to fall back under 15(a).
Reading both of those, some of the same words are used.
Some would say there is really no distinction between the two.
You apparently have made a distinction between the requirement
under the President's letter to consider the qualitative and
quantitative amounts for the cost-benefits. Why the distinction
with pulling yourself out of that one sentence?
Mr. Gensler. An excellent question, because Congress
actually has prescribed a very detailed way that we do this
under what is called 15(a), and it includes considering the
price discovery market, lowering risk, the integrity of
markets, and so we feel that we have a prescribed way and that
we have to follow Congress. I think it is consistent. We have
also asked the public in each of our rules, please comment on
the cost-benefit analysis, share anything quantitative with us
so we can be better informed as we move to final rule.
So we do want to hear from the public on any quantitative
means, but we need to follow Congress----
Mr. Conaway. So you are thinking 15(a) is a stricter or
more informative way to look at the cost-benefit analysis than
what the President used in his letter?
Mr. Gensler. Well, I don't want to comment on the
President, but it is more informed because Congress tells us
what we have to do, so we do feel we have to follow Congress,
with all respect to his Executive Order.
Mr. Conaway. Yes, it looked like his Order was better.
Playing off of Mr. Johnson's question, if you do pick up
commercial firms, energy companies and others in your
definition of swap dealers, will you regulate their entire
business? How will you distinguish--will they have to set up
separate subsidiaries to run this through so that you don't
reach into their non-swap dealer positions that----
Mr. Gensler. It would only be on the legal entity. Some of
the largest integrated oil companies also have a risk
management business and it is in a separate legal entity, and
we are working with them very closely. We are being informed by
them even before we write the capital rules as to how they
should apply, for instance, capital rules, but it would only be
to the legal entity, or Congress gave us some authority to do
it on the activities. So we can----
Mr. Conaway. But your testimony to us is you have no
intention of going after ExxonMobil's non----
Mr. Gensler. No, no, no.
Mr. Conaway. Whether they set up a separate entity and/or
they just conducted it under the mother ship.
Mr. Gensler. No, it would just be the legal entity that
registered.
Mr. Conaway. Pushing the OTC markets into an exchange-like
environment where we have problems with the exchange-like
environment, a phrase that is new to me, but maybe you guys are
all--high frequency algorhythmic trading, which may have caused
a flash crash, a new phrase. How is--how will you protect these
new entities or this new exchange-like environment from, as we
said earlier, new products and/or these existing kinds of
massive consumer-driven trades that with your transparency and
instant reporting allow folks to get ahead, whatever, take
advantage of positions as these folks have?
Mr. Gensler. At the risk of giving a shout-out to the CME
over here, I know Terry is here, but the futures exchanges have
very solid risk management practices--they are called
safeguards--before you can enter a trade. So what we did in our
execution platform, the SEF proposal, is we said to the public,
please tell us which risk safeguard should be as a minimum
involved here.
What at a minimum should be there for this very reason?
Also, Scott O'Malia, who heads our technology advisory
committee, has asked that committee for a full report on what
we can do in this way as well.
Mr. Conaway. Thank you. One final comment. I am hopeful
that, given the extensive input you are getting from users and
everybody involved in your testimony and what you are actually
doing, that there will be, between the proposed rules and the
final rules, clear evidence that you did listen and that you
did consider what folks had to say to you as opposed to just,
here are the proposed rules. We received this massive
information that is just too much to deal with. Here is the
final rule.
Mr. Gensler. We are absolutely listening and the five
Commissioners--the back and forth is working. Not every comment
will we agree with, but many of them are really helpful. They
are all helpful, many of them we agree with.
Mr. Conaway. Very politic of you.
The Chairman. The gentleman's time has expired. I now
recognize the gentleman from Iowa, Mr. Boswell, for 5 minutes.
Mr. Boswell. Thank you, Mr. Chairman, and thank you, Mr.
Gensler, for your good work. I have been pretty impressed over
the last couple years, and I think you have a good crew and you
are working very hard and very diligently. I appreciate it.
I would associate myself with Mr. Conaway and, in fact,
everyone who has spoken. I think we sincerely--and what they
have said and what you said, we want transparency. Transparency
kind of reveals all, and I would be interested what comment you
might make--further comment. What is the resistance to
transparency? I think I kind of know what it is, but I would
like to hear what your thoughts are on it. What is the
resistance, you know? Out in the rest of the world we would
probably say they must have something to hide.
Mr. Gensler. Well, information does sometimes lead to
profits. If one has a profit motive--and absolutely, I honor
this. I was on Wall Street for 18 years. Information is part of
fulfilling your role to customers, but it is also a way to make
profit.
So I think Congress adjusted the information advantage a
little bit more towards the end-user and the public, and a
little bit away from the financial community. Not dramatically,
but that little change has some resistance. Some also say it
lowers liquidity. I don't necessarily concur with that. I think
the transparency increases liquidity, as long as you have an
appropriate exception for the large block trades. I think
Congress asked us to do that, and we are looking forward to the
public comment on whether or not we got the block trading
exception correct.
Mr. Boswell. Well, I think you are right on and I
appreciate that, so I compliment your work. Keep it up.
With that, since I am agreeing with what you said, Mr.
Chairman and Ranking Member, I am going to yield back.
The Chairman. The gentleman yields back his time. I now
recognize the gentleman from Georgia, Mr. Scott, for 5 minutes.
Mr. Austin Scott of Georgia. Thank you, Mr. Chairman.
Chairman Gensler, did I understand your correctly to say
that you don't have the budget currently to implement the rules
and regulations that you are mandated to implement under Dodd-
Frank?
Mr. Gensler. You heard me correct. We don't have the budget
or resources to oversee. We can complete the rule-writing
through this summer and early fall. We are human. Some of these
will slip, but we only have about 680 people. We estimate that
we probably need upwards to 400 more people. The markets are
seven times larger and far more complex than the markets we
currently oversee, and we think we need also to probably double
our technology budget over some time.
This is a challenge because our great nation has too much
debt, and I appreciate this is not an easy ask that we might be
asking this Congress to think about.
Mr. Austin Scott of Georgia. Yes, sir, and it is one that
might not happen. I would appreciate it if you would submit to
the Committee an analysis of your anticipated budget and what
positions those people would be hired into and what their roles
would be.
Mr. Gensler. We look forward to doing that, actually, I
think next Monday or Tuesday. When the President reveals his
overall budget, we also will send to this Committee, as we do
annually, a full detail of that.
Mr. Austin Scott of Georgia. Okay. Did I understand when
you talked about the number of entities that when you were
confirmed, you said it would be 15 to 20, now you are saying--I
heard as many as 200 and then I heard well, some of the
entities would do--so maybe seven times 20 is 140, but are we
150, are we 200? I mean, how many different entities are we
going to be----
Mr. Gensler. We made an estimate for budgeting purposes,
and we have looked closely at the International Swap and
Derivative Association membership list. We have also looked at
who has come in and knocked on our door, but you are absolutely
right. Those 15 or 20 many have anywhere from four to seven
each. Then we looked at the smaller entities that might only
have one or two.
Part of what happened is Congress included a provision that
was associated with Chairman Lincoln at the time that said that
some of the things had to be moved out of the bank into an
affiliate, so that push-out provision sort of multiplied the
number of potential dealers.
Mr. Austin Scott of Georgia. If I may, Mr. Chairman?
I guess, Chairman Gensler, one of the things I am having a
difficult time with in the math there is how many employees you
expect to have per entity that you are going to be regulating?
I mean, if you do that math, in simple terms, what are you
talking, six, eight, ten employees per entity that you are
going to regulate?
Mr. Gensler. Well actually, I wish it were that simple, but
we currently only have the staff that we roughly had in the
1990s to oversee the futures marketplace, so we oversee many
other entities that are not swap dealers. They are called
futures commission merchants and clearinghouses and the like.
We were 620 people in 1992, we are 680 people now. With
Congress's help we sort of got back to where we were to cover
the futures market, but not for the swaps marketplace, these
upward of 400 people would be to oversee potentially 300 to 400
entities. We are going to work very closely with something
called the National Futures Association and see how much we can
delegate to them. The National Futures Association and Dan
Roth, they are ready and willing to help out and take on many
of these things, but we probably can't and shouldn't move
everything to them.
Mr. Austin Scott of Georgia. But again, you acknowledge
that you don't have the budget necessary to handle the
implementation of the rules?
Mr. Gensler. That is a yes.
Mr. Austin Scott of Georgia. And how does a bill get passed
without--that mandates an increase in spending that doesn't
have the spending tied to it?
Mr. Gensler. Well, partly because there are different
committees of authorization and appropriation--and we are on an
annual budget cycle. Also, we are one of the few financial
regulators that is not self-funded. I am not asking for that. I
am just noting it. So many of the other financial entities
are--have self-funding. The SEC and CFTC work with Congress and
I look forward to this continuing dialogue on this.
Mr. Austin Scott of Georgia. Thank you, Mr. Chairman. I
yield the remainder of my time.
The Chairman. The gentleman's time has expired, and it is a
good thing the Chairman is not asking, because he is not
getting that.
I now recognize the gentleman from Georgia, Mr. Scott, for
5 minutes.
Mr. David Scott of Georgia. Thank you, Mr. Chairman.
First of all, Mr. Gensler, let me ask you. I have heard
from a few of our market participants that the CFTC's proposed
rule on margin segregation is highly problematic, and perhaps
unnecessary. According to them, the proposal could potentially
raise the cost of clearing with only small risk management
benefits, and since we are not requiring the same customer
protection in future clearinghouses which have never failed, I
question the need for the change, given the fact that swaps and
futures should be regulated in an equivalent manner.
So my question to you is this. If what these folks are
saying is true, then can you explain why CFTC is exploring this
issue when, number one, it is not required to do so by the
Dodd-Frank legislation, and number two, it could be very
expensive for market participants, and number three, it is
directed towards a problem that does not even seem to exist.
Mr. Gensler. The question that Congressman Scott asks
relates to what we put out, an advance notice of proposed
rulemaking, not a proposal, but it is a way to gather input on
the question of segregating customer funds at the
clearinghouses. Congress says that funds should not be
commingled, except for convenience. That is roughly how it is
worded. In the futures industry, customer funds have been
commingled for convenience.
Many of the buy-side, meaning big pension funds and asset
managers, asked us to explore segregated accounts. So rather
than making a proposal, we actually just ask a series of
questions. That comment period recently closed. We are
reviewing--and you are right, Congressman, many people said to
go to full segregation might raise costs, and so the
Commissioners and the staff are reviewing those comments even
before we make the proposal. It has been very beneficial.
There are some differing views. Some, I will say, on the
pension side and asset management side would like to continue
to have segregated accounts. Many in the clearing community and
others raised the cost factors, and we are going to sort this
through even before we make a proposal.
Mr. David Scott of Georgia. Well, that is very good because
I think that you should, and especially since it is not
required by the Dodd-Frank legislation. If some of these folks
are saying that it is very, very expensive, I think--and my
suggestion is you really look at it with a very jaundiced eye
here. I appreciate that.
Let me ask you another question. I want to go back to
something Mr. Johnson had brought up into this whole issue of
the carve-out, the de minimis carve-out. Can you tell me
specifically how the CFTC came up with the proposed notional
value dollar amount, one, and the yearly swap limit?
Mr. Gensler. In working with the Securities and Exchange
Commission--this was a joint role--we had to start somewhere.
What is the meaning of the word de minimis, and to remember,
all end-users are out. It is just if you do some risk
management services, if you offer yourself as a dealer, when is
it de minimis? So I think we proposed a $100 million notional
amount. I apologize; I can't remember the exact statistics on
the number of counterparties. We are looking forward to public
comment on that, but we are trying to follow Congressional
intent. End-users are out, but what does this word de minimis
mean and working with the SEC and hearing in many of these pre-
meetings what some people do, we have made a proposal.
Mr. David Scott of Georgia. Yes. Can you tell me what kind
of firm that the CFTC had in mind when crafting this carve-out,
and does such a firm even exist?
Mr. Gensler. It was a firm that, in essence, did not have
end-users behind them of any magnitude. So if you are holding
yourself out to end-users and making markets, then it is
possible that you are actually a swap dealer. If, in fact, you
just have five or ten counterparties, it is far more likely you
are an end-user.
So it was trying to relate that somebody that just has five
or ten counterparties, that is not a swap dealer. That doesn't
have----
Mr. David Scott of Georgia. And are you willing to revise
this carve-out to make it meaningful to non-systematically
risky commercial companies that offer swaps, so that they can
conduct their business without being caught up in the same net
as the large banks?
Mr. Gensler. Well, we look forward to the public comment on
all of these, so revisions, as I said to Congressman Conaway,
there are going to be numerous revisions. I just don't know in
this de minimis area how it will be revised. There are some
non-bank swap dealers, a few of the very largest integrated oil
companies have come in and we are talking to them and working
with them, who actually provide risk management services
downstream to hundreds of end-users. I think it was Congress's
intent that there will be some non-banks. In essence, AIG was a
non-bank swap dealer. But we take very serious that there is a
de minimis exemption, and we look forward to the public's
comment on it.
Mr. David Scott of Georgia. Thank you very much, and thank
you, Mr. Chairman.
The Chairman. The gentleman's time has expired. I now
recognize the gentleman from Tennessee, Mr. Fincher, for 5
minutes.
Mr. Fincher. Thank you, Mr. Chairman. Thank you for your
time today.
A couple of questions, just quick. Have you assessed the
impact of derivatives business moving to the foreign markets?
Mr. Gensler. We are working very closely with the foreign
regulators to ensure, as best we can, with different cultures
and different political systems that we have consistent
regulatory treatment. I am optimistic. Certainly in the
clearing world, the end-user exemption, the data repositories,
the dealer world, Europeans and we are quite aligned. They are
still probably time-wise behind us. They are not moving as
quickly, but I think this spring and summer they will probably
take it up in their European Parliament, so we are working very
closely to ensure, as best we can, consistency.
We have done one other thing, if I might say. We actually
have shared a lot of our internal work paper, our memos and
everything in the fall with the Europeans and in some instances
in Japan and Asia, the actual documents to get their feedback
so we could be as aligned as possible, again, given they
haven't passed their law yet.
Mr. Fincher. The second question--and I will echo what Mr.
Boswell said a few minutes ago about transparency being the key
here. We can see what is happening. Which regions of the
country may be affected the most?
Mr. Gensler. Well unfortunately, every region of the
country had to put up $180 billion into AIG, so I think
transparency lowers the risk of these toxic assets for every
region of the country. And I think every region of the country
uses these derivatives. There are $300 trillion, which if you--
just the arithmetic is $20 of swaps for every dollar in the
economy. It could be when somebody drives up to a gas station
in Wichita or Frederick, Maryland, or anywhere that that gas
tank somewhere somebody has hedged behind it. So greater
transparency and lower risk will benefit the economy at large.
Mr. Fincher. Thank you. Thank you, Mr. Chairman.
The Chairman. The gentleman's time has expired. I now
recognize the gentlelady from Ohio, Ms. Fudge, for 5 minutes.
Okay. I now recognize the gentlelady from Alabama, Ms. Sewell.
I now recognize Mr. McGovern for 5 minutes.
Mr. McGovern. All the questions I was going to ask have
already been asked, but I appreciate very much your being here,
your testimony, and look forward to working with you. I am
particularly concerned about the issue of making sure you have
adequate funding to be able to carry out your enormous task
here. I just want to say thank you for your great work.
Mr. Gensler. I thank you. It is good to see you again.
Mr. McGovern. Nice to see you again.
The Chairman. The chair now recognizes the gentlelady from
Missouri, Mrs. Hartzler.
Ms. Hartzler. Thank you, Mr. Chairman.
I have had a lot of interesting discussions over the last
few weeks with people in my district, people in my area, and I
represent a large agriculture area. I have visited with people
from the Kansas City Board of Trade last weekend. I visited
with the utilities in my district, and I can tell you the
common thread among all of them is that your staff is going far
beyond the--what the bill's original intent is. It is a huge
amount of regulations. It is going to be very onerous on
businesses and on the way things are supposed to be conducted.
I understand you have over 31 teams of people writing these
rules, and yet the people that are going to be impacted by them
don't have teams, and they have one, two, three individuals
that are trying to wade through. The proposals that you have
put forth for these rules are 45 pages long, 26 pages long, 60
pages long. Here is a specific comment that was made by the
President of the Kansas City Board of Trade in a letter, and I
would like for you to, just in general, respond to it. It says
``As you might suspect, we have been suffering through the
myriad of regulations pouring out of the CFTC's result of the
financial regulatory reform legislation. We are concerned and
disappointed that the CFTC is using the Dodd-Frank legislation
to not only implement a regulatory regime for previously
unregulated OTC trading, but as an opportunity to propose
unnecessary and extremely prescriptive regulations on already
regulated derivative markets. The regulated markets were not
the cause of the 2008 financial crisis. In fact, these
regulated markets operated exemplary under regulatory
initiatives required to implement under extreme market
volatility and pressures. We are left wondering why, with all
the regulatory initiatives required to implement the provisions
of Dodd-Frank, does the CFTC find it necessary to impose
prescriptive regulations on an already well-functioning
regulated marketplace?'' That is just one of the comments that
I have heard. I would like for you to respond.
Mr. Gensler. I thank you. Two thoughts. One is really, we
encourage the public, if you have a comment on any of the
rules, even if a comment period has closed, we have discretion,
the staff and the Commissioners, to still consider that. I note
that one of the rules that people most focus on is this
definition of swap dealer. That comment period closes in a
couple weeks, February 22, to be more precise. I would hope
that the public, if you have, looking at the whole mosaic, want
to comment, comment. We will get it to the right staff, we will
get it to all the Commissioners. We have that discretion.
The second thought I just wanted to share with you because
it comes from the really fine people at the Kansas City Board
of Trade. One of the reasons we have taken up rules with regard
to clearinghouses and what is called designated contract
markets of futures exchange as the Kansas City Board is, is
because now they can also offer swaps. Congress said that a
clearinghouse, if they wanted to at the Kansas City Board or
their exchange, could offer swaps.
So the product can also be there. I haven't personally read
his letter. Now I will make sure to read it closely. The
futures marketplace has been a strong, vibrant, transparent
marketplace, and largely we want to make sure the swaps
marketplace learns from that and is similar to the futures
marketplace.
Ms. Hartzler. Yes. I would just hope that the CFTC doesn't
use--only abides by the parameters in the legislation, and we
can discuss what has been passed. I would like to repeal a lot
of it, but that is currently on the books and don't overstep
what is there to try to reach out further. We need less
regulations overall, I believe.
Mr. Gensler. Let me assure you, I share your view. July 20,
the day before the President signed a bill, we got the 30 team
leads together and I said we shouldn't over-read this statute
nor under-read this statute. We should just do what the statute
tells us to do. It is a very historic piece of legislation.
That is what we are doing and hopefully with public comment, we
will keep being reminded of that.
Ms. Hartzler. Thank you. Transparency, yes, is important,
but it is more important or just as important that in our
economy, we don't hurt businesses that are currently working
for jobs and for our overall country. Thank you.
Mr. Gensler. Thank you.
The Chairman. The gentlelady's time has expired. We now
turn to the gentlelady from Maine. We now turn to the gentleman
from North Carolina for his 5 minutes.
Mr. Kissell. Thank you, Mr. Chairman. Mr. Gensler, thank
you for being here today.
We have heard a lot of comments about public comments, and
not trying to speculate or to foresee where the comments might
be going, but just curious, what do you feel is the area the
public is most concerned about, has commented about, maybe
misunderstands, maybe just--you know, what is the feel for what
the public is saying so far?
Mr. Gensler. That is an excellent question. We have had
about 2,800 comments before we made the proposals, 500
meetings, and 1,100 comments after the proposal so far. It is a
little hard to bring it all together. Usually comments are
about something that affects them. That is a natural thing.
End-users, which we have had a lot of debate and discussion
about, want to ensure that the margining doesn't cover them. I
think hopefully we have addressed that in these prepared
remarks that we don't see extending margin to these non-
financial end-users, at least at the CFTC.
There have been a lot of end-users that wanted to make sure
they weren't caught up in the major swap participant
definition. That seems to have calmed down greatly once we put
the proposal out, because we really made those numbers very
large and systemic. There are still, as people have talked back
and forth, end-users who don't want to be caught up in this
swap dealer definition.
So I am giving you some sense of it. If you move over into
the Wall Street community, the Wall Street community is largely
about timing of implementation, that they need to get the
resources to do it, and so forth. There is a back and forth
about transparency. Transparency tends to help the end-users.
It probably shifts some of the advantages away from the
financial community, modestly.
So there is a lot of back and forth about transparency with
the financial community.
But I am trying to summarize. I guess that would be about
4,000 comments and 500 meetings. It is not fair to any one
commenter to try to summarize all of that.
Mr. Kissell. Thank you, sir, and I yield back, Mr.
Chairman.
The Chairman. The gentleman yields back. The gentleman from
Kansas is now recognized for 5 minutes.
Mr. Huelskamp. Thank you, Mr. Chairman. I appreciate the
opportunity to ask a couple questions here. I just want to
follow up on a few of the earlier questions, if I may.
Mr. Chairman, you did note--made some comment, I guess, if
one does have a profit motive--I think it was a reference to
those that would qualify. Are there folks in this marketplace
that do not have a profit motive?
Mr. Gensler. There are many nonprofit entities that use
derivatives and should be allowed to use derivatives,
hospitals, municipalities and so forth.
Mr. Huelskamp. I was presuming when you said they didn't
have a profit motive that somehow they weren't trying to
protect a risk or had a financial interest, but they certainly
all have a financial interest, correct?
Mr. Gensler. Oh, I think that is correct. I think it is
hedging a financial interest, hedging a commodity, wheat or
corn. There can be speculators, who are certainly a very
important part of the markets as well.
Mr. Huelskamp. And which portions of the markets would the
speculators versus the end-users that are hedgers?
Mr. Gensler. Well, the way that Congress laid out the end-
user provision, if it is not a financial company, so not a bank
or insurance company, and it was hedging a commercial risk, it
is out of clearing and we believe out of margin. We put a
proposal out that said you could be hedging any input, any
service, you could be hedging a factory, a loan, any commodity.
We look forward to the public comment, but we tried to be very
expansive and exhaustive in terms of defining that hedging out
widely. Again, we will get the public comment to see if we
missed something, but we tried to be pretty expansive on that.
Mr. Huelskamp. Thank you, and I appreciate that.
It is my understanding as well that you do have the
authority to exempt small banks and small Farm Credit System
institutions and credit unions from the clearing requirement. I
just want to know for certain, do you intend to exempt these
entities?
Mr. Gensler. We look forward to hearing from the public. We
have not as a Commission made any determination, other than
Congress gave us the authority to exempt and we have asked
questions from the public as to how we should address that
authority.
Mr. Huelskamp. Any information or any discussions
internally? I mean, do you--can you give a sense whether you
plan on using that authority, or you are just going to wait
until July and let us all know then?
Mr. Gensler. No, I think our comment period will close
earlier, and if we were to use it, we would have to propose an
exemption, but I don't want to get ahead of the staff and my
fellow Commissioners. I think we need to really take in what
people have said. This is with regard to the clearing
exception.
Mr. Huelskamp. Do you--so you believe you could wait until
July 1 to let folks know whether they are exempted or not, or
will you let them know before that time period? Any thoughts on
that?
Mr. Gensler. Well, again, we have an active schedule to
review the comments, to take those up. If we were to exempt, we
would be making a proposal well in advance. I mean, that is
part of our spring agenda is to take up the clearing
requirements.
Mr. Huelskamp. So do you expect these small entities to
comment on all the proposed rules and tell if and when they
find out they are exempt?
Mr. Gensler. Well, the small entities to which you are
referring by and large are not swap dealers. There may be one
or two exceptions that--I can't speak for thousands. There are
7,000 or 8,000 small banks in this country. I doubt many of
them are swap dealers.
So this is just about the clearing requirement, and we are
getting comments in about this authority to possibly exempt,
whether it be the Farm Credit, the credit unions, or the banks.
We are also working with the regulators. We worked very
closely with Debbie Mantz and her people, and of course, the
folks at the Farm Credit Administration and the banking
regulators.
Mr. Huelskamp. Do you believe these small financial
institutions pose a threat to the stability of your system?
Mr. Gensler. I think the threat is the other way. Clearing
lowers risk to the whole economy, and I would hate to come to
the day when a Secretary of the Treasury says I can't let a big
bank fail because they are so interconnected to the Farm Credit
System. The risk is the other way in that some 10, 20 years
from now a Secretary of the Treasury says I can't let them fail
because they will bring down the Farm Credit System. That is
the problem.
Mr. Huelskamp. So in your opinion, they do not pose a risk?
It is the risk the other way?
Mr. Gensler. Yes, but then it is this interconnectedness
that is the risk.
Mr. Huelskamp. Thank you, Mr. Chairman.
The Chairman. The chair now turns to the gentleman from
Vermont for 5 minutes.
Mr. Welch. Thank you very much, Mr. Chairman.
Mr. Gensler, as I understand it, there are two goals here.
One is to make certain that the hedging a benefit is absolutely
available at the least possible costs and the least possible
threat to the overall financial condition of the economy to
end-users. Is that correct?
Mr. Gensler. I believe that is a key goal in transparency
and competition helps avail to that goal.
Mr. Welch. Right, and those are--transparency and
competition are seen as tools to help provide benefit--economic
benefit to the end-user, correct?
Mr. Gensler. Correct.
Mr. Welch. Then ultimately the American public.
Mr. Gensler. Right.
Mr. Welch. And there is--if you have end-users, they also
rely on some financial institutions in order to carry out the
trades that provide them with the hedging protection. Is that
more or less what the relationship is?
Mr. Gensler. That has been historically correct, but there
are also on-exchange transactions. Even in the futures market
it is relying on the marketplace. It could be a speculator on
the other side or another hedger on the other side anonymously
on the other side through centralized markets, which work very
well, and in fact, often have more transparency.
Mr. Welch. All right. So if you are an end-user, an airline
or a farm operation, your interest, presumably, is in getting
the best price for the product you are buying to hedge,
correct?
Mr. Gensler. And also to get something that fits your
hedging needs is very important.
Mr. Welch. Is there any reason why transparency in
immediate or reporting that is as soon as technologically
possible as to the transaction would be an impediment to a
hedger from getting what they need?
Mr. Gensler. I believe as long as we follow Congress's
mandate that the blocks are delayed and second, that we protect
that the confidentiality of the parties, that it is not an
impediment, but we still need to make sure that we protect the
confidentiality of the parties, of course.
Mr. Welch. All right. So some of the financial
institutions, I understand, have raised questions about this,
and I am wondering if you could just state what you understand
to be their arguments?
Mr. Gensler. Their argument is that it could take time to
hedge their product. If it is a block trade they would have a
time to hedge their product. Certainly if it is on an exchange,
one would hope that they have enough liquidity.
The second argument they would say is that somehow we are
diminishing liquidity. I don't actually think the economic
study shows that. I think transparency enhances liquidity, not
diminishes liquidity, but they would take the other side of
that, and I respect that we might have a difference on that.
Mr. Welch. And just, if you could, try to explain to us
what they claim is the rationale for that argument.
Mr. Gensler. They might say that they themselves would take
on less risk. This is a marketplace that is very large, $300
trillion. If I could just do a little arithmetic, one percent
of one percent is $30 billion, so if transparency brings just a
little better pricing, one percent of one percent, which is
called a basis point on Wall Street, is $30 billion. So you
could see what is--there is a lot at stake here, and end-users
can't always see these little basis points, but they add up
like the grains of sand in the financial sector.
Mr. Welch. When the NASDAQ market went to a more
transparent system and there was more transparency in immediate
reporting between the bid and the ask price, were some of the
arguments that were made in opposition to making that change
similar to what you are hearing now?
Mr. Gensler. I don't want to say they are identical, but
they are often similar.
Mr. Welch. And has it played out with the changes that were
made in NASDAQ that did increase transparency and timeliness of
reporting, has that proven to be an impediment to the financial
firms?
Mr. Gensler. As I understand it, it has increased
competition and increased liquidity in the marketplace. It also
narrowed what is called the spreads or bid offer spreads in the
marketplace.
Mr. Welch. Okay, thank you. I yield back, Mr. Chairman.
The Chairman. The gentleman yields back his time. I now
turn to the gentleman from Illinois, Mr. Hultgren, for his 5
minutes.
Mr. Hultgren. Thank you, Chairman Lucas. Thank you,
Chairman Gensler.
Under Title VII, Congress took an appropriate step and
provided an exemption from the major swap participant
definition for pension funds. While the protected pension--this
protected them from inappropriate regulations as MSPs, pension
funds are included under the definition of financial entities.
I am concerned about the substantial cost this will impose on
pension funds, especially from Illinois and see the significant
strain that our state and other states are feeling, and I am
very concerned about the unfunded obligation that we are facing
there.
Chairman Gensler, my question is can you commit to this
Committee that in the rules that will impact pension funds and
their trading relationships, the CFTC will take every
precaution not to impose significant and additional new costs
on pension funds?
Mr. Gensler. Well, I think that we are--when we look at all
the rules, if I can expand a bit, past pension funds, we take
seriously the guidance from this Congress about cost-benefit
analysis. Pension funds, I don't believe that there is a
pension fund that has come in after we proposed the rules that
say that they are going to be a major swap participant, so I am
not aware there are any. But please, I look forward to
continuing a dialogue if you know of some. We want to know what
we need to do there in the major swap participant area, but
more broadly, I think your question is to ensure that pension
funds get the benefit of the transparency in these markets.
Pension funds, some of them were the ones that asked us to look
at that earlier issue that Congressman Scott asked about. So,
we are working and listening to a lot of pension funds who want
transparency and issues resolved for their benefit in this
marketplace.
Mr. Hultgren. So pretty much to answer the question, you
don't see any additional cost that you would expect from the
rulemaking--from the decisions that you will be making that
will impact pension funds?
Mr. Gensler. Well, I think that pension funds are going to
benefit from the additional transparency, the safeguards in
clearing, the safeguards in segregation of their funds. I don't
know if we will come out with individual or commingled or funds
some other issue.
I don't know of any pension fund that will be a dealer or a
major swap participant. Again, if there is one, I am sure my
saying this they will find us. They all seem to find us.
Mr. Hultgren. One quick question here as my time is winding
down.
Competitiveness is very important for us, especially in the
world stage here. How does the CFTC ascertain whether its rules
will cause U.S. firms or swap transactions to move overseas,
and if you have made any determination there, what are you
doing to make sure that we keep firms here?
Mr. Gensler. Congress included in statute a provision to
cover transactions that have a direct and substantial effect in
the U.S., 722(d). I know it well because I have read it so many
times. Most of the international banks have been in and say
they will register swap dealers because they are doing business
with U.S. end-users. So, all these major banks say they will
register. We still have a lot to sort through on this, and it
is going to be very helpful to hear from the financial
community that we are covering the trades that have that 722(d)
effect. It affects the U.S. markets and the U.S. end-users and
so forth.
We are also working with the international regulators to
ensure the best they can that they adopt similar rules. We have
a very close partnership with the European community, and with
the folks in London. Japan moved ahead of us. They adopted
their rules last year. But we are working together very
closely. I think I am going to be back in Europe again in
March, and the European Parliament is taking up their
legislation.
Mr. Hultgren. So you do recognize that the rules that you
make could affect whether firms decide to remain here in
America or move overseas, and that will be part of your
calculation or part of your planning? Is that right?
Mr. Gensler. It is absolutely part, but we are, as mandated
by Congress to ensure that we cover those transactions that are
happening with U.S. entities or other direct and substantial
affect here. So regardless, even if it is an overseas entity
dealing with a U.S. counterparty, that overseas swap dealer is
likely covered under the Act and will be registering. Most of
them have come in and say they anticipate registering to deal
with U.S. counterparties.
Mr. Hultgren. Thank you, Mr. Chairman.
The Chairman. The gentleman's time is now expired. We turn
to the gentleman from California to be recognized for 5
minutes.
Mr. Costa. Thank you very much, Mr. Chairman.
Just to kind of continue to pursue that line of
questioning. You said the Japanese in the process of
implementing their regulations and the Europeans--I do some
work with the European Parliament, I know, are under their
deliberation. There has been a lot of speculation, I know, 2
years ago when we talked about the whole notion of
clearinghouses and whether or not there would be a competitive
advantage or disadvantage on either continent, based upon the
new set of rules we were establishing. The question is
speculative, but could one not determine or think that based
upon what is going in Japan, and now what is going on in
Europe, that there is not going to be some sort of a sense in
which there is a similarity in terms of the way ultimately this
gets worked out so that--I mean, or do you think that when you
meet and confer with your counterparts in Europe, that they are
trying to seek a competitive advantage or disadvantage that
would allow those to register in one continent versus the
other?
Mr. Gensler. Excellent question. As it relates to clearing,
I think we are very much in line. There is an international
forum called IOSCA that works on these international standards
for clearing and elsewhere. We currently have registered 15
clearinghouses. We think that will grow to 20 or 21, maybe
there will be some others. Some of those are overseas. For
instance, the largest interest rate swap clearinghouse we have
today is in London. It has been registered with us since 2001.
It has $240 trillion of interest rate swaps.
Mr. Costa. I think we met with them.
Mr. Gensler. So we already have that, and so even if it is
over in Europe or in Japan and wants to do business here in the
U.S., we will register it. We will then work on a Memorandum of
Understanding with that foreign regulator so we can leverage
off their expertise. We are resource constrained anyway, but we
work and we have these Memoranda of Understanding with the
Europeans, with Canada, and a number of other places.
Mr. Costa. As this process continues, I think we will want
to revisit that. It should be very interesting to see how it
settles.
Mr. Gensler. I think you are absolutely right, and I think
that there will be some attempts for regulatory arbitrage. I
don't think it will be in the clearing space, but I am not
naive. It could be.
Mr. Costa. Getting back to the--and I believe the Chairman
touched on it in his opening comments, obviously this is a
complex law that you are in the process of doing your
rulemaking and your implementation. We talked about the
timeline for public input, and then following there your
process. Are you going to come out with some actual timelines
for us in the near future that you can present to the Committee
as to how this will roll out over the course of this year and
when the rules will actually be published in the Federal
Register, and where will you go from there?
Mr. Gensler. We are going to take this pause period,
February and March as I call it a pause to look at the whole
mosaic. We probably--I hope that we will have some further
roundtables to hear from the public about the implementation
phase and what can be done early, what can be done later in
terms of implementation. And as we firm that up, I think we
would be sharing it.
The other piece----
Mr. Costa. But I mean after the public input is complete,
then, I mean, you are going to need time to them formulate----
Mr. Gensler. That is right.
Mr. Costa.--the rules and--I mean, do you see this all
being concluded by the end of this year?
Mr. Gensler. I think so. Congress has actually asked us to
do it by July, and we are human, so some of it will certainly
be after July. But I would envision it starting this spring and
summer we will be taking up the final rules. We will be
publishing. Some of them will be the easier, maybe less
controversial ones early.
Mr. Costa. Two quick questions here before my time is
expired. What percent of the swap markets do you believe are
between the non-financial end-users and financial entities, and
does the size of the swap markets allow exemption to safely
exist?
Mr. Gensler. Based on Bank for International Settlements
data, it is somewhere in the order of nine or ten percent of
notional amount is between non-financial entities or the end-
user exception. I believe Congress addresses----
Mr. Costa. Quickly, before my last question. Foreign
currency swaps, will they be regulated under the swaps under
the law by the Secretary of the Treasury? Have you spoken with
the Secretary of the Treasury?
Mr. Gensler. I think you would have to ask the Secretary of
the Treasury what he is going to do on that, with all respect.
Congress gave him the authority and he and I have spoken about
it, but it is certainly the Secretary of the Treasury's
determination to make and to share with Congress.
Mr. Costa. Do you expect a decision for him to make--when
do you expect a decision for him to make? Do you----
Mr. Gensler. I don't know. Certainly I would be glad to
direct your question to the Treasury and ask them to comment to
you. I don't know if they have made that public.
Mr. Costa. Thank you, Mr. Chairman. My time has expired.
The Chairman. The gentleman's time has expired. The chair
now turns to the gentleman from New York, Mr. Gibson, for 5
minutes.
Mr. Gibson. Thanks very much, Mr. Chairman, and I want to
apologize to our witness. I have multiple hearings that I am
taking care of today. I did confer with my aide before I got
back in, and it has been a very comprehensive hearing, and you
have answered nearly all of the questions that I had.
Really, just a simple one remains. How big do you assess
the over-the-counter market is, in terms of dollars and
participants?
Mr. Gensler. The market worldwide is about $600 trillion
notional, about a little less than half of that is here, but
let us call it $300 trillion. The 25 largest bank holding
companies have about $277 trillion, as of the most recent data
from the Comptroller of the Currency. Participants, thousands
of participants are in it because they use it as a hedging, all
these we have been calling end-users use it to hedge, but I
can't tell you how many. It is probably over 10,000 that
actually use it.
Mr. Gibson. And so given that, it is certainly a daunting
challenge. Do you feel that the pace of which you are going to
unfold these regulations can be absorbed by this market?
Mr. Gensler. I think that through the extensive work that
Congress did in its oversight and putting together the Act and
the extensive work the Securities and Exchange Commission and
CFTC are doing, the major market participants who will be
either swap dealers or clearinghouses and so forth have been
very seriously engaged. The end-users, by and large, are
exempted from clearing, trading, and I believe should be from
the margining.
So I would say yes, in terms of these large clearinghouses
and financial entities. They are very engaged. I think as it
relates to the CFTC, I think this schedule that Congress has
laid out is doable. We are human. Some of it will slip, and I
believe we are committed to looking at our whole rule book as
the President put in the Executive Order. We are going to look
at the rest of our rule book and see if that needs to be
updated as well. We are going to publish some plan to do that
in the next 120 days or 120 days from when he made his
Executive Order.
Mr. Gibson. Okay, I appreciate the responses. I am somewhat
concerned, but I have noted what you said and I look forward to
working with you as we go forward.
Mr. Gensler. I look forward to working with you directly as
well.
Mr. Gibson. I yield back.
The Chairman. The gentleman yields back the balance of his
time. The chair recognizes the gentleman from Illinois, Mr.
Schilling, for 5 minutes.
Mr. Schilling. Thank you, Mr. Chairman. Thank you, Mr.
Gensler.
A lot of my questions have already been answered. I am just
a small business owner from Illinois and you know, one of the
things that I have noticed that really kind of got me to run
for an office for the first time in my entire life is that a
lot of times our government tends to see something and then
overreact to it, and move too rapidly. You know, growing up as
a kid and through most of my adult life, we didn't--businesses
could be over-taxed, over-regulated, and there wasn't really
much they could do. I guess one of my big concerns is that what
is going to happen is we are going to rush this through. We
have talked several times about how important this is, and I
think we are moving very fast with it. I know you are under
time constraints, but you know, my concern is we are going to
have companies like CME and others that are going to say,
``Hey, you know what, we are going to move out of the
country,'' and we are going lose more jobs here in the United
States, which is one of the reasons why I showed up here.
You know, that is thing. I am just hoping that when we move
along--you know, as a business owner, I look at the long-term
effects of every decision that I make because it makes me
successful or not. I think that is the--what has been--the
burden that has been laid upon your shoulders. I know that is a
big burden, but you know, American families, the people that
are raising their kids and buying houses and things like that,
that when we do make decisions that we make sure we give a
thorough thought.
But I mean, all of my questions have been answered. That
was just kind of my comment to you, sir.
Mr. Gensler. I thank you. Since we just met, what is the
business that you are in?
Mr. Schilling. St. Giuseppe's Pizza. It is an Italian
restaurant.
Mr. Gensler. Terrific. We take this very seriously. The
American public doesn't connect necessarily day-to-day with
derivatives, but they stand behind even that pizza that you
sold. Somewhere in that supply chain, someone was using
derivatives to hedge a product along the way. It may have been
the wheat that went, ultimately, into that pizza. But also, the
crisis was very real in 2008, and that $180 billion went into
AIG, which was an ineffectively regulated non-bank in the
derivatives marketplace, which you know, is $600 for every one
of your constituents, if you just do the arithmetic.
So I think that is what we are trying to do and what
Congress really did, and we have to comply with that statute to
lower the risk, make sure that end-users aren't caught up into
it inadvertently, but that the dealer community is regulated,
the clearinghouses lower risk, and then all the end-users get
the benefit of the transparency.
Mr. Schilling. All right, very good. I thank you for your
time. I yield back.
The Chairman. The gentleman yields back. The chair now
recognizes the gentleman from Nebraska for 5 minutes.
Mr. Fortenberry. Thank you, Mr. Chairman. I appreciate the
time.
I would like to step away from the immediate discussion and
talk about some broader perspectives. If we understand the very
fundamental purpose of these markets to be to mitigate risk and
to inform price discovery, we traditionally had--and perhaps
you can answer this if I am not correct--80 percent of the
market traditional hedgers versus 20 percent speculators, or
maybe 70/30. It is my understanding that some of those
proportions are now inverted. If you look at where we are today
in terms of our own economic situation, you can trace the
beginnings of this back to the run-up in commodity speculation
in oil prices, which then began to create some problems in the
economy, create layoffs, which then exposed the housing bubble
due to liberalized credit, which had all the various
manifestations after that of problematic, bizarre, and
financial instruments on Wall Street, and here we sit after a
couple years of the Treasury Secretary coming to us and saying
you must do this and bail out all these firms in order to
prevent economic Armageddon.
The point being is the very markets designed to mitigate
risk, had they created risk?
Mr. Gensler. I think in the case of this swaps market or
what is called over-the-counter derivatives, you are correct,
that they did help many entities mitigate risk, but they also
concentrated risk. That the crisis was for many reasons, the
housing bubble as you talked about and other reasons, but part
of it was the derivatives marketplace, particularly this
product called credit default swaps. I think it also helped
concentrate risks. Rather than mitigating and spreading risk,
it concentrated risk so that in the height of the crisis the
Administration at that time felt it needed to come to Congress,
and as you know, extend bailouts to these large financial
entities, AIG and others. We shouldn't put the American public
at that risk. There should be a freedom to fail, that these
firms can fail and not be so interconnected through their
derivatives contracts with the rest of the financial entities.
Mr. Fortenberry. I had a local Chamber of Commerce group
come to see me a year or so back, including a number of small
bankers, and I asked any of them if they had ever used or heard
of a synthetic collateralized debt obligation, and they just
stared at me with blank stares.
Mr. Gensler. I am guessing----
Mr. Fortenberry. Thank you for not knowing exactly what
that means. Again, when you have institutions that are
disconnected from an understanding of the underlying asset
value and a machine out there that pops up the bad information
in terms of ratings and insurers that are, again, not
understanding that underlying asset value in those portfolios
and raking in commissions, and no check mechanisms on that.
That was the manifestation of the full extent of the
problem due to liberalized credit that was out there, but also
a lack of mechanisms that prevented, as you say, the
concentration of risk and oversight mechanisms that would have
stopped this type of development.
But let us go back to that earlier point. Do we have now a
disproportionate number of hedgers versus speculators, and is
that a related problem to these markets becoming investment
markets versus markets designed to mitigate risk?
Mr. Gensler. This is an age old debate, the role of
speculators and hedgers in markets. Our markets----
Mr. Fortenberry. But it is traditionally--we are in a
different period now where the proportion of speculators is
much, much higher, if my understanding is correct, than
traditional hedgers.
Mr. Gensler. In some markets that is certainly the case.
Speculators and hedgers both have a role in markets. Agencies
such as ours and SEC work hard to protect against fraud and
manipulation. Congress has also asked our agency to use
something called position limits to protect against the burdens
of what is called excessive speculation, and we have done that
over the decades in certain physical commodity markets.
Mr. Fortenberry. Do you see any parallel between the run up
and commodity speculation at the moment and what happened in
2008?
Mr. Gensler. Well, I think that the American public, which
you are correct, is observing this run up and the costs they
see in the gas tank and so forth are very real. We put out
proposals on position limits to use the authority that this
body--and in fact, this Committee was probably the first
Committee that asked us to do that back in 2008 if I remember.
Congressman Peterson will probably remind me, and Chairman
Lucas.
So we are looking forward to the public comment on that
related to the energy market. It will get a lot of comment. We
got 8,200 comments on the proposal we put out a year ago.
Mr. Fortenberry. Well, I look forward to hearing the
results of that.
Mr. Gensler. Thank you.
Mr. Fortenberry. Thank you.
The Chairman. The gentleman's time has expired. The
gentleman from Arkansas is recognized for 5 minutes.
Mr. Crawford. Thank you, Mr. Chairman, and thank you, Mr.
Gensler, for being here. I apologize for my tardiness. I also
had another hearing to attend.
You just alluded to one of the questions I was going to
ask, and that was the empirical data. In your opinion, the
diverse fluctuation in the commodity prices, is that due to
spec trading or is that due to fundamental market activity? And
based on--is your opinion going to be based on some empirical
data you can cite?
Mr. Gensler. Speculators and hedgers each meet in a
marketplace and both have roles in the marketplaces. We as an
agency have been asked by Congress to ensure that the markets
have integrity, free of fraud, manipulation. We do not regulate
prices or the level of prices, or volatility itself, but we
have to ensure that the markets have integrity. Part of that is
this position limit regime to ensure that--and over the decades
we have used it in the agricultural commodities, and at times
with the exchanges worked together to do it in the energy
markets to ensure that they are not so concentrated, that there
are only a handful of actors, rather than a diversity of actors
within a marketplace so that price function, that price
discovery function has a diversity of folks in there. That is
what is underlying our approach with regard to this
marketplace.
I know it didn't directly answer your question, but it gave
you sort of a concept as to how we have done it.
Mr. Crawford. It did. It kind of leads me to my next
question.
Over the last several years, the open outcry price
discovery mechanism has been, particularly for agricultural
end-users, farmers that were hedging, that has been pretty
critical to real price discovery in the marketplace for them.
As you said, hedgers and spec traders meet. What role do you
think e-trading has played in a broad sense to possibly
exacerbate the problem?
Mr. Gensler. Well, it has been a very significant change
over the last 10 years. Nearly 90 percent of the futures
market--again, Terry could tell you a better number. I think it
is 88 percent maybe of the markets now are electronic. That
doesn't mean high frequency, just electronic. I think that
technology will continue in that direction, and so we have to
have the tools and the exchanges have to have the tools to be
able to monitor that electronic trading, that there are
appropriate safeguards before somebody enters a trade, and
appropriate pauses if the markets get so unbalanced. Like on
May 6, there was actually a pause in the trading that I think
was at a critical time. We have asked the public a lot of
questions to make sure that that reality--and it is a reality
that we are in electronic markets now--still works for the
benefit of the investing and hedging public.
Mr. Crawford. Does the 24/7 model global marketplace, does
that play into this volatility? Does it increase volatility
because we are used to seeing the pit close, and that was your
closing price? Now with e-trading and 24/7, has that sort of
created more of a volatility issue?
Mr. Gensler. Well, I think it has extended it across a 24
hour timeframe, and that there are more news events that can
move a market overnight, certainly in the currency and
financial markets, and in the oil markets, which is very
global--energy markets are very global. For some of the
agricultural markets, their real liquidity is during the period
of time that it is open in the futures market.
Mr. Crawford. Thank you, Mr. Chairman. I yield back.
The Chairman. The gentleman's time has expired. The time
the Member has is expired.
With the Ranking Member's indulgence, I would like to ask
the Chairman of the Commission a couple more questions before
we release him.
You know, Mr. Chairman, I have been very sensitive, as a
number of my colleagues have, as we discuss the margin
questions and potential impact for end-users. Do you believe
that you have the authority to impose a margin requirement on
both parties in transactions involving end-users? Do you
believe you have the authority?
Mr. Gensler. I believe we have the authority not to, and
that is what we plan to do if I move forward. Only we ever see
the non-banks, so we need to address that. I think that is
consistent with what Congress did in the clearing area.
The Chairman. So if you believe--and I am not putting words
in your mouth--that you don't have the authority? Is that the
way I should interpret that?
Mr. Gensler. No, I said I believe we have the authority not
to impose it, and that is what certainly my recommendation to
the staff is and the Commission, moving forward.
The Chairman. That is an interesting answer. Well, in the
rule it will finally come together, will it leave open the
possibility for dealers to require end-users to post margin?
Mr. Gensler. We haven't written it, but I believe the
dealers today have that. It is a matter of individual
negotiation, and many dealers extend credit, because that is
really what it means when you don't post margin is extending
credit. Many dealers extend credit to end-users, but often--
dealers often require margin to be posted after you hit a
certain trigger. And that would still be allowed. Dealers would
have the same authorities they would have today to do that by
individual negotiation, depending upon end-user's balance
sheet, if an end-user might have assets that are good enough,
then the dealer can make that determination.
The Chairman. Let me think this through one more time.
So you believe you have the authority not to impose. I
guess that means you have the authority to make a decision, so
you could, but the rule would indeed leave the possibility in
certain circumstances for dealers to require--so is the
outcome--would it still be that end-users, in order--
potentially the outcome would be for end-users, in order to
engage in these transactions, would either face a margin
requirement from the dealer or increased costs associated with
the margin requirement imposed by their dealer?
Mr. Gensler. No, I don't think so. I think it would be
exactly where it is right now. Dealers today entering into
transactions with non-financial entities and individually
negotiate those arrangements, as they might negotiate a line of
credit or negotiate any arrangement. It would have to be
documented. We are proposing that they have documentation. That
helps lower risk. But it would be up to the--at least where I
am. I can't speak for all the other fellow regulators. That
would still be up to that individually negotiated arrangement
between the dealer and the end-user, as it is today.
The Chairman. Thinking back, Chairman, to a letter at some
point in the process from Senator Dodd and Senator Lincoln to
myself and the Ranking Member, which tried to clarify
legislative intent, I believe the letter explicitly said the
legislation does not authorize regulators to impose on the
marginal end-users. I guess I just simply note, sir, that it
sounds like as your friends on the authorizing committee, we
are going to be watching and working very closely with you in
the coming days.
Mr. Gensler. I look forward to that. I think that that
would help us.
The Chairman. We will have a lot of fun, Mr. Chairman.
With that, thank you for your time. You are excused.
Mr. Gensler. Thank you, and for all the very excellent
questions.
The Chairman. And while the Chairman is stepping away from
the table, we will prepare for our next panel.
As our second panel is coming to the table and preparing
for the testimony, I would like to welcome them and introduce
them.
First is Edward Gallagher, President, Dairy Risk Management
Services, Dairy Farmers of America, and Vice President, Risk
Management, the Dairylea Cooperative, on behalf of the National
Council of Farmer Cooperatives in Syracuse, New York. Also
joining him at the table will be Mr. Terrence Duffy, Executive
Chairman, CME Group Incorporated, Chicago, Illinois. Mr. Robert
Pickel, Executive Vice Chairman at the International Swaps and
Derivatives Association, Incorporated, New York City. Mr. Scott
Morrison, Senior Vice President and CFO, Ball Corporation, on
behalf of the Coalition for Derivatives End-Users from
Bloomfield, Colorado, and Lee Olesky, Chief Executive Officer
of Tradeweb, New York, New York.
And with that, Mr. Gallagher, whenever you are prepared,
you may begin.
STATEMENT OF EDWARD W. GALLAGHER, PRESIDENT, DAIRY RISK
MANAGEMENT SERVICES, DAIRY FARMERS OF
AMERICA; VICE PRESIDENT, RISK MANAGEMENT, DAIRYLEA COOPERATIVE,
WASHINGTON, D.C.; ON BEHALF OF NATIONAL COUNCIL OF FARMER
COOPERATIVES
Mr. Gallagher. I am sorry. Implementation of the Dodd-Frank
Act--I appreciate the opportunity to discuss the role of the
over-the-counter derivatives market and helping farmers and
farmer-owned cooperatives manage commodity price risks.
As I was introduced, I am Edward Gallagher. I am the
President of Dairy Risk Management Services at DFA, and Vice
President, Dairylea. I am here representing both DFA, Dairylea,
and the National Council of Farmer Cooperatives.
Farmer cooperatives, businesses owned, governed, and
controlled by farmers, ranchers, and growers are an important
part of the success of American agriculture, and provide a
comprehensive array of services for their members. Providing
risk management tools is among those services. These tools help
to mitigate commercial risk in the production, processing, and
selling of a large portion of this country's food supply.
We ask that the implementation of the Dodd-Frank law
enhance opportunities for farmers and their cooperatives. It is
imperative that we continue to mitigate these market risks, and
it is imperative that we forebear regulatory changes that
reduce program offerings and increase the very risks that the
law was intended to address.
A cooperative can aggregate its own members' small volume
hedges or forward contracts, and offset that risk with a
futures contract or by entering into a customized hedge via the
swap market. More and more producers are depending on their
cooperatives to provide them with these tools to manage this
risk, and assist them in locking in margins or creating
insurance-like margin safety nets. Please refer to my written
statement for some examples of these.
Dairylea, DFA, and the National Council support elements of
the Dodd-Frank Act bringing more transparency and oversight to
the OTC derivatives markets. Our overall objective in the
implementation of the Act is to preserve the ability of
cooperatives to manage commercial risk and support the growing
demand from our member-owners for products to help them
mitigate the growing volatility in commodity markets.
We have had a number of opportunities to express our
concerns to the CFTC, and they have been accessible and engaged
and open in our issues, and I appreciate the comment that I
heard from Chairman Gensler this morning.
At this juncture, our largest concerns are in the
uncertainty around the definitions in capital margin rules.
While the CFTC continues to propose regulations for swaps and
swap dealers, it is, although perhaps made a little bit more
clear today what transactions and who will be subject to those
additional regulations.
Further, some activities of cooperatives would appear to be
captured under the swap dealer definition contained in CFTC's
initial draft regulations. We believe that by applying the
interpretive approach for identifying whether a person is a
swap dealer as outlined in the proposed rules, CFTC would
likely capture a number of entities that were never intended to
be regulated as swap dealers, including farmer-owned
cooperatives.
If farmer cooperatives were to be regulated as dealers,
increased requirements for posting capital and margin and
perhaps complying with reporting, record-keeping, and other
regulatory requirements, could make providing those services
uneconomical to our members. Such action would result in the
unintended consequence of increasing the very risk that the law
intends to mitigate. We do not believe that this was Congress's
intention, and would urge the Committee, as you have today, to
reiterate that with the CFTC. Thank you for doing that.
It is also our understanding that there will be no
requirements for imposing margins on end-users who are hedging
or mitigating commercial risk. We trust that will be the case
when the regulations are put in place. However, we would be
concerned over excessive margin requirements on dealers and
major swap participants on transactions entered into with end-
users who are hedging. We fear an increased cost structure
associated with our hedging operations due to higher
transaction costs would ultimately discourage prudent hedging
practices all the way back to the farm.
Last, it is vitally important to the economic viability of
producers to continue to utilize forward contracting
transactions with their cooperatives as a means of mitigating
their commercial business risk. These forward contracts create
cash price delivery contracts, allowing producers to mitigate
risk and have more certainty over future price input, costs,
and margins. We ask that the definitions acknowledge that
forward contracts, including those using imbedded price
options, continue to be excluded from CFTC swap regulations.
Thank you again for the opportunity to testify today before
the Committee, and thank you for your leadership and interest
in the implementation of the Dodd-Frank Act. We look forward to
working with you and the CFTC on this endeavor, and others that
may arise that impact the well-being of America's farmers and
the agricultural cooperatives they own and govern.
Thank you.
[The prepared statement of Mr. Gallagher follows:]
Prepared Statement of Edward W. Gallagher, President, Dairy Risk
Management Services, Dairy Farmers of America; Vice President, Risk
Management, Dairylea Cooperative, Washington, D.C.; on Behalf of
National Council of Farmer Cooperatives
Chairman Lucas, Ranking Member Peterson, and Members of the
Committee, thank you for the opportunity today to discuss the role of
the over-the-counter (OTC) derivatives' market in helping farmers and
farmer-owned cooperatives manage commodity price risks, and some of the
key issues we see in implementation of the Dodd-Frank Wall Street
Reform and Consumer Protection Act.
I am Edward Gallagher, President of Dairy Risk Management Services,
a division of Dairy Farmers of America (DFA), and Vice President of
Economics and Risk Management at Dairylea Cooperative. Together, those
two cooperatives represent more than 17,000 dairy farmer members in 48
states.
I also serve on the National Council of Farmer Cooperatives' (NCFC)
Commodity Futures Trading Commission (CFTC) working group, which was
formed to provide technical assistance to NCFC on commodity markets,
including implementation of Title VII of the Dodd-Frank Act. On behalf
of the DFA-Dairylea dairy farmer-owners, and more broadly the more than
two million farmers and ranchers who belong to farmer cooperatives, I
appreciate the Committee for holding this hearing on the key issues of
implementing the Dodd-Frank Act.
Farmer cooperatives--businesses owned and controlled by farmers,
ranchers, and growers--are an important part of the success of American
agriculture, and provide a comprehensive array of services for their
members. These diverse organizations handle, process and market
virtually every type of agricultural commodity produced. They also
provide farmers with access to infrastructure necessary to manufacture,
distribute and sell a variety of farm inputs.
In all cases farmers are empowered, as elected board members, to
make decisions affecting the current and future activities of their
cooperative. Earnings derived from these activities are returned by
cooperatives to their farmer-members on a patronage basis thereby
enhancing their overall farm income.
America's farmer cooperatives also generate benefits that
strengthen our national economy. They provide jobs to nearly 250,000
Americans with a combined payroll over $8 billion. Many of these jobs
are in rural areas where employment opportunities are often limited.
Cooperatives' Use of the OTC Market
As processors and handlers of commodities and suppliers of farm
inputs, farmer cooperatives are commercial end-users of the futures
exchanges as well as the OTC derivatives markets. We are considered
end-users because we own, produce, manufacture, process and/or
merchandise agricultural commodities. Often times, the end-user status
is based on our operations being the aggregators of our individual
farmer-owners risks--either the risks directly associated with
operating their individual farm business or the risks associated with
operating the multi-farm aggregated risk of manufacturing or processing
plant operations.
Due to market volatility in recent years, cooperatives are
increasingly using OTC products to better manage exposure by
customizing their hedges. This practice increases the effectiveness of
risk mitigation and reduces costs to the cooperatives and their farmer
members.
In addition, OTC derivatives offer cooperatives the ability to
provide customized products to producers to help them better manage
their risk and returns. A cooperative can aggregate its owner-members'
small volume hedges or forward contracts and offset that risk with a
futures contract or by entering into another customized hedge via the
swap markets. More and more producers are depending on their
cooperatives to provide them with these tools to manage price risk and
to assist them in locking in margins or creating insurance-like margin
safety nets.
Some examples include:
Local grain cooperatives offer farmers a minimum price for
future delivery of a specific volume of grain. The local
elevator then offsets that risk by entering into a customized
hedge with a cooperative in a regional or federated system.
Cooperatives offer livestock producers customized contracts
at non-exchange traded weights to better match the
corresponding number of head they have, while also reducing
producers' financial exposure to daily margin calls. The
cooperative offsets its risk of those contracts by entering
into a corresponding hedge with another counterparty.
Customized solutions are developed by the cooperative to
assist individual farmers with their fuel hedging needs as
individual farmers do not have the fuel demands necessary to
consume a standard 42,000 gallon monthly NYMEX contract.
A cooperative aggregates its members' small volume hedges or
forward contracts and transfers that risk to a swap partner. A
swap dealer or other commercial counterparty would otherwise
not have the interest in servicing such small entities.
While my colleagues at grain, farm supply, and livestock
cooperatives could provide greater details on how the above programs
work for those sectors, they are all similar in concept and purpose to
the risk management programs we provide to our Dairylea-DFA producers.
We enter into OTC derivatives to hedge the price risk of the
commodities we supply, process or handle.
Our member-owners include small farms (such as a 50 cow member-
owner in Pennsylvania), mid-size farms (such as a 350 cow member-owner
in Wisconsin) and larger farms with 1,000 or more cows. This diversity
in member-owners requires us to offer a broad range of tools to meet
their risk management needs, including services to help members
mitigate the commercial risk associated with the high volatility in
milk and input prices.
We offer our members a forward contracting program as a primary
means of mitigating commercial risk. As one alternative under the
forward contracting program, we offer our member-owners a fixed price
for their milk and a hedge on their feed purchases. These risk
mitigation tools are critical for our farmers. Many producers are not
able to use the futures markets to hedge input risk because of the
larger volumes underlying the relevant futures contracts. Furthermore,
corn and soybean contracts do not trade on a monthly basis--while most
of our members purchase livestock feed on a monthly basis. However,
through our forward contracting program, we can offer a more customized
solution for our member-owners. Yet, we can only provide this service
to our member-owners because of our ability to enter into swaps for
customizable volumes and time periods different from the applicable
futures contract.
Implementation of the Dodd-Frank Act
Dairylea-DFA and NCFC support elements of the Dodd-Frank Act that
bring more transparency and oversight to the OTC derivatives markets.
We also recognize the complexity involved in crafting the implementing
rules. We have had a number of opportunities to express our concerns to
the CFTC and they have been accessible and engaged on our issues. We
thank them for being open to NCFC members and staff in gaining a better
understanding of how cooperatives are using the OTC market. In fact,
several CFTC Commissioners recognized this at their public meeting on
January 20th.
However, the current ``definitions'' proposed rule appears to be
headed down a path that would sweep farmer cooperatives into
regulations intended for swap dealers and would increase costs and
inhibit our ability to provide risk management tools to producers.
We do not believe this was Congress's intention and would urge this
Committee to reiterate that with the CFTC. Furthermore, we do not
believe that any Member of this Committee would want any action taken
that would reduce the price and risk management options available to
our producer-members, especially during these highly volatile economic
times. Yet on its current path, that may well be the consequence of the
rulemaking process unless the Committee makes known its desires
otherwise.
Our overall objective in the implementation of the Act is to
preserve the ability of cooperatives to use the OTC market to manage
commercial risks, and at the same time support the growing demand from
our member-owners for hedging products to help them mitigate the
growing volatility in commodity prices.
At this juncture, our largest concerns are in the uncertainty
around the ``definitions'' and ``capital and margin'' rules. While the
CFTC continues to propose regulations for swaps and swap dealers, it is
unclear to us what transactions, and who, will be subjected to those
additional regulations.
Further, the above examples are activities that would appear to be
captured under the ``swap dealer'' definition contained in CFTC's
initial draft regulations. We believe that by applying the
``interpretive approach for identifying whether a person is a swap
dealer'' as outlined in the proposed rule, CFTC would likely capture a
number of entities that were never intended to be regulated as swap
dealers, including farmer cooperatives. This is because cooperatives
engage in activities that look very similar to those of a dealer when
they enter into swaps with farmers, local elevators, and customers as
they provide risk mitigation services and products throughout the
agriculture and energy sector.
If farmer cooperatives were to be regulated as dealers, increased
requirements for posting capital and margin, complying with reporting,
record keeping and other regulatory requirements intended for large
systemically important institutions could make providing those services
uneconomical to our members. Such action would result in the unintended
consequence of increasing the very risk the law intends to mitigate.
It is also our understanding that there will be no requirements for
imposing margin on end-users who are hedging or mitigating commercial
risk--we trust that will be the case when the regulations are put in
place. However, we would be concerned over excessive margin
requirements on dealers and major swap participants on transactions
entered into with end-users who are hedging. We fear an increased cost
structure associated with our hedging operations due to higher
transaction costs would ultimately be passed on in the form of higher
prices for inputs to our farmer-owners while discouraging prudent
hedging practices.
Last, it is vitally important to the economic viability of our
members to continue to utilize forward contracting transactions with
their cooperatives as a means of mitigating their commercial business
risk. These forward contracts create cash-price delivery contracts
allowing our members mitigate risk and have more certainty over future
price, input costs and margins. We ask that the definitions acknowledge
that forward contracts, including those using embedded price options--
allowing for such forward contracts as a minimum milk price that gets
adjusted upwards if feed prices rise, but the minimum milk price does
not change if feed prices fall--continue to be excluded from CFTC swap
regulation.
In closing, NCFC seeks the following:
Treat agricultural cooperatives as end-users since they
aggregate the commercial risk of individual farmer-members and
are treated as such by the CFTC, currently;
Exclude agricultural cooperatives from the definition of a
swap dealer; and
Exempt agricultural cooperatives from mandatory clearing or
margining but allow them to perform either at their discretion.
Thank you again for the opportunity to testify today before the
Committee. And thank you for your leadership and interest in the
implementation of the Dodd-Frank Act. We appreciate your role in
ensuring that farmer cooperatives will continue to be able to
effectively hedge commercial risk and support the viability of their
members' farms and cooperatively-owned facilities.
Recently, the CFTC wrote: ``Permitting agricultural swaps to trade
under the same terms and conditions as other swaps should provide
greater certainty and stability to existent and emerging markets so
that financial innovation and market development can proceed in and
effective and competitive manner.'' \1\ We whole-heartedly agree with
the CFTC. As it relates to agricultural cooperatives, who are the
primary source of hedging innovation for farmers, we trust the rules
permitting these actions will not stifle the very innovation it is
trying to create--or worse yet reduce our ability to help producers
manage their ever increasing commercial risks.
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\1\ Federal Register, Vol. 76, No. 23, Thursday, February 3, 2011,
page 6103.
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Thank you.
The Chairman. The gentleman's time has expired. The chair
now recognizes Mr. Duffy for 5 minutes.
STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME GROUP,
INC., CHICAGO, IL
Mr. Duffy. Chairman Lucas, Ranking Member Peterson, Members
of the Committee, thank you for the opportunity to testify on
the CFTC's rulemaking to implement the Dodd-Frank Wall Street
Reform and Consumer Protection Act. I am Terry Duffy, Executive
Chairman of CME Group, which includes our clearinghouse and our
four exchanges, the CME, the CBOT, NYMEX, and COMEX.
In 2000, Congress leveled the playing field with our
foreign competitors and permitted us to prosper as an engine of
economic growth in Chicago, New York, and the nation as a
whole. I have had the opportunity on numerous occasions to
testify in front of this Committee. I am sorry to report today
that however, the CFTC's Dodd-Frank rulemaking threatens that
prosperity and the growth of our markets.
In 2008, the financial crisis focused well-warranted
attention on the lack of regulation on OTC financial markets.
The industry learned a number of important lessons, and
Congress crafted legislation that we hope reduces the risk that
there could be a repeat performance of that near disaster. It
is important to note that regulated futures and markets and
futures clearinghouses operated flawlessly during and after the
crisis. Futures markets performed all of their essential
functions without interruption, and despite failures of
significant financial firms, our clearinghouse experienced no
default. Significantly, no customer on the futures side lost
their collateral or were unable to transfer positions
immediately and continue to manage risk.
We support the goals of the Dodd-Frank Act, to reduce
systemic risk to central clearing and exchange trading of
derivatives, to increase data transparency and price discovery,
and to prevent fraud and market manipulation. However, with
respect to futures exchanges and clearinghouses, the CFTC has
devoted significant resources to regulations. They impose
unwarranted costs and stifle innovation, and many are
inconsistent or not required by Dodd-Frank. Several
Commissioners have counseled caution on the rulemaking front in
recognition of budgetary constraints. A less welcome response
has been the suggestion that the CFTC's budget limitations will
mean delayed approval for applications and findings necessary
to operate in compliance with Dodd-Frank. Such delay would,
among other things, stifle innovation, job creation, and
economic growth in our industry. We do not object to the CFTC
receiving an appropriate budget; however, we do object to the
CFTC wasting scarce resources to impose uncalled for
regulations and duplicating the oversight of self-regulatory
organizations subject to its jurisdiction.
Furthermore, they may impose burdens on the industry that
require increased CFTC staff and expenditures that could never
have been justified if an adequate cost-benefit analysis had
been performed.
Some of the CFTC's objectionable rule proposals might be
explained by the rush to push proposals out the door before
they are ready in order to permit the CFTC to adopt final rules
in time to meet statutory deadlines; however, the consistent
theme of the CFTC's rulemaking has been to expand its authority
by changing its role from an oversight agency whose purpose has
been to assure compliance with sound principles, to a front-
line decision maker that imposes its business judgments on
every operational aspect of derivatives trading and clearing.
This role reversal would require doubling of the
Commission's staff and budget. It will also impose astronomical
costs on the industry and the end-users of derivatives. Sadly,
there is no evidence that any of this is necessary or even
likely to be useful.
Some Members of the Commission clearly recognize these
issues. They have been forthright in suggesting that the CFTC
deliberate further to ensure that the public interest, rather
than haste in meeting deadlines, temperates an ambitious
agenda. Others do not. Dodd-Frank was not an invitation to pile
irrational regulatory burdens on exchanges, clearinghouses, and
other participants. While the Commission was granted
discretion, it was directed to make fact-based determinations,
grounded in evidence and sound economic theory, that
regulations are necessary, cost effective, and will accomplish
the overall purpose. Unfortunately, the Commission's extensive
obligations under Dodd-Frank are making it all but impossible
for the Commission's staff to document the need for many of the
agency's rulemaking. Instead, the Commission has either ignored
its obligations to justify its proposed rules, or simply
ignored clear direction that such justification is necessary.
For example, Congress preserved and expanded a scheme of
principle-based regulation by expanding the list of core
principles, and granting self-regulatory organizations
reasonable discretion in establishing the manner in which the
self-regulatory organization complies with the core principles.
The Commission asked for, and Congress gave it power, to adopt
rules respecting core principles, but Congress did not direct
the agency to put an end to principals based regulation. Yet
the Commission, immediately and for no apparent reason,
proposed comprehensive regulations to convert all of the core
principles into a prescriptive rules-based regulatory system.
This is the ultimate solution in search of a problem. It adds
unnecessary bureaucratic red tape to a well-functioning system,
while at the same time the President and the Congress have
called for an end to such overreaching.
My written testimony includes numerous additional examples
of misdirected or improper rulemaking. This Congress can
mitigate some of the problems that have plagued the CFTC
rulemaking process. It can do this by extending the rulemaking
schedule so that professionals, including exchanges,
clearinghouses, dealers, market makers, and end-users can have
their views heard. This would give the CFTC a realistic
opportunity to assess those views and measure the real cost
imposed by its new regulations. Otherwise, the unintended
adverse consequences of these ambiguities and the rush to
regulation will stifle effective exchange innovation. It will
also block the most important growth pass in our industry,
including clearing of the OTC transactions. This is
inconsistent with the Dodd-Frank's goal of increasing
transparency and limiting risks by moving more derivatives
transactions onto clearinghouses.
I look forward to answering the questions of the Committee.
Thank you.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Terrence A. Duffy, Executive Chairman, CME Group,
Inc., Chicago, IL
Chairman Lucas, Ranking Member Peterson, Members of the Committee,
thank you for the opportunity to testify respecting implementation of
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (P.L. 111-203, July 21, 2010) (``DFA''). I am Terry Duffy,
Executive Chairman of CME Group, which is the world's largest and most
diverse derivatives marketplace. CME Group includes four separate
exchanges--Chicago Mercantile Exchange Inc. (``CME''), the Board of
Trade of the City of Chicago, Inc. (``CBOT''), the New York Mercantile
Exchange, Inc. (``NYMEX'') and the Commodity Exchange, Inc. (``COMEX'')
(together ``CME Group Exchanges''). The CME Group Exchanges offer the
widest range of benchmark products available across all major asset
classes, including futures and options based on interest rates, equity
indexes, foreign exchange, energy, metals, agricultural commodities,
and alternative investment products. CME also includes CME Clearing, a
derivatives clearing organization and one of the largest central
counterparty clearing services in the world; it provides clearing and
settlement services for exchange-traded contracts, as well as for over-
the-counter (``OTC'') derivatives transactions through CME Clearing and
CME ClearPort'.
The CME Group Exchanges serve the hedging, risk management and
trading needs of our global customer base by facilitating transactions
through the CME Globex' electronic trading platform, our
open outcry trading facilities in New York and Chicago, as well as
through privately negotiated transactions. In addition, CME Group
distributes real-time pricing and volume data through a global
distribution network of approximately 500 directly connected vendor
firms serving approximately 400,000 price display subscribers and
hundreds of thousands of additional order entry system users. CME`s
proven high reliability, high availability platform coupled with robust
administrative systems represent vast expertise and performance in
managing market center data offerings.
The financial crisis focused well-warranted attention on the lack
of regulation of OTC financial markets. We learned a number of
important lessons and Congress crafted legislation that, we hope,
reduces the likelihood of a repetition of that near disaster. However,
it is important to emphasize that regulated futures markets and futures
clearing houses operated flawlessly. Futures markets performed all of
their essential functions without interruption and, despite failures of
significant financial firms, our clearing house experienced no default
and no customers on the futures side lost their collateral or were
unable to immediately transfer positions and continue managing risk.
We support the overarching goals of DFA to reduce systemic risk
through central clearing and exchange trading of derivatives, to
increase data transparency and price discovery, and to prevent fraud
and market manipulation. Unfortunately, DFA left many important issues
to be resolved by regulators with little or ambiguous direction and set
unnecessarily tight deadlines on rulemakings by the agencies charged
with implementation of the Act. In response to the urgent schedule
imposed by DFA, the Commodity Futures Trading Commission (``CFTC'' or
``Commission'') has proposed hundreds of pages of new or expanded
regulations.
In our view, many of the proposals are inconsistent with DFA, not
required by DFA, and/or impose burdens on the industry that require an
increase in CFTC staff and expenditures that could never be justified
if an adequate cost-benefit analysis had been performed. In the view of
many experienced derivative industry professionals, the CFTC has been
selectively reading DFA to implement a policy that is likely to defeat
the real goals of DFA.
We realize that the Commission is under immense pressure to
complete many rulemakings within a very short time period. Put simply,
DFA set forth an unrealistic rulemaking schedule. And even more
problematically, many of the rulemakings required by DFA are
interrelated. That is, DFA requires many intertwined rulemakings with
varying deadlines. Entities such as CME often cannot fully anticipate
the meaning of a proposed rule when that proposed rule is reliant on
another rule that is not yet in its final form. As a result, interested
parties are unable to comment on the proposed rules in a meaningful
way, because they cannot know the full effect of the proposed rules.
This Congress can mitigate some of the problems that have plagued
the CFTC rulemaking process by extending the rulemaking schedule so
that professionals, including exchanges, clearing houses, dealers,
market makers, and end-users can have their views heard and so that the
CFTC will have a realistic opportunity to assess those views and
measure the real costs imposed by its new regulations. Otherwise, the
unintended adverse consequences of those ambiguities and the rush to
regulation will impair effective exchange innovation and stifle the
most important growth paths in our industry, including the clearing of
OTC transactions. Indeed, the threat of such policies has already
driven major customers to move business off U.S. markets.
Several Commissioners clearly recognize this issue and have been
forthright in suggesting that the CFTC temper its ambitions. For
example, in her recent statement opposing proposed rules in the area of
position limits, Commissioner Sommers expressed concern regarding the
lack of analysis performed before proposal of the rules. She
specifically noted that she was troubled by the lack of analysis of
swap markets and of whether the proposal would ``cause price discovery
in the commodity to shift to trading on foreign boards of trade,'' and
that ``driving business overseas remains a long standing concern.''
Further, Commissioner Sommers noted that, in any case, the Commission
did not have the capacity to enforce the proposed rule.\1\ Commissioner
Dunn has echoed our concerns regarding the lack of CFTC funding and the
potential detrimental effects of a prescriptive, rather than
principles-based, regime upon the markets. More specifically, he
expressed concern that if the CFTC`s ``budget woes continue, [his] fear
is that the CFTC may simply become a restrictive regulator. In essence,
[it] will need to say `No' a lot more . . . No to anything [it does]
not believe in good faith that [it has] the resources to manage'' and
that ``such a restrictive regime may be detrimental to innovation and
competition.'' \2\ Commissioner O'Malia has likewise expressed concern
regarding the effect of proposed regulations on the markets. More
specifically, the Commissioner has expressed concern that new
regulation could make it ``too costly to clear.'' He noted that there
are several ``changes to [the] existing rules that will contribute to
increased costs.'' Such cost increases have the effect of ``reducing
the incentive of futures commission merchants to appropriately identify
and manage customer risk. In the spirit of the Executive Order, we must
ask ourselves: Are we creating an environment that makes it too costly
to clear and puts risk management out of reach.'' \3\
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\1\ In full, Commissioner Sommers stated: ``I oppose the proposal
before us today because I believe it is flawed in a number of respects.
First, I believe we should conduct a complete analysis of the swap
market data before we determine the appropriate formula to propose. We
have not done that. Second, without data on swap market positions, the
spot month limits we are proposing are not enforceable. I think it is
bad policy to propose regulations that the agency does not have the
capacity to enforce. Third, in Section 4a(a)(1) of the Commodity
Exchange Act, Congress specifically authorized the Commission to
consider different limits on different groups or classes of traders.
This language was added in Section 737 of Dodd-Frank. The proposal
before us today does not analyze, or in any way consider, whether
different limits are appropriate for different groups or classes of
traders. Finally, Section 737 of Dodd-Frank states that the Commission
shall strive to ensure that position limits will not cause price
discovery in the commodity to shift to trading on foreign boards of
trade. This proposal does not contain any analysis of how the proposal
attempts to accomplish this goal. In fact, the proposal does not even
mention this goal. Driving business overseas is a long standing concern
of mine, and that concern remains unaddressed.''
Commissioner Jill E. Sommers, Opening Statement, Open Meeting on
the Ninth Series of Proposed Rulemakings under the Dodd-Frank Act,
(January 13, 2011) http://www.cftc.gov/PressRoom/SpeechesTestimony/
sommersstatement011311.html.
\2\ Commissioner Dunn stated: ``Lastly, I would like to speak
briefly about the budget crisis the CFTC is facing. The CFTC is
currently operating on a continuing resolution with funds insufficient
to implement and enforce the Dodd-Frank Act. My fear at the beginning
of this process was that due to our lack of funds the CFTC would be
forced to move from a principles based regulatory regime to a more
prescriptive regime. If our budget woes continue, my fear is that the
CFTC may simply become a restrictive regulator. In essence, we will
need to say `No' a lot more. No to new products. No to new
applications. No to anything we do not believe in good faith that we
have the resources to manage. Such a restrictive regime may be
detrimental to innovation and competition, but it would allow us to
fulfill our duties under the law, with the resources we have
available.''
Commissioner Michael V. Dunn, Opening Statement, Public Meeting on
Proposed Rules Under Dodd-Frank Act (January 13, 2011) http://
www.cftc.gov/PressRoom/SpeechesTestimony/dunnstatement011311.html.
\3\ In Facing the Consequences: ``Too Costly to Clear,''
Commissioner O'Malia stated: ``I have serious concerns about the cost
of clearing. I believe everyone recognizes that the Dodd-Frank Act
mandates the clearing of swaps, and that as a result, we are
concentrating market risk in clearinghouses to mitigate risk in other
parts of the financial system. I said this back in October, and
unfortunately, I have not been proven wrong yet. Our challenge in
implementing these new clearing rules is in not making it `too costly
to clear.' Regardless of what the new market structures ultimately look
like, hedging commercial risk and operating in general will become more
expensive as costs increase across the board, from trading and
clearing, to compliance and reporting.''
``In the short time I have been involved in this rulemaking
process, I have seen a distinct but consistent pattern. There seems to
be a strong correlation between risk reduction and cash. Any time the
clearing rulemaking team discusses increasing risk reduction, it is
followed by a conversation regarding the cost of compliance and how
much more cash is required.''
``For example, there are several changes to our existing rules that
will contribute to increased costs, including more stringent standards
for those clearinghouses deemed to be systemically significant. The
Commission staff has also recommended establishing a new margining
regime for the swaps market that is different from the futures market
model because it requires individual segregation of customer
collateral. I am told this will increase costs to the customer and
create moral hazard by reducing the incentive of futures commission
merchants to appropriately identify and manage customer risk. In the
spirit of the Executive Order, we must ask ourselves: Are we creating
an environment that makes it too costly to clear and puts risk
management out of reach.''
Commissioner Scott D. O'Malia, Derivatives Reform: Preparing for
Change, Title VII of the Dodd-Frank Act: 732 Pages and Counting,
Keynote Address (January 25, 2011) http://www.cftc.gov/PressRoom/
SpeechesTestimony/opaomalia-3.html.
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We are concerned that many of the Commission's rulemakings to date
would unnecessarily convert the regulatory system for the futures
markets from the highly successful principles-based regime that has
permitted U.S. Futures markets to prosper as an engine of economic
growth for this nation, to a restrictive, prescription-based regime
that will stifle growth and innovation. We are also concerned that many
of the Commission's proposed rulemakings go beyond the specific
mandates of DFA, and do not comply with the Administrative Procedure
Act's requirements that rulemakings be legitimately grounded in
evidence and strong economic theory. I will now address, in turn,
several proposed rules issued by the Commission that illustrate these
problems.
1. Proposed Rulemaking on Position Limits \4\
---------------------------------------------------------------------------
\4\ 76 Fed. Reg. 4752 (proposed Jan. 26, 2011) (to be codified at
17 CFR pts. 1, 150-51).
---------------------------------------------------------------------------
One example of this is the Commission's proposal to impose broad,
fixed position limits for all physically delivered commodities. The
Commission's proposed position limit regulations ignore the clear
Congressional directives, which DFA added to section 4a of the
Commodity Exchange Act, to set position limits ``as the Commission
finds are necessary to diminish, eliminate, or prevent'' ``sudden or
unreasonable fluctuations or unwarranted changes in the price of'' a
commodity.\5\ Without any basis to make this finding, the Commission
instead justified its position limit proposal as follows:
---------------------------------------------------------------------------
\5\ My December 15, 2010, testimony before the Subcommittee on
General Farm Commodities and Risk Management of the House Committee on
Agriculture includes a more complete legal analysis of the DFA
requirements.
The Commission is not required to find that an undue burden on
interstate commerce resulting from excessive speculation exists
or is likely to occur in the future in order to impose position
limits. Nor is the Commission required to make an affirmative
finding that position limits are necessary to prevent sudden or
unreasonable fluctuations or unwarranted changes in prices or
otherwise necessary for market protection. Rather, the
Commission may impose position limits prophylactically, based
on its reasonable judgment that such limits are necessary for
the purpose of ``diminishing, eliminating, or preventing'' such
burdens on interstate commerce that the Congress has found
result from excessive speculation. 76 Federal Register 4752 at
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4754 (January 26, 2011), Position Limits for Derivatives.
At the December 15, 2010, hearing of the General Farm Commodities
and Risk Management Subcommittee of the House Agriculture Committee on
the subject of the implementation of DFA's provisions respecting
position limits, there was strong bipartisan agreement among the
Subcommittee Members with the sentiments expressed by Representative
Moran:
Despite what some believe is a mandate for the Commission to
set position limits within a definite period of time, the Dodd-
Frank legislation actually qualifies CFTC's position-limit
authority. Section 737 of the Dodd-Frank Act amends the
Commodity Exchange Act so that Section 4A-A2A states, ``The
Commission shall, by rule, establish limits on the amount of
positions as appropriate.'' The Act then states, ``In
subparagraph B, for exempt commodities, the limit required
under subparagraph A shall be established within 180 days after
the date of enactment of this paragraph.'' When subparagraphs A
and B are read in conjunction, the Act states that when
position limits are required under subparagraph A, the
Commission shall set the limits within 180 days under paragraph
B. Subparagraph A says the position-limit rule should be only
prescribed when appropriate.
Therefore, the 180 day timetable is only triggered if position
limits are appropriate. In regard to the word ``appropriate,''
the Commission has three distinct problems. First, the
Commission has never made an affirmative finding that position
limits are appropriate to curtail excessive speculation. In
fact, to date, the only reports issued by the commission or its
staff failed to identify a connection between market trends and
excessive speculation. This is not to say that there is no
connection, but it does say the commission does not have enough
information to draw an affirmative conclusion.
``The second and third issues relating to the appropriateness of
position limits are regulated to adequacy of information about OTC
markets. On December 8, 2010, the commission published a proposed rule
on swap data record-keeping and reporting requirements. This proposed
rule is open to comment until February 7, 2011, and the rule is not
expected to be final and effective until summer at the earliest.
Furthermore, the commission has yet to issue a proposed rulemaking
about swap data repositories. Until a swap data repository is set up
and running, it is difficult to see how it would be appropriate for the
commission to set position limits.'' CME group is not opposed to
position limits and other means to prevent market congestion; we employ
limits in most of our physically delivered contracts.
However, we use limits and accountability levels, as contemplated
by the Congressionally-approved Core Principles for Designated Contract
Markets (``DCMs''), to mitigate potential congestion during delivery
periods and to help us identify and respond in advance of any threat to
manipulate our markets. CME Group believes that the core purpose that
should govern Federal and exchange-set position limits, to the extent
such limits are necessary and appropriate, should be to reduce the
threat of price manipulation and other disruptions to the integrity of
prices. We agree that such activity destroys public confidence in the
integrity of our markets and harms the acknowledged public interest in
legitimate price discovery and we have the greatest incentive and best
information to prevent such misconduct.
We don't want to lose sight of the real economic cost of imposing
position limits that are unwarranted. For the last 150 years, modern
day futures markets have served as the most efficient and transparent
means to discover prices and manage exposure to price fluctuations.
Regulated futures exchanges operate centralized, transparent markets to
facilitate price discovery by permitting the best informed and most
interested parties to express their opinions by buying and selling for
future delivery. Such markets are a vital part of a smooth functioning
economy. Futures exchanges allow producers, processors and agribusiness
to transfer and reduce risks through bona fide hedging and risk
management strategies. This risk transfer means producers can plant
more crops. Commercial participants can ship more goods. Risk transfer
only works because speculators are prepared to provide liquidity and to
accept the price risk that others do not. Futures exchanges and
speculators have been a force to reduce price volatility and mitigate
risk. Overly inclusive position limits adversely impact legitimate
trading and impair the ability of producers to hedge. Worse, the drive
certain classes of speculators into physical markets and distort the
physical supply chain and prices.
2. Proposed Rulemaking on Mandatory Swaps Clearing Review Process \6\
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\6\ 75 Fed. Reg. 667277 (proposed Nov. 2, 2010) (to be codified at
17 CFR pts. 1, 150, 151).
---------------------------------------------------------------------------
Another example of a rule proposal that raises concerns and could
produce consequences counter to the fundamental purposes of DFA is the
Commission's proposed rule relating to the process for review of swaps
for mandatory clearing. The proposed regulation treats an application
by a derivatives clearing organization (``DCO'') to list a particular
swap for clearing as obliging that DCO to perform due diligence and
analysis for the Commission respecting a broad swath of swaps, as to
which the DCO has no information and no interest in clearing. In
effect, a DCO that wishes to list a new swap would be saddled with the
obligation to collect and analyze massive amounts of information to
enable the Commission to determine whether the swap that is the subject
of the application and any other swap that is within the same ``group,
category, type, or class'' should be subject to the mandatory clearing
requirement.
This proposed regulation is one among several proposals that impose
costs and obligations whose effect and impact are contrary to the
purposes of Title VII of DFA. The costs in terms of time and effort to
secure and present the information required by the proposed regulation
would be a massive disincentive to DCOs to voluntarily undertake to
clear a ``new'' swap. The Commission lacks authority to transfer the
obligations that the statute imposes on it to a DCO. The proposed
regulation eliminates the possibility of a simple, speedy decision on
whether a particular swap transaction can be cleared--a decision that
the DFA surely intended should be made quickly in the interests of
customers who seek the benefits of clearing--and forces a DCO to
participate in an unwieldy, unstructured and endless process to
determine whether mandatory clearing is required. Regulation section
39.5(b)(5) starkly illustrates this outcome. Every simple request to
clear a swap is converted into a marathon that is likely to kill the
runner before Athens is in sight. No application is deemed complete
until all of the information that the Commission needs to make the
mandatory clearing decision has been received. The Commission is the
sole judge of completion and the only test is its unfettered
discretion. Only then does the 90 day period begin to run. This turns
DFA on its head.
3. Conversion from Principles-Based to Rules-Based Regulation \7\
---------------------------------------------------------------------------
\7\ See, 75 Fed. Reg. 80747 (proposed Dec. 22, 2010) (to be
codified at 17 CFR pts. 1, 16, 38).
---------------------------------------------------------------------------
Some of the CFTC's rule proposals are explained by the ambiguities
created during the rush to push DFA to a final vote. For example,
Congress preserved and expanded the scheme of principles-based
regulation by expanding the list of core principles and granting self
regulatory organizations ``reasonable discretion in establishing the
manner in which the [self regulatory organization] complies with the
core principles.'' Congress granted the Commission the authority to
adopt rules respecting core principles, but did not direct it to
eliminate principles-based regulation.
The agency's prescriptive regulatory approach would convert its
role from an oversight agency, whose role is to assure compliance with
sound principles, to a front line decision maker that imposes its
business judgments on every operational aspect of derivatives trading
and clearing. This role reversal will require doubling of the
Commission's staff and budget and impose astronomical costs on the
industry and the end-users of derivatives. Yet there is no evidence
that this interpretation of Congressional intent behind DFA is
necessary or will be beneficial to the public or to the functioning of
the markets. This approach will also unnecessarily deplete the agency's
limited resources. In keeping with the President's Executive Order to
reduce unnecessary regulatory cost, the CFTC should be required to
reconsider each of its proposals with an eye toward performing those
functions that are clearly mandated by DFA.
Prior to DFA, the Commodity Exchange Act (``CEA''), as amended by
the Commodity Futures Modernization Act of 2000 (``CFMA''), prohibited
the CFTC from mandating exclusive means of compliance with the Core
Principles applicable to regulated entities. See CEA 5c(a)(2). The CFTC
set forth ``[g]uidance on, and Acceptable Practices in, Compliance with
Core Principles,'' but these statements operated only as guidance or as
a safe harbor for compliance--not as requirements.
Changes to the CEA made by DFA gave the Commission discretion to,
where necessary, step back from this principles-based regime. That is,
they changed the language of the CEA to state that boards of trade
``shall have reasonable discretion in establishing the manner in which
they comply with the core principles, unless otherwise determined by
the Commission by rule or regulation.'' See, e.g., DFA 735(b),
amending Section 5(d)(1)(B) of the CEA. To begin, this language assumes
that the principles-based regime will remain in effect and that, as
such, regulated entities will have reasonable discretion as to the
manner with which they comply with the Core Principles except in
limited circumstances in which more specific rules addressing
compliance with a core principle are necessary. The Commission has used
this change in language, however, to propose specific requirements for
multiple Core Principles--almost all Core Principles in the case of
DCMs--and effectively eviscerate the principle-based regime that has
fostered success in CFTC-regulated entities for the past decade.
The principles-based regime of the CFMA has facilitated tremendous
innovation and allowed U.S. exchanges to compete effectively on a
global playing field. Principles-based regulation of futures exchanges
and clearing houses permitted U.S. exchanges to regain their
competitive position in the global market. U.S. futures exchanges are
able to keep pace with rapidly changing technology and market needs by
introducing new products, new processes and new methods by certifying
compliance with the CEA and thereby avoiding stifling regulatory
review. Indeed, U.S. futures exchanges have operated more efficiently,
more economically and with fewer complaints under this system than at
any time in their history.
(a) Proposed Rulemaking under Core Principle 9 for DCMs
One example of the Commission's unnecessary and problematic
departure from the principles-based regime is its proposed rule under
Core Principle 9 for DCMs--Execution of Transactions, which states that
a DCM ``shall provide a competitive, open and efficient market and
mechanism for executing transactions that protects the price discovery
process of trading in the centralized market'' but that ``the rules of
a board of trade may authorize . . . (i) transfer trades or office
trades; (ii) an exchange of (I) futures in connection with a cash
commodity transaction; (II) futures for cash commodities; or (III)
futures for swaps; or (iii) a futures commission merchant, acting as
principle or agent, to enter into or confirm the execution of a
contract for the purchase or sale of a commodity for future delivery if
that contract is reported, recorded, or cleared in accordance with the
rules of the contract market or [DCO].''
Proposed rule 38.502(a) would require that 85% or greater of the
total volume of any contract listed on a DCM be traded on the DCM's
centralized market, as calculated over a 12 month period. The
Commission asserts that this is necessary because ``the price discovery
function of trading in the centralized market'' must be protected. 75
Fed. Reg. at 80588. However, Congress gave no indication in DFA that it
considered setting an arbitrary limit as an appropriate means to
regulate under the Core Principles. Indeed, in other portions of DFA,
where Congress thought that a numerical limit could be necessary, it
stated so. For example, in Section 726 addressing rulemaking on
Conflicts of Interest, Congress specifically stated that rules ``may
include numerical limits on the control of, or the voting rights'' of
certain specified entities in DCOs, DCMs or Swap Execution Facilities
(``SEFs'').
Congress did not sanction arbitrary proscriptions by the
Commission, and the 85% exchange trading requirement is completely
arbitrary. That is, the Commission justifies the requirement only with
its observations as to percentages of various contracts traded on
various exchanges--it provides no support for a position that the 85%
requirement provides or is necessary to provide a ``competitive, open,
and efficient market and mechanism for executing transactions that
protects the price discovery process of trading in the centralized
market of the board of trade,'' as is required under Core Principle 9.
Further, Core Principle 9, as noted above, expressly permits DCMs to
authorize off-exchange transactions including for exchanges to related
positions pursuant to their rules.
The Commission does not assert in its proposal that the 85%
exchange trading requirement has any regulatory benefit for either it
or market participants. Indeed, there is no such benefit. The
Commission does not receive any additional information regarding the
market through the proposed 85% requirement. That is, if an instrument
is not traded on an exchange, it will in many cases simply be traded on
an SEF or in the OTC market as a swap. Following DFA, the swap and OTC
markets, like the futures market, is regulated by the Commission. Thus,
the Commission will receive the same information for use in regulation
regardless of whether the instrument is traded in the centralized
market or not.
Moreover, imposition of the proposed 85% exchange trading
requirement will have extremely negative effects on the industry. The
85% requirement would significantly deter the development of new
products by exchanges like CME. This is because new products generally
initially gain trading momentum in off-exchange transactions. Indeed,
it takes years for new products to reach the 85% exchange trading
requirement proposed by the Commission. For example, one now popular
and very liquid foreign exchange product developed and offered by CME
would not have met the 85% requirement for 4 years after it was
initially offered. The product's on-exchange trading continued to
increase over 10 years, and it now trades only 2% off-exchange. Under
the proposed rule, CME would have had to delist this product.\8\
---------------------------------------------------------------------------
\8\ More specifically, the product traded 32% off-exchange when it
was first offered in 2000, 31% off-exchange in 2001, 25% in 2002, 20%
in 2003, finally within the 85% requirement at 13% off-exchange in
2004, 10% in 2005, 7% in 2006, 5% in 2007, 3% in 2008, and 2% in 2009
and 2010.
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Imposition of an 85% exchange trading requirement would also have
adverse effects on market participants. If instruments that are most
often traded off-exchange are forced onto the centralized market,
customers will lose cross-margin efficiencies that they currently enjoy
and will be forced to post additional cash or assets as margin. For
example, customers who currently hold open positions on CME
Clearport' will be required to post a total of approximately
$3.9 billion in margin (at the clearing firm level, across all clearing
firms).
(b) Proposed Comparable Fee Structures Under Core Principle 2 for DCMs
In the case of certain proposed fee restrictions to be placed on
DCMs, the Commission not only retreats needlessly from principles-based
regulation but also greatly exceeds its authority under DFA. DCM Core
Principle 2, which appears in DFA Section 735, states, in part, that a
DCM ``shall establish, monitor, and enforce compliance with rules of
the contract market including . . . access requirements.'' Under this
Core Principle, the Commission has proposed rule 38.151, which states
that a DCM ``must provide its members, market participants and
independent software vendors with impartial access to its market and
services including . . . comparable fee structures for members, market
participants and independent software vendors receiving equal access
to, or services from, the [DCM].''
The CFTC's attempt to regulate DCM member, market participant and
independent software vendor fees is unsupportable. The CFTC is
expressly authorized by statute to charge reasonable fees to recoup the
costs of services it provides. 7 U.S.C. 16a(c). The Commission may not
bootstrap that authority to set or limit the fees charged by DCMs or to
impose an industry-wide fee cap that has the effect of a tax. See
Federal Power Commission v. New England Power Co., 415 U.S. 345, 349
(1974) (``[W]hole industries are not in the category of those who may
be assessed [regulatory service fees], the thrust of the Act reaching
only specific charges for specific services to specific individuals or
companies.''). In any event, the CFTC's overreaching is not supported
by DFA. Nowhere in the CEA is the CFTC authorized to set or limit fees
a DCM may charge. To the extent the CFTC believes its authority to
oversee impartial access to trading platforms may provide a basis for
its assertion of authority, that attempt to read new and significant
powers into the CEA should be rejected.
3. Provisions Common to Registered Entities \9\
---------------------------------------------------------------------------
\9\ 75 Fed. Reg. 67282 (proposed Nov. 2, 2010) (to be codified at
17 CFR pt. 40).
---------------------------------------------------------------------------
The CFMA streamlined the procedures for listing new products and
amending rules that did not impact the economic interests of persons
holding open contracts. These changes recognized that the previous
system required massive, worthless paper pushing efforts by exchanges
and by the CFTC's staff. It slowed innovation and offered no
demonstrable public benefit. Our ability to compete on a global scale,
which had been progressively eroded by the disparity between the U.S.
process and the rules under which foreign competitors operated, was
restored.
Under current rules, before a product is self-certified or a new
rule or rule amendment is proposed, DCMs and DCOs conduct a due
diligence review to support their conclusion that the product or rule
complies with the Act and Core Principles. The point of the self-
certification process that Congress retained in DFA is that registered
entities that list new products have a self-interest in making sure
that the new products meet applicable legal standards. Breach of this
certification requirement potentially subjects the DCM or DCO to
regulatory liability. In addition, in some circumstances, a DCM or DCO
may be subject to litigation or other commercial remedies for listing a
new product, and the avoidance of these costs and burdens is sufficient
incentive for DCMs and DCOs to remain compliant with the Act.
Nothing in the last decade of self-certification suggests that this
concept is flawed or that registered entities have employed this power
recklessly or abusively. During 2010, CME launched 438 new products and
submitted 342 rules or rule amendments to the Commission. There was no
legitimate complaint respecting the self-certification process during
this time. Put simply, the existing process has worked, and there is no
reason for the Commission to impose additional burdens, which are not
required by DFA, to impair that process.
Section 745 of DFA merely states, in relevant part, that ``a
registered entity may elect to list for trading or accept for clearing
any new contract, or other instrument, or may elect to approve or
implement any new rule or rule amendment, by providing to the
Commission a written certification that the new contract or instrument
or clearing of the new contract or instrument, new rule, or rule
amendment complies with this Act (including regulations under this
Act).'' To be sure, DFA in no way directs the Commission to require the
submission of all documents supporting such a certification nor to
require a review of the legal implications of the product or rule with
regard to laws other than DFA. Essentially, it requires exactly what
was required prior to the passage of DFA--a certification that the
product, rule or rule amendment complies with the CEA. Nonetheless, the
Commission has taken it upon itself to impose these additional and
burdensome submission requirements upon registered entities.
The new requirements are likely to significantly impair the speed
and value of innovation by U.S. exchanges and clearing houses, which
will be required to watch their innovations brought to market by
foreign competitors while the U.S. agency checks boxes to insure that
filings are complete. Moreover, given the volume of filings required by
the notice of proposed rulemaking, the Commission will require
significant increases in staffing and other resources. The Commission's
resources should be better aligned with the implementation of the goals
of DFA rather than ``correcting'' a well-functioning and efficient
process.
The proposed rules greatly and unnecessarily increase the
documentation burden associated with this submission process, and it
seems inevitable that they will greatly slow the process of new rule
and product introduction. First, a registered entity must submit ``all
documentation'' relied upon to determine whether a new product, rule or
rule amendment complies with applicable Core Principles. This
requirement is, to begin with, vague, and thus is likely to result in
the submission of unnecessary and non-useful information. More
importantly, this requirement imposes an additional burden on both
registered entities, which must compile and produce all such
documentation, and the Commission, which must review it. The benefits,
if any, to be gathered by this requirement are significantly outweighed
by the costs imposed both on the marketplace and the Commission.
Second, the proposed rules require registered entities to examine
potential legal issues associated with the listing of products and
include representations related to these issues in their submissions.
Specifically, a registered entity must provide a certification that it
has undertaken a due diligence review of the legal conditions,
including conditions that relate to contractual and intellectual
property rights. The imposition of such a legal due diligence standard
is clearly outside the scope of DFA and is unnecessarily vague and
impractical, if not impossible, to comply with in any meaningful
manner. An entity, such as CME, involved in product creation and design
is always cognizant of material intellectual property issues that might
arise. This amorphous and potentially vast legal diligence requirement
could require that registered entities expand what could reasonably be
considered to be a material or colorable intellectual property analysis
and undertake extensive intellectual property analysis, including
patent, copyright and trademark searches in order to satisfy the
regulatory mandates. This would greatly increase the cost and timing of
listing products without providing any true corresponding benefit to
the marketplace. Indeed, the Commission itself admits in its NOPR that
these proposed rules will increase the overall information collection
burden on registered entities by approximately 8,300 hours per year. 75
Fed. Reg. at 67290.
Further, these rules steer the Commission closer to the product and
rule approval process currently employed by the SEC, about which those
regulated by the SEC complained at the CFTC-SEC harmonization hearings.
Indeed, William J. Brodsky of the Chicago Board of Options Exchange
testified that the SEC's approval process ``inhibits innovation in the
securities markets'' and urged the adoption of the CFTC`s certification
process.
4. Requirements for Derivatives Clearing Organizations, Designated
Contract Markets, and Swap Execution Facilities Regarding
Mitigation of Conflicts of Interest \10\
---------------------------------------------------------------------------
\10\ 75 Fed. Reg. 63732 (proposed October 18, 2010) (to be codified
at 17 CFR pts. 1, 37, 38, 39, 40).
---------------------------------------------------------------------------
The Commission's proposed rules regarding the mitigation of
conflicts of interest in DCOs, DCMs and SEFs (``Regulated Entities'')
also exceed its rulemaking authority under DFA and impose constraints
on governance that are unrelated to the purposes of DFA or the CEA. The
Commission purports to act pursuant to Section 726 of DFA but ignores
the clear boundaries of its authority under that section, which it
cites to justify taking control of every aspect of the governance of
those Regulated Entities. Section 726 conditions the Commission's right
to adopt rules mitigating conflicts of interest to circumstances where
the Commission has made a finding that the rule is ``necessary and
appropriate'' to ``improve the governance of, or to mitigate systemic
risk, promote competition, or mitigate conflicts of interest in
connection with a swap dealer or major swap participant's conduct of
business with, a [Regulated Entity] that clears or posts swaps or makes
swaps available for trading and in which such swap dealer or major swap
participant has a material debt or equity investment.'' (emphasis
added) The ``necessary and appropriate'' requirement constrains the
Commission to enact rules that are no more intrusive than necessary to
fulfill the stated Congressional intent--in other words, the
regulations must be narrowly-tailored to minimize their burden on the
industry. The Commission failed to make the required determination that
the proposed regulations were ``necessary and proper'' and,
unsurprisingly, the proposed rules are not narrowly-tailored but rather
overbroad, outside of the authority granted to it by DFA and
extraordinarily burdensome.
The Commission proposed governance rules and ownership limitations
that affect all Regulated Entities, including those in which no swap
dealer has a material debt or equity investment and those that do not
even trade or clear swaps. Moreover, the governance rules proposed have
nothing to do with conflicts of interest, as that term is understood in
the context of corporate governance. Instead, the Commission has
created a concept of ``structural conflicts,'' which has no recognized
meaning outside of the Commission's own declarations and is unrelated
to ``conflict of interest'' as used in the CEA. The Commission proposed
rules to regulate the ownership of voting interests in Regulated
Entities by any member of those Regulated Entities, including members
whose interests are unrelated or even contrary to the interests of the
defined ``enumerated entities.'' In addition, the Commission is
attempting to impose membership condition requirements for a broad
range of committees that are unrelated to the decision making to which
Section 726 was directed.
The Commission's proposed rules are most notably overbroad and
burdensome in that they address not only ownership issues but the
internal structure of public corporations governed by state law and
listing requirements of SEC regulated national securities exchanges.
More specifically, the proposed regulations set requirements for the
composition of corporate boards, require Regulated Entities to have
certain internal committees of specified compositions and even propose
a new definition for a ``public director.'' Such rules in no way relate
to the conflict of interest Congress sought to address through Section
726. Moreover, these proposed rules improperly intrude into an area of
traditional state sovereignty. It is well-established that matters of
internal corporate governance are regulated by the states, specifically
the state of incorporation. Regulators may not enact rules that intrude
into traditional areas of state sovereignty unless Federal law compels
such an intrusion. Here, Section 726 provides no such authorization.
Perhaps most importantly, the proposed structural governance
requirements cannot be ``necessary and appropriate,'' as required by
DFA, because applicable state law renders them completely unnecessary.
State law imposes fiduciary duties on directors of corporations that
mandate that they act in the best interests of the corporation and its
shareholders--not in their own best interests or the best interests of
other entities with whom they may have a relationship. As such,
regardless of how a board or committee is composed, the members must
act in the best interest of the exchange or clearinghouse. The
Commission's concerns--that members, enumerated entities, or other
individuals not meeting its definition of ``public director'' will act
in their own interests--and its proposed structural requirements are
wholly unnecessary and impose additional costs on the industry--not to
mention additional enforcement costs--completely needlessly.
5. Prohibition on Market Manipulation \11\
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\11\ 75 Fed. Reg. 67657-62 (proposed Nov. 3, 2010) (to be codified
at 17 CFR pt. 180).
---------------------------------------------------------------------------
The Commission's proposed rules on Market Manipulation, although
not representing as clear an overstepping of its boundaries under DFA,
are also problematic because they are extremely vague. The Commission
has proposed two rules related to market manipulation: Rule 180.1,
modeled after SEC Rule 10b-5 and intended as a broad, catch-all
provision for fraudulent conduct; and Rule 180.2, which mirrors new CEA
Section 6(c)(3) and is aimed at prohibiting price manipulation. See 75
Fed. Reg. at 67658. Clearly, there is a shared interest among market
participants, exchanges and regulators in having market and regulatory
infrastructures that promote fair, transparent and efficient markets
and that mitigate exposure to risks that threaten the integrity and
stability of the market. In that context, however, market participants
also desire clarity with respect to the rules and fairness and
consistency with regard to their enforcement.
As to its proposed rule 180.1, the Commission relies on SEC
precedent to provide further clarity with respect to its interpretation
and notes that it intends to implement the rule to reflect its
``distinct regulatory mission.'' However, the Commission fails to
explain how the rule and precedent will be adapted to reflect the
differences between futures and securities markets. See 75 Fed. Reg. at
67658-60. For example, the Commission does not provide clarity as to if
and to what extent it intends to apply insider trading precedent to
futures markets. Making this concept applicable to futures markets
would fundamentally change the nature of the market, not to mention all
but halting participation by hedgers, yet the Commission does not even
address this issue. Rule 180.1 is further unclear as to what standard
of scienter the Commission intends to adopt for liability under the
rule. Rule 180.2 is comparably vague, providing, for example, no
guidance as to what sort of behavior is ``intended to interfere with
the legitimate forces of supply and demand'' and how the Commission
intends to determine whether a price has been affected by illegitimate
factors.
These proposed rules, like many others, have clearly been proposed
in haste and fail to provide market participants with sufficient notice
of whether contemplated trading practices run afoul of them. Indeed,
the proposed rules are so unclear as to be subject to constitutional
challenge. That is, due process precludes the government from
penalizing a private party for violating a rule without first providing
adequate notice that conduct is forbidden by the rule. In the area of
market manipulation especially, impermissible conduct must be clearly
defined lest the rules chill legitimate market participation and
undermine the hedging and price discovery functions of the market by
threatening sanctions for what otherwise would be considered completely
legal activity. That is, if market participants do not know the rules
of the road in advance and lack confidence that the disciplinary regime
will operate fairly and rationally, market participation will be
chilled because there is a significant risk that legitimate trading
practices will be arbitrarily construed, post hoc, as unlawful.
6. Anti-disruptive Practices Authority Contained in DFA \12\
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\12\ 75 Fed. Reg. 67301 (proposed November 2, 2010) (to be codified
at 17 CFR pt. 1).
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Rules regarding Disruptive Trade Practices (DFA Section 747) run
the risk of being similarly vague and resulting in chilling of market
participation. At this juncture, the Commission has issued only an
Advance notice of proposed rulemaking (``ANPR'') on this issue, and the
ANPR demonstrates the Commission's understanding that it must provide
clarity beyond that provided by DFA. Still, it is worthy of note that
Section 747 of DFA, which authorizes the Commission to promulgate
additional rules if they are reasonably necessary to prohibit trading
practices that are ``disruptive of fair and equitable trading,'' is
exceedingly vague as written and does not provide market participants
with adequate notice as to whether contemplated conduct is forbidden.
Hasty rulemaking resulting in vague rules in the area of disruptive
trade practices will have the same effect as such rulemaking in the
area of market manipulation--participation in the market and the
hedging and price discovery functions of the market will be chilled due
to uncertainty among participants as to whether their contemplated
conduct is acceptable.
The above are merely a few examples of instances in which CME
believes the Commission has proposed rules inconsistent with DFA or
that impose unjustified costs and burdens on both the industry and the
Commission. We ask this Congress to extend the rulemaking schedule
under DFA to allow time for industry professionals of various
viewpoints to fully express their views and concerns to the Commission
and for the Commission to have a realistic opportunity to assess and
respond to those views and to realistically assess the costs and
burdens imposed by the new regulations. We urge the Congress to ensure
that implementation of DFA is consistent with the Congressional
directives in the Act and does not unnecessarily harm hedging and risk
transfer markets that U.S. companies depend upon to reduce business
risks and increase economic growth.
The Chairman. Mr. Pickel, 5 minutes.
STATEMENT OF ROBERT G. PICKEL, EXECUTIVE VICE
CHAIRMAN, INTERNATIONAL SWAPS AND DERIVATIVES
ASSOCIATION, INC., NEW YORK, NY
Mr. Pickel. Mr. Chairman, Ranking Member Peterson, and
Members of the Committee, thank you for the opportunity to
testify once again today before this Committee, this time
regarding implementation of Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act.
Like all of you here today, ISDA is very supportive of
efforts to build a more robust and effective financial
regulatory framework. We fully share the goal of U.S.
policymakers and policymakers around the world to enhance the
safety and soundness of our financial markets. ISDA has taken
numerous steps over the years to make OTC markets safe and
efficient, and has a strong incentive to see the Dodd-Frank Act
implemented effectively. We are actively at work in key areas,
such as reducing counterparty risk and increasing transparency,
that support these goals.
We are, however, concerned at the volume of, and the
compressed timeframe for, finalizing the rules required under
the Act that may work against the law's essential purpose,
impede the availability of hedging tools that U.S. companies
need to manage their risks, and adversely impact the
competitiveness of U.S.-based derivatives markets.
The timelines contained in the Dodd-Frank Act require the
CFTC and the SEC to move at a speed that we believe will make
it difficult to establish a sound regulatory environment. Thus,
we strongly support a phased in implementation of any new
regulatory requirements to protect against unintended
consequences.
In light of the already difficult timelines, we are also
concerned that some of the proposed regulations go beyond the
statutory requirements of the Dodd-Frank Act, pulling resources
away from implementation of regulations focused on safety and
soundness and creating new rules that will adversely affect the
existing swaps market with little apparent benefit.
We also urge the agencies and this Committee as the
rulemaking process moves forward, to take the time to consider
the aggregate effect of the totality of the regulations.
As I listened to the first--Chairman Gensler on the first
panel, there were several questions about the size of this
market, the size of this business. We often use this notion of
notional amount, which is $600 trillion globally, roughly $300
trillion here in the United States. What I think is also
important to focus on is despite that size, trading in the OTC
markets is relatively limited in terms of number of contracts.
Roughly 5,500 interest rate swaps contracts are executed each
day in over 20 currencies around the globe. This compares to
the approximately 300,000 tickets per day that are executed in
the U.S. Government and Euro dollar futures contracts on the
CME. Daily OTC interest rate swap volume is two percent of the
corresponding CME Group futures contracts. The daily volume of
trades executed in U.S. dollars is less than one percent of the
corresponding futures contracts. If we look at the more
standardized trades, those trades that will likely go into a
clearing environment and perhaps traded on a swap execution
facility, there are approximately 2,000 standardized interest
rate swaps executed on an average day. The largest maturity for
10 year U.S. dollar swaps trade about 200 times a day, or once
every 4 minutes, quite different from the frequency of trading
of a contract that you would see on the CME. I think it is
important, as we look at issues of implementation, as we look
at issues of block trading and transparency, that we keep in
mind the number of contracts that are traded each day in the
OTC markets around the world.
As the Committee moves forward, I urge you to consider
three important factors as it considers the rules that are
being implemented at the CFTC. ISDA strongly believes that
preserving market liquidity is a critical consideration in the
promulgation of new regulatory requirements. Liquidity is the
lifeblood of the financial system. It is universally recognized
as a key element of an efficient marketplace, and necessary for
financial markets to remain viable. We would recommend, then,
that when considering aspects of the Dodd-Frank Act that could
impact liquidity, such as appropriate exceptions to real-time
reporting for block trades, that the Commission engage in
robust market and impact analyses of these proposals prior to
finalizing their rules.
Although adverse effects on liquidity can be avoided or
mitigated in the implementation process, increased costs
related to new regulations are often unavoidable. It is
imperative that the Commission recognize the need to accurately
assess all costs, both explicit and implicit, and mitigate
these costs to the maximum extent possible. These costs can be
alleviated by leveraging existing industry processes and
practices, and by ensuring that new regulations do not go
beyond the mandates set by the Dodd-Frank Act.
Last, I would urge the Committee to consider--and as
certainly indicated in numerous remarks today--that as the
Commissions proceed, they should consider the competitiveness
of the U.S. financial markets and U.S. financial firms when
setting these new requirements. Over 90 percent of the largest
U.S. companies use OTC derivatives to manage their business and
financial risks. We are concerned that overly restrictive
requirements, coupled with increased and unnecessary costs, may
result in transfers of business and eventually jobs overseas.
In conclusion, we appreciate the enormous task that has
been set out for the CFTC and the SEC in promulgating the
number of Dodd-Frank Act rulemakings, and we appreciate the
transparency that they have provided in this process. We
recommend, however, that the Commissions assure that their
rulemaking processes allow for an iterative process between
their staff and industry commentators, a complete assessment,
an analysis of proposed rules potential impact on markets,
firms, and the U.S. swaps and derivatives markets, and an
orderly transition to this new regulatory regime.
Thank you, and I look forward to your questions.
[The prepared statement of Mr. Pickel follows:]
Prepared Statement of Robert G. Pickel, Executive Vice Chairman,
International Swaps and Derivatives Association, Inc., New York, NY
Chairman Lucas, Ranking Member Peterson and Members of the
Committee:
Thank you for the opportunity to testify today regarding
implementation of Title VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act. Like all of you here today, ISDA is very
supportive of efforts to build a more robust and effective financial
regulatory framework. We fully share the goal of policymakers in the
U.S. and around the world to enhance the safety and soundness of our
financial markets. As you will hear, we are actively at work in key
areas--such as reducing counterparty risk and increasing transparency--
that support these goals. We are, however. concerned that the volume of
and the compressed timeframe for finalizing the rules required under
the Act may work against the law's essential purpose, impede the
availability of hedging tools that U.S. companies need to manage their
risks and adversely impact the competitiveness of the U.S.-based
derivatives markets. We also are concerned that some of the proposed
regulations go beyond the statutory requirements of the Dodd-Frank Act
and will create new rules with that will adversely affect the existing
swaps markets with little apparent benefit.
Introduction
The International Swaps and Derivatives Association, or ISDA, was
chartered in 1985 and has over 800 member institutions from 54
countries on six continents. Our members include most of the world's
major institutions that deal in privately negotiated derivatives, as
well as many of the businesses, governmental entities and other end-
users that rely on over-the-counter derivatives to manage efficiently
the financial market risks inherent in their core economic activities.
ISDA's focus is primarily on making the OTC derivatives markets
safe and efficient. Over its 25 year history, ISDA has pioneered
efforts to identify and reduce the sources of risk in the derivatives
and risk management business through documentation that is the
recognized standard throughout the global market, legal opinions that
facilitate enforceability of agreements, the development of sound risk
management practices, and advancing the understanding and treatment of
derivatives and risk management from public policy and regulatory
capital perspectives.
In the years leading up to and since the passage of the Dodd-Frank
Act, ISDA, the major dealers, buy-side institutions and other industry
associations have worked collaboratively to deliver structural
improvements to the global over-the-counter (OTC) derivatives markets.
These actions were undertaken as part of an ongoing dialogue with and
commitments to global supervisors, including the Federal Reserve Bank
of New York, the Securities and Exchange Commission (SEC), the
Commodity Futures Trading Commission (CFTC), the Office of the
Comptroller of the Currency and the Office of Thrift Supervision.
Through this process, the industry has made and continues to make
substantial progress in three key areas: reducing counterparty risk;
increasing transparency and enhancing the operational infrastructure of
the swaps and derivatives business.
As to the reduction in counterparty risk, the industry is making
significant progress through both clearing and portfolio compression.
Today, about $248 trillion of interest rate swaps, representing more
than 40 percent of the market, is centrally cleared.\1\ Another $106
trillion of interest rate swaps has been eliminated due to portfolio
compression.\2\ In the credit default swaps markets, more than $15
trillion has been centrally cleared.\3\ Portfolio compression has
eliminated more than $70 trillion of CDS.\4\ In fact, by virtue of the
combination of central clearing and portfolio compression, the size of
the CDS market has been reduced by 75 percent in the past several
years. We believe the volume of cleared swaps could double in the next
2 to 3 years.
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\1\ http://www.lchclearnet.com/swaps/
swapclear_for_clearing_members/.
\2\ http://www.trioptima.com/services/triReduce.html.
\3\ http://ir.theice.com/releasedetail.cfm?ReleaseID=545362.
\4\ http://www.trioptima.com/services/triReduce/triReduce-
credit.html.
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As for our goal of increasing transparency, it is important to keep
in mind that a distinction should be made between regulatory
transparency and market transparency. Regulatory transparency means
that regulators should have access to trade information on a timely
basis in order to monitor market risk. ISDA fully supports this goal.
The Association has helped establish trade repositories that provide
global regulators with significant visibility into firm and
counterparty risk exposures. This means that the uncertainties that
occurred in the recent financial crisis regarding risk exposures of
Lehman Brothers simply could not happen again.
Another aspect of transparency is market transparency, or price
visibility for market participants. Recent ISDA surveys and tests
demonstrate that users of most derivatives have tremendous pricing
transparency and extremely competitive pricing. To obtain competitive
pricing, the large majority of users receive price quotations from
multiple dealers. Their concern is that these products remain available
and affordable. A recent blind test of interest rate swap pricing for
three American investment firms found tremendous price competition in
both the dollar and Euro markets. When measured against a benchmark
screen, these firms were able to obtain firm pricing on nearly $2
billion of swaps at a spread of 0.001% over the middle of the bid-offer
on the screen. These swaps were for maturities from 2 to thirty years
and for sizes up to $250 million.\5\
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\5\ http://isda.org/media/pdf/ISDATestReport.pdf.
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While the evidence indicates there is a significant level of price
transparency in the OTC derivatives markets, the industry is actively
exploring ways to improve further improve upon this and ISDA has
sponsored research to this effect. We believe it is important that any
efforts to build greater market transparency be done after careful
analysis and evaluation of its benefits, its impact on liquidity and on
the ability of end-users to use derivatives to manage their risks.
As to the operational infrastructure of the OTC derivatives
business, over the past several years, the industry has made
significant improvements in reducing backlogs, and improving and
automating middle- and back-office processes.
Our commitment in these areas has been detailed in a series of
letters, beginning in September 2005, to the group of global
supervisors referenced above, the latest of which, dated March 1, 2010,
is attached to this testimony.\6\ These actions by ISDA, the major
dealers, buy-side institutions and other industry associations have
improved the way OTC derivatives are traded, processed and cleared and
reflect significant investment of resources and capital. They are a
powerful indication of the commitment the industry has made to improve
the market infrastructure as a means to achieving the shared policy
goals of reducing systemic risk and increasing transparency. The
industry recently met again with global supervisors and is in
discussions about an additional commitment letter that will provide a
roadmap to achieving compliance with regulatory requirements both in
the United States and elsewhere.
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\6\ http://www.newyorkfed.org/newsevents/news/markets/2010/
100301_letter.pdf.
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Dodd-Frank Rulemaking Process
The Dodd-Frank Act is a wide-ranging and comprehensive piece of
legislation. As a result, all of the Federal financial regulatory
agencies have been faced with an unprecedented level of obligated
rulemaking. The CFTC and SEC, in particular, have an especially
challenging task as they attempt to create a new regulatory regime for
the OTC derivatives markets. Since the passage of the Dodd-Frank Act
last July, ISDA has continued to work closely with various U.S.
regulators with the goal of helping them develop rules that achieve the
goals of the Act, while mitigating against any undesirable, unintended
adverse consequences.
It is vital that this new regulatory regime create a framework that
increases transparency and mitigates systemic risk, while preserving
the ability of derivatives users to hedge and manage risk in a prudent
and cost-effective manner. As the regulators attempt to strike this
very difficult balance, we have several recommendations that we believe
may be helpful regarding the rulemaking process that take into
consideration key issues regarding the market's structure and
liquidity, the costs and availability of derivatives and hedging for
end-users, and the continued competitiveness of the U.S. firms in the
global swaps and derivatives markets.
The Process
We applaud the efforts of the CFTC and SEC to create an open and
transparent rulemaking process. The Commissions have diligently posted
and reported all meetings with stakeholders and have held a series of
public roundtables to consider a number of issues related to Dodd-Frank
Act rulemakings. ISDA has taken part in this transparent rulemaking
process and has filed approximately 30 formal comment letters. In
addition, ISDA has had a number of discussions with the Chairpersons
and Commissioners of the CFTC and SEC and the Staffs of both
Commissions, and has participated in a number of public roundtables.
Of course, in addition to transparency, a key to the promulgation
of effective and meaningful rulemaking is to allow for, in essence, an
iterative process between the Commissions and commentators. We are
concerned that the volume of proposed rulemakings and the Commissions'
compressed statutory time frame for promulgating their new rules may
impair such a process, and hamper the ability of commentators to
provide thoughtful and comprehensive comments and of agency staff to
digest and assess the comments that are submitted. Toward that end,
ISDA and a number of trade associations jointly wrote to the
Commissions to urge them to use their discretion to propose, adopt and
implement rules in an appropriate sequence and timeframe.\7\
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\7\ http://www.isda.org/speeches/pdf/Comment-Letter-on-Regulatory-
Process-and-Phase-In.pdf.
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Some of the proposed rules, for example, contain or are based on
standards or numbers that will be hardwired into the regulatory
framework. This includes the requirement that trades below $250 million
in notional principal be subject to real-time reporting requirements, a
level that does not take into account the structure of the derivatives
market. This proposed rule could disrupt risk transfer by American
companies and impede the capital formation process that is essential to
economic growth.
We also are concerned that some of the proposed regulations go
beyond the statutory requirements of the Dodd-Frank Act and will create
new obligations or set new standards that will fundamentally and
negatively affect the existing swaps markets with little apparent
benefit. For example, the CFTC's proposes to require that swaps
execution facilities (SEFs) must have access to quotes from five
dealers. There is to our knowledge no objective evidence that supports
this decision or that indicates why five is the optimal number of
dealers on a SEF. The law itself only specifies that such quotes be
sent to multiple dealers.
Finally, we are encouraged that the agencies appear to recognize
the need to phase-in the requirements of the Dodd-Frank Act and stress
that the transition to this new regulatory regime occur incrementally
in a way that ensures the continued viability of the market and that
also protects overall liquidity.
Liquidity
As noted, ISDA strongly believes that consideration of the effects
of any rule on market liquidity is critical in connection with the
promulgation of new regulatory requirements. Liquidity is the lifeblood
of the financial system; it is universally recognized as a key element
of an efficient marketplace and necessary for financial markets to
remain viable. A market's liquidity is a function of its structure. For
example, despite its size, trading in the OTC derivatives markets is
quite limited. Roughly 5,500 interest rate swap contracts are executed
each day in over 20 currencies. This compares to the approximately
300,000 tickets per day in the U.S. Government and Eurodollar futures
contracts traded at the CME Group. Daily OTC interest rate swap volume
is two percent of the corresponding CME Group futures contracts. The
daily volume of trades executed in U.S. dollars is less than one
percent of the corresponding futures markets.\8\
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\8\ http://www.trioptima.com/repository.html.
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Congress recognized the importance of liquidity throughout the
Dodd-Frank Act. For example, when setting real-time reporting
requirements, the CFTC and SEC are required to consider the effects on
liquidity when setting block trading exemptions. This is important
considering that the average size of a 10 year U.S. dollar interest
rate swap was $75 million during 2010, whereas comparable transactions
in futures and securities markets are substantially smaller ($2 million
for 10 year U.S. Treasury Notes futures and $3 million for U.S.
corporate bonds, respectively.) \9\ ISDA believes that block trade
thresholds should be set so that liquidity is not impaired, in order to
ensure that these vital markets enable cost-effective risk-hedging, so
vital to the preservation of economic stability. In addition, we do not
believe that there is a ``one size fits all'' solution; rules should be
tailored to products and markets. Rules for relatively less liquid
products should be different from rules for more liquid products.
Uniform rules that do not take into account the structure of the
derivatives market will discourage the transfer of risks by U.S.
companies, particularly during times of market stress. Firms will be
extremely wary of offering firm quotes if they can not effectively
hedge the risks they are taking on because of post-trade transparency
rules.
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\9\ http://www.isda.org/c_and_a/pdf/EquitiesTransparency-Study.pdf.
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The Commissions also are required to consider liquidity when
determining which instruments should be subject to new clearing
requirements. ISDA believes it is imperative that any new requirements
do not impair existing liquidity. Failure to consider such impacts will
hurt the fairness, stability and efficiency of the overall market and,
in many instances, make it more difficult, or even impossible, to hedge
or mitigate risk in an efficient and cost-effective way. We recommend
that when considering aspects of the Dodd-Frank Act that could impact
liquidity, such as appropriate exceptions to real-time reporting
requirements for ``block'' trades, that the Commissions engage in
robust market and impact analyses of these proposals prior to
finalizing their rules. ISDA has conducted research on the structure of
the interest rate, credit default and equity swaps markets and has
sponsored a test on interest rate swaps pricing that is publicly
available for review.
Another concern regarding the impact of the Dodd-Frank Act on the
liquidity of the derivatives markets and the ability of end-users to
hedge their risks relates to the foreign exchange (FX) market. Under
the law, the Treasury Department has the ability to exempt FX swaps and
forwards from the definition and related regulation of swaps under the
law. The FX market is large, liquid, a vital part of the commercial
banking market and essential to economic activity. Classification of FX
swaps and forwards as swaps would subject many FX transactions to
clearing and execution requirements and would have significant adverse
effects on the market for these transactions. For these reasons, ISDA
urges the Treasury Department to use the exemptive authority that the
Dodd-Frank Act provides to it.
Costs
Although adverse effects on liquidity can be avoided or mitigated
in the implementation process, increased costs related to new
regulations are often unavoidable. These costs are even higher when
creating a new regulatory regime from whole cloth as is the case with
the swaps markets; as a result, it is imperative that the Commission
recognize the need to accurately assess all costs (both explicit and
implicit) and mitigate these costs to the maximum extent possible.
These costs can be alleviated by leveraging existing industry processes
and practices and by ensuring that new regulations do not go beyond the
mandate set by the Dodd-Frank Act.
U.S. Competitiveness
Perhaps most importantly, the implementing Commissions should
consider the competitiveness of the U.S. financial markets and U.S.
financial firms when setting new requirements. Over 90 percent of the
largest U.S. companies use OTC derivatives to manage their business and
financial risks. A broader survey of the top 2,200 American companies
found that 65 percent use derivatives.\10\
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\10\ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=962942.
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We are concerned that overly restrictive requirements, coupled with
increased and unnecessary costs, may result in transfers of businesses
and, eventually, jobs overseas. Although the U.S. remains the most
dynamic, innovative marketplace in the world, we note that transaction
volume in London already exceeds that in New York. We also note that
the five largest U.S.-based dealers reported a notional amount
outstanding equal to only 37 percent of the total notional amount for
interest rate, credit, and equity derivatives.\11\ We strongly
recommend that the CFTC and SEC engage in thorough market analyses
before promulgating new requirements, to ensure that such requirements
are not unduly burdensome or likely to create incentives to do business
outside the U.S.
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\11\ http://www.isda.org/media/press/2010/press102510.html.
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* * * * *
In conclusion, we applaud the efforts of the CFTC and SEC to
promulgate the massive number of Dodd-Frank Act rulemakings and
appreciate the transparency they have attempted to provide. We
recommend, however, that the Commissions assure that their rulemaking
processes allow for an iterative process between their staff and
industry commentators, a complete assessment; an analysis of proposed
rules' potential impacts on markets, firms and the U.S. swaps and
derivatives markets; and an orderly transition to this new regulatory
regime.
Attachment
March 1, 2010
Identical versions of this letter have been addressed directly to the
heads of the primary supervisory agency of each of the regulated
signatories.
Hon. William C. Dudley,
President,
Federal Reserve Bank of New York,
New York, NY.
Dear Mr. Dudley,
The undersigned dealers (each, a G14 Member) and buy-side
institutions continue to work collaboratively to deliver structural
improvements to the global over-the-counter derivatives markets (OTC
Derivatives Markets).\1\ This effort is undertaken as part of our
ongoing partnership with Supervisors, government departments, trade
associations, industry utilities and private vendors. The purpose of
this letter is to set forth goals and commitments the fulfillment of
which will continue to move the market to the standards of resilience
and robustness envisaged by bodies such as the G20.\2\
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\1\ The commitments or undertakings described throughout this
letter are subject to the applicable fiduciary responsibilities of
signatory firms, including any and all client-specific duties,
obligations and instructions.
\2\ Pursuant to this, we strongly support many of the goals and
aspirations set out in relevant white papers and consultation documents
published by, inter alia, the European Commission, the FRBNY and the UK
Treasury/FSA.
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The industry recognizes the significant work that lies ahead, and
re-affirms its commitment to aggressively pursue improvements along
five overarching themes:
In order to increase transparency and better understand
transparency needs in the OTC Derivatives Market, the
signatories will: (a) continue to advance the development of
global data repositories; (b) provide relevant Supervisors
with: (i) an inventory of existing forms of transparency in OTC
Derivatives Markets by product and asset class; (ii) a study
which describes and evaluates the spectrum of methods that can
be used to increase transparency, analyzes the benefits and
costs and attempts to identify to whom such benefits and costs
accrue and (iii) relevant transaction data to support the
Supervisors' own analysis.
In order to deliver robust, efficient and accessible central
clearing to the OTC Derivatives Markets, the signatories make a
strong commitment to increase: (a) the range of products
eligible for clearing and (b) the proportion of open interest
in the products that are cleared. In support of this
commitment, where appropriate, the signatories will work
towards the inclusion of users, either through direct access or
through indirect client access, including extension of
segregation and portability. In order to better reflect the
composition of the credit default swap (CDS) market, the
signatories who are participants on the ISDA Credit Derivatives
Determinations Committees (each, a DC) will propose a framework
to involve CDS central counterparties (each, a CCP) in the DC
process.
Drive a high level of product, processing and legal
standardization in each asset class with a goal of securing
operational efficiency, mitigating operational risk and
increasing the netting and clearing potential for appropriate
products (recognizing that standardization is only one of a
number of criteria for clearing eligibility). Accordingly,
workstreams have been established to analyze existing, and
where appropriate, potential opportunities for further
standardization by asset class and by product.
Continue to work to enhance bilateral collateralization
arrangements to ensure robust risk management, including strong
legal and market practices and operational frameworks. In
particular, continue the work on resolution procedures for
variation margin disputes arising out of bilateral derivatives
transactions, and on publication and adoption of best practices
among the G14 Members and other signatories. Additionally,
continue the consideration of the risks, mitigants and
enhancements associated with initial margin.
Build on improvements in operational performance, with a
focus on driving `electronification', straight-through-
processing, and trade date matching, affirmation and
processing.
Having recognized the need to act expeditiously to implement a
robust and resilient framework for OTC derivatives risk management and
market structure, and acknowledging the importance of OTC Derivatives
Markets, we have laid out goals with specific targets to the
Supervisors in five previous joint industry commitment letters. Since
the June 2, 2009 letter, we have completed the following steps:
Implementation of the industry governance model put forward
by ISDA in 2009.
Further standardization of Credit Derivatives.
The successful launch of CDS clearing in Europe.
Initial extension of clearing services to buy-side firms.
Substantial progress in the implementation of global data
repositories.
Delivery of proposals for improvements to the OTC bilateral
collateral processes.
Continued improvement in industry infrastructure.
These commitment letters represent not only a powerful statement of
intent but also evidence of positive action from the industry, and also
reflect significant investment of resources and capital.
Contained in the attached Annexes are a series of further
commitments which reflect these common themes, and which will support
continued progress towards our shared goals of a resilient and robust
OTC Derivatives Markets infrastructure. We believe that fulfillment of
these commitments will deliver structural improvements to the OTC
Derivatives Markets and will thus enable them to continue to perform
their crucial function of risk management, while, where appropriate,
retaining flexibility in terms of products and execution in a
systemically sound construct.
We look forward to our continued collaboration and strong dialogue
with the Supervisors and legislators as we drive forward with these
fundamental industry initiatives.
From the Managements of:
AllianceBernstein;
Bank of America-Merrill Lynch;
Barclays Capital;
BlackRock, Inc.;
BlueMountain Capital Management LLC;
BNP Paribas;
Citadel Investment Group, L.L.C.;
Citi;
Credit Suisse;
Deutsche Bank AG;
D.E. Shaw & Co., L.P.;
DW Investment Management LP;
Goldman Sachs & Co.;
Goldman Sachs Asset Management, L.P.;
HSBC Group;
International Swaps and Derivatives Association, Inc.;
J.P.Morgan;
Managed Funds Association;
Morgan Stanley;
Pacific Investment Management Company, LLC;
The Royal Bank of Scotland Group;
Asset Management Group of the Securities Industry and Financial Markets
Association;
Socite Generale;
UBS AG;
Wachovia Bank, N.A.;
Wellington Management Company, LLP.
Identical versions of this letter have been addressed directly to
the heads of the primary supervisory agency (each, a Supervisor) of
each of the regulated signatories, including:
Board of Governors of the Federal Reserve System;
Connecticut State Banking Department;
Federal Deposit Insurance Corporation;
Federal Reserve Bank of New York;
Federal Reserve Bank of Richmond;
French Secretariat General de la Commission Bancaire;
German Federal Financial Supervisory Authority;
Japan Financial Services Agency;
New York State Banking Department;
Office of the Comptroller of the Currency;
Securities and Exchange Commission;
Swiss Financial Market Supervisory Authority;
United Kingdom Financial Services Authority.
CC:
Commodity Futures Trading Commission;
European Commission;
European Central Bank.
ANNEX A--RECENT ACHIEVEMENTS
1. The implementation of a revised and formal ISDA Governance
framework, with increased participation of the buy-side in the
strategic agenda, policy formation and decision-making process.
The newly created ISDA Industry Governance Committee (IIGC),
under the auspices of the ISDA Board, provides governance and
strategic direction for the product level steering and working
groups, and acts as a focal point for the Supervisors and
legislators to engage effectively with the industry.
2. Significant progress on product standardization for Credit
Derivatives, including, the completion of the 2009 ISDA Credit
Derivatives Determinations Committees, Auction Settlement and
Restructuring CDS Protocol (often referred to as the ``Small
Bang''), which allowed existing Credit Derivative contracts to
be modified to provide for Auction Settlement for Restructuring
Credit Events.
3. The successful completion of the auction settlement process for
Credit Derivatives that included the Modified Modified
Restructuring Credit Event after the Thomson Restructuring.
4. The successful application of the DC External Review procedure
for the Cemex S.A.B. de C.V. Restructuring Credit Event.
5. Meeting or exceeding clearing targets set in respect of dealer-
to-dealer new and historic volume for clearing Eligible Trades
\3\ in Interest Rate and Credit Derivative products. In excess
of 90% of new dealer-to-dealer volume in Eligible Trades of
Interest Rate Derivative products, and total dealer-to-dealer
volume in Eligible Trades of Credit Derivative products is now
cleared through CCPs.
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\3\ ``Eligible Trade'' is defined in our prior commitment letter
dated September 8, 2009.
6. Twenty-six of the largest Interest Rates Derivative market
makers are currently utilizing the LCH.Clearnet Ltd. SwapClear
(LCH) service to clear Interest Rate Derivatives. Six new
dealers joined the service in 2009 as direct clearing members
and twelve eligible dealers are expected to join in 2010. The
service was extended to support clearing of Overnight Index
Swaps (OIS) in July 2009. By the end of 2009, the platform had
$215 trillion notional and 1.57 million sides outstanding on
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the system.
7. The successful launch of CDS clearing in Europe and the recent
launch of Single Name clearing in Europe and North America.
8. The initial extension of clearing services to the buy-side, with
the launch of initial client access to the clearing of Credit
Derivatives (ICE Trust on December 14, 2009 and CME on December
15, 2009) and Interest Rate Derivatives (LCH on December 17,
2009).
9. Significant progress in the implementation of global data
repositories, with the successful launch of coverage for Credit
Derivative and Interest Rate Derivative products. In addition,
the selection process for the global data repository for Equity
Derivative products has concluded, with launch anticipated on
schedule on July 31, 2010.
10. Delivery of proposals for improvements to the OTC collateral
process, through Dispute Resolution Procedures that would
employ, inter alia, portfolio reconciliation, along with formal
dispute resolution for intractable disputes.
11. Publication in 2009 of the Roadmap for Collateral Management,
which is a forward-looking blueprint for evolving
collateralization into a more efficient and effective
counterparty credit risk reduction technique. Market
participants have implemented several commitments outlined by
the Roadmap to date; for example, a regime of daily portfolio
reconciliations for collateralized portfolios, allowing firms
to identify mismatches and achieve more complete
collateralization of risk, and publication of an open standard
to facilitate future electronic messaging of margin calls and
automation of collateral processes.
12. Continued improvement in industry infrastructure, as measured
by further reduction, and in some cases elimination, of
unsigned transaction confirmation backlogs, and continued
improvement in operating performance metrics.
ANNEX B--TRANSPARENCY
(1) Transparency Study
With respect to the Credit Derivatives, Interest Rate
Derivatives and Equity Derivatives Markets, the
signatories will deliver to the Supervisors:
an inventory of existing forms of
transparency in OTC Derivative
Markets by product and asset class (1st
Deliverable);
a study which (a) describes the
spectrum of methods that can be
used to increase transparency, (b) analyzes
the benefits and costs
by product and asset class and (c) attempts
to identify to whom the
benefits accrue and to whom the costs
accrue (2nd Deliverable);
and
relevant transaction data that can
be used by the Supervisors to
conduct analysis on post trade transparency
(3rd Deliverable).
The target dates with respect to Credit Derivatives,
Interest Rate Derivatives and Equity Derivatives are:
------------------------------------------------------------------------
1st Deliverable 2nd Deliverable 3rd Deliverable
------------------------------------------------------------------------
Credit March 31, 2010 June 30, 2010 July 31, 2010
Derivatives
Interest Rate March 31, 2010 August 31, 2010 September 30,
Derivatives 2010
Equity March 31, 2010 August 31, 2010 September 30,
Derivatives 2010
------------------------------------------------------------------------
We commit to provide to the Supervisors, by March 31,
2010, a plan and timeline, including concrete
milestones and target dates, for accomplishing the 3rd
Deliverable.
Each of the Commodities and Foreign Exchange market
participants will separately continue their dialogue
relating to market transparency issues with the
relevant regulators.
(2) Global Data Repositories
(a) Equity Derivatives
We re-affirm our commitment made in the June 2, 2009
letter to Supervisors to implement a centralized
reporting infrastructure for all OTC Equity Derivatives
by July 31, 2010, with launch currently anticipated on
schedule. We will work with the Supervisors to
implement a reporting process that is both practical
and meets regulatory expectations in regard to the
agreed information held in the Equity Derivatives
Reporting Repository.
(b) Interest Rate Derivatives
The global Interest Rate Reporting Repository (IRRR)
was launched on December 31, 2009, and the G14 Members
are now providing monthly reporting from this global
data repository on outstanding non-cleared trades to
primary regulators. Since initial launch, enhancements
have been made to normalize submissions between
dealers,\4\ and we will continue to work with
regulators and the legal community to expand and
enhance this reporting process. Our efforts will
include the following:
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\4\ Since inception of the IRRR, G14 Members have been working with
the service provider to ensure that the data aggregation process is as
thorough as possible and does not double count trades where G14 Members
face each other.
Include cleared trades in the
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submission scope by March 15, 2010.
Expand regulators' reporting to
include participant type (G14/CCP/
Non-G14) by April 15, 2010.
Provide public access to aggregate
industry notional and trade
count data on a monthly basis, in order to
provide greater position
transparency by April 30, 2010.
Increase submission and reporting
frequency to weekly beginning
September 30, 2010.
ANNEX C--CENTRAL CLEARING
(1) Targets
(a) Submission Targets \5\ \6\
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\5\ ``Eligible Trade'' is defined in our prior commitment letter
dated September 8, 2009.
\6\ An example of why a dealer would want to exclude an Eligible
Trade from clearing for counterparty risk management purposes would be
where such dealer faces a counterparty bilaterally on two trades which
offset each other from a net exposure perspective but where only one
trade is an Eligible Trade. Moving the Eligible Trade to a CCP could
immediately create a large uncollateralized payable from the
counterparty to the dealer with respect to the uncleared (ineligible)
trade, thereby increasing counterparty risk. In addition, even where
the counterparty posted collateral with respect to such payable within
the prescribed timeframe, the lack of the offsetting trade facing the
counterparty would increase the dealer's jump to default risk with
respect to such counterparty. This problem is magnified considerably
where the analysis above is applied on a multi billion dollar OTC
derivatives portfolio. With respect to accounting, regulatory capital
and balance sheet issues, an example of why a dealer would want to
exclude an Eligible Trade from clearing would be where the dealer is
hedging an outstanding loan position with the Eligible Trade. The
automatic compression that results from trades placed in clearing could
effectively ``remove'' the matched offsetting CDS hedge from the
dealer's book. Since the outstanding loan is no longer ``paired'' with
an identifiable hedge (notwithstanding that the dealer's risk position
has not changed), the hedge accounting treatment of the loan could be
impacted and the dealer could incur increased regulatory capital
charges and detrimental balance sheet treatment.
---------------------------------------------------------------------------
(i) Credit Derivatives
On September 8, 2009, each G14 Member
(individually) committed to submitting
95% of new Eligible Trades (calculated
on the basis of previously agreed
methodology) for clearing. We reaffirm
this commitment. Each G14 Member will
work with its primary regulator to
assess its performance against this
target by March 31, 2010. The G14
Members have agreed with the
Supervisors to re-evaluate by June 30,
2010, the appropriate target percentage
and definition of Eligible Trades to
better reflect the need to preserve
certain bilateral trades for
counterparty risk management,
accounting, regulatory capital, balance
sheet and customer reasons.
(ii) Interest Rate Derivatives
On September 8, 2009 each G14 Member
(individually) committed to submitting
90% of new Eligible Trades (calculated
on a notional basis) for clearing. The
G14 Members now commit to extend this
target so that, each G14 Member
(individually) commits to submitting
92% of new Eligible Trades (calculated
on a notional basis) for clearing by
June 30, 2010.
(b) Clearing Targets
(i) Credit Derivatives
On September 8, 2009, the G14 Members
(collectively) committed to clearing
80% of new and historical Eligible
Trades (calculated on the basis of
previously agreed methodology). The G14
Members (collectively) increase their
commitment to clearing from 80% of new
and historical Eligible Trades
(calculated on the basis of previously
agreed methodology) to 85%.
(ii) Interest Rate Derivatives
On September 8, 2009 the G14 Members
(collectively) committed to clearing
70% of new Eligible Trades (calculated
on weighted average notional basis).
The G14 Members (collectively) increase
their commitment to clearing from 70%
of new Eligible Trades (calculated on
weighted average notional basis) to 90%
by June 30, 2010.
On September 8, 2009 the G14 Members
(collectively) committed to clearing
60% of historical Eligible Trades
(calculated on a weighted average
notional basis). The G14 Members
(collectively) increase their
commitment to clearing from 60% of
historical Eligible Trades (calculated
on weighted average notional basis) to
75% by June 30, 2010.
(2) Expansion of Products Eligible for Clearing
The signatories to this letter commit to continue to
provide considerable risk, legal and operational
resources and to actively engage with CCPs, regulators
and Supervisors globally to broaden the set of OTC
Derivatives eligible for clearing, taking into account
risk, liquidity, default management and other
processes.
Significant issues will need to be analyzed and
addressed by CCPs, regulators and market participants
in order to begin clearing additional products. The
analysis must address risk, legal and operational
issues as well as the constraints associated with
liquidity, volumes, standardization and fungibility.
The process is different at each CCP, but generally
requires consultation by a CCP with one or more working
groups, a recommendation from a CCP's risk manager,
approval by the CCP's risk committee and consultation
with or approval by the CCP's primary regulator.
(a) Credit Derivatives
To assist in this analysis, the signatories
have asked the Depository Trust & Clearing
Corporation (DTCC) to perform an analysis of
all CDS trades in the Warehouse Trust \7\ which
are on products not yet eligible for clearing.
DTCC expects to deliver the completed analysis
by April 15, 2010.
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\7\ DTCC is in the process of transferring the operations of the
Trade Information Warehouse for CDS to a recently organized subsidiary,
The Warehouse Trust Company LLC (Warehouse Trust).
---------------------------------------------------------------------------
We will prioritize outstanding index
transactions not already eligible and single
name components of the indices. To that end,
(i) the G14 Members have delivered to each
relevant CCP (and commit to deliver on a
monthly basis) a list of recommended launch
targets for new products in order of priority,
and (ii) the end-user signatories have
delivered (and commit to deliver on a monthly
basis) a substantially similar document to each
relevant CCP. The signatories will encourage
each relevant CCP to provide these lists
together with their perspectives to the
relevant Supervisors.
(b) Interest Rate Derivatives
We will work with CCPs to prioritize zero
coupon swaps, single currency basis swaps and
additional swap features utilized by end-users
this year, including extending the maximum
tenors that can be cleared. Further analysis is
required to assist CCPs in prioritizing the
next phase of product expansion but we are
considering including Forward Rate Agreements,
cross-currency swaps, caps, floors, European
swaptions and inflation swaps. We commit to
developing a plan for the next phase of product
expansion before the end of 2010.
(3) Customer Access to Derivatives Clearing
Remaining impediments to the expansion of buy-side
access to clearing include legal and regulatory, risk
management, and operational issues. Pursuant to our
prior commitments, the signatories commit to work
together with each relevant CCP \8\ to resolve these
remaining impediments to the expansion of buy-side
access to clearing and to collectively agree the
timeframes for the resolution of each such impediment.
The process and priorities for each asset class will be
targeted to achieve the following goals:
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\8\ As per the June 2, 2009 commitment letter, a CCP that has (a)
broad buy-side and dealer support and (b) a commitment to develop
viable direct and indirect buy-side clearing models.
resolution of all risk, margin,
default management, legal and regu-
latory issues as required to meet the
product roll-out schedules es-
tablished with each CCP, without volume or
---------------------------------------------------------------------------
open interest caps;
reasonable automated operational
access, and completion of end-to-
end testing, for qualifying clearing
members and their buy-side
customers to meet the product roll-out
schedules established with
each CCP; and
reasonable access to facilities to
allow backloading of trades in eli-
gible products.
Upon the achievement of the above goals, the
signatories will make reasonable efforts to work
towards increasing utilization of client clearing
services. We understand that the Supervisors will
closely monitor the industry's progress against the
goals above and that if in their monitoring, the
Supervisors determine that progress in meeting those
goals is unsatisfactory, they will work with industry
participants and CCPs to establish concrete methods to
ensure that a meaningful amount of open interest in
buy-side transactions will be centrally cleared.
To the extent that any impediment requires regulatory
action and/or legislative change, the signatories
commit to proactively inform the relevant regulatory or
legislative bodies.
(a) Credit Derivatives
Pursuant to our prior commitment, customer
access to CDS clearing was initiated on
December 14, 2009. While this launch represents
a significant milestone, it is preliminary and
requires further substantial work in order to
effectively implement the prior commitment.
To that end, (i) the G14 Members have
delivered to each relevant CCP (and commit to
deliver on a bi-weekly basis) a current list of
open items categorized by importance and
priority, the suggested action plan,
responsible parties and target date for
completion of all critical items and the
current targets for launching new products as
referenced above, and (ii) the end-user
signatories have delivered (and commit to
deliver on a monthly basis) a substantially
similar document to each relevant CCP. The
signatories will encourage each relevant CCP to
provide these lists together with their
perspectives to the relevant Supervisors
expeditiously. In addition, the signatories
commit to work with each relevant CCP to arrive
at a unified list of open items and to
encourage each relevant CCP to provide such
lists to the Supervisors on an ongoing basis.
(b) Interest Rate Derivatives
Customer access to Interest Rate Derivatives
clearing was initiated in the LCH service on
December 17, 2009. This launch represents a
significant milestone in extending clearing
services to clients. Clients access the LCH CCP
through the existing direct clearing members,
and the eligible product set is aligned with
those products that can currently be cleared
through the existing inter-dealer service.
The signatories recognize the Supervisors'
policy goal of making available to the buy-side
the benefits of client clearing for Interest
Rate Derivatives. The signatories commit to
work together to make available to the industry
an effective client clearing framework.
We commit to creating working groups for
relevant CCPs (where they do not exist already)
by March 31, 2010, encompassing key buy-side,
sell-side and CCP representation. These CCP
working groups will meet at least monthly and
focus on identifying and resolving the barriers
to clearing to the extent possible and will
report progress back to Supervisors on an
ongoing basis.
(4) CCP Involvement in ISDA Credit Derivatives Determinations
Committees
Interim Regulatory Guidance on CCP Governance and
Market Protocols issued by the CPSSIOSCO RCCP Working
Group on December 15, 2009, states that CCPs' interests
should be represented on the DCs as they participate in
the Credit Derivatives Market by providing clearing
services and are expected to adhere to market
protocols. The signatories who are members of the
various DCs agree to put forth by April 30, 2010 a
specific proposed framework \9\ to implement observer
status for CCPs and will urge the various DCs to act
promptly thereon. The signatories commit, from time to
time upon the request of the CCPs, to ask the DCs, in
consultation with Supervisors, to re-evaluate the CCPs'
observer status to determine the appropriate membership
role of CCPs.
---------------------------------------------------------------------------
\9\ Inclusion of CCPs active in credit default swap clearing as
observers on various DCs will require amendments to the Credit
Derivatives Determinations Committee Rules. Amendments of this type
require a supermajority (80%) vote as well as a 7 day public
consultation period. The signatories who are on the various DCs will
consult with the regulators on preparation of this framework.
---------------------------------------------------------------------------
ANNEX D--STANDARDIZATION
(1) Credit, Interest Rate and Equity Derivatives
We commit to drive a high level of product,
processing and legal standardization in each asset
class with a goal of securing operational efficiency,
mitigating operational risk and increasing the netting
and clearing potential for appropriate products
(recognizing that standardization is only one of a
number of criteria for clearing eligibility).
Accordingly, workstreams have been established to
analyze existing, and where appropriate, potential
opportunities for further standardization, and a
standardization matrix will be completed in partnership
with the Supervisors.
(2) Equity Derivatives
A very significant portion of the Equity Derivatives
market is highly standardized and is already traded on-
exchange and settled through a clearing house. The OTC
portion of the Equity Derivatives Market consists of a
number of different products at varying levels of
standardization, complexity, and customization.
Documentation standardization improvements will
therefore vary by product and region.
We re-affirm our commitment to review, update and
expand the 2002 Equity Definitions by December 31, 2010
in accordance with the Equity Documentation framework
document published on January 30, 2009.
The project is multifaceted and includes:
consolidation, review and updating
of the 2002 Equity Definitions
and subsequent master confirmation
agreement (MCA) publica-
tions;
expansion of existing 2002 Equity
Definitions coverage to include
a wider set of product types, pay offs and
underliers; and
introduction of a menu approach to
facilitate standardization of
contractual terms and product flexibility.
During the 2011 implementation of the 2010 Equity
Definitions, the signatories commit to using the range
of menu items as published in the 2010 Equity
Definitions to create matrices and MCAs for products
agreed by the industry.
We commit to providing verbal updates to the
Supervisors on 2010 Equity Definitions progress on a 6
weekly basis commencing March 31, 2010.
Alongside the 2010 Equity Definitions, we commit to
complete the following MCA projects by April 30, 2010:
European Interdealer Index Swap
Annex (Annex EFIS);
EMEA EM Options Annex (Interdealer);
and
European Interdealer Fair Value Swap
Annex (Annex FVSS).
We will continue to monitor non-electronically
eligible volume in order to identify product
eligibility for documentation standardization,
according to our previously committed 2% threshold. We
will use this information to ensure that the products
identified have appropriate coverage in the 2010 Equity
Definitions so delivery of new MCAs can be prioritized
after the 2010 Equity Definitions are published.
Furthermore, we commit, upon request from a relevant
counterparty (dealer or buy-side), to review existing
MCAs with the counterparty in order to determine if
with respect to an existing MCA there exists a
preference to have the relevant ISDA published MCA
govern all relevant new transactions executed after an
agreed future date in lieu of such existing MCA. If
such preference exists, the parties commit to negotiate
in good faith a new MCA utilizing the ISDA published
MCA with such modifications as the parties may agree in
good faith and will mutually agree whether to migrate
existing transactions under the new MCA or to leave
existing transactions under previously agreed MCAs
until termination or maturity.
ANNEX E--COLLATERAL
In this letter we set out new goals in the areas of Portfolio
Reconciliations and Dispute Resolution. We also commit to update the
Roadmap for Collateral Management. In particular, addressing one of the
top concerns of the Supervisors, we re-affirm our intention to develop
an enhanced industry framework for resolving disputed margin calls. The
industry has made good progress in developing and testing the initial
Dispute Resolution Procedure (DRP). In addition to the DRP, which
focuses on the resolution of disputes after they have occurred, market
participants recognize that disputes must also be tackled by prevention
and increased escalation to regulators. The new commitments below
reflect a multi-pronged strategy to address margin disputes, including
measures designed to prevent, detect, resolve and report them to
regulators.
The signatories are pleased to make the following new commitments:
(1) Collateral Roadmap
We commit to update the Roadmap for Collateral
Management by April 15, 2010 based on the
recommendations from the Independent Amount white paper
(March 1, 2010) and the Market Review of
Collateralization (March 1, 2010). Because of the wide-
ranging nature of those recommendations, we will seek
engagement from dealers, end-users, custodians,
regulators and legislators as appropriate in order to
determine the best path towards implementation.
(2) Portfolio Reconciliation
The commitments already made by the industry with
respect to Portfolio Reconciliation have proven
effective at reducing the incidence and size of margin
disputes.\10\ In addition, ISDA has published a
Feasibility Study for Extending Collateralized
Portfolio Reconciliations (December 2009) and the
follow-on Implementation Plan for Wider Market Roll-out
(February 2010).\11\ Consistent with those recent
publications, we commit that:
---------------------------------------------------------------------------
\10\ This is illustrated by the dispute reporting provided in
private by firms to their regulators showing dispute levels
significantly reduced from a year ago.
\11\ These documents embody a response to recommendation V-10 of
``Containing Systemic Risk: The Road to Reform'' (CRMPG III, August
2008).
(a) The signatories will undertake
reconciliation (bilateral where possible and
otherwise unilateral) \12\ of collateralized
portfolios with any OTC counterparty comprising
more than 1,000 trades at least monthly by June
30, 2010.
---------------------------------------------------------------------------
\12\ The majority of smaller portfolios are between G14 Members and
end-users, not all of whom are equipped to perform bilateral portfolio
reconciliation (where both parties work together using a central
reconciliation service to resolve trade level differences). Therefore,
although bilateral reconciliation is preferred, as a fallback this
commitment is based on a unilateral reconciliation performed by the
dealer. In order to promote the extension of portfolio reconciliation
discipline more deeply into the wider market, the only practical
solution is for dealers to perform the reconciliation for both parties
where necessary. In order for a dealer to perform a unilateral
reconciliation, a dealer's counterparty needs to provide a data file
representing such counterparty's view of the portfolio in a
reconcilable and standard format. ISDA has published Collateralized
Portfolio Reconciliation Best Practices and data Minimum Market
Standards to guide the market in this respect. Dealers will use
commercially reasonable efforts to gain the cooperation of their
counterparts in obtaining these files. The degree to which these
requests are satisfied will be made transparent in the expanded
portfolio reconciliation reporting provided to regulators, and after a
period of several months industry participants and regulators should
review cooperation levels.
(b) Signatory firms will expand the current
monthly Portfolio Reconciliation reports
submitted to the Supervisors to reflect the
---------------------------------------------------------------------------
above commitment by July 31, 2010.
(3) Dispute Resolution
Market experience has shown that although disputed
margin calls may need to be addressed by formal methods
of dispute resolution in some rare circumstances, a
larger proportion of dispute events can be addressed by
prevention and escalation to regulators. Therefore we
make the commitments below which reflect the three
distinct ways in which the risks of disputed margin
calls must be addressed:
(a) Preventing Disputes From Arising
As described above under ``Portfolio
Reconciliation''.
(b) Detecting Disputes Early and Resolving Them Definitively
The DRP continues to undergo the process of
testing and further refinement commenced in Q4
2009. We commit to provide regular updates for
each phase of the DRP evolution with the
intention to complete this process by September
30, 2010.
(c) Reporting Disputed Collateral and Exposure Amounts
We commit to develop consistent reporting
that provides the Supervisors with the ability
to assess the top margin disputes that
potentially pose significant risk by May 31,
2010. We will provide a pro forma template for
such reporting to the Supervisors by April 15,
2010 to seek their input on content and
presentation.\13\
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\13\ Industry practitioners will work with regulators over coming
weeks to establish the appropriate reporting criteria and thresholds.
The intention is to identify margin disputes of significance. Included
in this consideration for materiality are likely to be dispute scale
(disputes exceeding an established amount) and dispute persistence
(disputes aged over an established number of days).
---------------------------------------------------------------------------
ANNEX F--OPERATIONAL EFFICIENCY TARGETS
(1) Credit Derivatives
(a) Central Settlement
The Credit Derivatives market has benefitted
from the increased usage of central
settlement,\14\ and industry participants
remain committed to settlement automation. The
quality of the existing bilateral settlement
mechanisms, coupled with the likely increased
penetration of clearing into the Credit
Derivatives market, limits the benefits
associated with any additional central
settlement service beyond the existing use of
CLS. As a consequence, the industry's resources
will focus on the resolution of the other
commitments identified within this letter.
---------------------------------------------------------------------------
\14\ 79% of all CDS trades in the Warehouse Trust were centrally
settled for the December 2009 quarterly roll Electronic Confirmation
Targets Submission.
---------------------------------------------------------------------------
(b) Submission Timeliness/Matching
MarkitSERV remains the primary service
provider within the Credit Derivatives realm,
with more than 99% of electronically confirmed
trades being processed on MarkitSERV and
greater than 90% of these trades confirmed
electronically on trade date. We reiterate our
commitment to achieving T+0 submission and
matching.
Given the significant architectural changes
to the Credit Derivatives infrastructure in
support of our efforts to achieve (i)
interoperability with clearing solutions and
(ii) trade date matching through improvements
to the novation consent process and associated
technology enhancements, we commit to an
ongoing periodic review of existing commitments
for both T+0 submission (currently 90%) and T+2
matching (currently 94%), for electronically
eligible transactions, with the Supervisors.
(2) Equity Derivatives
(a) Electronic Eligibility
We re-affirm our commitment to set blended
targets for electronically eligible OTC Equity
Derivative transactions. For purposes of
measuring targets, confirmations that are
deemed eligible for inclusion (Electronically
Eligible Confirmations) will include:
(i) confirmations for products (Electronically
Eligible Products) that;
(A) have an ISDA published MCA
(irrespective of whether such
ISDApublished form or pre-existing
bilateral form is used),\15\ and
---------------------------------------------------------------------------
\15\ Products which do not have an ISDA published MCA will not be
included in this target irrespective of whether a bilateral MCA exists.
(B) can be matched on an electronic
---------------------------------------------------------------------------
platform; and
(ii) confirmations of Confirmable Lifecycle
Events \16\ for transactions which were
executed on an electronic platform under
existing bilateral MCAs but for which an ISDA
MCA is subsequently published and which are
currently confirmable on an electronic platform
will be deemed Electronically Eligible
Confirmations as of the date that the relevant
product becomes an Electronically Eligible
Product. Confirmations of Confirmable Lifecycle
Events for transactions that were originally
confirmed on paper will not be deemed
Electronically Eligible Confirmations.
---------------------------------------------------------------------------
\16\ Confirmable Lifecycle Events will be identified in the
Electronic Eligibility Matrix.
---------------------------------------------------------------------------
(b) Electronic Confirmation Targets
We commit to processing, by June 30, 2010,
75% of Electronically Eligible Confirmations on
an electronic platform. We further commit to
increasing this target to 80% by September 30,
2010.
Furthermore, we commit to publishing an
Electronic Eligibility Matrix \17\ of
Electronically Eligible Products and
Confirmable Lifecycle Events by March 1, 2010
and will publish an updated version of this
matrix on a quarterly basis.\18\
---------------------------------------------------------------------------
\17\ The matrix will be published on the ISDA website on March 1,
2010 and on a quarterly basis thereafter.
\18\ New products will be deemed Electronically Eligible Products
90 days following the date on which both an ISDA MCA has been published
and such product is supported by an electronic platform.
---------------------------------------------------------------------------
(c) Submission Timeliness/Matching
We commit to the following targets:
By June 30, 2010, 95% T+1
submission and 95% T+3 matching
of global options and variance
swaps between G14 Members
for Electronically Eligible
Confirmations processed on an elec-
tronic platform.
By June 30, 2010, 70% T+1
submission and 75% T+5 matching
of Discrete total return swaps \19\
between G14 Members for
Electronically Eligible
Confirmations processed on an elec-
tronic platform.
---------------------------------------------------------------------------
\19\ As defined in the December 10, 2008 EFS Roadmap.
By September 30, 2010, 90%
T+1 submission and 90% T+5
matching for G14 Members versus all
counterparties for Elec-
tronically Eligible Confirmations
processed on an electronic
---------------------------------------------------------------------------
platform.
(d) Confirmation Backlog Reduction
By June 30, 2010, we commit that outstanding
confirmations aged more than 30 calendar days
are not to exceed 1 business day of trading
volume based on average daily volume in the
prior 3 months.
(e) Cash Flow Matching
We commit to publishing a cash flow matching
implementation plan to the Supervisors by March
31, 2010 with a further commitment to deliver
cash flow matching functionality by December
31, 2010.
(3) Interest Rate Derivatives
(a) Central Settlement
The increased penetration of central clearing
into the Interest Rate Derivatives market in
2010 will significantly reduce the volume and
size of bilateral settlements between market
participants. This reduction in bilateral
activity will take place against a backdrop of
strong existing risk management practices where
only 0.59% of gross settlements have post-value
date discrepancy \20\ and 0.1% of these issues
persist 30 days after settlement date. As a
consequence, the industry's resources will be
focused on the delivery of the other
commitments identified in this letter. We will
continue to monitor the incidence of post value
date issues of gross settlements over time to
ensure no risk mitigating initiatives are
required.
---------------------------------------------------------------------------
\20\ A post-value date discrepancy may be defined as any mismatch
in settlement amounts or value-date or a failure to settle funds on the
date expected. Such discrepancies are typically investigated and
resolved by operational control groups within the respective
organizations.
---------------------------------------------------------------------------
(b) Rates Allocation Commitment
MarkitSERV will deliver electronic allocation
delivery functionality consistent with the
requirements gathered at the Allocation
Industry Working Group meetings. We will
provide the Supervisors with a plan by March
31, 2010 to achieve this.
The scope of the project will include the
ability for buy-side users to electronically
submit allocations to dealers in either a
single step, where allocations plus
confirmation occur, or a two-step process,
where electronic allocation delivery is
distinct from confirmation. Further planned
functionality caters to additional workflows
where buy-side clients submit allocations
directly on pending trades or where the system
matches grouped allocations to dealer block
trades. Confirmation of Independent Amount
percentage at an allocation level will be in
scope.
(c) Electronic Confirmation Targets
We commit to the following electronic
confirmation targets:
By June 30, 2010, 93% of
electronically eligible confirmable
events with G14 Members will be
processed on electronic plat-
forms, with a further commitment to
achieve 95% by December
31, 2010; and
By June 30, 2010, 60% of
electronically eligible confirmable
events with all other participants
will be processed on elec-
tronic platforms with a further
commitment to provide a plan
for the implementation of a more
streamlined process for low
volume clients also by June 30,
2010.\21\
---------------------------------------------------------------------------
\21\ The Rates Implementation Group is performing analysis on the
non-G14 Member volume to understand the material impact of those
customers executing four or fewer electronically eligible trades per
month.
---------------------------------------------------------------------------
(d) Submission Timeliness/Matching
The launch of MarkitSERV's interoperable
confirmation service enables market
participants to use DTCC Deriv/SERV or
Markitwire, regardless of what service their
counterparty uses. Interoperability eliminates
the requirement to process confirmations
independently on Markitwire or DTCC/DerivSERV
and we believe the process should be subject to
new performance targets. With 87% of
electronically confirmed trades being processed
on Markitwire and greater than 98% of these
trades confirmed on trade date, we commit to
the following targets upon adoption of
MarkitSERV interoperability, with a commitment
to review and re-evaluate these targets with
Supervisors on a quarterly basis to get to a
steady state and progress toward T+0 submission
and matching:
Submit 90% of electronic
confirmations no later than T+0 busi-
ness days by September 30, 2010.
Match 97% of electronic
confirmations no later than T+2 busi-
ness days by September 30, 2010.
(e) Confirmation Backlog Reduction
By April 30, 2010: We commit that electronic
and paper outstanding confirmations aged more
than 30 calendar days are not to exceed 0.20
business day of trading volume based on the
prior 3 months rolling volume and we commit to
continue reporting these targets on a monthly
basis. We commit to review and re-evaluate this
target with Supervisors on a quarterly basis to
get to a steady state and progress towards T+0
matching.
The Chairman. Thank you, Mr. Pickel. Mr. Morrison for 5
minutes.
STATEMENT OF SCOTT C. MORRISON, SENIOR VICE
PRESIDENT AND CFO, BALL CORPORATION; CHAIRMAN,
NATIONAL ASSOCIATION OF CORPORATE TREASURERS, BROOMFIELD, CO;
ON BEHALF OF THE COALITION FOR
DERIVATIVES END-USERS
Mr. Morrison. Thank you, Mr. Chairman, Ranking Member
Peterson, and the Committee. My name is Scott Morrison. I am
Senior Vice President and Chief Financial Officer of Ball
Corporation, and Chairman of the National Association of
Corporate Treasurers. Collectively, we are also members of the
Coalition for Derivatives End-Users. The Coalition represents
thousands of companies across the U.S. that employ derivatives
to manage risks. It is a privilege to speak with you today.
Ball Corporation is based in Colorado, and we operate over
30 manufacturing locations in the U.S. We operate in nearly 70
percent of the states represented by the Agriculture Committee
that I have the honor of addressing today. We are a 131 year-
old publicly traded company with deep roots in supplying
packaging to the food, beverage, and consumer product
industries in the U.S. Approximately 65 percent of our 14,500
employees work in the United States. We support the efforts of
this Committee to reduce systemic risk and increase
transparency in the over-the-counter derivatives markets.
While I agree that the reckless and over-leveraged use of
derivatives by systemically significant institutions can have
dire consequences, the prudent use of derivatives by end-users
like us should not be put into the same category. For end-users
like ourselves, OTC derivatives provide a critical risk
management tool to reduce commercial risk and volatility in our
normal business operations, allowing us to create sustainable
and prosperous businesses. I am here today to share with you
our perspective on a couple of these matters.
Our use of derivatives is driven by the desire to reduce
commercial risk associated with our business. Ball's largest
business, beverage can manufacturing, involves buying over $3
billion of aluminum coils per year, converting those coils into
cans, and selling them to large beverage and food companies. We
are able to use OTC swaps to exactly match the prices and
timing of when we buy coils of aluminum to when we sell the
completed cans. This risk management technique allows us to
prudently manage our costs and reduce volatility of price
changes during the manufacturing process and over multi-year
sales agreements. We have used this risk management process for
over 15 years with no adverse consequences.
We believe a broad end-user exemption is a critical feature
of derivatives legislation. During the regulatory process, we
have sought to ensure that the exemption provided for by
Congress would not be unduly narrowed. In particular, we have
urged regulators to give thoughtful consideration to key
definitions to ensure that end-users like us are not regulated
as if we dealt in speculative swaps.
The second area I would like to address is that of margin
to be posted on future or even previously entered into
contracts. Such a requirement would be particularly troublesome
to end-users like Ball. A requirement for end-users to post
margin would have a serious impact on our ability to invest in
and grow our business. For example, Ball is currently investing
significant amounts of capital in plant expansions in Texas,
Indiana, California, and Colorado, totaling well in excess of
$150 million, and adding several hundred jobs when complete.
Tying up capital for initial and variation margin could put
those types of projects at risk at a time when our economy can
ill afford it. The impact of posting initial margin for us can
easily exceed $100 million, while the change in value on our
trades over time could easily surpass $300 million. Diverting
more than $400 million of working capital into margin accounts
would have a direct and adverse impact on our ability to grow
our business and create and maintain jobs.
In short, margin requirements will cost the communities in
which we are located literally hundreds of good new jobs.
Additionally, because of the importance of this market to
main street businesses like Ball, we believe it is critical to
get the regulation right. The current rulemaking timeline is
aggressive, and may force regulators to prioritize speed over
quality. We would urge Congress to provide regulators with more
time for rulemaking and for regulators to allow market
participants sufficient time for implementation. This is
critical to ensure that the market participants have ample
opportunity to provide useful feedback and ensuring this
important market continues to function with minimal disruption.
As regulators go about the important work of finalizing the
rules that address the lessons learned from the financial
crisis, it is of the utmost importance that they do so in a
manner that does not break those things that function well.
Though it may be tempting to view all derivatives ask risky
financial products that were central to the credit crisis, we
must remember that these are important tools upon which
thousands of companies like ours depend to manage risks in the
economy.
Thank you for your time.
[The prepared statement of Mr. Morrison follows:]
Prepared Statement of Scott C. Morrison, Senior Vice President and CFO,
Ball Corporation; Chairman, National Association of Corporate
Treasurers, Broomfield, CO; on Behalf of Coalition for Derivatives End-
Users
Good afternoon, my name is Scott Morrison. I am Senior Vice
President and Chief Financial Officer of Ball Corporation and Chairman
of the National Association of Corporate Treasurers (``NACT''), an
organization of Treasury professionals of several hundred of the
largest public and private companies in this country. Collectively, we
are also a member of the Coalition for Derivatives End-Users
(``Coalition''). The Coalition represents thousands of companies across
the United States that employ derivatives to manage risks they face in
connection with their day-to-day businesses. It is a privilege to have
the opportunity to speak with you today on behalf of both our company,
and the NACT about the new derivatives legislation. Ball Corporation is
based in Colorado and we operate over 30 manufacturing locations in the
U.S. We operate in nearly 70% of the states represented by the
Agriculture Committee I am addressing today. We also operate another 25
locations around the world. We are a 131 year old publicly traded
company with deep roots in supplying packaging to the food, beverage
and consumer product industries in the U.S.; our customers include
Coca-Cola, Pepsi, Miller Coors and Anheuser Busch InBev along with
ConAgra Foods, Abbott Labs and numerous family-owned beverage fillers
and food packers. Approximately 75% of our 14,500 employees reside in
the United States.
We understand and support the efforts of this Committee to reduce
systemic risk throughout the financial system to avoid the issues that
contributed to the financial turmoil that boiled over in 2008 and also
we applaud your efforts to increase transparency in the over-the-
counter (``OTC'') derivatives markets. While I would agree that the
reckless and over-leveraged use of derivatives by systemically
significant institutions can have dire consequences, the prudent use of
derivatives by manufacturers such as ourselves and the vast majority of
end-users like us should not be put into the same category. For end-
users like ourselves the prudent use of derivatives provides us a
critical risk management tool to reduce commercial risk and volatility
in our normal business operations allowing us to create sustainable and
prosperous businesses. I am here today to share with you our
perspective on these matters and want to specifically address three
areas of the legislation: an appropriate end-user exemption; margin
requirements; and the need to avoid overly complex clearing and
reporting. I would like to take a minute to address each in greater
detail.
Our use of derivatives is driven by the desire to reduce commercial
risk associated with our business. Ball's largest business (beverage
can manufacturing) involves buying over $3 billion of aluminum coils
per year, converting those coils into cans and selling them to large
beverage and food companies mentioned earlier. As aluminum is an
actively traded commodity, we are able to use OTC swaps to exactly
match the prices and timing of when we buy coils of aluminum to when we
sell the completed cans. This risk management technique allows us to
prudently manage our costs and reduce volatility of price changes
during the manufacturing process as well as over the life of multi-year
contracts. We have used this risk management process for over 15 years
with no adverse consequences. We clearly are not a trading operation.
Our policies state that speculation is forbidden--a policy consistently
applied by end-users generally. While our use of derivatives can be
substantial, our hedges are executed to reduce commercial risk. Not
executing the swaps would create more volatility in our business
outcomes. We believe a broad end-user exemption is a critical feature
of derivatives legislation. During the regulatory process, we have
sought to ensure that the exemption provided for by Congress would not
be unduly narrowed. In particular, we have urged regulators to give
thoughtful consideration to key definitions, including major swap
participant and swap dealer, to ensure that manufacturers and other
end-users like us are not regulated as if we dealt in speculative
swaps.
The second area I would like to address is that of margin to be
posted on future or even previously entered into contracts; this
requirement would be particularly troublesome to end-users like Ball
Corporation. Retroactive application of a margin requirement would
upset the reasonable expectations we had when entering into existing
risk management contracts. These expectations are negotiated
extensively in ISDA agreements that we have with our financial
counterparties. Those arrangements have already included a credit cost
that we have paid, so retroactive application of margin requirements
would essentially double our costs. A requirement for end-users like
Ball Corporation to post margin to its counterparties would have a
serious impact on our ability to invest in and grow our business. For
example, Ball Corporation is currently investing significant amounts of
capital in plant expansions we are currently executing in Texas,
Indiana, California and Colorado. Those expansions alone are
investments totaling well in excess of $150 million and will add
several hundred jobs when complete. Tying up capital for initial and
variation margin could put those types of projects at risk at a time
when our economy can ill afford it. The impact of posting initial
margin for us can easily exceed $100 million, while the change in value
on our trades over time could easily surpass $300 million in required
capital that would be removed from productive economic use. Notably,
diverting more than $400M of working capital into margin accounts would
have a direct and adverse impact on our ability to grow our business
and create and maintain jobs. In short, margin requirements will cost
the communities in which we are located literally hundreds of good, new
jobs.
The third area to focus on is avoiding the creation of rigid and
expensive trading requirements that could cause the unintended
consequence of companies either retaining more risk or to seek risk
management alternatives overseas. We are not a ``trading house'' our
activity in derivatives is not daily or even weekly. In addition, by
utilizing over-the-counter swaps we are able to customize our hedges to
perfectly match the underlying exposure. If we were required to use
only standardized or exchange traded hedge products we would not create
the risk offset we currently achieve today and this would result in
both accounting and real economic volatility. Though end-users are not
directly subject to such requirements, excessive capital requirements
imposed on our financial counterparties could significantly increase
our costs. Though these capital requirements should be appropriate for
the risk of the product, they should not be increased in such a manner
so as to deter prudent use of uncleared over-the-counter derivatives by
end-users. The end result and unintended consequence of margin
requirements applied to end-users or excessive capital requirements
applied to our financial counterparties could be to reduce the risk
management activity of end-users, a result which would actually
increase systemic risk or even push transactions offshore. Neither of
these would be favorable to our economy.
Additionally, because of the importance of this market to main
street businesses like Ball Corporation, we believe it is critical to
get the regulation right. The current rulemaking timeline is
aggressive, and may force regulators to prioritize speed over quality.
Doing so could hurt companies' ability to manage their risks. We would
urge Congress to provide regulators with more time for rulemaking, and
for regulators to allow market participants sufficient time for
implementation. This is critical to ensuring that market participants
have ample opportunity to provide useful feedback, and to ensuring this
important market continues to function with minimal disruption.
Chairman Gensler has reached out to businesses for input on a realistic
implementation timeline. That is a positive step and one that we
appreciate greatly. However, developing a workable implementation
timeline still would not fix the problem of too many rules being
promulgated over too little time. The statutory effective date must be
extended for end-users to be able to participate meaningfully in the
regulatory development process.
As regulators go about the important work of finalizing the rules
that address the lessons learned of the financial crisis, it is of the
utmost importance that they do so in a manner that does not break those
things that functioned well. I am confident that the way in which these
products are utilized by our company, and end-users generally, provides
important benefits to the economy, including reduced volatility and
greater stability to a significant sector of the economy. Though it may
be tempting to view all derivatives as risky financial products that
were central to the credit crisis, we must remember that these are
important tools upon which thousands of companies depend to managing
risks in the real economy. Thank you for your time and I am happy to
answer any questions that you have.
The Chairman. Thank you, Mr. Morrison. Mr. Olesky? Did I
butcher your name?
Mr. Olesky. Olesky.
The Chairman. Olesky, sorry about that.
STATEMENT OF LEE OLESKY, CHIEF EXECUTIVE OFFICER, TRADEWEB, NEW
YORK, NY
Mr. Olesky. Thank you, Mr. Chairman, Ranking Member
Peterson, and Members of the Committee. Good afternoon. Thank
you for inviting me to participate in this hearing. My name is
Lee Olesky. I am Chief Executive Officer of Tradeweb, and I
appreciate the opportunity to testify today about the
implementation of Title VII of the Dodd-Frank Act.
For the last 12 years, Tradeweb has been on the forefront
of creating electronic trading solutions for the bond markets.
Before platforms like Tradeweb were established, institutional
clients picked up the phone and spoke to one or more dealers in
order to buy or sell U.S. Treasury government bonds. In 1998,
Tradeweb established an electronic marketplace for U.S.
Treasury securities and transformed a phone-based opaque
government bond market into a more transparent and efficient
market.
As a result of this evolution, institutional clients such
as asset managers and pension funds now have access to
regulated trading systems that provide greater price
transparency and more efficient execution, which has the added
benefit of reducing operational risk, the very goals of Title
VII of Dodd-Frank.
Several years ago, Tradeweb expanded into derivatives and
began offering an execution facility for interest rate and
credit derivatives. So when Congress passed Dodd-Frank and
created a new type of registered trade execution venue, a swap
execution facility, or SEF, Tradeweb was extremely well-
positioned to become a SEF and meet the stated policy
objectives for SEFs to improve price transparency, and promote
the trading of swaps on regulated electronic markets.
Whether it is for government bonds or any other instrument
traded on the 20 markets we operate around the world, our focus
has always been on using technology to create products and
services for our clients. This has resulted in more transparent
and efficient bond markets globally.
What we have learned in the last 12 years is how important
it is to evolve our technology based on our client's current
and future needs. Thus, while Tradeweb is supportive of the
goals of the Act, Congress and the regulators should understand
and give due consideration to the needs of the market
participants. We believe the key for achieving the policy
objectives for SEFs, which is greater transparency and
promoting the trading of swaps on regulated markets, is to
provide for flexibility in the way that market participants can
trade swaps on those regulated markets.
By ensuring that the rules retain sufficient flexibility
for market participants, clients can trade in a manner that
suits their trading strategies and risk profiles. Some
institutions will want to transact on live prices, some will
want to use a disclosed request for quote model, known as an
RFQ, others will still want to transact through an anonymous
order book, which is similar to an exchange. We believe
regulators should not mandate that clients pick one model to
trade on. They must be flexible to achieve the goals of the Act
without materially disrupting the market. Creating arbitrary or
artificially prescriptive limitations on the manner in which
market participants interact and trade could result in
liquidity drying up, and add increased costs to trade swaps.
This could move participants away from executing in the swap
markets, which we know is not the goal of Title VII, Congress,
or the regulators.
Along the same lines, overly prescriptive ownership limits
or governance requirements for SEFs or DCMs will impact the
ability to attract investment capital in new or existing
platforms. A careful balance needs to be reached between
mitigating conflicts and encouraging private enterprise, which
will encourage investment and innovation. For example, it would
have been very difficult for Tradeweb to have raised its seed
capital in future investments if investors were told that more
than half of our Board would be made up of independent
directors with no ties to the company.
In conclusion, we are supportive of the goals to reform the
derivatives markets, and indeed, we provide the very solutions
the regulations seek to achieve, but we are concerned the
Commissions may overreach in their interpretation and
implementation of Dodd-Frank, and in doing so, create
unintended consequences for market participants and the
marketplace as a whole.
We hope that our experience in the electronic markets can
be helpful and instructive as Congress and the regulators take
on the great challenge of implementing Title VII of Dodd-Frank.
Thank you.
[The prepared statement of Mr. Olesky follows:]
Prepared Statement of Lee Olesky, Chief Executive Officer, Tradeweb,
New York, NY
Tradeweb Markets LLC (``Tradeweb'') appreciates the opportunity to
provide testimony to the House Agriculture Committee with respect to
swap execution facilities (``SEFs'') and the impact of the
implementation of Title VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (the ``Dodd-Frank Act'') under the proposed
regulations from the Commodity Futures Trading Commission (``CFTC'')
and U.S. Securities and Exchange Commission (``SEC'', together with the
CFTC, the ``Commissions'').
I. Background on Tradeweb
Tradeweb is a leading global provider of electronic trading
platforms and related data services for the OTC fixed income and
derivatives marketplaces. Tradeweb operates three separate electronic
trading platforms: (i) a global electronic multi-dealer to
institutional customer platform through which institutional investors
access market information, request bids and offers, and effect
transactions with, dealers that are active market makers in fixed
income securities and derivatives, (ii) an inter-dealer platform,
called Dealerweb, for U.S. Government bonds and mortgage securities,
and (iii) a platform for retail-sized fixed income securities.\1\
---------------------------------------------------------------------------
\1\ Tradeweb operates the dealer-to-customer and odd-lot platforms
through its registered broker-dealer, Tradeweb LLC, which is also
registered as an alternative trading system (``ATS'') under Regulation
ATS promulgated by the SEC under the Securities Exchange Act of 1934.
Tradeweb operates its inter-dealer platform through its subsidiary,
Hilliard Farber & Co., Inc., which is also a registered broker-dealer
and operates Dealerweb as an ATS. In Europe, Tradeweb offers its
institutional dealer-to-customer platform through Tradeweb Europe
Limited, which is authorized and regulated by the UK Financial Services
Authority as an investment firm with permission to operate as a
Multilateral Trading Facility. In addition, Tradeweb Europe Limited has
registered branch offices in Hong Kong, Singapore and Japan and holds
an exemption from registration in Australia.
---------------------------------------------------------------------------
Founded as a multi-dealer online marketplace for U.S. Treasury
securities in 1998, Tradeweb has been a pioneer in providing market
data, electronic trading and trade processing in OTC marketplaces for
over 10 years, and has offered electronic trading in OTC derivatives on
its institutional dealer-to-customer platform since 2005. Active in 20
global fixed income, money market and derivatives markets, with an
average daily trading volume of more than $250 billion, Tradeweb's
leading institutional dealer-to-customer platform enables 2,000
institutional buy-side clients to access liquidity from more than 40
sell-side liquidity providers by putting the liquidity providers in
real-time competition for client business in a fully-disclosed auction
process. These buy-side clients comprise the majority of the world's
leading asset managers, pension funds, and insurance companies, as well
as most of the major central banks.
Since the launch of interest rate swap (``IRS'') trading in 2005,
the notional amount of interest rate derivatives traded on Tradeweb has
exceeded $5 trillion from more than 65,000 trades. Tradeweb has spent
the last 5 years building on its derivatives functionality to enhance
real-time execution, provide greater price transparency and reduce
operational risk. Today, the Tradeweb system provides its institutional
clients with the ability to (i) view live, real-time IRS (in six
currencies, including U.S., Euro, Sterling, Yen), and Credit Default
Swap Indices (CDX and iTraxx) prices from swap dealers throughout the
day; (ii) participate in live, competitive auctions with multiple
dealers at the same time, and execute an array of trade types (e.g.,
outrights, spread trades, or rates switches); and (iii) automate their
entire workflow with integration to Tradeweb so that trades can be
processed in real-time from Tradeweb to customers' middle and back
offices, to third-party affirmation services like Markitwire and DTCC
Deriv/SERV, and to all the major derivatives clearing organizations.
Indeed, in November 2010, Tradeweb served as the execution facility for
the first fully electronic dealer-to-customer interest rate swap trade
to be cleared in the U.S. Tradeweb's existing technology maintains a
permanent audit trail of the millisecond-by-millisecond details of each
trade negotiation and all completed transactions, and allows parties
(and will allow SDRs) to receive trade details and access post-trade
affirmation and clearing venues.
With such tools and functionality in place, Tradeweb is providing
the OTC marketplace with a front-end swap execution facility. Moreover,
given that it has the benefit of offering electronic trading solutions
to the buy-side and sell-side, Tradeweb believes that it can provide
the Commissions with a unique and valuable perspective on the proposed
rules.
As additional background, Tradeweb was established in 1998 with
financial backing from four global banks that were active in, and
interested in expanding and fostering innovation in, fixed income (U.S.
Government bond) trading. After 6 years of growth and expansion into 15
markets globally, in 2004, Tradeweb's bank-owners (which had grown from
four to eight over that time) sold Tradeweb to The Thomson Corporation,
which wholly-owned it until January 2008. Although the original bank-
owners continued to be a resource for Tradeweb from 2004 to 2008, The
Thomson Corporation recognized that bank ownership was an important
catalyst of Tradeweb's development and sold through a series of
transactions a strategic interest in Tradeweb to a consortium comprised
of ten global bank owners. Today, Tradeweb is majority owned by Thomson
Reuters Corporation (successor to The Thomson Corporation) and minority
stakes are held by the bank consortium and Tradeweb management.
Accordingly, Tradeweb was launched by market participants and has
benefitted from their investment of capital, market expertise and
efforts to develop and foster more transparent and efficient markets.
With the support of its ownership and its board comprised of market and
non-market participants, Tradeweb has, since its inception, brought
transparency and efficiency to the OTC fixed income and derivatives
marketplace.
II. Summary
With the goal of increasing transparency and efficiency, and
reducing systemic risk, in the derivatives markets, Congress passed
Title VII of the Dodd-Frank Act, and in doing so, created a new type of
registered entity--known as a swap execution facility or ``SEF.''
Congress expressly created SEFs to promote the trading of swaps on
regulated markets, and provide a broader level of price transparency
for end-users of swaps. While the definition of a SEF has been the
subject of much debate and speculation, the plain language of the Dodd-
Frank Act requires the Commissions to recognize the distinction between
SEF's on the one hand and designated contract markets (``DCMs'') or
exchanges on the other. There was a recognition by Congress that
alternatives to traditional DCMs and exchanges were necessary,
particularly in light of the current working market structure and
manner in which OTC derivatives trade. We applaud the direction of the
regulation, but want to ensure that the Commissions adopt rules that
are clear and allow for flexibility in the manner of execution for
market participants.\2\ This will give the end-users choices,
confidence and liquidity, and will do so in a regulated framework that
promotes the trading of swaps, in an efficient and transparent manner
on regulated markets.
---------------------------------------------------------------------------
\2\ The term `swap execution facility' has been defined in the
Dodd-Frank Act as a trading system or platform in which multiple
participants have the ability to execute or trade swaps by accepting
bids and offers made by multiple participants in the facility or
system, through any means of interstate commerce, including any trading
facility, that--(A) facilitates the execution of swaps between persons;
and (B) is not a designated contract market. The Dodd-Frank Act amends
Section 1a of the Commodities Exchange Act with a new paragraph (50,
and Section 761(a)(6) of the Dodd-Frank Act amends Section 3(a) of the
Securities Exchange Act of 1934 by adding a new paragraph (77)
(defining a ``security-based swap execution facility''). We refer to
both as a SEF in this submission.
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Since 1998, Tradeweb has been operating a regulated marketplace for
the OTC fixed income marketplace and has played an important role in
providing greater transparency and improving the efficiency of the
trading of fixed income securities and derivatives. Indeed, Tradeweb
has been at the forefront of creating electronic trading solutions
which support price transparency and reduce systemic risk, the
hallmarks of Title VII of the Dodd-Frank Act. Accordingly, Tradeweb is
supportive of the Act and its stated goals, and while our existing
electronic trading capabilities will allow us to readily adapt to the
trading, clearing and reporting rules ultimately promulgated by the
CFTC and SEC, it is important for this Committee, Congress as a whole
and the regulators to understand and give due consideration to the
needs of market participants. The aim must be to achieve the goals of
the Act without materially disrupting the market and the liquidity it
provides to end-users who use derivatives to manage their varying risk
profiles. Market participants need confidence to participate in these
markets and if careful consideration is not given to what the rules say
and how they will ultimately be implemented, we fear that this
confidence could be materially shaken.
To that end, the rules relating to Title VII must be flexible
enough so as not to deter the trading of swaps on regulated platforms.
By ensuring that the rules retain sufficient flexibility to allow end-
users to elect where and how they transact business, it provides for
the most competitive execution of trades. The Act clearly recognizes
the existence and importance of electronic platforms in achieving these
objectives, and we believe regulation should foster the benefits these
venues provide, rather than inhibit them. Accordingly, the rules should
not limit the choices of trading protocols available for end-users to
efficiently and effectively manage their risks.
For example, if the rules regarding how market participants must
interact with each other from a trading perspective and accessing
liquidity are arbitrary and artificially prescriptive, and thus not
flexible enough to accommodate the varying methods of execution, market
participants simply will not participate and will seek alternative,
less efficient markets to manage their risk. We certainly do not
believe that is the ultimate goal of Title VII.
Similarly, arbitrary or artificially prescriptive ownership limits
or governance requirements will deter investment of capital in new or
existing platforms. A careful balance needs to be reached between
safeguarding the system and encouraging private enterprise, which will
allow end-users access to choose among robust trading venues and
clearing organizations. To be clear, we favor having an independent
voice on the Board of registered entities, but the rules should not go
so far as to make that the predominant voice--one that creates a
conflict of interest on the opposite extreme.
It is important in this regard, and for other reasons, that there
is a consistent approach between regulators, both in the U.S. and
globally, as overly rigid regulation in one jurisdiction will
materially impact how other regulators promulgate rules in an effort to
maintain a harmonized approach to overseeing the derivatives markets.
The potential result is a movement of the market outside the U.S., and
that would likewise be an unfortunate unintended consequence.
Accordingly, we believe it is important that the implementation of
the new regulations be conducted in a flexible manner. An overly hasty
or ill thought-out timetable for implementation could directly impact
the health of the derivatives markets by disenfranchising the inter-
connected members of this complex ecosystem. In short, implementing
these regulations in one ``big bang'' is unrealistic and as such, we
favor a phased-in approach.
Tradeweb is supportive of the goals to reform the derivatives
markets and indeed we provide the very solutions the regulation seeks
to achieve, but we are concerned that the Commissions may overreach in
their interpretation and implementation of Dodd-Frank, and in doing so
create unintended consequences for end-users and the marketplace as a
whole.
III. Background on the OTC Rates and Credit Derivatives Marketplace
There are generally two institutional marketplaces for over-the-
counter (OTC) credit and rates derivatives: the dealer-to-customer
market (institutional) and the interdealer market (wholesale). In the
institutional market, certain dealers act as market makers and buy and
sell derivatives with their institutional customers (e.g., asset
managers, corporations, pension funds, etc.) on a fully-disclosed and
principal basis. In the institutional market, the provision of
liquidity is essential for corporations, municipalities and government
organizations (i.e., end-users), which have numerous different asset
and liability profiles to manage. The need for customized risk
management solutions has led to a market that relies on flexibility--so
end-users can adequately hedge interest rate exposure--and liquidity
providers, who have the ability to absorb the varied risk profiles of
end-users by trading standard and customized derivatives. These market
makers then often look to the wholesale market--the market wherein
dealers trade derivatives with one another--to obtain liquidity or
offset risk as a result of transactions effected in the institutional
market or simply to hedge the risk in their portfolios.
In the wholesale or inter-dealer market, brokers (``IDBs'') act as
intermediaries working to facilitate transactions between dealers.
There is no centralized exchange (i.e., derivatives are traded over-
the-counter), and as a result, dealers look to IDBs to obtain
information and liquidity while at the same time preserving anonymity
in their trades. Currently, in the United States, these trades are
primarily accomplished bilaterally through voice brokering. By
providing a service through which the largest and most active dealers
can trade anonymously, IDBs prevent other dealers from discerning a
particular dealer's trading strategies, which in turn (i) reduces the
costs associated with the market knowing a particular dealer is looking
to buy or sell a certain quantity of derivatives, (ii) allows the
dealer to buy or sell derivatives in varying sizes, providing stability
to the marketplace, and (iii) enhances liquidity in the marketplace.
Both the wholesale and institutional derivatives markets trade
primarily through bilateral voice trading, with less than 5% of the
institutional business trading electronically. In these markets, trades
are often booked manually into back office systems and trades are
confirmed manually (by fax or other writing), and some (but not all)
derivatives trades are cleared.
With the implementation of the Dodd-Frank Act, we expect that most
of the interest rate and credit derivatives markets will be subject to
mandatory clearing, and therefore be traded on a regulated swap market.
Accordingly, with increased electronic trading, the credit and rates
derivatives markets will be much more transparent (with increased pre-
trade price transparency) and efficient, and systemic risk will be
greatly reduced as the regulated swaps markets will have direct links
to designated clearing organizations (``DCOs'') and swap data
repositories (``SDRs'').
In light of the foregoing and with the forthcoming business conduct
standards, we believe the trading mandate was not intended to be and
does not need to be artificially and arbitrarily prescriptive to
achieve the goals of the Dodd-Frank Act. Indeed, to do so, would
undermine these goals. For example, by mandating a minimum of five
liquidity providers from which a market participant can seek prices
would likely reduce liquidity and effectively reduce the ability for
end-users to adequately manage their risk. In short, regulated swap
market trading (without regard to trading model but with the
appropriate transparency and regulatory oversight) and clearing is what
will accomplish the policy goals without hurting liquidity and
disrupting the market. It is critical that the Commissions do not
propose rules that artificially and unnecessarily hurt the market and
undermine the goals of the Dodd-Frank Act.
IV. Key Considerations for SEF Rulemaking
SEFs
As noted above, it is imperative that the Commissions adopt rules
that are clear and allow for flexibility in the manner of execution for
market participants. This will give the market choices, confidence and
liquidity, and will do so in a regulated framework that promotes the
trading of swaps, in an efficient and transparent manner.
Consistent with the goals of the Dodd-Frank Act, for institutional
users, a SEF should (i) provide pre-trade price transparency through
any appropriate mechanism that allows for screen-based quotes that
provide an adequate snapshot of the market (e.g., through streaming
prices for standardized transactions and competitive real time quotes
for larger or more customized transactions), (ii) incorporate a
facility through which multiple participants can trade with each other
(i.e., must have competition among liquidity providers), (iii) have
objective standards for participation that maintain the structure of
liquidity providers (like swap dealers) providing liquidity to
liquidity takers (institutional buy-side clients), (iv) have the
ability to adhere to the core principles that are determined to be
applicable to SEFs, (v) provide access to a broad range of participants
in the OTC derivatives market, allowing such participants to have
access to trades with a broad range of dealers and a broad range of
DCOs; (vi) allow for equal and fair access to all the DCOs and allow
market participants the choice of DCO on a per trade basis, and (vii)
have direct connectivity to all the SDRs.
In order to register and operate as a SEF, the ``trading system or
platform'' must comply with the enumerated Core Principles in the Dodd-
Frank Act applicable to SEFs. Regulators have the authority to
determine the manner in which a SEF complies with the statutory core
principles, and there is discretion for the Commissions to retain
distinct regulatory characteristics for SEFs versus DCMs. It is
critically important for the Commissions to apply the principles with
flexibility given the market structure in which swaps are traded.
Accordingly, regulators should interpret core principles in a way in
which SEF's can actually comply with them. While many of the SEF Core
Principles are broad, principle-based concepts--which make sense given
the potential for different types of SEFs and trading models--some of
the Core Principles are potentially problematic for SEFs that do not
operate a central limit order book or clearing.\3\
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\3\ For example, the Position Limits or Accountability Core
Principle continues to be a big issue in terms of a SEF's ability to
know and react to the parties' positions (i.e., each SEF will need a
full market view to have the appropriate transparency to monitor this
issue). This would require cooperation among all the venues (SEFs, DCMs
and DCOs), including position information sharing agreements, so that
if a position was exceeded, the SEF could block any execution. This
might work in a futures exchange environment where contracts are
particular to the exchange; this will be significantly problematic
where multiple venues (SEFs and/or DCMs) will trade the same products.
---------------------------------------------------------------------------
Ownership and Governance
As noted above, Tradeweb was launched by market participants, and
has benefitted from their investment of capital, market expertise, and
efforts to foster the development of more transparent and efficient
markets. With the help of its board, comprised of market and non-market
participants, Tradeweb has since its inception brought transparency and
efficiency to the fixed income and derivatives marketplace.
The success story of Tradeweb may not have been possible if overly
prescriptive governance and ownership limits had been imposed at the
time. It was highly unlikely that under those circumstances, any of the
banks would have made an investment. Moreover, beyond the initial seed
capital, the banks' participation also allowed Tradeweb to continue to
invest in its infrastructure and evolve with the market--thus building
the robust and scalable architecture that has allowed it to expand to
20 markets, technologically survive 9/11 (Tradeweb's U.S. office was in
the North Tower of the World Trade Center), and develop connectivity
with over 2000 institutions globally. Under the proposed rules of the
CFTC and the SEC, ownership and independent director limits will be
imposed on the different registered entities that will provide the
technological infrastructure to the swaps market--from trading to
clearing. Tradeweb believes that independent directors are a very good
idea, in terms of bringing an independent perspective to the governing
board, but their duties must be consistent with other board members.
However, artificial caps on ownership or excessive requirements for
independent directors on the board (such as 51% of the voting power) go
too far. As a practical matter, ownership limits will impair registered
entities such trading platforms and clearing organizations from raising
capital, and overly restrictive director requirements will likewise
hurt investment because investors will lack a sufficient say in how
their investment will be governed. Moreover, Dodd-Frank provides other,
more direct, ways in which to mitigate conflicts of interest, and
employing each of these tools in a reasonable fashion will, in the
aggregate, address the potential conflicts of interest without
negatively impacting investment of capital and innovation in the
marketplace.
Finally, in terms of oversight, Tradeweb asks that the Committee
consider the substantial expense and burden that regulatory oversight
departments can create on entities. Tradeweb ironically may be the
beneficiary of stricter rules, because it would deter new entrants into
the marketplace, but this would not be best for competition, and the
end-user would suffer. Additionally, if costs mount for SEFs, these
will inevitably be passed on to the end-user. Along with other costs
resulting from the Dodd-Frank Act, such as central clearing, the result
could be that derivatives themselves become less attractive vehicles
for managing risk.
For these reasons, we urge legislators and regulators to consider a
more reasoned approach to mitigating conflicts of interest.
Implementation
Because of its technological experience and expertise, Tradeweb
will be in a position to implement whatever trading rules are imposed
by the CFTC and SEC for SEFs shortly after registration. However, as we
note above, the implementation of Title VII of the Dodd-Frank Act will
require cooperation between regulators (both domestically and abroad)
in their rulemaking and implementation plan, as well as the cooperation
and investment of market participants. It is critical therefore that in
the first instance, the rulemaking is flexible but clear, and that each
facet is implementation is thought through--because a lack of
confidence in implementation will result in a lack of confidence in the
marketplace, the result of which would be a marketplace which would not
best serve the interests of the end-user.
* * * * *
In sum, while we are supportive of the goals of the Dodd-Frank Act
and believe increased regulatory oversight is good for the derivatives
market, we want to emphasize that flexibility in trading models for
execution platforms are critically important to maintain market
structure so end-users can manage their risks in a flexible manner. If
you have any questions concerning our comments, please feel free to
contact us. We welcome the opportunity to discuss these issues further
with the Committee and their members.
The Chairman. Thank you, Mr. Olesky. I appreciate that. We
will now go to questions from the Committee, and I will yield
my time to Mr. Hultgren at the front, who was way down on the
list the first time around. Mr. Hultgren for 5 minutes.
Mr. Hultgren. Thank you. It pays to stick around. Thank you
very much. I appreciate all of you being here. I really
appreciate your very extensive testimony today, but also the
testimony that you have given to us to work with.
I hear some very common themes through your testimony of
real concern of overreach from Dodd-Frank, and impact on all of
our economy, albeit specifically the work that you are doing.
So I have quick questions I would like to ask for each of
you in my time available, so I would ask if you can respond
quickly, that would be terrific.
First for Mr. Gallagher, what will be the impact of
procedures if they can no longer--excuse me, of producers if
they can no longer access their customized hedges through the
co-op?
Mr. Gallagher. The opportunity for them to mitigate their
risk will likely be diminished. For the most part, large swap
dealers generally do not have an interest in dealing with
individual farms because of their lack of understanding about
the financials on the farms, and the small net worth that they
may have, and so they are--our member's opportunities are
through aggregate and through cooperative DFA or Dairylea or
other national council members, in order to access the swap
markets on their behalf.
Mr. Hultgren. Thank you. Mr. Duffy, what is your view on
the concerns we have heard today regarding the special speed
and sequence with which the CFTC is issuing rules, and to be
able to maybe provide some specific examples of how that speed
of rules is affecting the Chicago Mercantile Exchange and
others?
Mr. Duffy. Yes, I think the speed of rules, as I said in my
testimony, concerns us for a lot of different reasons. One,
because they are going more from a principles-based regime
looking to go into more of a rules-based regime, and they are
also coming out with--we have a big legal team at the CME
Group, and we have external legal folks. They are having a very
hard time keeping up with it, so we are concerned how in the
world can the rest of the Commissioners actually have an
opportunity to look at this information and analyze it and make
good decisions. So, we are overwhelmed on our side. We don't
know how we are going to get good responses into the CFTC so
they can make a good analysis of the public comments, going
forward.
So that is one of the big things that concerns us.
Mr. Hultgren. Mr. Pickel, in your testimony you expressed
concerns regarding the proposed metric for determining block
trades. How does the CFTC proposal fall short in this regard,
and how would you propose that we could revise that?
Mr. Pickel. I think our principle focus--and we did a study
which we filed as part of our comment letter that looked at
experiences in other markets with transparency and block
trades, and we just--we feel that the thresholds that they are
talking about are far too high. Keep in mind that as much as
those requirements are there for dealers, they are also there
for end-users. We have heard from a lot of larger asset
management firms who will do a large trade with their dealer
and put the burden effectively on the dealer to parcel that out
into the marketplace. If that trade, large as it may be, is
still below the block trading thresholds, then the dealer may
be reluctant to take on that burden because as soon as that
trade is done with the asset manager, that will need to be
disclosed to the marketplace.
So we are focusing very much on those thresholds, trying to
get the information, and then urging the Commission to in
turn--both Commissions, actually, because they both have rules
regarding block trading--but both Commissions to do studies to
analyze the effects on liquidity. Because once you have dealers
pulling back, you have a much less liquid market and
effectively, you have put the burden on the asset manager in
that circumstance to do smaller trades, which may be not as
efficient for them.
Mr. Hultgren. Thank you. Mr. Morrison, if I could ask you a
quick question. How would you respond to the claim that
clearing and exchange trading is in the best interest of end-
users because it prevents dealers from charging them high
prices to engage in OTC transactions, especially reflective
from Chairman Gensler's remarks today?
Mr. Morrison. We feel that we have good transparency today
in terms of the markets and in terms of the prices. There are
numerous information services, whether it is Bloomberg or
Reuters or bank trading systems or direct links to the LME
which we trade on, and so we are not concerned. We use multiple
counterparties, and so we think we have sufficient transparency
today in terms of the prices and credit spreads and things that
we are paying.
Mr. Hultgren. Thanks. Just to wrap up, Mr. Olesky, as you
know, the SEC and CFTC proposals for SEFs have significant
differences. How would this lack of harmonization impact SEFs
and their customers?
Mr. Olesky. Well, as much as possible we like to see
consistency, but I don't think the differences are the issue. I
think the key is, again, how we phase in these rules, how
flexible they are, and how much they take into consideration
the market participation and the impact it is going to have on
the market as a whole.
Mr. Hultgren. Well thank you all very much. I really do
appreciate you being here today. I appreciate your testimony.
We are going to need your help, going forward, as we work
though this, so it really does mean a lot to me and the rest of
my colleagues that you are here.
Thank you, Mr. Chairman.
The Chairman. The gentleman yields back. Mr. Peterson for 5
minutes.
Mr. Peterson. Thank you, Mr. Chairman. Mr. Duffy, your
clearinghouse, you launched clearing for interest rate swaps
and credit swaps, apparently, but you are not showing much
volume, I guess, at the moment. Is that correct?
Mr. Duffy. That is correct.
Mr. Peterson. And do you believe that the big dealers of
these swaps are resisting clearing in general, or your
clearinghouse in particular?
Mr. Duffy. I think, personally, the large dealer community
is waiting for some of these rules to be written to see exactly
where they are going to be at. They know that they have
alternatives in clearing swaps, whether it be at CME Group, ICE
Trust, LCH, or whoever else decides they are going to open up a
swaps clearing entity. So I think they know they have the
ability to ramp up very quickly from a technology standpoint to
have the pipes go to these clearinghouses, so I think they are
actually waiting as long as possible to see where the rules
come out.
We have been dealing with--we have about 925 million
cleared interest rate swaps to date, and we started the
initiative back in December, so for the most part, it is a
situation to your point, sir.
Mr. Peterson. How much do you think this reporting here
that they are getting together, these big guys and this secret
cabal in New York has to do with this?
Mr. Duffy. If you are asking me, I don't think it has
anything to do with it. I don't think there is a cabal at all
amongst the dealers in this.
Mr. Peterson. They are not trying to keep control of this
for themselves?
Mr. Duffy. No, I think what the dealers are looking at,
they have the most to lose because they are the largest influx
of cash entities, clearing entities, so when you have a smaller
participant come in with a large transaction, he could take
down somebody who put up all the money, so I think that they
are a little concerned that that wouldn't be an appropriate
thing to have happen. I agree with what Chairman Gensler said
earlier about that they should put up small capital, they
should be able to do small transactions. You know, I am sure
the banks are trying to work with some of these other clients
to figure out how that waterfall system would work. But their
main concern is, and I don't blame them, is that they would
have a transaction coming into that clearing entity that they
have put all the money up for that is not well capitalized that
has a tremendous amount of risk associated with it.
Mr. Peterson. All right. Mr. Gallagher and Mr. Morrison, do
your--do you, when you are doing these over-the-counter swaps
that are not standardized, I assume you do some of that----
Mr. Gallagher. Yes.
Mr. Peterson. How does it work? Do you have six of these
big banks that you go and give this out, or is there just one
entity that you normally do business with, or how does that
work?
Mr. Gallagher. I can comment on how DFA operates. We have a
number of entities, I believe only two of them may be banks,
but a number of entities who we have ISDA agreements with that
we can do swap transactions with, and we will contact them
looking to see which one we can get the best pricing at.
Mr. Peterson. So you lay out the terms of the swap and you
send it to these folks, and you take the best----
Mr. Gallagher. If we have enough time to do that, we do.
Some of what we do, for instance, one of the swap transactions
we may do would be for a Class IV price, and there is a futures
contract on the Class IV price, but the volume is very limited
and sometimes it is easier for us to get that trade done on
behalf of a member by writing a swap with an entity, and so
there may be one or two or three entities we know that would
consider that, and so we would contact them and see what their
pricing is. In some cases, we go there just because we can't
get the volume done on the futures exchange.
Mr. Peterson. And are you in the school that doesn't think
that the transparency that they are trying to get going here is
going to actually give you more information so you are going to
be able to get better deals?
Mr. Gallagher. We think transparency will always lead to
better information. The degree of the value of that I am
uncertain with yet because I am not sure what types of things
will be posted for public information.
Mr. Peterson. It depends on how it is set up?
Mr. Gallagher. That is right. If it is limited to what is
currently the Commitment of Traders Report, I am not sure there
would be much additional value.
Mr. Peterson. Mr. Morrison, is it a similar situation?
Mr. Morrison. Similar in that we use multiple information
sources where we can see live prices, and then we have
approximately ten different counterparties that we can use. So
we know exactly what kind of credit spread we are paying, and
so we think we have sufficient transparency today.
Mr. Peterson. That is for your company?
Mr. Morrison. That is for our company.
Mr. Peterson. But there is probably other companies out
there that don't have the information, from what I can tell. I
am not, you know----
Mr. Morrison. Perhaps very small companies that don't do a
lot of this, that could be the case.
Mr. Peterson. But wouldn't you agree, as Mr. Gallagher
said, that the more information that is out there, the better
prices you are going to get? You know, if you believe in the
free market and----
Mr. Morrison. I am worried about the unintended consequence
of some of the transparency. Having to report trades real-time
and the--I believe that will reduce liquidity in certain
markets, especially longer dated markets. So I think that will
actually drive costs up.
Mr. Peterson. Well, I am not sure we would know it until we
actually tried it, but if I might, Mr. Chairman, I just
wanted--what--I forgot what I was going to ask now, so maybe it
will have to wait until later. Thank you.
The Chairman. The gentleman yields back. Mr. Johnson, 5
minutes.
Mr. Johnson. Mr. Duffy, if I could ask you, I think it is
apparent that these regulations and the compliance process with
Dodd-Frank is going to be very costly. I think it is also at
least apparent to me that the volume that you are to be
expected to address of new swaps under this Act is going to be
gigantic. I also think it is apparent, without trying to
prejudice your answer, that this is going to have an effect--
large or maybe less than large--on the competitiveness of U.S.
financial markets with European and otherwise.
Can you just address some of those issues in particular as
to how it is going to impact you, because I think it is also
obvious that virtually every district in the country, and
certainly ours, is going to be dramatically impacted by
regulations that affect you that in turn affect us. So I am
just concerned about what this is going to do to us in a
competitive structure, and also what it is going to do in terms
of costs of compliance that inevitably are going to have to be
passed along to somewhere else.
Mr. Duffy. I think the latter part of your question is the
more important and relevant one, sir, and that is the costs
associated with it, because what--some of the things we are
seeing coming out of the rulemaking process under the agency is
basically duplicating what an SRO or a self-regulatory
organization already does today. CME Group already does these
things today, so what it appears to us what the agency is doing
is just creating a duplicate process which is adding tax and
burden--adding the burden to the taxpayers to fund that
particular entity when we can do it. They already have the
ability, sir. If we are not acting appropriately, they can come
in and obviously have the oversight of our business. But at the
same time, we have what is called a principles-based regime
which was put into place in 2000 by this Congress under the
Commodity Futures Modernization Act so we can grow and prosper
throughout the world. That is being taken away and it is being
done with prescriptive rules that were not to be put in place
for the futures exchanges.
So yes, I am very concerned about the competitiveness of
U.S. entities as we go forward.
Mr. Johnson. In terms of the process that--the process by
which the CFTC issues rules, do you think that they are
sequentially and in a timely manner issuing rules or do you
think there are problems? And if so, could you maybe give us a
few examples of where you see issues that have arisen?
Mr. Duffy. You know, I think what we are going to try to
do--and I talked to the Chairman the other day. He called and
asked me something very similar to that, and I think on a
sequential basis as the rules come out, we want to put a very
thoughtful process into place and give him our best opinion,
and I didn't want to do that in that conversation with him, so
to answer your question, Congressman Johnson, we are actually
formulating all that data now for a meeting with the agency
next week about the implementation and the timing of those
rules, how they should come out.
Mr. Johnson. As you probably know, Mr. Duffy, today and
tomorrow the full House is addressing issues of what some
people see as regulatory excesses. I don't necessarily expect
or want you to engage in that debate, but I am assuming that
CME has been either victimized by or at least affected by
regulatory excesses, perhaps in excess, so to speak, of what
the Congress ever intended. Do you think it is----
Mr. Duffy. That is an excellent summary, sir. When you have
a history--and I heard Mr. Morrison talk about they have been a
publicly traded company for 139 years. We have been around for
156 years. We have never had a customer lose a penny due to one
of our clearing member defaults. I think that is a pretty
stellar record, and something that we cherish very much. We
weren't the cause of the 2008 crisis, yet we seem to be the
bright shiny object in the room, so let us try to implement a
bunch of new rules on futures houses and clearinghouses
associated with them. It doesn't make a bit of sense to me.
They should be focusing on what put us into this situation, not
what has helped preserve the stability of the financial
markets.
Mr. Johnson. Speaking only for myself, but I believe this
probably would reflect the viewpoint of some other Members of
this Committee and Congress generally, I would welcome hearing
from you and your colleagues in the panel and related entities
about what we can do as a Congress to be able to address some
of those issues that you face along the way, because I believe
the current law as it is being implemented is going far too
far, if you will, and that we really need your help in being
able to address the practical effects of these things and how
we can work with you to make the world better for all of us, so
to speak.
Mr. Duffy. If I may just give two quick examples, Mr.
Chairman, if you will allow me to?
The Chairman. Absolutely.
Mr. Duffy. You know, to that point, sir, we have new
contracts that we put up every day, and some are successful.
Most are not. We have to put these up in a way that makes sense
for the end-users of our product line, so a lot of times we
will put them up as an OTC contract because they trade very,
very little, and if they ever get a higher volume then we
migrate them onto our central limit order book, and that is the
way we do it.
The CFTC is now saying if you don't have that liquidity, or
85 percent of that liquidity traded on your central limit order
book, that product needs to go away. Well, I have contracts
that have listed for 5 years with no volume, but all of a
sudden, they trade one million contracts. Why? Because the
world changes. Maybe our timing was a little off. So that is
one example.
Another example is they want to have the ability to decide
who is on my nominating committee, because they think they have
a better--what is in the best interest of my shareholders about
what is the composition of that. These are things that are way
overreaching from a regulator into our business and into other
businesses.
So I look forward to the opportunity to work with you and
other Members, sir.
Mr. Johnson. Thanks so much for your help.
The Chairman. The gentleman yields back. Mr. Boswell for 5
minutes.
Mr. Boswell. Thank you, Mr. Chairman. I appreciate everyone
being with us today and I think this is good. Early on, I think
we discussed, if you didn't cause the problem, why are you in
so much oversight? But again, we are trying to protect the
public so I appreciate you being here.
I think I will start with Mr. Morrison and Mr. Gallagher.
You heard in Chairman Gensler's testimony a statement of
transactions involving non-financial entities do not present
the same risk to the financial system, as those solely between
financial entities. Therefore, proposed rules on margin
requirements should focus only on transactions between
financial entities rather than those transactions that involve
non-financial end-users. Does this statement address your
concerns about margin requirements for swap dealers and major
swap participants for their transactions with your members?
Mr. Gallagher. I believe it can. I would like to read what
comes out. Right now, we have a concern on margins because that
is part of--we have to margin, we have to utilize working
capital. Others have testified how if you have to--if you don't
have to use your working capital now to margin some of your
swaps and you do later on, that you are taking that working
capital away from doing other things in your business that, in
our specific part of the economy, is going eventually come back
to providing less opportunity for farmers. So I would like to
be able to see what they are writing, because sometimes I think
they may think that they are excluding us, but the way they
write things maybe captures us, so I would like to see it in
writing before I----
Mr. Boswell. I think your point is valid. Long-time
Chairman of the local board, I appreciate that working capital
concern and it depends on time of year and a number of things.
Mr. Morrison. I have a similar concern. If end-users are
exempt from posting margin, what I would be concerned with is
if we conduct a trade with a bank, for instance, and that bank
then offsets that exposure with another bank, does that require
margin somewhere in the system? And my concern is that if there
is margin required somewhere in the system on that trade, it is
going to come back to me in higher costs.
Mr. Boswell. Okay, let us move along. Mr. Gallagher, in
your testimony you expressed concern that the CFTC may impose
over-excessive margin requirements. Is that part of what you
are referring to?
Mr. Gallagher. Yes, certainly. One of the things right now
is we aggregate the risk of our member-owners, and then we go
into the market as the swap entity. Depending on how they
define what a swap dealer is, we could easily fall into that,
just the notion that we act like one----
Mr. Boswell. Do you think Mr. Gensler kind of set that
aside for you in his statement, or are you still concerned?
Mr. Gallagher. I am still concerned about how we will be
viewed as we call up different entities saying we have some
risk on something like buttermilk powder, where there is no
market for--no futures market for, we call up different
entities. Are we going to be considered a swap dealer because
we are calling up different entities, and then are we going to
be a swap dealer because we have to do this more than 20 times
a year, and we--to mitigate our risk, we are doing it with ten
different entities? I would hope that wouldn't qualify us as a
swap dealer.
Mr. Boswell. Well, I think we can monitor that and see how
that gets defined.
Thank you. I yield back.
The Chairman. The gentleman yields back. Mr. Stutzman, 5
minutes.
Mr. Stutzman. Thank you, Mr. Chairman, and I appreciate you
all coming in here today. I apologize that I wasn't here for
most of the testimony. I have had a budget committee meeting
going on simultaneously, so--but I have been trying to read
through some of your testimony. Coming from northeast Indiana
and an agricultural community, a manufacturing community, of
course Ball being in Indiana, we are very familiar with you all
and appreciate the business that you do there.
I guess what I want to start out with, the testimony that
Mr. Gallagher gave. Being in small town America, we are very
familiar with co-ops. I guess my initial question is what
distinguishes a co-op and the services they provide to their
members from a swap dealer?
Mr. Gallagher. Cooperatives have a governance structure,
much like the House of Representatives, where they have farmers
that are elected to boards. Boards govern the management of the
organization, and any earnings that may accumulate at the
business end eventually come back to the member-owners. So
there is a significant difference between what agricultural
cooperatives do and how they are managed, and how they pass
back earnings is probably different than any other business
entity.
Mr. Stutzman. I grew up on a dairy, and thankfully my dad
had decided not to continue on as us boys got older and just
focused mostly on grain, but what would the impact on producers
be if co-ops or if they can no longer access their customized
hedges through the co-op?
Mr. Gallagher. Okay. One of the things that we are doing
right now is that because of the extraordinary explosion in
grain prices, feed is the single biggest input cost on a dairy
farm. So we are customizing our forward contracts so that they
can not only manage a milk price, but they can manage that feed
price, all in context as a milk price. In order for us to do
that, we have to go to the swap market to lay that risk off,
because typically we have farmers that--they don't utilize
5,000 bushels of feed in a month, or they may need that
contract to carry out every single month, and the futures
market doesn't trade feed every single month. So they need our
help customizing that for them so that we can then lay that
risk off for them on a swap basis in the swap market. And if
something happens where we are prevented--if we get regulated
as a swap dealer, I am not sure we would continue offering that
particular program, and then I am afraid that because of the
size of the farms and their ability to get working capital on
the farm, that they come to us because they don't have the
working capital to have their own futures account. We provide
that working capital for them through our forward contracting
process. I am concerned that they will not have the ability to
manage that significant input price risk if they are taking on
right now--and that will reduce their profitability in the long
term.
Mr. Stutzman. And I am not, I guess, aware of any problems
before Dodd-Frank in particular. Do you know of any problems
that were, I guess, maybe publicized? I am a freshman here in
Congress, so I mean, you know--I guess kind of how did you get
brought into this? What is kind of the history of--behind Dodd-
Frank and you all and why you are kind of pulled into this
situation?
Mr. Gallagher. Okay. We have had--forward contracts have
been excluded and we want them to continue to be excluded.
There have been certain information in some of the stuff coming
out of the CFTC rulemaking that suggests maybe they are going
to regulate options that are imbedded in--price options that
are imbedded in forward contracts. That would be a travesty for
agriculture if that happened.
We then are concerned because we have been building these
swap books to help our members mitigate their risks. My
colleagues in some of the other organizations use swaps far
more than my organization does, and for some of the things that
they are doing, if something happens where they get regulated
as--we get regulated as swap dealers and we have to margin, we
are not sure we are going to have the working capital to be
able to provide the same benefits that we have been providing
in the past. So we are concerned that this--as this rolls out,
it rolls out the right way and that right now, it seems like at
least the stuff we have read today, that the mesh on that net
is pretty tight, and it is capturing a lot of fish that
probably don't need to be captured. So we need a little bit of
a wider mesh to capture the big fish and not harm the small
fish.
Mr. Stutzman. Can you quick just answer, how is this going
to affect a smaller dairy, which I have more smaller dairies,
even though we have large dairies in Indiana as well?
Mr. Gallagher. We wouldn't be able to--we would likely not
be able to help them hedge their feed.
The Chairman. The gentleman yields back. Mr. Welch for 5
minutes.
Mr. Welch. Thank you, Mr. Chairman. I will follow up on
some of the questions Mr. Stutzman was asking. Vermont is a
dairy state, so we have some of the challenges that you were
just asking about and answering.
The goal here is to try to get the regulation right.
Something bad happened as you indicated, Mr. Duffy, but we are
getting it right means that we don't blame the folks who were
doing it right in the first place. So I am just going to ask a
couple of questions.
Let me start with you, Mr. Olesky. The AIG problem was
brutal, and it ended up costing every taxpayer about $600. As I
understand it, it was their overexposure in the derivatives
market that led to their downfall and the taxpayer rescue. What
were the specific failures that led to that default?
Mr. Olesky. I am not sure of all the specifics with respect
to AIG. I do think, though, that the regulation and the
legislation that has been--the legislation has passed and the
regulation has been proposed, is going to bring an awful lot of
transparency into the marketplace. We wholly support that. In
addition to transparency, we think it is going to lead to more
electronic trading, risk reduction, certainly systemic risk
reduction through using central counterparties, and a lot more
information in the hands of regulators on a real-time basis.
Mr. Welch. All right, so let me just interrupt. This is
helpful. I mean, I have a lot of community bankers who are very
upset about some of the regulatory impacts of Dodd-Frank, and
they were not the ones that caused the problem, but they
acknowledged that a problem is there and has to be corrected.
So that is what I think is a mutual goal here, to try to get it
right.
Mr. Duffy, you were describing your situation, and you have
this incredible record of 156 years without losing anybody a
nickel. That is pretty--how do we invest, by the way. But what
are the specifics that did need to be attended to that we saw
in AIG that Mr. Olesky was speaking about?
Mr. Duffy. Well first of all, you can lose money, we don't
lose money because of our risk management.
Mr. Welch. Right, I got that.
Mr. Duffy. So we have a stellar record of risk management
to make sure that you don't lose your money.
You know, I have testified in front of this Committee over
the last couple years, and maybe against our own book when I
said that I didn't think clearing should be mandatory. I
thought that clearing should be an incentive to be done, so the
end-users, if they want to use it, they should have a capital
charge of X if they don't clear and Y if they do clear. So that
is what my whole stance has been all along. You know I was the
one that appeared to be the winner in this, because we already
had the largest clearinghouse in the United States and we would
get all this supposed business. I didn't see it that way
because I can see it as business either not getting done, or
being forced overseas. So we have never subscribed to this
mandatory law of clearing, and I still am not going to
subscribe to it, even though it is law today, so we will
comply.
As far as AIG goes, sir, in all due respect it is no
different than an options trader who is selling premium because
when you sell premium on an options transaction, you receive
the cash and your exposure gets bigger and bigger and you have
nothing to back it up with.
Mr. Welch. All right, but there was a total lack of
regulation. They didn't have any margin requirements, and it
led to outsize risk taking.
Mr. Duffy. There was no margin. There was capital and they
were--you know, what is capital? So they were adding up
everything in a room and calling it capital and putting a value
on it, and that is the way they were backing up the positions
with a balance sheet.
Mr. Welch. Right, and they nearly blew up the financial
system.
Mr. Duffy. I am well aware what happened.
Mr. Welch. Right, so what steps would we need to take in
order to protect, in effect, not just the taxpayers who ended
up having to bail them out, but a lot of main street businesses
that needed stability in the credit markets?
Mr. Pickel. If I----
Mr. Welch. Mr. Pickel, go ahead.
Mr. Pickel. If I might jump in there, I think that--first
of all, that AIG utilized derivatives to take exposure to real
estate. That is what they did with their derivatives. They also
used secured lending to take that exposure. So ultimately, that
was the driver there.
I think, though, that let us look at what is in the law and
let us look at what is, going forward, to deal with the AIG
situation. This major swap participant definition is a critical
piece of that, and when it was first proposed, it was proposed
as that to catch the next AIG. And so I think that is why
people are very concerned about where that definition goes
because if it is drawn narrowly to catch whatever that next AIG
might be, everybody is in agreement. Let us do that. And I
think that Chairman Gensler today gave an indication that they
would expect a fairly small number of entities to fall into
that definition. So that is very helpful, but if it were
defined more broadly, I think it would go beyond the intended
purpose.
The other thing is a couple things regarding AIG. First of
all, with these data repositories which were in existence
before Dodd-Frank, but obviously given greater relevance in
Dodd-Frank, there is more information to the regulators about
the exposures that are building up in the system, particularly
in the credit default swap world. That is the most mature of
these data repositories to date. So that information will be
available to regulators around the world.
There is also--because of the major swap participants,
there is greater regulation of that entity. AIG was overseen by
the Office of Thrift Supervision, but you know, obviously not
every effectively and so that was one of the reasons that they
had the problems that they did.
There would also be greater use of collateral. Collateral
was used by AIG, but its policies were such that it aggravated
the situation in a sense, because it was not used from day one,
it was only used when AIG was downgraded, which led to kind of
cliff effects and liquidity effects for AIG.
The other thing, just to mention, is the trades that they
did there were very customized. They are not going to lend
themselves to clearing via the CME platform, any of the other
platforms that exist for clearing credit default swaps. It is
more customized and therefore needs greater scrutiny by the
regulator.
Mr. Welch. Okay, thank you. I see my time has expired and I
yield back. Thank you, Mr. Chairman.
The Chairman. Thank you. Just a couple of questions to
finish off with.
Let me pose a question that I asked to Mr. Gensler with
respect to these high frequency algorhythmic trading systems
that are in exchange environments today. Will someone have an
opportunity to do that in the exchanges that are being
contemplated with respect to these derivatives? Anybody on the
panel want to answer?
Mr. Duffy. Well, the question being will the new products
that are listed for trade, OTC products listed for trade, will
the high frequency or algorhythmic trader have access to them,
is that the question?
The Chairman. Yes, I mean will we create a new arena for
that technique to be used by pushing all these derivatives on
an exchange----
Mr. Duffy. I think we have to wait for the CFTC to come out
with a definition of what a SEF is and who qualifies for a SEF,
which is a swaps execution facility, which these products will
be traded on. So, if the banks get to have their own SEF, I may
not have access to it as a high frequency trader, because I may
not meet their qualifications to trade on their SEF. I guess it
is yet to be completely determined what a SEF is going to look
like.
The Chairman. Yes, but you have to push your side of the
trade 15 seconds before you execute, doesn't that open up a
window of opportunity for computer-driven mischief?
Mr. Duffy. I don't believe so, no.
Mr. Pickel. Mr. Chairman, I think that it really is a
question--and I know Mr. Olesky will comment as well, he is
ready to push the button. It really is a question of how these
SEFs develop. I mentioned in my remarks at the opening that the
number of trades done--and we are talking about standardized
trades--2,000 standardized trades currently done around the
world in the most liquid products, U.S. dollar swaps, 10 year
swaps, maybe 400 over the course of a day around the world. So
we are not at that kind of volume that would lend itself to
that. Now if SEFs are successful and there are more
transactions being done on those platforms, perhaps down the
road, but that is certainly something I think we will have some
time to see how it develops, although the definitions are
certainly critical.
The Chairman. Sure.
Mr. Olesky. I would just add that this is a key point for
us. We think it is incredibly important for market participants
that the rules allow for sufficient flexibility to give the
participants what they need. So if you are an end-user, if you
are an asset manager, you need to be able to access liquidity
in a way where it is not going to be impeded, where you can go
and get your business done without interference. And that has
been core to our position is that there should be real
flexibility in the rules so that you have a variety of
different places to execute these businesses on regulated
markets, such as SEFs. But it is that flexibility that is key.
The Chairman. Thank you. The cost estimates a year ago when
Dodd-Frank was being kicked around versus the cost estimates
today are dramatically different. In terms of your compliance,
the CFTC's side, have you guys been able to make any kind of an
analysis at this early stage as to where those increased costs
are going to wind up versus the shrinking and spreads from the
transparency that may occur? Who is going to--if we are just
going to create more costs for no benefit, we ought to address
that, obviously.
Mr. Pickel. I think that that is yet to be determined. We
have not done a thorough study. We did, at the time that the
bill was passed, point out that because of the lack of clarity
on the application of the margin requirements to end-users,
potentially it could have under various assumptions and
scenarios, cost end-users as much as $1 trillion. Now
obviously, that is very----
The Chairman. Subjective.
Mr. Pickel.--different--well, it is based on some numbers
and makes a certain amount of assumptions. We can share that
with the Committee. But I think it is very important and
noteworthy that the indication from Chairman Gensler today is
that that will not be a requirement, so that is very helpful.
The Chairman. Right. Mr. Gallagher, what are the--I am
sorry, go ahead.
Mr. Olesky. I was just going to--one quick point is that
frankly the longer there is a lack of clarity and the longer
the whole process goes on, the more expensive it is. So I can
just say for our business it is a complex situation. We are
building technology to try to be responsive, but all of us in
the marketplace I think suffer from the uncertainty, and the
longer it goes on, the more challenging it is and the more
expensive it ends up being.
The Chairman. All right, thank you for that.
Mr. Gallagher, one of the center points for Dodd-Frank was
to be able to identify systemic risk or systemic risk players
in the market. Can you--would your co-op, in your mind, ever
remotely be a systemic risk as a swap dealer, if you wind up
being tagged with that definition? Can you create the kind of
volume for your membership that would be a systemic risk as we
understand that happening?
Mr. Gallagher. I can't see DFA or Dairylea or for that
matter, and probably any of the members of the national
council, having enough volume to create systemic risk that we
could cause any type of damage to the U.S. economy. I can't
envision that right now.
The Chairman. All right. Thank you, gentlemen, I appreciate
it, Mr. Duffy, one last thing.
Mr. Duffy. Just one comment on the cost side of this. A
rush to judgment, I understand, can be even a bigger cost in my
opinion than getting some clarity on this. I appreciate what
the gentleman said about it is costing us--so we don't
understand that, but if we don't get this right, I assure you
the cost will be the least of our problems. If you looked at
some of the announcements that happened yesterday between some
of the major exchanges in Germany and coming into the U.S. to
do a deal with the New York Stock Exchange, this is what I have
been talking about for years with this Committee, about how
business is going to go overseas, and this is another way they
can do it, do it by mergers and acquisitions.
So by getting these rules right, it is just as important as
the cost burden today. Let us get the rules right so--to my
testimony I would hope that this Committee would remind the
CFTC that this is a very important rulemaking process.
The Chairman. Well thank you. We are constantly--we will
have another hearing next week. Just one word, in a
conversation that the Ranking Member and I had with Mr. Gensler
ahead of the meeting, he assured us that he had all the
flexibility he needed for a common sense implementation phase.
In other words, he has legal restrictions on creating the
rules, but yet he has all the flexibility he needs to implement
this in a way that makes sense. So be thinking about that
statement that he made in y'all's analysis--he obviously has
legal counsel that gets paid--you know, feeds his family making
those judgments, but it would be helpful next week if you
thought about--due to the fact they have--the law is in effect
and the rules are going to be in place. You guys have to comply
with them whether they get the rules right or not, and so you
have the cost of doing business as a risk. You may or may not
be able to lay off some swap market with another regulator that
you have to comply with the law during this timeframe.
So again, thank you all for coming. I appreciate your time,
and with no other comments, we are adjourned.
[Whereupon, at 1:00 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Questions
Response from Hon. Gary Gensler, Chairman, Commodity Futures Trading
Commission *
---------------------------------------------------------------------------
* There was no response from the witness by the time this hearing
went to press.
---------------------------------------------------------------------------
Questions Submitted by Hon. K. Michael Conaway, a Representative in
Congress from Texas
Major Swap Participant
Question 1. I believe that various companies are interested in
understanding whether the Commission believes the hedging of financial
or balance sheet risks are included in the definition of commercial
risk. In particular, would the definition allow for the hedging of debt
or duration mismatches? Are there particular hedging strategies that
the Commission believed should be excluded?
Question 2. Although the Commission proposed to subtract collateral
when assessing whether a person has substantial position, the
Commission also requested comment on whether collateral should indeed
be excluded. It has been suggested to me that companies believe that
posting collateral fundamentally reduces or eliminates a risk position.
Do you affirm that it is appropriate for the Commission to have
subtracted collateral?
Swap Dealer
Question 3. As you may know, some end users, including non-
financial end users, centralize certain treasury functions, including
hedging operations, out of one or more entities that execute trades
with the dealer banks and then document an off-setting transaction with
the affiliate entity or entities, under the same parent company, that
require the hedge. I have been made aware that these end users have
several concerns over whether these trades could subject them to a
variety of new regulatory burdens, including the following:
(1) The market-facing entity could be considered to be a swap
dealer;
(2) The market-facing and inter-affiliate transactions could be
counted toward the major swap participant thresholds;
(3) The inter-affiliate transactions could be subject to the
clearing and trading requirements; and
(4) The inter-affiliate transactions could be subject to the
reporting requirements.
Can you please comment on whether these inter-affiliate
transactions will be treated the same as the market-facing
transactions?
Swap Dealer
Question 4. Do you intend to apply margin requirements to non-
cleared swaps that market participants have negotiated and entered into
before Title VII becomes effective?
Question 5. Is it the Commission's intent that margin requirements
should apply to firms that are neither swap dealers nor major swap
participants?
Question 6. Do you believe that the Dodd-Lincoln letter and
subsequent Frank-Peterson colloquy make clear Congress' intent with
respect to whether margin should be imposed on end-users?
HEARING TO REVIEW IMPLEMENTATION OF TITLE VII OF THE DODD-FRANK WALL
STREET REFORM AND CONSUMER PROTECTION ACT
----------
TUESDAY, FEBRUARY 15, 2011
House of Representatives,
Subcommittee on General Farm Commodities and Risk
Management,
Committee on Agriculture,
Washington, D.C.
The Subcommittee met, pursuant to call, at 1:00 p.m., in
Room 1300, Longworth House Office Building, Hon. K. Michael
Conaway [Chairman of the Subcommittee] presiding.
Members present: Representatives Conaway, Neugebauer,
Schmidt, Gibbs, Huelskamp, Ellmers, Hultgren, Schilling,
Boswell, Kissell, McGovern, David Scott of Georgia, Courtney,
Welch, and Sewell.
Staff present: Tamara Hinton, John Konya, Kevin J. Kramp,
Ryan McKee, Debbie Smith, Clark Ogilvie, and Jamie W. Mitchell.
OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE
IN CONGRESS FROM TEXAS
The Chairman. Good afternoon. We will start the hearing.
Just for the witnesses' knowledge, we have votes called at
approximately 1:20, but we will go through our opening
statements and we will start with yours and then go vote. And
then if you could please stay and wait, we will come back and
resume the hearing as soon as we get clear of the votes.
With that, good afternoon. Welcome to the first hearing of
the Subcommittee on General Farm Commodities and Risk
Management for the 112th Congress. I am honored to hold the
gavel and look forward to a productive Congress.
We are here today to continue examination of the impact of
the multitude of new rules proposed by the Commodity Futures
Trading Commission pursuant to the enactment of the Dodd-Frank
Wall Street Reform and Consumer Protection Act.
We have several new Members to the Subcommittee, and I am
looking forward to their full participation.
Dodd-Frank requires the promulgation of a extraordinary
number of new regulations governing our financial markets, and
much of that overhaul has fallen on the shoulders of leadership
and staff of the CFTC to implement.
To say that Congress has set high expectations for the CFTC
is an understatement. For the Commission it means a dramatic
expansion of authority and discretion over the markets under
its control.
Last week we focused on the process the Commission
undertook and what data they utilized in drafting their
proposals. Our work today, while similar, is focused on what
these new rules mean to market participants.
By the end of this hearing, I hope to have a better
understanding of how much compliance will cost, what business
practices will have to be altered, and how much the new
regulatory burdens will impact economic growth. As discussed
here last week, many Members of this Committee, including
myself, remain worried about the burdens of these new rules on
businesses and individuals alike.
Chairman Lucas and I have repeatedly requested Chairman
Gensler voluntarily to submit to the Committee the principles
established in the President's recent Executive Order on
approving regulation and regulatory review, which include
comprehensive cost-benefit analysis and the use of both
quantitative and qualitative data in rulemaking.
For the time being, the Chairman has refused to fully
embrace the President's call, citing a conflict with the law.
Having examined his claims, I am uncertain how existing law
precludes them from full compliance, but I will continue to
request that the Commission adhere to the President's Executive
Order in full rather than just in principle.
I believe the law of unintended consequences is the
hallmark of hastily considered rules and ill-conceived
regulation. There is significant concern that the CFTC's
process for implementing Dodd-Frank has been just that: Rules
have been proposed in an irrational sequence; industry groups
have complained that the CFTC has underestimated certain
compliance costs by a factor of two or three and as much as 63
for some; and the commissioners appear to be stretching the
regulatory mandates far beyond the intent of Congress.
I am pleased to welcome a broad spectrum of market
participants this afternoon to share with us how they view the
pending regulations and what their suggestions are for
improving the process and the output of the CFTC rulemaking.
Also with our witnesses today, Glenn English has submitted
testimony to the Committee on behalf of the National Rural
Electric Cooperative Association.
I ask unanimous consent to insert that into the record.
[The document referred to is located on p. 193.]
The Chairman. For my own part, I have supported the CFTC's
collaborative regulatory process. For over 30 years, the
consultative light-handed principles-based approach to
regulating the commodities and derivatives markets have served
our nation well. In that time, new markets and new financial
products have flourished, creating innovative ways for
participants to plan for the future.
Without question, these financial instruments have been a
blessing to agriculture producers and manufacturers and many
others. It is these business and investment strategies, those
that were once novel but are today routine that this Committee
must protect as we oversee the implementation of Dodd-Frank.
In the last 10 years, our financial markets have grown more
complex and participants in the market have grown more savvy.
New financial instruments have unlocked capital and reduced
risks for millions of investors. These innovations cannot be
rolled back. Eliminating or restricting them will serve only to
increase the relative costs of doing business in the United
States. It is incumbent on this Committee to ensure that the
rules proposed by the CFTC are not overly burdensome and do not
choke off legitimate financial instruments with onerous rules
or heavy compliance costs.
I look forward to this opportunity to hear from our
panelists today as we discuss the many rules proposed by the
CFTC over the past year. I hope they can each share with us
where the Commission did it right and where our panelists think
the commissioners need to go back and rewrite their proposals.
Thank you each for being here today, and I look forward to
an informative and productive hearing.
With that, I ask the Ranking Member for his comments.
OPENING STATEMENT OF HON. LEONARD L. BOSWELL, A REPRESENTATIVE
IN CONGRESS FROM IOWA
Mr. Boswell. Thank you, and I have no quarrel with what you
said. I could stop there, but I am going to make a couple of
remarks.
First off, I appreciate and congratulate you for having the
chairmanship of this Committee, and I look forward to us
continuing our work together, and I am confident we will.
Just to reflect a little bit. You know, when we went
through this debacle, if you will, we handled this bipartisanly
with our bosses, our chairs and us together, we recognized it
was a SEC challenge, not CFTC. And we think we somewhat brought
that to daylight, and we are glad we were able to do that.
But the goal of the legislation was and is to give
transparency to the over-the-counter derivatives market and, at
the same time, not to hinder the ability of folks like
yourselves and those out there that I have said over and over
and over that if I have a bias, it is towards that producer out
there. And I guess I will confess that is still where it is.
You have to be able to use the tools because it is so capital
intensive. There is so much risk involved. So they have to have
the tools. So I want us to do that. And I think that is our
goal.
And to meet the ends that are set forth in the Dodd-Frank
legislation, the Title VII goals of transparency, we must--I
think we have to have transparency. And I have said before I
came into this environment and never intended to do it--maybe
you have had it on your wish list; it wasn't on mine--but you
know don't be afraid to put daylight on it, transparency. And
if you are doing it right, keep doing it right. If you are not
doing it right, then be courageous and make the adjustments.
So I think we went through their process, and I think there
is still some stuff right, I would guess, from the field, if
you will. We are going to find some things that probably could
be more right or not good. But your suggestions, your positive
workable attainable suggestions that we can deal with is very
important to what we want to do here.
So I welcome the Committee and the witnesses and take us to
school and just be straight with us. And I think you will. Just
be straight with us. What do you really need to be transparent,
and you know, you have to be competitive I understand that. But
if we don't have anything to hide, then let us just get right
out there and grow this country and grow those markets and do
what we need to do. And actually, the CFTC has been pretty
successful overall. And we need to remember that, too.
So, with that, I yield back and look forward to what is
next.
[The prepared statement of Mr. Boswell follows:]
Prepared Statement of Hon. Leonard L. Boswell, a Representative in
Congress from Iowa
I would like to thank everyone for joining us here today as we
review the state of the implementation provisions of the Dodd-Frank
Wall Street Reform and Consumer Protection Act. I would especially like
to thank our witnesses today as this Committee looks forward to hearing
your valuable insight.
The goal of this legislation is to bring greater transparency to
Wall Street and the over-the-counter derivatives markets. In doing so,
we must ensure that we provide necessary oversight of these markets
without hindering legitimate consumers from operating within them.
In regulating over-the-counter derivatives, Congress made certain
exceptions for end-users who utilize swaps to hedge risk and keep their
businesses stable. I believe it is imperative that the regulations
implemented reflect the true intent of Congress. Our goal should not
punish the end-users who, like consumers, were victims in the financial
crisis. Our efforts instead should focus on preventing the markets from
being manipulated by a few players, and making sure that never again
are American taxpayers left with the bill.
To truly meet the ends set forth in the Dodd-Frank legislation and
title seven's goals of transparency and competition, we must have
transparency in our regulatory process and ensure that the rules and
definitions fit the needs of the markets and stakeholders, and the aims
of this legislation.
I think all of us on this Subcommittee would agree that the CFTC
and SEC must take the time to get this right. However, these
commissions must also move quickly to ensure that individuals who use
these markets for bona fide hedging purposes can have confidence that
these markets are fair markets. Confidence in these markets is
critical.
I look forward to hearing from the witnesses today, and gathering
insight and expertise on this issue from a variety of industries. I am
committed to working with you and the Commissions to ensure the
regulations being crafted regulate this market with efficiency and
transparency without hindering its practical uses. Your thoughts and
submitted comments on this matter are appreciated. Thank you.
The Chairman. Thank you, Ranking Member.
I, too, look forward to working with you on this Committee.
I would ask unanimous consent to insert a letter from the
National Cattleman's Beef Association, and National Corn
Growers Association, and Natural Gas Supply Association into
the record.
[The documents referred to are located on p. 196.]
The Chairman. With that, we now go to our witnesses.
And our first is Shawn Bernardo, Managing Director of
Americas Head of Electronic Broking, Tullett Prebon, and Vice
Chairman, Wholesale Markets Brokers Association, Americas,
Jersey City, New Jersey.
Mr. Bernardo.
STATEMENT OF SHAWN BERNARDO, MANAGING DIRECTOR, AMERICAS HEAD
OF ELECTRONIC BROKING, TULLETT PREBON; VICE CHAIRMAN, WHOLESALE
MARKETS' BROKERS ASSOCIATION, AMERICAS, JERSEY CITY, NJ
Mr. Bernardo. Chairman Conaway, Ranking Member Boswell, and
Members of the Subcommittee. Thank you for providing me this
opportunity to participate in today's hearing.
My name is Shawn Bernardo. I am a Managing Director and a
member of the Americas Executive Committee for Tullett Prebon,
the leading global interdealer broker of over-the-counter
financial products.
I am also the Vice Chairman of the Wholesale Markets
Brokers Association, Americas, an independent industry body
whose membership includes the largest North American inter-
dealer brokers.
Tullett Prebon's acts as intermediary in the wholesale
financial markets where we execute trades on behalf of our
customers. Our business covers a wide variety of products
including U.S. Treasuries, interest rate derivatives, energy
and credit, and offers voice, hybrid, and electronic broking
solutions for these products.
I am here today as a practitioner in the formation of
liquidity, transparency, and execution in over-the-counter
markets. I began my career in the inter-dealer broker industry
in 1996 as a U.S. Treasuries broker. At that time, the U.S.
Treasury market was brokered predominantly in an open outcry
pit where trades were executed by voice commands.
Today, the secondary market in U.S. Treasuries is an
exclusively over-the-counter market but has evolved to include
both electronic and voice trading and stands as an example as
one of most liquid and efficient markets in the world.
My experience as a broker allowed me to help create
electronic broking systems for U.S. Treasuries and CDS Index
products. And I have spent the vast majority of the past 15
years building various electronic and hybrid broking platforms
to promote more efficient markets.
Title VII of the Dodd-Frank Act seeks to reengineer the
U.S. swaps market on two key pillars: central counterparty
clearing and mandatory execution of clearable trades through
registered intermediaries, such as swap execution facilities,
or SEFs. Wholesale brokers are today's essential marketplaces
in the global swaps market and, as such, are the prototype of
these new entities being called SEFs.
We are experts in forcing liquidity and transparency in
global swaps markets by utilizing trade execution methodologies
that feature a hybrid blend of knowledgeable and qualified
brokers as well as sophisticated electronic technology.
Tullett and the WMBA support Dodd-Frank's attempts to
ensure regulatory transparency and compliance but are concerned
that the regulatory agencies may interpret these goals in such
a way that hinders the creation of liquidity for market
participants.
Such a result will impose increased costs, particularly for
end-users, or potentially render OTC derivatives markets
ineffective for the purpose of hedging commercial risks.
In considering appropriate regulations, it is important to
remember that liquidity in today's swaps markets is
fundamentally different than liquidity in futures and equities
markets. While some swaps are standardized, the general deal
flow for swaps is not continuous. Wholesale brokers' varied
execution methodologies are specifically tailored to the unique
liquidity characteristics of particular swaps markets. This is
why Congress permits SEFs to execute trades through any means
of interstate commerce.
From the perspective of the inter-dealer broker community,
it is critical that the regulators gain a thorough
understanding of the many modes of execution currently deployed
by wholesale brokers and then accommodate those methods and
practices in their SEF rulemaking.
While the Commissions and staffs of the relevant agencies
have worked extremely hard and have been attempting to better
understand these markets, because of the tight time frames
mandated by the Dodd-Frank Act, regulators at the SEC and CFTC
have not had sufficient time and/or opportunity to properly
study and understand the unique nature of the markets they are
now endeavoring to write rules on and regulate.
As a result, too many of the SEC's and CFTC's proposed
rules are derived directly from rules governing the equities
and futures markets and are ill-suited for the fundamentally
different liquidity characteristics of the swaps markets. I
would suggest that there are four critical elements regulators
need to get right.
First, SEFs must be able to use the multiple modes of trade
execution successfully used today to execute swap transactions.
Second, the goal of pre-trade transparency must be realized
through means that do not destroy market liquidity from market
participants and end-users. Third, the final rules for
derivatives clearing organizations must comply with the
nondiscriminatory access provision of the Dodd-Frank Act. And
finally, regulators need to carefully structure a public trade
reporting regime that takes into account the unique challenges
of fostering liquidity in a diverse range of swaps markets.
I thank you for your time and look forward to answering any
questions you may have.
[The prepared statement of Mr. Bernardo follows:]
Prepared Statement of Shawn Bernardo, Senior Managing Director,
Americas Head of Electronic Broking, Tullett Prebon; Vice Chairman,
Wholesale Markets Brokers Association, Americas, Jersey City, NJ
Chairman Conaway, Ranking Member Boswell and Members of the
Subcommittee, thank you for providing this opportunity to participate
in today's hearing.
My name is Shawn Bernardo. I am a Senior Managing Director and a
member of the Americas executive committee for Tullett Prebon, a
leading global inter-dealer broker of over-the-counter financial
products.\1\ I am also the Vice Chairman of the Wholesale Markets
Brokers Association, Americas (the ``WMBAA''), an independent industry
body whose membership includes the largest North American inter-dealer
brokers.\2\
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\1\ Tullett Prebon (LSE: TLPR) (www.tullettprebon.com) is one of
the world's largest inter-dealer brokers and operates as an
intermediary in wholesale financial markets facilitating the trading
activities of its clients, in particular commercial and investment
banks. The business now covers seven major product groups: Rates,
Volatility, Treasury, Non Banking, Energy and Commodities, Credit and
Equities. Tullett Prebon Electronic Broking offers electronic solutions
for these products. In addition to its brokerage services, Tullett
Prebon offers a variety of market information services through its IDB
Market Data division, Tullett Prebon Information. Tullett Prebon has
its principal offices in London, New Jersey, Hong Kong, Singapore and
Tokyo, with other offices, joint ventures and affiliates in Bahrain,
Bangkok, Frankfurt, Houston (Texas), Jakarta, Luxembourg, Manila,
Mumbai, New York, Paris, Seoul, Shanghai, Sydney, Toronto, Warsaw and
Zurich.
\2\ The WMBAA is an independent industry body representing the
largest inter-dealer brokers (``IDBs'') operating in the North American
wholesale markets across a broad range of financial products. The WMBAA
and its member firms have developed a set of Principles for Enhancing
the Safety and Soundness of the Wholesale, Over-The-Counter Markets.
Using these Principles as a guide, the WMBAA seeks to work with
Congress, regulators, and key public policymakers on future regulation
and oversight of institutional markets and their participants. By
working with regulators to make wholesale markets more efficient,
robust and transparent, the WMBAA sees a major opportunity to assist in
the monitoring and consequent reduction of systemic risk in the
country's capital markets. The five founding members of the WMBAA are
BGC Partners; GFI Group; ICAP; Tradition and Tullett-Prebon. More about
the WMBAA can be found at: www.WMBAA.org.
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Tullett Prebon's business covers treasury products, fixed income,
interest rate derivatives, equities, and energy products, and offers
voice, hybrid, and electronic broking solutions for these products.
Tullett also offers a variety of market information services through
its inter-dealer broker market data division, Tullett Prebon
Information.
I began my career in the inter-dealer broker industry in 1996 as a
U.S. Treasuries broker. As you may know, the secondary market in U.S.
Treasuries traded exclusively over-the-counter, both electronically and
via voice, and stands as an example of one of the most liquid and
efficient markets in the world. My experience as a broker allowed me to
help create electronic brokering systems for U.S. Treasuries and CDS
Index products and I have spent the vast majority of the past 15 years
building various electronic and hybrid brokering platforms to promote
more efficient markets in Fixed Income, Energy, Credit, FX Options and
Interest Rates.
I welcome this opportunity to discuss with you implementation of
the Dodd-Frank Wall Street Reform and Consumer Protection Act (``Dodd-
Frank'' or ``DFA'') from the perspective of the primary intermediaries
of over-the-counter swaps operating today here in the United States and
across the globe.
In my written testimony, I plan to cover the following points:
Wholesale brokers are today's central marketplaces in the
global swaps markets and, as such, are the prototype of swap
execution facilities or ``SEFs.''
Wholesale brokers are experts in fostering liquidity and
transparency in global swaps markets by utilizing trade
execution methodologies that feature a hybrid blend of
knowledgeable and qualified brokers as well as sophisticated
electronic technology.
Liquidity in today's swaps markets is fundamentally
different than liquidity in futures and equities markets and
the unique characteristics of this liquidity are what naturally
determine the optimal mode of market transparency and trade
execution.
Wholesale brokers' methodologies for price dissemination and
trade execution are specifically tailored to the unique
liquidity characteristics of particular swaps markets.
It is critical that regulators gain a thorough understanding
of the many modes of swaps trade execution currently deployed
by wholesale brokers and how these methods accommodate the
variety of markets in which we operate. In the extremely tight
time frames mandated by the DFA, regulators at the Securities
and Exchange Commission (``SEC'') and the Commodity Futures
Trading Commission (``CFTC'') have not had sufficient
opportunity to properly study and understand the unique nature
of the markets they are now endeavoring to write rules on and
regulate.
As a result, too many of the SEC's and CFTC's Title VII
proposals seem to rely heavily on rules governing the equities
and futures markets and are ill-suited for the fundamentally
different liquidity characteristics of today's swaps markets.
Three critical elements that regulators need to get right
under Title VII are:
SEFs must not be restricted from deploying the many
varied and beneficial trade execution methodologies and
technologies successfully used today to execute swaps
transactions;
The ``goal'' of pre-trade transparency must be
realized through means that do not destroy market liquidity
for market participants and end-users; and
Regulators need to carefully structure a public trade
reporting regime that is not ``one size fits all'', but
rather takes into account the unique challenges of
fostering liquidity in the diverse range of swaps markets.
As the WMBAA has proposed in formal comment letters with the
SEC and CFTC,\3\ a block trade standards advisory board (the
``Swaps Standards Advisory Board'') should be established and
made up of recognized experts and representatives of registered
SDRs and SEFs to make recommendations to the SEC and CFTC for
appropriate block trade thresholds for swaps and security-based
swaps.
---------------------------------------------------------------------------
\3\ See Comment Letter from WMBAA (January 18, 2011) (``1/18/11
WMBAA Letter'').
Congress can assist with technical corrections to Dodd-Frank
and, crucially, by providing regulators with adequate time and
resources to thoroughly understand the challenges and current
---------------------------------------------------------------------------
solutions to garnering trading liquidity in the swaps markets.
Taking adequate time to get the Title VII regulations right
will expedite the implementation of the worthy goals of Dodd-
Frank: central counterparty clearing and effective trade
execution by regulated intermediaries in order to provide end-
users with more competitive pricing, increased transparency and
deeper trading liquidity for their risk management needs.
Background on Tullett Prebon and Wholesale Brokers
My firm, Tullett Prebon, has a presence in over 20 countries and
employs over 2,400 people. In the United States, we have operations in
New York, New Jersey, Alabama, and Texas, employing nearly 500 brokers
and 700 total employees at these locations. Tullett Prebon's history
stretches back to 1868 in England as one of the first money brokers in
the City of London and, though we have grown through various mergers
over the years, we have maintained a proud tradition of brokering on
behalf of our clients and providing transparency and liquidity in the
over-the-counter markets through world-class expertise and service.
We provide a marketplace for a relatively small number of
sophisticated institutional buyers and sellers of OTC financial
products where their trading needs can be matched with other
sophisticated counterparties having reciprocal interests in a
transparent, yet anonymous, environment. To persons unfamiliar with our
business, I often describe interdealer brokers as something of a
virtual trading floor where large financial institutions buy and sell
financial products that are not suited to and, therefore, rarely trade
on an exchange.
As we sit here today, interdealer brokers are facilitating the
execution of hundreds of thousands of OTC trades corresponding to an
average of $5 trillion in notional size across the range of foreign
exchange, interest rate, Treasury, credit, equity and commodity asset
classes in both cash and derivative instruments. We are wholesale
brokers (sometimes called ``inter-dealer'' brokers). WMBAA member firms
account for over 90% of intermediated swaps transactions taking place
around the world today. Our industry does not serve household or retail
customers. Rather, we operate at the center of the global wholesale
financial markets by aggregating and disseminating prices, providing
price transparency and fostering trading liquidity for financial
institutions around the world. The roots of our industry go back over a
century in the world's major financial centers. Our activities in most
of the markets we serve today are highly regulated.
Wholesale brokers provide highly specialized trade execution
services, combining teams of traditional ``voice'' brokers with
sophisticated electronic trading and matching systems. As in virtually
every sector of the financial services industry in existence over the
past 50 years, wholesale brokers and their dealer clients began
connecting with their customers by telephone. As technologies advanced
and markets grew larger, more efficient, more diverse and global, these
systems have advanced to meet the changing needs of the market. Today,
we refer to this integration of voice brokers with electronic brokerage
systems as ``hybrid brokerage''. Wholesale brokers, while providing
liquidity for markets and creating an open and transparent environment
for trade execution for their market participants, do not operate as
single silo and monopolistic ``exchanges.'' Instead, we operate as
competing execution venues, where wholesale brokers vie with each other
to win their customers' business through better price, provision of
superior market information and analysis, deeper liquidity and better
service. Our customers include large national and money center banks
and investment banks, major industrial firms, integrated energy and
major oil companies and utilities.
Increasingly, the efficiencies of the market have inevitably led to
a demand for better trading technology. To that end, we develop and
deploy sophisticated trade execution and support technology that is
tailored to the unique qualities of each specific market. For example,
Tullett Prebon's customers in certain of our more complex, less
commoditized markets may choose among utilizing our
tpCreditdealTM, tpEnergytradeTM,
tpMatchTM or TradeBlade' electronic brokerage
platforms to trade a range of fixed income derivatives, interest rate
derivatives, foreign exchange options, repurchase agreements and energy
derivatives entirely on screen or they can execute the same transaction
through instant messaging devices or over the telephone with qualified
Tullett Prebon brokers supported by sophisticated electronic
technology. It is important to note that the migration of certain
products to electronic execution was not and has never been because of
regulatory or legal mandate but simply part of the natural evolution
and development of greater market efficiencies in particular markets.
The electronic platforms mentioned above serve our customers needs
in various ways. Some of the platforms are hybrid where the customer
has the choice of speaking with a broker to bid, offer or execute or
the customer can execute directly on the screen. While other platforms
are fully electronic and there is no broker intervention, the customers
bid, offer and execute on their own behalf. These systems have evolved
over time to meet the demands of the markets and need of the customers.
At no time in my experience on Wall Street has there been a regulatory
or legal mandate that helped these markets evolve. There are times when
we have attempted to migrate markets onto an electronic system
prematurely and were unsuccessful because the market was not ready.
The critical point is that competition in the marketplace for
transaction services has led interdealer brokers to develop highly
sophisticated transaction services and technologies that are well
tailored to the unique trading characteristics of the broad range of
swaps and other financial instruments that trade in the over-the-
counter markets today. Unlike futures exchanges, we enjoy no execution
monopoly over the products traded by our customers. Therefore, our
success depends on making each of our trading methods and systems right
for each particular market we serve. From our decades of competing for
the business of the worlds' largest financial institutions, we can
confirm that there is no ``one size fits all'' method of executing
swaps transactions.
Fostering Liquidity in Swaps Markets
The essential role of a wholesale broker is to enhance trading
liquidity. In essence, liquidity is the degree to which a financial
instrument is easy to buy or sell quickly with minimal price
disturbance. The liquidity of a market for a particular financial
product or instrument depends on several factors, including the
parameters of the particular instrument such as tenor and duration of a
swap, the degree of standardization of instrument terms, the number of
market participants and facilitators of liquidity, and the volume of
trading activity. Liquid markets are characterized by substantial price
competition, efficient execution and high trading volume.
While the relationship between exchange-traded and OTC markets
generally has been complimentary, each market provides unique services
to different trading constituencies for products with distinctive
characteristics and liquidity needs. As a result, the nature of trading
liquidity in the exchange-traded and OTC markets is often materially
different. It is critically important that regulators recognize the
difference.
Highly liquid markets exist for both commoditized, exchange-traded
products, and the more standardized OTC instruments, such as U.S.
Treasury securities, equities and certain commodity derivatives.
Exchange-traded markets provide a trading venue for the most
commoditized instruments that are based on standard characteristics and
single key measures or parameters. Exchange-traded markets with central
counterparty clearing rely on relatively active order submission by
buyers and sellers and generally high transaction flow. Exchange-traded
markets, however, offer no guarantee of trading liquidity as evidenced
by the high percentage of new exchange-listed products that regularly
fail to enjoy active trading. Nevertheless, for those products that do
become liquid, exchange marketplaces allow a broad range of trading
customers (including retail customers) meeting relatively modest margin
requirements to transact highly standardized contracts in relatively
small amounts. As a result of the high number of market participants
and the relatively small number of standardized instruments traded and
the credit of a central counterparty clearer, liquidity in exchange-
traded markets is relatively continuous in character.
In stark contrast, most swaps markets and other less commoditized
cash markets feature a far broader offering of less-standardized
products and larger-sized orders that are traded by far fewer
counterparties, almost all of which are institutional and not retail.
Trading in these markets is characterized by sporadic or non-continuous
liquidity. To offer one simple example, of the over 4,500 corporate
reference entities in the credit default swaps market, 80% trade less
than five contracts per day.\4\ Such thin liquidity can often be
episodic, with liquidity peaks and troughs that are often related to
key events such as unemployment reports, meetings of the Federal
Reserve and tied to external market economic and geopolitical
conditions (e.g., many credit and interest rate products).
---------------------------------------------------------------------------
\4\ ISDA & SIFMA, ``Block Trade Reporting for Over-the-Counter
Derivatives Markets,'' January 18, 2011, (``ISDA/SIFMA Block Trade
Study''). Available at http://www.isda.org/speeches/pdf/Block-Trade-
Reporting.pdf.
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General Comparison of OTC Swaps Markets to Listed Futures Markets \5\
---------------------------------------------------------------------------
\5\ See ISDA/SIFMA Block Trade Study.
\6\ Inclusive of all tenors, strikes and duration.
------------------------------------------------------------------------
Characteristic OTC Swaps Listed Futures
------------------------------------------------------------------------
Trading Counterparties 10s-100s (no 100,000s (incl.
retail) retail)
Daily Trading Volume 1,000s 100,000s
Tradable Instruments 100,000s 6 1,000s
Trade Size Very large Small
------------------------------------------------------------------------
Drawing a simple comparison, the futures and equities exchange
markets generally handle on any given day hundreds of thousands of
transactions by tens of thousands of participants (many retail),
trading hundreds of instruments in small sizes. In complete contrast,
the swaps markets provide the opportunity to trade tens of thousands of
instruments that are almost infinitely variable. Yet, on any given day,
just dozens of large institutional counterparties trade only a few
thousand transactions in very large notional amounts.
The effect of these very different trading characteristics results
in fairly continuous liquidity in futures and equities compared with
limited or episodic liquidity in swaps. There is richness in those
differences, because taken together, this market structure has created
appropriate venues for trade execution for a wide variety of financial
products and a wide variety of market participants. But the difference
is fundamental and a thorough understanding of it must be at the heart
of any effective rule making under Title VII of DFA. The distinct
nature of swaps liquidity has been the subject of several studies and
comment letters presented to the CFTC and the SEC.\7\
---------------------------------------------------------------------------
\7\ ISDA/SIFMA Block Trade Study; Comment Letter of JPMorgan
(January 12, 2011) (``JP Morgan Letter'').
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It is because of the limited liquidity in most of the swaps markets
that they have evolved into ``dealer'' marketplaces for institutional
market participants. That is, corporate end-users of swaps and other
``buy side'' traders recognize the risk that, at any given time, a
particular swaps marketplace will not have sufficient liquidity to
satisfy their need to acquire or dispose of swaps positions. As a
result, these counterparties may chose to turn to well capitalized
sell-side dealers that are willing to take on the ``liquidity risk''
for a fee. These dealers have access to secondary trading of their
swaps exposure through the marketplaces operated by wholesale and
inter-dealer brokers. These wholesale marketplaces allow dealers to
hedge the market risk of their swaps inventory by trading with other
primary dealers and large, sophisticated market participants. Without
access to wholesale markets, the risk inherent in holding swaps
inventory would cause dealers to have to charge much higher prices to
their buy side customers for taking on their liquidity risk, assuming
they remain willing to do so.
Dodd-Frank Impact on Swaps Market Structure: Clearing and Competing
Execution
Title VII of Dodd-Frank was an earnest and commendable effort by
Congress to reform certain aspects of the OTC swaps market. The DFA's
core provisions concerning swaps are: one, replacing bilateral trading
where feasible with central counterparty clearing, and two, requiring
that cleared swaps transactions between swaps dealers and major swaps
participants be intermediated by qualified and regulated trading
facilities, including those operating under the definition of ``Swap
Execution Facilities (SEFs)'' through which ``multiple participants
have the ability to execute or trade swaps by accepting bids and offers
made by multiple participants in the facility or system, through any
means of interstate commerce . . .'' \8\ These two operative provisions
seek to limit the current market structure where swaps and the
underlying counterparty risk may be traded directly between
counterparties without the use of trading intermediaries or clearing,
and to replace it for most transactions with a market structure in
which a central clearing facility acts as the single counterparty to
each market participant (i.e., buyer to each seller and seller to each
buyer) and where those cleared transactions must be traded through SEFs
and other intermediaries and not directly between the counterparties.
---------------------------------------------------------------------------
\8\ See Commodity Exchange Act (``CEA'') Section 1a(50).
---------------------------------------------------------------------------
In enacting these structural changes, DFA wisely rejected the anti-
competitive, single silo, exchange model of the futures industry, in
which clearing and execution are intertwined thereby giving the
exchange an effective execution monopoly over the products that it
clears.\9\ Rather, by requiring central clearing counterparties to
provide non-discriminatory access to unaffiliated execution facilities,
DFA promotes a market structure in which competing SEFs and exchanges
will vigorously compete with each other to provide better services at
lower cost in order to win the execution business of sophisticated
market participants. In this regard, DFA preserves the best competitive
element in the existing swaps landscape: competing wholesale brokers.
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\9\ As the Justice Department observed in a 2008 comment letter to
the Treasury Department, where a central counterparty clearing facility
is affiliated with an execution exchange (such as in the case of U.S.
futures), vertical integration has hindered competition in execution
platforms that would otherwise have been expected to: result in greater
innovation in exchange systems, lower trading fees, reduced ticket size
and tighter spreads, leading to increased trading volume and benefits
to investors. As noted by the Justice Department, ``the control
exercised by futures exchanges over clearing services . . . has made it
difficult for exchanges to enter and compete.'' In contrast to futures
exchanges, equity and options exchanges do not control open interest,
fungibility, or margin offsets in the clearing process. The absence of
vertical integration has facilitated head-to-head competition between
exchanges for equities and options, resulting in low execution fees,
narrow spreads and high trading volume. See Comments of the Department
of Justice before the Department of the Treasury Review of the
Regulatory Structure Associated With Financial Institutions, January
31, 2008. Available at http://www.justice.gov/atr/public/comments/
229911.htm.
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Tullett Prebon and the WMBAA members heartily support Dodd-Frank's
twin requirements of clearing and intermediation. Their advocacy of
swaps intermediation is fundamental to their business success in
fostering liquidity, providing price transparency, developing and
deploying sophisticated trading technology tools and systems and
operating efficient marketplaces in global markets for swaps and other
financial products.
Wholesale Brokers Will Serve as Responsible SEFs
As noted, interdealer brokers actively deploy a range of execution
services, technologies and other ``means of interstate commerce'' to
display prices to ``multiple participants'' to connect them with other
``multiple participants'' in billions of dollars of daily swaps trades.
As such, wholesale brokers are the true prototype for prospective
independent and competitive SEFs under DFA.
More importantly, Tullett Prebon and other members of the WMBAA
look forward to performing our designated roles as SEFs under DFA. The
wholesale brokerage industry is working hard and collaboratively with
the two Commissions to inform and comment on proposed rules to
implement DFA. The WMBAA has submitted several comment letters \10\
(copies attached) and expects to provide further written comments to
the CFTC and SEC. The WMBAA has also hosted the first conference,
SEFCON 1 \11\, dedicated specifically to SEFs. Further, the WMBAA has
conducted numerous meetings with Commissioners and staffs. We and the
wholesale brokerage industry are determined to play a constructive role
in helping the SEC and the CFTC to get the new regulations under Title
VII of DFA right.
---------------------------------------------------------------------------
\10\ See Comment Letter from WMBAA (November 19, 2010) (``11/19/10
WMBAA Letter''); Comment Letter from WMBAA (November 30, 2010) (``11/
30/2010 WMBAA Letter''); 1/18/11 WMBAA Letter; Comment Letter from
WMBAA (February 7, 2011) (``2/7/11 WMBAA Letter'').
\11\ SEFCON 1 was held in Washington, D.C. on October 4, 2010. The
keynote address was given by CFTC Commissioner Gary Gensler.
---------------------------------------------------------------------------
Three Critical Elements To Get Right
There are many things to get right under DFA. Given that DFA
requires all clearable trades to be transacted through an intermediary
(either an exchange or a Swap Execution Facility), three critical
elements are:
1. Permitted Modes of Swaps Execution.
2. Pre-Trade Price Discovery & Transparency for Market
Participants.
3. Post-Trade Price Transparency & Reporting.
1. Permitted Modes of Execution
As stated, DFA defines SEFs as utilizing ``any means of interstate
commerce'' to match swaps counterparties. This is an appropriate
allowance by Congress as the optimal means of interaction in particular
swaps markets varies across the swaps landscape. Congress recognized
that it was best left to the marketplace to determine the best modes of
execution for various swaps and, thereby, foster technological
innovation and development. Congress specifically did not choose to
impose a Federally mandated ``one-size-fits-all'' transaction
methodology on the regulated swaps market.
As the swaps market has developed, it has naturally taken on
different trading, liquidity and counterparty characteristics for its
many separate markets. For example, in more liquid swaps markets with
more institutional participants, such as certain U.S. Treasury, foreign
exchange and energy products, wholesale brokers operate fully
interactive electronic trading platforms, where counterparties can view
prices and act directly through a trading screen and also conduct a
range of pre- and post-trade activities like on-line price analysis and
trade confirmation. These electronic capabilities reduce the need for
actual voice-to-voice participant interaction for certain functions,
such as negotiation of specific terms, and allow human brokers to focus
on providing market intelligence and assistance in the execution
process. And yet, even with such technical capabilities, the blend of
electronic and voice assisted trading methods still varies for
different contracts within the same asset class.
In markets for less commoditized products where liquidity is not
continuous, Tullett Prebon and its competitors provide a range of
liquidity fostering methodologies and technologies. These include
hybrid modes of: (a) broker work up methods of broadcasting completed
trades and attracting others to ``join the trade'' and (b) auction-
based methods, such as matching and fixing sessions. In other swaps
markets, brokers conduct operations that are similar to traditional
``open outcry'' trading pits where qualified brokers communicate bids
and offers to counterparties in real time through a combination of
electronic display screens and hundreds of installed, always-open phone
lines, as well as through other e-mail and instant messaging
technologies. In every case, the technology and methodology used is
well calibrated to disseminate customer bids and offers to the widest
extent and foster the greatest degree of liquidity for the particular
market.
The WMBAA has been active in seeking to educate U.S. regulators
about the multiple modes of execution utilized in the swaps markets
today. We have given technology demonstrations to regulators in their
offices and hosted tours of our New York brokerage operations to CFTC
Commissioners O'Malia and Chilton. We are in the process of trying to
schedule these educational tours for other CFTC and SEC Commissioners
and staff who are actually writing the rules, the majority of whom have
never seen an actual swaps trade transacted. We understand that budget
constraints currently facing these agencies may be a hindrance for
additional tours and demonstrations. Yet, we believe it is critical
that the CFTC and SEC completely understand these markets and
familiarize themselves with the many modes of execution currently
deployed in the marketplace to accommodate the varying characteristics
of different swaps markets before finalizing the rules governing trade
execution.
CFTC Commissioner Bart Chilton had this to say about a recent visit
he made to one of the WMBAA member's New York brokerage floor, ``I was
surprised by what I didn't know . . . Well, these are big, dynamic
operations, not just a couple of guys in a back room with a phone. I
don't think we have a full appreciation of the OTC markets yet.'' \12\
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\12\ Energy Metro DESK, February 7, 2011. p. 6. (``Chilton Desk
Interview''). The article further states, ``Chilton says his trip . . .
changed his opinion about SEFs and OTC transparency in general. He says
the hybrid broker model (voice and screens) for example, which actually
is the rule and not the exception around the market, was news to him.''
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It is vitally important that SEF rules promulgated by the CFTC and
SEC encompass the many varied and beneficial trading methodologies that
are used today to execute swaps in these very competitive swap markets.
Under Dodd-Frank, Congress wisely permitted SEFs to utilize ``any means
of interstate commerce'' to transact swaps. Congress recognized that
restricting methods of execution of swaps instruments with non-
continuous liquidity could do substantial harm to the orderly operation
of U.S. swaps markets overall, to the detriment of those market
participants who need to manage risk. There is no basis in Dodd-Frank
for regulations designed to restrict or promote any one component or
other of the hybrid means of swaps execution utilized by wholesale
brokers and SEFs. Moreover, we believe it would be detrimental to
liquidity in the swaps markets for the CFTC or SEC to mandate unduly
restrictive or prescriptive transaction methodologies. Similarly, we
believe it would be harmful to liquidity for the CFTC or SEC to mandate
swaps trading methodologies taken from the highly commoditized equities
or futures markets that are inappropriate and ill suited for the
multiple and varied U.S. swaps markets. We are highly concerned about
seemingly artificial and arbitrary divisions between electronic and
human-assisted modes of swaps execution that would be imposed under the
CFTC's SEF proposals.
The WMBAA is currently drafting comment letters on the CFTC and SEC
SEF proposals. We will be happy to provide this Committee copies as
soon as those letters are filed. At this stage we are concerned that
the rules have not provided enough flexibility or sufficient guidance
to ensure that all modes of trade execution utilizing ``any means of
interstate commerce'' will be embraced, a very clear directive of the
DFA. We believed this is rooted in a lack of sufficient exposure and
understanding as to how trades are currently executed in the wholesale
markets in a way that employs a wide array of technology to provide a
vibrant and transparent market for ``multiple participants [to] have
the ability to execute or trade swaps by accepting bids and offers made
by multiple participants in the facility or system.''
It is worth noting that European regulators do not appear to be
considering rules with similarly proscriptive limits on trade execution
methodology. We are not aware of any significant regulatory efforts in
Europe to mandate electronic execution of cleared swaps by
institutional market participants. In a world of competing regulatory
regimes, business naturally flows to the market place that has the best
regulations--not necessarily the most lenient, but certainly the ones
that have the optimal balance of liquidity, execution flexibility and
participant protections. In a market without retail participants, we
question what useful protections are afforded to large institutions
(required to transact swaps on SEFs) by proposed U.S. regulations that
would limit the methods by which market participants may execute their
orders. Rather, U.S. regulations need to be in harmony with regulations
from foreign jurisdictions to avoid driving trading liquidity away from
U.S. markets towards markets offering greater flexibility in modes of
trade execution.
2. Pre-Trade Price Transparency
The SEF provisions in Dodd-Frank contain a rule of construction for
their operation: ``to promote pre-trade price transparency in the swaps
market.'' \13\ Not surprisingly, interdealer brokers operate in
furtherance of that goal. Our business model is driven by revenues from
commissions paid on transactions. Our goal is to complete more
transactions with more customers. Therefore, it is in each of our
firm's economic interest to naturally and consistently disseminate
trade bids and offers to the widest practical range of customers with
the express purpose of price discovery and the matching of buyers and
sellers. We employ a number of means of pre-trade transparency from
software pricing analytics to electronic and voice price dissemination
to electronic price work up technology. There is no reason we should be
required to or would wish to curtail these transparency techniques upon
qualification as SEFs. We endorse and currently promote the goal of
pre-trade price transparency by providing market information by voice
and electronic means to multiple market participants to create greater
trading liquidity, the natural activity of intermediaries.
---------------------------------------------------------------------------
\13\ See CEA Section 5h(e).
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We are concerned, however, that this pre-trade price transparency
rule of construction not be used as the basis for the imposition of
artificial and, somewhat, experimental restrictions on market activity.
For example, the CFTC's SEF proposals require ``a minimum pause of 15
seconds between entry of two potentially matching customer-broker swap
orders or two potentially matching customer-customer orders'' \14\
(Referred to below as the ``15 Second Rule''). We are concerned that
this provision could have a potentially devastating impact on liquidity
in most swaps markets and we intend to address it in formal comments to
the CFTC.
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\14\ Core Principles and Other Requirements for Swap Execution
Facilities, 76 FR 1214 (January 7, 2011).
---------------------------------------------------------------------------
As noted earlier, buy-side customers often look to swaps dealers to
undertake the liquidity risk of trading in swaps for which there is
non-continuous liquidity. Under DFA, the dealer would take on that risk
by placing both the customer's sale order and the dealer's buy order
into a SEF for execution. One adverse impact of the proposed 15 Second
Rule may be that the dealer will not know until the expiration of 15
seconds whether it will have completed both sides of the trade or
whether another market participant will have taken one side. Therefore,
at the time of receiving the customer order the dealer has no way of
knowing whether it will ultimately serve as its customer's principal
counterparty or merely as its executing agent. The result will be
greater uncertainly for the dealer in the use of its capital and,
possibly, the reduction of dealer activities leading, in turn, to
diminished liquidity in and competitiveness of U.S. markets with
detrimental results for buy-side customers and end-users.
As a general matter, we note the conflict between, on the one hand,
a rule of construction to promote pre-trade price transparency and, on
the other hand, the express mandate under Dodd-Frank to allow delayed
reporting of trade information for block trades because of the impact
disclosure would have on liquidity in the market. In the first case,
there are no operative provisions for pre-trade price transparency in
Dodd-Frank that correspond to the non-binding rule of construction. In
the second case, DFA specifically requires delayed reporting of block
trades to preserve market liquidity and counterparty anonymity. We
believe the specific DFA requirement for delayed block trade reporting
takes precedence in implementation over the non-binding rule of
construction to promote pre-trade transparency. We believe the
Commissions should place great emphasis on complying with the operative
requirements \15\ of Dodd-Frank regarding block trading, ensuring
liquidity of markets and preserving anonymity of parties to a trade as
they relate to public reporting of trade information and ensuring that
those requirements are not conflicted in the arbitrary pursuit of a
``goal'' of pre-trade transparency. We do not believe that the goal of
pre-trade transparency justifies imposing on SEF's experimental trade
execution mechanisms that are ill-suited for the unique characteristics
of the swaps markets.
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\15\ Section 727 of the Dodd-Frank Act; Section 763(i) of the Dodd-
Frank Act.
---------------------------------------------------------------------------
3. Post-Trade Price Reporting & Transparency
It is certainly true that the right measure of pre and post trade
transparency can benefit market liquidity. Yet, it is also true that
absolute transparency can harm liquidity. The objective must be to
strike the right balance. The impact on market liquidity of the CFTC
and SEC's proposals on swaps trade reporting and transparency depend on
finding the right balance in the final rules governing large block
trading. If the rules do not properly define block trade size and
thresholds in the context of the unique characteristics of various
swaps markets, then the trade reporting of blocks could negatively
impact market liquidity, disturbing businesses' ability to hedge
commercial risk, to appropriately plan for the future and, ultimately,
stifle economic growth and job creation.
Brokers have long recognized that in the less liquid swaps markets
where a smaller number of primary dealers and market makers cross
larger size transactions, the disclosure of the intention of a major
institution to buy or sell could disrupt the market and lead to poor
pricing. If a provider of liquidity to the market perceives greater
danger in supplying liquidity, it will step away from providing tight
spreads and leave those reliant on that liquidity with poorer hedging
opportunities. From a market structure standpoint, liquidity ``takers''
benefit from liquidity providers acting in a competitive environment.
The liquidity providers compete with each other, often deriving
reasonably small profits per trade from a large volume of transactions.
By relying on their ability to warehouse trades and post capital to
make markets and using their distribution and professional know-how to
offer competitive prices to their customer base, dealers and market
makers provide liquidity essential to the execution of hedging and
other risk management strategies.
By imposing a regulatory regime where the market is quickly alerted
whenever providers of liquidity take on risk, it becomes difficult for
the risk takers to offset such risk without significant loss. The
effect is greater risk, higher costs and, ultimately, less liquidity.
Disseminating the precise notional amount of a particular large
transaction could jeopardize the anonymity of the counterparties to
such trades, making counterparties less willing to engage in
transactions of size. Similarly, the effect of having no delay, or only
a short dissemination delay, for a block trade report that includes the
full notional size will discourage market makers from committing
capital and providing liquidity to the broader market. For these
reasons, having either no delay or a short dissemination delay will
actually erode price discovery and the level of price efficiency in the
market. We note and echo the concerns expressed by the Coalition for
Derivatives End-Users that, ``An across-the-board 15 minute time delay
that does not account for the instrument type and market conditions is
too simplistic to be effective for the derivatives market.'' \16\
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\16\ Comment Letter from Coalition for Derivatives End-Users
(February 7, 2011) (``2/7/11 Coalition Letter'').
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There are historical examples of markets that have sought to
achieve full post-trade transparency without adequate block trade
exemptions. The results were not positive. In 1986, the London Stock
Exchange (``LSE'') enacted post trade reporting rules designed for
total transparency with no exceptions for block sizes. What ensued was
a sharp drop in trading liquidity as market makers withdrew from the
market due to increased trading risk.\17\ The LSE thereafter engaged in
a series of amendments to make its block trade rules more flexible and
detailed over time.
---------------------------------------------------------------------------
\17\ ISDA/SIFMA Block Trade Study, p. 8.
---------------------------------------------------------------------------
Achieving the right balance in block trade rules for swaps markets
requires recognition that the thresholds and reporting delay must be
different by asset class and instrument and need to be tailored with
the greatest of precision. A ``one-size-fits-all'' approach will not
work. The elements of trade size, delay period and disclosed
information set should be individually established based upon the
unique liquidity requirements of particular instruments and markets. It
is vitally important that block trade thresholds and reporting periods
be matched properly to the markets to which they apply; otherwise, the
markets will adversely adapt to arbitrary rules leading to all manner
of dislocation and misuse.
It is worth noting that the trade reporting regime that is often
cited positively as a model for swaps trade reporting is the TRACE
system for U.S. corporate bonds. That system was phased in over 3
years. We believe that markets as complex as the swaps markets require
at least as long a phase-in period to be cautious and make sure the
formulas and mechanisms work properly. Furthermore, as with TRACE,
during the phase-in period, there should be appropriate study of the
effects on market liquidity, as required by the statute.
We also note that because of the fundamental differences in
liquidity in the swaps markets from those in the futures and equities
markets, those markets provide inadequate and inappropriate models for
the swaps markets for block trade calculations of size, content and
time delay. As a result of the unique non-continuous nature of
liquidity in certain swaps markets (with fewer participants), we
believe that the CFTC and SEC need to carefully structure a public
trade reporting regime that is not ``one size fits all'', but rather
takes into account the unique challenges of fostering liquidity in the
diverse range of swaps markets, provides for the transacting of larger
transactions without unnecessary regulatory burdens, and does not
materially reduce market liquidity.
The WMBAA has proposed \18\ the formation of a block trade
standards advisory board (the ``Swaps Standards Advisory Board'') made
up of recognized experts and representatives of registered SDRs and
SEFs to make recommendations to the Commissions for appropriate block
trade thresholds for swaps and security based swaps. (Copy attached.)
The WMBAA cites the role of existing CFTC advisory committees, such as
the in Agricultural Advisory Committee, Global Markets Advisory
Committee, Energy and Environmental Markets Advisory Committee, and the
Technology Advisory Committee, which serve to receive market
participant input and recommendations related to regulatory and market
issues. While the Commission is authorized under Dodd-Frank to
establish block trade standards on its own, we believe that a Swaps
Standards Advisory Board, similar to the above-referenced advisory
committees, could provide the Commission with meaningful statistics and
metrics from a broad range of contract markets, SDRs and SEFs to be
considered in any ongoing rulemakings in this area.
---------------------------------------------------------------------------
\18\ 1/18/11 WMBAA Letter.
---------------------------------------------------------------------------
A Swaps Standards Advisory Board would work with the Commissions to
establish and maintain written policies and procedures for calculating
and publicizing block trade thresholds for all swaps reported to the
registered SDR in accordance with the criteria and formula for
determining block size specified by the Commissions. The Swaps
Standards Advisory Board would also undertake the market studies and
research at industry expense that is necessary to help establish such
standards. This arrangement would permit SEFs, as the entities most
closely related to block trade execution, to provide essential input
into the Commission's block trade determinations and work with
registered SDRs to distribute the resulting threshold levels to SEFs.
Further, the proposed regulatory structure would reduce the burden on
SDRs, remove the possibility of miscommunication between SDRs and SEFs,
and ensure that SEFs do not rely upon dated or incorrect block trade
thresholds in their trade execution activities.
Areas Where Congress Can Help
In this testimony, I have called on the CFTC and SEC to better
understand the distinct nature of the swaps markets and not align their
rulemaking with familiar and inappropriate models of the futures and
equities markets simply because they do not have the time necessary to
understand the unique nature of how the swaps market works due to the
arbitrary time constraints set forth in the DFA. I have criticized a
specific rule proposal (the 15 Second Rule) and arbitrary limits on
SEFs' use of ``any means of interstate commerce'' to transact customer
orders.
I commend the two Commissions (SEC and CFTC) and their staffs for
their evident good faith and determination. They are working very hard
to get this right. I and many colleagues in the wholesale brokerage
industry are optimistic that, given enough time, we can work with the
regulators to fine tune rules regarding modes of intermediation,
transparency and non-discrimination towards SEFs. That said, there are
two areas where Congress can help.
Time Frames: In proscribing specific rule promulgation dates, DFA
did not give regulators enough time to complete an orderly
transformation of the multi-trillion Dollar U.S. swaps market to a
cleared and intermediated structure. The mandated time frames are just
too tight to get the details right. CFTC Commissioner Scott O'Malia has
called them ``unrealistic.'' \19\ They are indeed unrealistic and put
an unreasonable burden on the staff of the regulatory commissions to
sufficiently familiarize themselves with the workings of the OTC swaps
markets. Yet, such familiarity and, indeed, expertise, is absolutely
necessary since heretofore neither agency had direct regulatory
authority or involvement with these markets. Without the time or the
resources to understand these markets, each agency will have the
natural tendency to fall back on the familiarity of the markets they
already regulate. The CFTC's proposals rely heavily on the futures
exchange market model and the SEC's rules more prone to a securities
market model. Not only is the swap market and its diverse elements
unique, but it is critically important that there be consistency
between the two agencies. More time and resources would surely give
both agencies a better chance to first, do no harm and second, reach
the right outcome.
---------------------------------------------------------------------------
\19\ Keynote Address by Commissioner Scott D. O'Malia at Tabb Forum
Conference (January 25, 2011).
---------------------------------------------------------------------------
Several days after viewing a WMBAA member's New York brokerage
operations, CFTC Commissioner Bart Chilton put it thus in a speech: ``.
. . We are also working, in the crafting of SEF rules, to ensure that
we do not mess up platforms that are currently working well. This is a
delicate balancing act, and we need to hear from market participants
that have the expertise and interest in this area to make sure we get
it right.'' \20\ Commissioner Chilton is exactly correct that in
crafting SEF rules, regulators must better understand platforms that
are currently working well so as not to mess them up.
---------------------------------------------------------------------------
\20\ Speech of Commissioner Bart Chilton to the American Public Gas
Association Winter Conference, Fort Myers, Florida, (February 1, 2011).
---------------------------------------------------------------------------
What is needed is for Congress to give regulators the necessary
time to understand more precisely those swaps platforms that are
currently working well and discourage them from ``ready, fire, aim''
approach to the regulation. Commissioners like Bart Chilton and
responsible regulators must have the opportunity to better consider how
existing intermediaries function, how they deploy technology, how they
promote price transparency and how they use many means of execution to
connect multiple to multiple market participants. From an understanding
of the effectiveness of these systems for the markets they serve,
regulators may gain comfort to more fully endorse working execution
models rather than having to impose artificial models or those from
distinct markets. Market research and further studies may be required
to provide the thorough knowledge necessary to craft workable,
effective and appropriate rules and regulations, and this will take
time.
If regulators are given sufficient time and, frankly, resources to
craft SEF rules that are well tailored to the existing trading methods
in the swaps markets, a benefit may be a shorter and more effective
implementation period by the swaps industry. Rushing the rules will
make implementation slower, harder and more costly. Taking the time to
make the rules reflect the way the swaps markets actually work will
speed implementation and save money. As the adage goes, ``Measure
twice, cut once.''
Industry Efforts: Second, DFA failed to dot a few `i's and cross a
few `t's. For example, Dodd-Frank sets up a framework of competing SEFs
and DCMs, yet in its core principles requires that each SEF monitor and
enforce counterparty position limits and manipulative trading
practices.\21\ The requirement presumes that each SEF has sufficient
market and customer knowledge to comply. However, as competing
execution facilities, SEFs will rarely handle or be aware of a
counterparty's entire trading activity, which will be directed most
likely to numerous SEFs depending on best execution, price and
liquidity. Because SEFs are not structured as Designated Clearing
Organizations or Swap Data Repositories, they will have no way of
knowing the aggregate position limits or composite trading strategies
of their customers and will fail to comply with the respective Core
Principles.
---------------------------------------------------------------------------
\21\ CEA Section 5h(f)(6); See Section 733 of the Dodd-Frank Act.
---------------------------------------------------------------------------
Another practical impossibility is presented by Core Principle 4
which requires SEFs to monitor trading and trade processing.\22\ This
requirement provides that when a swap is settled by reference to the
price of an instrument traded in another venue the SEF must also
monitor trading in the market to which the swap is referenced. In other
words, a SEF that executes a trade of a credit default swap on a Ford
Motor Company bond must also monitor trading in Ford Motor Company
bonds. Yet, while SEFs certainly have the ability to monitor trades
that they execute, they are not in a position to independently and
effectively monitor positions and trading that takes place in other
markets.
---------------------------------------------------------------------------
\22\ CEA Section 5h(f)(4); See Section 733 of the Dodd-Frank Act.
---------------------------------------------------------------------------
As the CFTC states on their website \23\ regarding their trade
surveillance program, only it can ``consolidate data from multiple
exchanges and foreign regulators to create a seamless, fully-surveilled
marketplace'' due to the Commission's unique space in the regulatory
arena. The surveillance ``requires access to multiple streams of
proprietary information from competing exchanges, and as such, can only
be performed by the Commission or other national regulators''. The CFTC
correctly states that the surveillance ``can not be filled by foreign
and domestic exchanges offering related competing products'', and there
is no reason to believe a SEF would be better situated. And yet, unless
each SEF fills this sort of surveillance function, it will be in
violation of SEF core principles.
---------------------------------------------------------------------------
\23\ CFTC Market Surveillance Program. Available at http://
www.cftc.gov/IndustryOversight/MarketSurveillance/
CFTCMarketSurveillanceProgram/tradepracticesurveillance.html.
---------------------------------------------------------------------------
A further issue is that SEFs ideally should be able to delegate
relevant functions to a self-regulatory organization (``SRO'').
Unfortunately DFA does not expressly contemplate such delegation as,
for example, the CEA permits for other types of registered
entities.\24\ Further, it is not clear that even if permitted, SEFs
would voluntarily delegate responsibilities to the existing SROs.
---------------------------------------------------------------------------
\24\ See 7 U.S.C. 7a-2(b).
---------------------------------------------------------------------------
What is clear is that the proposed SEF rules create a host of new
obligations for SEFs, as well as for the CFTC and the SEC. It also
appears that the SEC and CFTC lack the resources necessary to implement
and enforce the new rules. And if projections of 50-100 SEFs are
correct, a new regulatory structure to facilitate compliance by SEFs
with the applicable laws and regulations will need to be developed.
To address some of these issues, the WMBAA proposes the
establishment of a common regulatory organization (CRO) \25\ that will
facilitate compliance with the core principles by each of its members
as well as for any other SEF that agrees to follow its rules. The CRO
would not itself have any direct regulatory responsibilities, but it
would, by way of contractual obligations, assist its members by
addressing compliance issues that are common to all SEFs. This solution
would be industry and not taxpayer financed. However, this solution is
not expressly authorized by DFA and would benefit from a Congressional
mandate to confirm its utility.
---------------------------------------------------------------------------
\25\ Distinguished from an SRO to avoid confusion with the legal
and regulatory implications of an SRO.
---------------------------------------------------------------------------
Conclusion
Dodd-Frank seeks to reengineer the U.S. swaps market on two key
pillars: central counterparty clearing and mandatory intermediation of
clearable trades through registered intermediaries such as SEFs.
Wholesale brokers are today's central marketplaces in the global swaps
markets and, as such, are the prototype of swap execution facilities.
Liquidity in today's swaps markets is fundamentally different than
liquidity in futures and equities markets and naturally determines the
optimal mode of market transparency and trade execution. Wholesale
brokers are experts in fostering liquidity in non-commoditized
instruments by utilizing methodologies for price dissemination and
trade execution that feature a hybrid blend of knowledgeable qualified
voice brokers and sophisticated electronic technology. Wholesale
brokers' varied execution methodologies are specifically tailored to
the unique liquidity characteristics of particular swaps markets.
It is critical that regulators gain a thorough understanding of the
many modes of swaps trade execution currently deployed by wholesale
brokers and accommodate those methods and practices in their SEF
rulemaking. Too many of the SEC's and CFTC's Title VII proposals are
based off of rules governing the equities and futures markets and are
ill-suited for the fundamentally different liquidity characteristics of
today's swaps markets.
Regulators are undoubtedly working hard to put in place appropriate
rules under Title VII. They have their work cut out for them and there
are at least three critical elements for success:
1. SEFs must not be restricted from deploying the many varied and
beneficial trade price dissemination and trade execution
methodologies and technologies successfully used today to
execute swaps.
2. The ``goal'' of pre-trade transparency must be realized through
means that do not destroy market liquidity for market
participants and end-users.
3. Regulators need to carefully structure a public trade reporting
regime that is not ``one size fits all'', but rather takes into
account the unique challenges of fostering liquidity in the
diverse range of swaps markets.
Congress can assist with technical corrections to Dodd-Frank and,
crucially, by providing regulators with adequate time and resources to
thoroughly understand the challenges and current solutions to garnering
trading liquidity in the swaps markets. Rushing the rule making process
and getting things wrong will negatively impact market liquidity in the
U.S. swaps markets, disturbing businesses' ability to hedge commercial
risk, to appropriately plan for the future and, ultimately, stifle
economic growth and job creation.
Taking adequate time to get the Title VII regulations right will
expedite the implementation of the worthy goals of Dodd-Frank: central
counterparty clearing and effective trade execution by regulated
intermediaries in order to provide end-users with more competitive
pricing, increased transparency and deeper trading liquidity for their
risk management needs. With Congress' help, and the input and support
of the swaps industry, regulators can continue their dedicated efforts
at well crafted rule making. If we are successful, our U.S. financial
system, including the U.S. swaps markets, can once again be the well
ordered marketplace where the world comes to trade.
Thank you for your consideration. I look forward to answering any
questions that you may have.
Attachments
November 19, 2010
Hon. Gary Gensler,
Chairman,
Commodity Futures Trading Commission,
Washington, D.C.
Hon. Mary Schapiro,
Chairman,
Securities and Exchange Commission,
Washington, D.C.
Dear Chairmen Gensler and Schapiro,
The Wholesale Markets Brokers Association, Americas (``WMBAA'' or
``Association'') appreciates the opportunity to submit to the U.S.
Commodity Futures Trading Commission (``CFTC'') and the U.S. Securities
and Exchange Commission (``SEC'' and, collectively with the CFTC, the
``Commissions'') general comments for your consideration. We appreciate
the great efforts of both Commissions to implement regulations under
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (``Dodd-Frank Act'') and are supportive of steps taken to ensure
stability in over-the-counter (``OTC'') derivatives markets.
As you and your fellow Commissioners discuss staff proposals for
rules governing swap execution facilities and security-based swap
execution facilities (``SEFs'') and other related issues, the WMBAA
offers the following comments for your consideration.
Pre-trade Transparency
The SEF provisions in the Dodd-Frank Act contain a rule of
construction that the goal is, in part, ``to promote pre-trade
transparency in the swaps market.'' Currently, the WMBAA member firms
each operate trading facilities that thrive as competitive sources of
liquidity because each facility naturally and consistently disseminates
market information to all its participants, with the express purpose of
matching buyers and sellers. As these fundamental principles are
applied to the establishment of SEFs, which themselves permit multiple
participants to accept bids and offers made by multiple participants in
the facility, the notion of intermediaries providing market information
to participants in an effort to create liquidity is one that the WMBAA
recognizes as essential to the vitality of OTC derivatives markets.
WMBAA members are supportive of providing information to their
participants through multiple modes of communication, depending on the
depth of liquidity and trading frequency of the asset class, to ensure
access to competitive pricing for counterparties. Further, the WMBAA
recognizes the required compliance with core principles that include a
mandate to (i) establish and comply with trading procedures for
entering and executing large notional swap or security-based swap
transactions (block trades) traded on the facility and (ii) comply with
the Commission-established time delay for reporting block trades. In
addition, the provisions in the Dodd-Frank Act related to the public
reporting of swap and security-based swap transaction data require
that, with respect to the providing for the public availability of
transaction and pricing data, rules promulgated by each Commission must
protect the identity of counterparties and take into account whether
public disclosure will materially reduce market liquidity. The WMBAA
believes that the Commissions should work carefully to ensure that any
reporting regime, whether for pre- or post-trade information,
adequately protects these interests and does not jeopardize OTC
derivatives as an effective source of liquidity.
The WMBAA urges the Commissions to consider the difficulties
associated with complying with pre-trade price transparency
requirements, on the one hand, and delayed reporting of trade
information for those transactions that qualify as block trades. The
publication of pre-trade price information does not comport with the
notion that, in certain instances, trade information should be reported
on a delayed basis to protect trade information and counterparty
anonymity. In addition, in reviewing the organization of the Dodd-Frank
Act, the WMBAA respectfully submits that the block trade reporting
delay, an obligation specifically enumerated in the Dodd-Frank Act,
takes precedence in implementation when compared with the rule of
construction provision which indicates that a goal of the legislation
is to merely promote pre-trade transparency. For that reason, the WMBAA
believes the Commissions should place great emphasis on complying with
the ``requirements'' of Sections 727 and 763(i) with regard to block
trading, ensuring liquidity of markets and preserving anonymity of
parties to a trade as they relate to public reporting of trade
information and ensuring that those requirements are not conflicted in
the pursuit of a ``goal'' of pre-trade transparency as described in a
rule of construction in the Dodd-Frank Act.
Multiple Modes of Execution
A SEF, by definition, may facilitate the trading or execution of
swaps and security-based swaps ``through any means of interstate
commerce.'' The WMBAA strongly supports the use of electronic, voice
and hybrid trading methods to bring parties together and foster a
competitive OTC derivatives market. This flexibility allows U.S.
markets to stay competitive, and provides greater options in servicing
the needs of market participants. The WMBAA embraces technological
advances that provide future advances in communication methods,
furthering transparency and liquidity to as many market participants as
is warranted.
The availability of multiple modes of execution widens the scope of
products which can be traded more frequently, broadening the base of
buyers and sellers participating in even deeper markets. This increased
trading activity results in higher trade volumes and more standardized
transactions, which will ultimately bring more clearable trades, and
thus accomplishing one of the primary objectives of the Dodd-Frank Act.
Nondiscriminatory Access to Clearing
As competitive swap execution facilities, the WMBAA members firmly
believe that the nondiscriminatory access to central clearinghouses
provided by the Dodd-Frank Act is necessary to the foundation of
competitive, liquid markets that provide affordable access to OTC
derivatives products. Any restrictions imposed on market participants'
access to clearing will result in disparate levels of transparency and
preclude certain derivatives counterparties from the benefits of
efficient markets.
Public Reporting of Transaction Data; Treatment of Block Trades
As previously discussed, both Commissions are authorized to write
rules to facilitate block trades. In general, the WMBAA is supportive
of trade reporting for all trades as soon as technologically
practicable. The Association believes that all trade reporting,
regardless of size, should be reported to the swap data repositories.
As interdealer brokers involved in the formulation and execution of
large derivatives transactions between swap and security-based swap
dealers, the distinction between block and non-block trades is vital to
ensure OTC derivatives markets can continue to provide liquidity to and
be a source for risk mitigation for businesses. Further, the CFTC and
SEC need to carefully structure a clearing and reporting regime for
block trades that protects counterparties' identities and provides for
the transacting of larger transactions without unnecessary regulatory
burdens.
While the WMBAA believes that each asset class has a threshold
amount that could be calculated and used to distinguish between typical
and block trades, its primary concern is that the block trade exception
be set at such a level that trading may continue without impacting
market participants' ability to exit or hedge their trades. In
addition, while the appropriate threshold amount will differ by asset
class, the notion of a block trade involves more than merely the size
of a transaction. A block trade is frequently assembled through a
series of actions. The WMBAA believes it is appropriate to provide
regulators with necessary market information for oversight purposes,
but the public dissemination of incremental activity that would
otherwise constitute a block trade could jeopardize identification of
counterparties and materially reduce market liquidity, which does not
comport with the reporting goals enumerated in the Dodd-Frank Act.
Finally, the WMBAA is committed to any regulatory regime
promulgated with electronic trade reporting requirements. As the
WMBAA's member firms have historically demonstrated through successful
Trade Reporting and Compliance Engine (``TRACE'') reporting, these
firms have the capabilities to comply with any requirement for
reporting swap and security-based swap transaction data as soon as
technologically practicable. Further, WMBAA members are willing to
report this information to any entity designated by each Commission,
including a swap/security-based swap data repository or the Commission
itself.
SEF Rule Enforcement
In order to ensure that SEFs establish and enforce consistent rules
with each other, it has been suggested that a self-regulatory
organization (``SRO'') would be established (or contracted with) to
ensure uniformity in investigations and enforcement. The WMBAA supports
ensuring that competitive SEFs are equal in enforcing trading rules,
but believes that any SRO must demonstrate adequate independence in its
organization and enforcement of rules in order to carry out this
important function. Furthermore, the WMBAA believes that while the
regulatory compliance responsibility cannot be shifted from a SEF to a
separate SRO, SEFs should be permitted to contract with an SRO to
provide regulatory services to help ensure consistent application of
rules under Core Principle number two.
Impartial Access
The SEF core principles in the Dodd-Frank Act require SEFs to
``establish and enforce trading, trade processing, and participation
rules that will deter abuses and have the capacity to detect,
investigate, and enforce those rules,'' including means ``to provide
market participants with impartial access to the market [emphasis
added].'' The WMBAA member firms fully expect that, under the Dodd-
Frank Act, each facility's participants should and will have impartial
access to the facility.
However, any expansion of the impartial access requirement beyond
market participants should be considered to be outside of the text of
the Dodd-Frank Act. Requiring that each SEF provide impartial access to
other SEFs, which are intermediaries and not market participants, would
have a stifling effect on competition, to the ultimate detriment of SEF
participants. Because these trading platforms compete to offer superior
service, technology, liquidity and commission prices to each other,
allowing SEFs knowledge of each other's price quotes would allow
facilities with lower quality services to exploit this information for
their gain and potentially cause a ``race to the bottom.'' The end
result would be that SEFs would only match the lowest common
denominator with respect to facility characteristics, to the detriment
of market participants who currently benefit from the fruits of a
competitive marketplace. Rules implementing the SEF core principles
should foster the environment of competitive, aggressive facilities to
ensure affordable access to and readily-available liquidity for various
asset classes. The WMBAA agrees that SEFs should provide ``impartial
access'' to market participants, but not to competing SEFs.
We would like to thank both of you, your fellow Commissioners, and
the staffs at the Commissions for being so willing to consider our
opinions and for conducting an open and transparent rulemaking process.
We appreciate the opportunity to share our opinions with you and are
available to discuss with you and your staffs at any time.
Sincerely,
Hon. Michael Dunn, Commissioner, CFTC;
Hon. Jill Sommers, Commissioner, CFTC;
Hon. Bart Chilton, Commissioner, CFTC;
Hon. Scott O'Malia, Commissioner, CFTC;
Hon. Kathleen Casey, Commissioner, SEC;
Hon. Elisse Walter, Commissioner, SEC;
Hon. Luis Aguilar, Commissioner, SEC;
Hon. Troy Paredes, Commissioner, SEC.
______
November 30, 2010
Hon. Gary Gensler,
Chairman,
Commodity Futures Trading Commission,
Washington, D.C.
Hon. Mary Schapiro,
Chairman,
Securities and Exchange Commission,
Washington, D.C.
Re: Self-Regulation and Swap Execution Facilities
Dear Chairman Gensler and Chairman Schapiro:
As you know, on July 29, 2010, the Wholesale Markets Brokers'
Association Americas \1\ (``WMBAA'') submitted to the Commodity Futures
Trading Commission (``CFTC'') and the Securities and Exchange
Commission (``SEC'') a Discussion Draft of Model Core Principles for
Swap Execution Facilities (``SEFs''). Since then the SEC and CFTC have
begun an ambitious process to write the rules to regulate the swaps
marketplace, including rules necessary to regulate swap execution
facilities and security based swap execution facilities (collectively
referred to herein as ``SEFs.'')
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\1\ The Wholesale Markets Brokers' Association Americas (WMBA
Americas) is an independent industry body representing the largest
inter-dealer brokers (``IDBs'') operating in the North American
wholesale markets across a broad range of financial products. The WMBA
and its member firms have developed a set of Principles for Enhancing
the Safety and Soundness of the Wholesale, Over-The-Counter Markets.
Using these Principles as a guide, the Association seeks to work with
Congress, regulators, and key public policymakers on future regulation
and oversight of over-the-counter (OTC) markets and their participants.
By working with regulators to make OTC markets more efficient, robust
and transparent, the Association sees a major opportunity to assist in
the monitoring and consequent reduction of systemic risk in the
country's capital markets.
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The Dodd-Frank Act (``DFA'') establishes a series of core
principles for SEFs that are in many cases the same or substantially
the same as the core principles for designated contract markets. These
include requirements to (i) establish, investigate and enforce rules,
and (ii) monitor trading and obtain information necessary to prevent
manipulation. Such requirements are typical for exchanges and self-
regulatory organizations.
However, many of the entities that will seek to become registered
as SEFs, including the WMBAA's members, are not exchanges. They operate
today as futures commission merchants (``FCMs''), broker-dealers and,
where applicable, as alternative trading systems (``ATS''). These
entities are required to join and follow the rules of one or more self-
regulatory organizations, such as FINRA or the NFA, which together with
the SEC and the CFTC, perform many of the regulatory functions assigned
by DFA to SEFs. In fact, the regulatory status of a SEF seems to most
closely resemble that of an ATS, which is defined as any organization,
association, person, group of persons, or system that brings together
purchasers and sellers of securities, but that does not (i) set rules
governing the conduct of subscribers other than the conduct of such
subscribers' trading on the alternative trading system; or (ii)
discipline subscribers other than by exclusion from trading.\2\
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\2\ See 17 CFR 242.300(a)
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Ideally SEFs would be able to delegate relevant functions to an
exchange or an SRO. Unfortunately DFA does not expressly contemplate
such delegation as, for example, the Commodity Exchange Act permits for
other types of registered entities.\3\ Further, it is not clear that
even if permitted, SEFs would voluntarily delegate responsibilities to
the existing SROs.\4\
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\3\ See 7 U.S.C. 7a-2(b).
\4\ It is possible that SRO membership could indirectly be required
if CFTC and SEC regulations were to require that SEFs also register as
FCMs and broker-dealers. Such regulations, however, would have
unintended consequences. First, it would create a conflicting web of
overlapping responsibilities as SEFs reconcile their obligations under
DFA with their obligations as members of the respective SROs. In
addition, mandatory broker-dealer or FCM registration for SEFs would
likely cause prospective SEFs to file new broker-dealer and FCM
applications rather than use existing registered entities that would
become subject to SEF regulations on ownership and conflicts of
interest. If projections of 50-100 SEF applications are correct, and
each SEF also files for registration as an FCM or broker-dealer, the
result could cause as many as 200-400 regulatory applications
associated with SEFs.
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However, it is clear that the new rules will create a host of new
obligations for swap execution facilities, as well as for the CFTC and
the SEC. It is also becoming clear that the SEC and CFTC lack the
resources necessary to implement and enforce the new rules. And if
projections of 50-100 SEFs are correct, it will become clear that a new
regulatory structure to facilitate compliance by SEFs with the
applicable laws and regulations will need to be developed.
To address these issues, members of the WMBAA and possibly others
propose to establish a common regulatory organization (``CRO'') \5\
that will facilitate compliance with the core principles by each of its
members as well as for any other SEF that agrees to follow its rules.
The CRO would not itself have any direct regulatory responsibilities,
but it would, by way of contractual obligations, assist its members by
addressing compliance issues that are common to all SEFs, including the
following:
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\5\ Distinguished from an SRO to avoid confusion with the legal and
regulatory implications of an SRO.
1. establishing and maintaining model provisions for each SEF's
rule book that would be adopted by each of its SEF members with
regard to core principles on investigations, enforcement
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authority, trade monitoring and obtaining information.
2. on behalf of its members, enter into one or more regulatory
services agreements with existing SROs pursuant to which the
CRO will have the capacity to detect, investigate, and enforce
those rules for its members. These services would including:
a. monitoring trading to prevent manipulation.
b. enforcing position limitations.
c. investigating possible violations of SEF, CFTC, SEC rules, or
other applicable laws.
d. establishing a code of procedure for administering discipline
for rule violations and conducting hearings when necessary
to determine if a violation may have occurred.
3. on behalf of its members, establish and enforce rules that will
allow the facility to obtain any necessary information from
other SEFs, other market participants and other markets to
perform any of the functions required by the core principles.
4. Review associated persons of each SEF to ensure that that are
not statutorily disqualified to be associated with a SEF.
Membership in the CRO would initially be open to any entity that
intended to register as a SEF. Membership in this CRO would be
voluntary, but members would be contractually bound to abide by the
rules. Upon implementation of the CFTC and SEC rules, membership would
become open to any entity that agreed to adopt the CRO's rules that was
either registered with the SEC or CFTC as a SEF, or intended to file
for registration with the SEC or CFTC to become a SEF.
The benefits to creating a CRO are several. First, it creates a
platform to ensure that certain key rules for SEFs are written fairly
and establish a uniform standard of conduct. This in turn would also
make it easier and more efficient for the SEC and CFTC to review
potential SEF applications in accordance with the above mentioned core
principles as any SEF that was a member of the CRO would agree to
implement the model provisions for their rule books, and would agree to
utilize the services offered by the CRO to aid with satisfying many of
their obligations under the core principles. Moreover, by acting as an
intermediary for compliance by its members, the CRO would simplify the
CFTC's and SEC's oversight responsibilities for SEFs.
Such a scheme would appear to be permissible under DFA, which
provides SEFs with ``reasonable discretion'' in establishing the manner
in which they comply with the core principles.\6\ Further, as a
voluntary organization, the CRO would not necessarily need legislative
or rule making authority to proceed. However the ambiguity caused by
the lack of an express Congressional mandate suggests that some degree
of authorization in the rulemaking process for a CRO would be desirable
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\6\ See 7 U.S.C. 7b-3(f)(1)(B).
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Otherwise the CRO could presumably be organized today with a
mandate from its originating members to provide services in accordance
with the core principles that could be implemented as soon as its
members agree, and not necessarily wait for the implementation of the
DFA (although any rules adopted may have to be revised to be consistent
with the CFTC and SEC rules). It would start by drafting rules,
identifying the resources, systems and agreements necessary to become
operational and conducting preliminary discussions with NFA, FINRA or
others to provide regulatory services where appropriate.
The result would be an entity that could help address the operating
issues created for SEFs by the DFA, and through the establishment of
uniform standards for its members, make their investigation,
surveillance and enforcement efforts more effective. It might also
allow the SEC and CFTC to perform their oversight duties with respect
to SEFs in a more efficient manner.
Sincerely,
______
January 18, 2011
Elizabeth Murphy,
Secretary,
Securities and Exchange Commission,
Washington, D.C.
Re: Regulation SBSR--Reporting and Dissemination of Security-Based Swap
Information (File Number S7-34-10)
Dear Ms. Murphy:
The Wholesale Market Brokers' Association, Americas (``WMBAA'' or
``Association'') \1\ appreciates the opportunity to provide comments to
the Securities and Exchange Commission (``SEC'' or ``Commission'') on
the proposed Regulation SBSR--Reporting and Dissemination of Security-
Based Swap Information (``Regulation SBSR'') under the Securities
Exchange Act of 1934 (``Exchange Act'').\2\
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\1\ The WMBAA is an independent industry body representing the
largest inter-dealer brokers (``IDBs'') operating in the North American
wholesale markets across a broad range of financial products. The WMBAA
and its member firms have developed a set of Principles for Enhancing
the Safety and Soundness of the Wholesale, Over-The-Counter Markets.
Using these Principles as a guide, the WMBAA seeks to work with
Congress, regulators, and key public policymakers on future regulation
and oversight of over-the-counter (``OTC'') markets and their
participants. By working with regulators to make OTC markets more
efficient, robust and transparent, the WMBAA sees a major opportunity
to assist in the monitoring and consequent reduction of systemic risk
in the country's capital markets.
\2\ See Regulation SBSR--Reporting and Dissemination of Security-
Based Swap Information, 75 Fed. Reg. 75208 (December 2, 2010).
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Summary of Response
As the Commission contemplates an appropriate regulatory regime for
reporting and dissemination of security-based swap (``SBS'')
information, the WMBAA believes it is incumbent upon the Commission to
follow the direction given in section 13(m)(1)(E) of the Exchange Act,
which requires that the Commission's rule providing for the public
availability of SBS transaction and pricing data contain provisions
that take into account whether public disclosure will materially reduce
market liquidity. The WMBAA, as an association representing the largest
inter-dealer brokers in OTC markets, believes that the impact of these
rules on market liquidity is highly dependent on how the policy
governing large block trading is finalized. If the policy governing
block trades does not properly define such a trade, the WMBAA remains
very concerned that possible rules related to the calculation of a
block trade threshold and trade reporting could negatively impact
market liquidity, disturbing businesses' ability to hedge commercial
risk, to appropriately plan for the future and, ultimately, stifle
economic growth and job creation.
The WMBAA is pleased to offer its comments related to: (i)
appropriate methods to calculate block trade thresholds; (ii)
appropriate entities to calculate and publish block trade thresholds;
(iii) post-trade dissemination of block trades; and (iv) the
publication of market data by market participants.
Discussion of Proposed Regulation SBSR
As interdealer brokers involved in the formulation and execution of
large derivatives transactions between swap and security-based swap
dealers, the distinction between block and non-block trades is vital to
ensure OTC derivatives markets can continue to provide liquidity to and
be a source for risk mitigation for end-users.
It is important that the Commission recognize that OTC derivatives
markets are different than financial markets that have significant
retail participation.\3\ While the relationship between exchange-traded
and OTC markets generally has been complimentary, as each market
typically provides unique services to different trading constituencies
for products with distinctive characteristics and liquidity needs, the
nature of trading liquidity in the exchange-traded and OTC markets is
fairly different. Liquidity is the degree to which a financial
instrument is easy to buy or sell quickly with minimal price
disturbance. The liquidity of a market for a particular financial
product or instrument depends on several factors, including: the number
of market participants and facilitators of liquidity, the degree of
standardization of instrument terms, and the volume of trading
activity.
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\3\ See, e.g., Comments from Yuhno Song, Merrill Lynch, (``I think
one of the distinctions we have is a market that may be more smaller in
retail based versus a market that is with far small number of
participant and that's institutional based.'') Public Roundtable to
Discuss Swap Data, Swap Data Repositories, and Real Time Reporting,
September 14, 2010 (``Roundtable Transcript'') at 332-333. Available
at: http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/
derivative18sub091410.pdf.
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Highly liquid markets exist for both commoditized, exchange-traded
products, and more standardized OTC instruments, such as the market for
U.S. treasury securities, equities and certain commodity derivatives.
Exchange-traded markets provide a trading venue for fairly simple and
commoditized instruments that are based on standard characteristics and
single key measures or parameters. Exchange-traded markets rely on
relatively active order submission by buyers and sellers and generally
high transaction flow. These markets allow a broad base of trading
customers meeting relatively modest margin requirements to transact
standardized contracts in a relatively liquid market. As a result of
the high number of market participants and the relatively small number
of standardized instruments traded, liquidity in exchange-traded
markets is relatively continuous in character.
In comparison, many swaps markets feature a broader array of less-
commoditized products and larger-sized orders that are traded by fewer
counterparties. Trading in these markets is characterized by variable
or non-continuous liquidity. Such liquidity can be said to be episodic,
with liquidity peaks and troughs that are seasonal (certain energy
products) or more volatile and tied to external market conditions
(certain credit products).
As a result of the episodic nature of liquidity in certain swaps
markets with fewer participants, we believe that the CFTC and SEC need
to carefully structure a clearing and reporting regime for block trades
that is not a ``one size fits all'' approach, but rather takes into
account the unique challenges of fostering liquidity in the broad range
of swaps markets, provides for the transacting of larger transactions
without unnecessary regulatory burdens, and does not materially reduce
market liquidity.
Formulation of Block Trade Threshold
While the WMBAA believes that each asset class and each swaps
instrument has a threshold amount that could be calculated and used to
distinguish between typical and block trades, its primary concern is
that the block trade exceptions be individually set for the unique
liquidity requirements of the broad range of swaps instruments so that
the process of completing a block trade is appropriately defined and
trading may continue without adversely impacting market participants'
ability to place, exit or hedge their trades.
With respect to block trade thresholds, while the appropriate
threshold amount will differ by asset class and instrument, the notion
of a block trade involves more than merely the size of a transaction.
The WMBAA member firms have witnessed an evolution in interdealer
markets with the development of a process referred to as ``work-up.''
In this model, once a price is agreed for trading, the resultant trade
is reported to market participants and they are offered the opportunity
to join the trade and increase liquidity. Work-up enables traders to
assess the markets in real-time and make real-time decisions on trading
activity, without the fear of moving the market one way or another. It
is vital that any block trade calculation recognize the role work-up
plays in forming liquidity. This is done to allow the market to find
the appropriate pricing levels to optimally complete the transaction
without prematurely causing the market impact of a large block.
The WMBAA believes it is appropriate to provide regulators with
necessary market information for oversight purposes, but the public
dissemination of incremental activity that would otherwise constitute a
block trade could jeopardize identification of counterparties and
materially reduce market liquidity, which does not comport with the
reporting goals enumerated in the Dodd-Frank Wall Street Reform and
Consumer Protection Act.\4\
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\4\ Pub. L. No. 111-203, H.R. 4173.
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Congress recognized the importance of tailored block trade
thresholds specific to an asset class and instrument.\5\ The WMBAA
advocates, as an example, a tiered solution for SBS classification and
reporting. The first tier would include all ``social'' size trades,
which must be reported immediately to market participants. The second
tier would include trades that are a certain multiple of the ``social''
size, dependent on the maturity, underlying credit, and frequency of
recent transactions in the specific instrument. Each of these
transactions would be reported to a security-based swap data repository
(``SDR'') within 15 minutes of trade execution. This, the WMBAA
believes, would be acceptable to the market participants in as much as
it would be less disruptive to their ability to place, hedge or exit
positions. Finally, the WMBAA would suggest a third tier for trades
greater than twice the amount of the block trade threshold, reported
with an indication that an extremely large block trade was executed.
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\5\ Statement of Senator Blanche Lincoln (``The committee expects
the regulators to distinguish between different types of swaps based on
the commodity involved, size of the market, term of the contract and
liquidity in that contract and related contracts, i.e.,, for instance
the size/dollar amount of what constitutes a block trade in 10 year
interest rate swap, 2 year dollar/euro swap, 5 year CDS, 3 year gold
swap, or a 1 year unleaded gasoline swap are all going to be
different.''). Senate Congressional Record S. 5921, July 15, 2010.
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Such a reporting regime would ensure market participants retain a
level of transparency acceptable to successful trading. It is important
to distinguish between public reporting to market participants and
regulatory reporting through the SDR, which would be privy to complete
trade information. By identifying an appropriate social size, the
Commission would encourage additional market participants to post
prices and provide liquidity on electronic platforms. This, in turn,
would support the Commission's objective of increasing the number of
market makers and bringing greater transparency into the swaps markets.
Block Trade Calculation and Publication
Proposed Regulation SBSR contemplates that a registered SDR would
be responsible for establishing and maintaining written policies and
procedures for calculating and publicizing block trade thresholds for
all security-based swap instruments reported to the registered SDR in
accordance with the criteria and formula for determining block size as
specified by the Commission.\6\ Under this framework, the Commission
would specify the criteria and formula for determining block size based
on the limited information provided to it consisting of SBS transaction
data reported to an SDR for completed SBSs. Such information only
provides a partial picture of the liquidity challenges of a particular
SBS marketplace. There is other information, such as the size and
quantity of bids and offers that do not result in completed
transactions, that is available to security-based swap execution
facilities (``SB SEFs'') as neutral intermediaries in the market.
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\6\ See 75 Fed. Reg. at 75287.
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The WMBAA believes that it is necessary to consider this more
complete scope of information in calculating block trade thresholds
that are truly appropriate for security-based swap markets. The WMBAA
therefore proposes the formation of a block trade standards setting
board (the ``Security-Based Swaps Standards Board'') made up of
recognized experts and representatives of registered SDRs and SB SEFs
to make recommendations to the Commission for appropriate block trade
thresholds for SBSs.
The Security-Based Swaps Standards Board would work with the
Commission to establish and maintain written policies and procedures
for calculating and publicizing block trade thresholds for all SBSs
reported to the registered SDR in accordance with the criteria and
formula for determining block size as specified by the Commission. The
Security-Based Swaps Standards Board would also undertake market
studies and research at its expense as is necessary to establish such
standards. This arrangement would permit SB SEFs, as the entities most
closely related to block trade execution, to provide essential input
into the Commission's block trade determinations and work with
registered SDRs to distribute the resulting threshold levels to SB
SEFs. Further, the proposed regulatory structure would reduce the
burden on SDRs, remove the possibility of miscommunication between SDRs
and SB SEFs, and ensure that SB SEFs do not rely upon dated or
incorrect block trade thresholds in their trade execution activities.
Further, if there is more than one registered SDR for an asset
class, it may prove difficult for the Commission to ensure that all
registered SDRs calculate the same block trade thresholds for the same
SBS instruments. In comparison, one common regulatory organization
responsible for facilitating SB SEF compliance with core principles
will be uniquely situated to prevent the problem posed by multiple
SDRs, which becomes further exacerbated if there are multiple
registered SDRs in the same asset class each with individual market
data feeds that need to be aggregated to calculate block trade
thresholds.
The determination whether an SBS transaction is a block trade
should reflect a risk-weighted basis, calculated on an instrument-by-
instrument basis. This threshold should be updated at an appropriate
time interval, taking into account the unique liquidity characteristics
and challenges of the market in which the instrument trades. Any
formulaic approach to computing the thresholds from trade size or other
population parameters should reflect the number of participants in the
market, the frequency of trading activity (daily, weekly and monthly)
and the average trade sizes and terms of the transactions.
The established block trade threshold could be subject to gaming,
particularly if the market perceives the threshold to be arbitrarily
determined. However, if the block threshold accurately captures the
risk and liquidity parameters related to trading activity, then gaming
would be ineffective, and less likely to occur.
With respect to inter-affiliate transactions or trades resulting
from portfolio compression, the WMBAA believes that if the block
thresholds are appropriately calculated, market participation will
increase, resulting in additional transparency and markets that better
serve the public interest. If the block trade levels allow market
makers time to appropriately hedge the risk that they've committed
capital to, then they will be better able to continue to provide
liquidity.
Reporting of Block Trades
The Commission remarks in the preamble to proposed Regulation SBSR
that because the registered SDR, and not the reporting party, would
have the responsibility to determine whether a transaction qualifies as
a block trade, the reporting party would be required to report an SBS
to a registered SDR or the Commission pursuant to the time frames set
forth in Rules 901(c) and (d), regardless of whether the reporting
party believes the transaction qualifies for block trade treatment.
Proposed Regulation SBSR does not include a delay in reporting block
trades to a registered SDR.\7\
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\7\ See id. at 75233.
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As noted in a previous letter, the WMBAA is supportive of trade
reporting for all trades as soon as technologically practicable. The
Association believes that all trade reporting, regardless of size,
should be reported to the SDR. The WMBAA members each possess the
technological capabilities to provide regulators with real-time
electronic trade information for transactions executed in multiple
financial markets.\8\
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\8\ See, e.g., Comments from Shawn Bernardo, Tullett Prebon
Americas Corp., representing Wholesale Markets Brokers Association,
(``All of the brokers have the capability to report trades to the
regulators in a timely fashion . . . as far as TRACE is concerned, we
have a track record of reporting those trades efficiently, and we have
the systems in place to do that, along with the various means . . . we
can do that voice, we can do it electronically, we can do it as hybrid
as far as the execution, but we send those trades electronically to
them in a timely fashion.'') Roundtable Transcript at 227-228.
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While the WMBAA believes that posting the full details of SB SEF-
executed transactions to market participants should be at the core of
the SB SEF obligations, the reporting obligations of the SB SEF should
reflect the information that the SB SEF possessed at the time of the
transaction. The SB SEF should not have the primary reporting
obligations. The SB SEF would likely not be privy to all of the terms
required to be reported in accordance with proposed Regulation SBSR,
such as, but not limited to: (i) contingencies of the payment streams
of each counterparty to the other; (ii) the title of any master
agreement or other agreement governing the transaction; (iii) data
elements necessary to calculate the market value of the transaction;
and (iv) other details not typically provided to the SB SEF by the
customer, such as the actual desk on whose behalf the transaction is
entered. Moreover, and quite critical, an SB SEF would not be in a
position or necessarily have the capabilities to report life cycle
event information. Indeed, even if an SB SEF were required to report
the transaction details as the proposed regulation requires, something
we do not think advisable, it would likely take at least 30 minutes to
gather and confirm the accuracy of that information.
Additionally, the post trade reporting requirements may have an
adverse effect on liquidity, particularly with respect to larger
transactions since the reporting of larger transactions will likely
have the effect of causing participants to refrain from entering the
market which those participants might not otherwise have done,
adversely impacting the ability of the parties to the large transaction
to mitigate the risks of that transaction by entering into separate,
offsetting transactions. This could effect a party's ability to hedge
its risks and mitigate the exposure of that legitimate hedge will be
diminished, resulting in fewer transactions of that nature and
potentially widening spreads, which in turn will increase end-user
costs.
Nevertheless, the WMBAA believes that trading counterparties with
reporting obligations should be able to contract with a SB SEF to
handle the reporting process without transferring their reporting
obligations. This will put smaller counterparties with limited trading
reporting technology in a less disadvantaged trading position to larger
trading counterparties.
Dissemination of Block Trade Information
Under proposed Regulation SBSR, a registered SDR must publicly
disseminate a transaction report of an SBS that constitutes a block
trade immediately upon receipt of information about the block trade
from the reporting party. Under proposed Regulation SBSR, the market
participants will learn the price, but not the size, of an SBS block
trade in real-time. The transaction report must contain all of the
information required under the real-time reporting rules, including the
transaction ID and an indicator that the report represents a block
trade. The SDR is required to publicly disseminate a complete
transaction report for a block trade (including the transaction ID and
the full notional size) as follows:
If the SBS was executed on or after 05:00 Coordinated
Universal Time (``UTC'') and before 23:00 UTC of the same day
(which corresponds to 12:00 midnight and 6:00 p.m. EST), the
transaction report (including the transaction ID and the full
notional size) will be disseminated at 07:00 UTC of the
following day (which corresponds to 2:00 a.m. EST of the
following day).
If the SBS was executed on or after 23:00 UTC and up to
05:00 UTC of the following day (which corresponds to 6:00 p.m.
until midnight EST), the transaction report (including the
transaction ID and the full notional size) will be disseminated
at 13:00 UTC of that following day (which corresponds to 8:00
a.m. EST of the following day).
All block trades will have at least an 8 hour delay before the full
notional size will be disseminated. The established cut-off time will
be 23:00 UTC, which corresponds to 6:00 p.m. EST. Block trades executed
on or after 05:00 UTC (which corresponds to midnight EST) and up to
23:00 UTC (6:00 p.m. EST) will have to have their full notional size
disseminated by 07:00 UTC, which corresponds to 2:00 a.m. EST. Under
the proposed approach, block trades executed during a period that runs
roughly from the close of the U.S. business day to midnight EST will
have their full sizes disseminated by a registered SDR at a time that
corresponds to the opening of business on the next U.S. day. If a
registered SDR is in normal closing hours or special closing hours at a
time when it will be required to disseminate information about a block
trade pursuant to this section, the registered SDR must disseminate
that information immediately upon re-opening.
The WMBAA would suggest that disseminating the specific notional
amount of a block could jeopardize the anonymity of the counterparties
to such trades, making counterparties less willing to engage in
transactions of size. Further, the effect of having no delay, or only a
short dissemination delay, for a block trade report that includes the
full notional size will discourage market makers from committing
capital and providing liquidity to the broader market. From a market
perspective, there is little gain from disseminating full notional size
information. Consistent with the experiences from the implementation of
the Financial Industry Regulatory Authority's Transaction Reporting and
Compliance Engine (``TRACE''), which provides regulators with full
trade information and publicly disseminates trades within a size range,
the WMBAA believes the Commission should implement a public reporting
methodology. This benefits market participants without exposing a
trade's notional size, which protects counterparty anonymity, and
preserves liquidity and price competition in the market.\9\
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\9\ See 75 Fed. Reg. at 75232, fn. 108. (``If the par value of the
trade exceeds $5 million (in the case of investment grade bonds) or $1
million (in the case of non-investment-grade bonds) the quantity
disseminated by TRACE will be either ``5 million+'' or ``1 million+''.
At no time will TRACE subsequently disseminate the full size of the
trade. See TRACE User Guide, version 2.4 (last update March 31, 2010),
at 50.'')
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Additionally, market participants will be wary of committing to
larger sized transactions knowing the rapidity in which other
participants will gain knowledge of these trades, leading to less
liquidity for the dealer market, and ultimately for end-user
participants. The WMBAA also believes that the public dissemination of
block trades, as proposed, will allow some market participants to infer
the identity of the parties to the transaction and materially reduce
market liquidity.
If a liquidity provider perceives greater danger in supplying
liquidity, it will step away from providing tight spreads and leave
those reliant on market maker liquidity with poorer hedging
opportunities. From a market structure standpoint, liquidity ``takers''
benefit from liquidity providers acting in a competitive environment.
The liquidity providers compete with each other, often deriving very
small profits per trade from a large volume of transactions. By relying
on their ability to warehouse trades and post capital to make markets
and using their distribution and professional know-how to offer
competitive prices to their customer base, market makers provide
liquidity essential to fulfill the need of hedgers. For these reasons,
having either no delay or a short dissemination delay will actually
erode price discovery and the level of price efficiency in the market.
Publication of Market Data
Proposed Regulation SBSR contemplates that no person other than a
registered SDR can make available to one or more persons (other than a
counterparty) transaction information relating to an SBS before the
earlier of 15 minutes after the time of execution of the security-based
swap, or the time that a registered SDR publicly disseminates a report
of that security-based swap.\10\ The preamble indicates that other
private sources of market data reflecting subsets of the security-based
swaps market could arise. The Commission remarks in the preamble to
proposed Regulation SBSR that SB SEFs would have information about SBSs
executed on its systems and could find that commercial opportunities
exist to sell such information.\11\ In a related release, the
Commission's proposed regulation concerning Security-Based Swap Data
Repository Registration, Duties, and Core Principles does not
specifically address commercial use of SBS data.\12\ However, under
proposed 17 CFR 240.13n-4(c)(3)(iii) the third core principle--rules
and procedures for minimizing and resolving conflicts of interest--
requires an SDR to establish, maintain and enforce policies and
procedures regarding the SDR's non-commercial and/or commercial use of
SBS data.\13\ In connection with the preamble discussion of this
requirement, the SEC makes several requests for comment on an SDR's
commercial use of data.\14\
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\10\ See 75 Fed. Reg. at 75286.
\11\ See id. at 75242, fn. 153.
\12\ See Security-Based Swap Data Repository Registration, Duties,
and Core Principles, 75 Fed. Reg. 77306 (December 10, 2010).
\13\ See id. at 77369.
\14\ See id. at 77325-26.
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The WMBAA member firms will report the required SBS transaction
information to a registered SDR in the mandated time frame as set forth
in Commission regulations. However, the provisions of such information
to SDRs should be for the specific and limited purpose of the SDR
fulfilling specific regulatory requirements (reporting data to
regulators for regulatory oversight and enforcement, public reporting
of trade information as specifically prescribed by the Commission).
Reporting such data to an SDR by a reporting entity (e.g., an SB SEF or
any other party reporting the transaction information) should not
relinquish ownership of such data by the SB SEF or other reporting
entity and would also not inhibit its right to use the data for other
purposes. Consistent with reporting practices in other markets, the
reporting of SBS transaction information to a registered SDR should not
bestow the SDR with the authority to use the SBS transaction data for
any purpose other than those explicitly enumerated in the Commission's
regulations.
The WMBAA is concerned that proposed rules inhibit an SB SEF's
ability to continue to have ownership and control over its data and the
ability to sell that data to the marketplace. The WMBAA would suggest
that Section 242.902(d) of proposed Regulation SBSR be revised in such
a way that an SDR would accept and maintain SBS transaction data for
use by regulators, but the SBS counterparties and SB SEFs continue to
have the ability to market and commercialize their own proprietary
data. This could be achieved, in part, by requiring SDRs to include
such a provision in its required policies and procedures regarding the
SDR's non-commercial and/or commercial use of SBS data required to be
established, maintained and enforced by the Commission's proposed SDR
rules. Ultimately, the WMBAA urges the Commission to take caution in
implementing a regulation that could be inconsistent with existing
models in equity and futures markets and might prevent entities with
the necessary technological capabilities from capturing, publishing,
and monetizing data for purposes outside of regulatory oversight.
Conclusion
The WMBAA thanks the Commission for the opportunity to comment on
the proposed Regulation SBSR. Please feel free to contact the
undersigned with any questions you may have on our comments.
Sincerely,
______
February 7, 2011
David A. Stawick,
Secretary,
Commodity Futures Trading Commission,
Washington, D.C.
Re: Real-Time Public Reporting of Swap Transaction Data (RIN 3038-AD08)
Dear Mr. Stawick:
The Wholesale Market Brokers' Association, Americas (``WMBAA'' or
``Association'') \1\ appreciates the opportunity to provide comments to
the Commodity Futures Trading Commission (``CFTC'' or ``Commission'')
on the proposed rules related to the real-time public reporting of swap
transaction data (``Proposed Rules'') \2\ under the Commodity Exchange
Act (``CEA'').
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\1\ The WMBAA is an independent industry body representing the
largest inter-dealer brokers (``IDBs'') operating in the North American
wholesale markets across a broad range of financial products. The WMBAA
and its member firms have developed a set of Principles for Enhancing
the Safety and Soundness of the Wholesale, Over-The-Counter Markets.
Using these Principles as a guide, the WMBAA seeks to work with
Congress, regulators, and key public policymakers on future regulation
and oversight of over-the-counter (``OTC'') markets and their
participants. By working with regulators to make OTC markets more
efficient, robust and transparent, the WMBAA sees a major opportunity
to assist in the monitoring and consequent reduction of systemic risk
in the country's capital markets.
\2\ See Real-Time Public Reporting of Swap Transaction Data, 75
Fed. Reg. 76140 (December 7, 2010).
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Summary of Response
As the Commission contemplates an appropriate regulatory regime for
reporting and dissemination of swap information, the WMBAA believes it
is incumbent upon the Commission to follow the direction given in
Section 2(a)(13)(E) of the CEA, which requires that the Commission's
rule providing for the public availability of swap transaction and
pricing data contain provisions that take into account whether public
disclosure will materially reduce market liquidity. The WMBAA, as an
association representing the largest inter-dealer brokers in OTC
markets, believes that the impact of these rules on market liquidity is
highly dependent on how the policy governing large block trading is
finalized. If the policy governing block trades does not properly
define such a trade, the WMBAA remains very concerned that possible
rules related to the calculation of a block trade threshold and trade
reporting could negatively impact market liquidity, disturbing
businesses' ability to hedge commercial risk, to appropriately plan for
the future and, ultimately, unnecessarily inhibit economic growth and
competitiveness.
The WMBAA is pleased to offer its comments related to: (i) the
importance of a harmonized regulatory regime for execution facilities;
(ii) methods to calculate block trade thresholds; (iii) appropriate
entities to calculate and publish block trade thresholds; and (iv) time
delays for post-trade dissemination of block trade information.
Importance of Harmonized Regulatory Regime
Several differences exist between the SEC's Proposed Regulation
SBSR--Reporting and Dissemination of Security-Based Swap
Information,\3\ and the CFTC's Proposed Rule. While the WMBAA does not
strongly support one Commission's proposed approach in its entirety
over the other, as entities likely to register as swap execution
facilities (``SEFs'') with the CFTC and security-based SEFs with the
SEC, respectively, it is important that the framework for block trade
calculation, reporting, and dissemination are consistent between the
two agencies and do not unreasonably burden market participants with
duplicative compliance requirements. The WMBAA does, however, believe
that the framework ultimately adopted should provide sufficient
discretion for market participants. In this regard, the WMBAA believes
the CFTC's Proposed Rules are more prescriptive when compared with the
SEC's proposed rules.
---------------------------------------------------------------------------
\3\ See Regulation SBSR--Reporting and Dissemination of Security-
Based Swap Information, 75 Fed. Reg. 75208 (December 2, 2010).
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The WMBAA encourages the use of block trade calculation provisions
that provide deference to the SEF in determining what constitutes a
block trade, which is most explicitly suggested in the SEC's proposed
rules for security-based SEFs.\4\ The SEC's proposed rules define the
term block trade in a way that gives each security-based SEF the
authority to set the criteria and formula for determining what
constitutes a block trade, as long as such criteria and formula comply
with the core principles relating to security-based SEFs (until the SEC
sets the requisite criteria).\5\ This approach allows the necessary
time and flexibility for the markets to establish the appropriate
criteria and formula based on actual trading on security-based SEFs in
each security-based swap category and should be considered by the
Commission for its corresponding rules.
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\4\ See Registration and Regulation of Security-Based Swap
Execution Facilities, Release No. 34-63825, File No. S7-06-11.
Available at http://www.sec.gov/rules/proposed/2011/34-63825.pdf.
\5\ See id. at 390. (``The term block trade has the same meaning as
242.900 (published at 75 FR 75208, Dec. 2, 2010), provided however
that until the Commission sets the criteria and formula for determining
what constitutes a block trade under 242.907(b), a security-based
swap execution facility may set its own criteria and formula for
determining what constitutes a block trade as long as such criteria and
formula comply with the Core Principles relating to security-based swap
execution facilities in section 3D of the Act (15 U.S.C. 78c-4) and the
rules and regulations thereunder.'').
---------------------------------------------------------------------------
Discussion of Proposed Rules
As interdealer brokers involved in the formulation and execution of
large derivatives transactions between swap dealers and major swap
participants, the distinction between block and non-block trades is
vital to ensure OTC derivatives markets can continue to provide
liquidity to and be a source for risk mitigation for end-users.
It is important that the Commission recognize that OTC derivatives
markets are different than financial markets that have significant
retail participation.\6\ While the relationship between exchange-traded
and OTC markets generally has been complimentary, as each market
typically provides unique services to different trading constituencies
for products with distinctive characteristics and liquidity needs, the
nature of trading liquidity in the exchange-traded and OTC markets is
often materially different. Liquidity is the degree to which a
financial instrument is easy to buy or sell quickly with minimal price
disturbance. The liquidity of a market for a particular financial
product or instrument depends on several factors, including the
parameters of the particular instrument, including tenor and duration,
the number of market participants and facilitators of liquidity, the
degree of standardization of instrument terms, and the volume of
trading activity.
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\4\ See, e.g., Comments from Yuhno Song, Merrill Lynch, (``I think
one of the distinctions we have is a market that may be more smaller in
retail based versus a market that is with far small number of
participant and that's institutional based.'') Public Roundtable to
Discuss Swap Data, Swap Data Repositories, and Real Time Reporting,
September 14, 2010 (``Roundtable Transcript'') at 332-333. Available
at: http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/
derivative18sub091410.pdf.
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Highly liquid markets exist for both commoditized, exchange-traded
products, and the more standardized OTC instruments, such as the market
for U.S. Treasury securities, equities, and certain commodity
derivatives. Exchange-traded markets provide a trading venue for fairly
simple and commoditized instruments that are based on standard
characteristics and single key measures or parameters. Exchange-traded
markets rely on relatively active order submission by buyers and
sellers and generally high transaction flow. These markets allow a
broad base of trading customers meeting relatively modest margin
requirements to transact standardized contracts in a relatively liquid
market. As a result of the high number of market participants and the
relatively small number of standardized instruments traded, liquidity
in exchange-traded markets is relatively continuous in character.
In comparison, many swaps markets feature a broader array of less-
commoditized products and larger-sized orders that are traded by fewer
counterparties, almost all of which are institutional and not retail.
Trading in these markets is characterized by variable or non-continuous
liquidity. Such liquidity can be episodic, with liquidity peaks and
troughs that can be seasonal (e.g., certain energy products) or more
volatile and tied to external market and economic conditions (e.g.,
many credit, energy, and interest rate products).
As a result of the episodic nature of liquidity in certain swaps
markets combined with the presence of fewer participants, the WMBAA
believes that the CFTC and SEC need to carefully structure a clearing
and reporting regime for block trades that is not a ``one size fits
all'' approach, but rather takes into account the unique challenges of
fostering liquidity in the broad range of swaps markets. Such a regime
would provide an approach that permits the execution of larger
transactions without unnecessary regulatory burdens, and does not
materially reduce market liquidity.
Formulation of Block Trade Threshold
Section 43.5(g) of the Proposed Rules describes the procedure and
calculations that a registered swap data repository (``SDR'') must
follow in determining the appropriate minimum block size. Specifically,
the Proposed Rules would require a registered SDR to set the
appropriate minimum block size at the greater resulting number of each
of the ``distribution test'' and ``multiple test.'' \7\
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\7\ See 75 Fed. Reg. at 76161.
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Distribution Test
The distribution test would apply the ``minimum threshold'' to the
``distribution of the notional or principal transaction amounts'' and
would require a registered SDR to create a distribution curve to see
where the most and least liquidity exists, based on the notional or
principal transaction amounts for all swaps within a category of swap
instrument. Under this proposed approach, a registered SDR must first
determine the distribution of the rounded notional or principal
transaction amounts of swaps and then apply the minimum threshold to
such distribution. The Proposed Rules describe the ``minimum
threshold'' as a notional or principal amount that is greater than 95%
of transaction sizes in a swap instrument or category during the period
of time represented by the distribution of the notional or principal
transaction amounts.
Multiple Test
The multiple test would require a registered SDR to multiply the
``block multiple'' by the ``social size'' to determine the appropriate
block threshold for each swap instrument. The Commission recognizes
that the social size for a swap varies by asset class, tenor, and
delivery points. Once the appropriate social size is determined, the
registered SDR must then apply the block multiplier, currently proposed
to be five. The resulting product would be the number that the
registered SDR compares to the resulting number from the distribution
test, the greater of which would be the appropriate minimum block size
for such swap instrument.\8\
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\8\ See id. at 76162.
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While the WMBAA believes that each asset class and each swaps
instrument has a threshold amount that could be calculated and used to
distinguish between typical and block trades, its primary concern is
that the block trade exceptions be individually set for the unique
liquidity requirements of the broad range of swaps instruments.
Appropriate threshold levels will ensure that the process of completing
a block trade is appropriately defined and trading may continue without
adversely impacting market participants' ability to place, exit, or
hedge their trades. As other industry participants have noted, academic
studies on the impact of transparency rules in major markets have found
evidence of an adverse impact of transparency in a range of markets.\9\
The WMBAA urges the Commission to implement a flexible, appropriate
regime that will provide increased transparency without impairing the
liquidity currently found in OTC derivatives markets.
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\9\ See International Swaps & Derivatives Association and the
Securities Industry and Financial Markets Association, ``Block Trade
Reporting for Over-the-Counter Derivatives Markets,'' January 18, 2011
(Citing Canadian stock markets, London Stock Exchange, and future
exchanges). Available at: http://www.isda.org/speeches/pdf/Block-Trade-
Reporting.pdf.
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With respect to block trade thresholds, while the appropriate
threshold amount will differ by asset class and instrument, the notion
of a block trade involves more than merely the size of a transaction.
WMBAA member firms have witnessed an evolution in interdealer markets
with the development of a process referred to as ``work-up.'' In this
model, once a price is agreed for trading, the resultant trade is
reported to market participants and they are offered the opportunity
for a brief, pre-set period of time to ``join the trade'' by placing a
firm bid or offer that is characterized by only two variables (the
quantify and whether the order is a ``buy'' or ``sell'' order). This
results in an increase in liquidity at the most recently established
market price. Work-up enables traders to assess the markets in real-
time and make real-time decisions on trading activity, without the fear
of moving the market one way or another. It is vital that any block
trade calculation recognize the role work-up plays in forming
liquidity. This is done to allow the market to find the appropriate
pricing levels to optimally complete the transaction without
prematurely causing the market impact of a large block trade. During
the ``work up'' or ``join the trade'' period, all market participants
have knowledge that a trade is taking place and are welcome to
participate in this transparent process. However, as the initiating
trade and other trades that take place are not fully complete until the
end of the work-up period, and may result in both block and non-block
trades, the reporting of the amounts executed during this process
should not be done until the short work-up period expires.
The WMBAA believes it is appropriate to provide regulators with
necessary market information for oversight purposes, but the public
dissemination of incremental activity that would otherwise constitute a
block trade could jeopardize identification of counterparties and
materially reduce market liquidity, which does not comport with the
reporting goals \10\ enumerated in the Dodd-Frank Wall Street Reform
and Consumer Protection Act (``Dodd-Frank Act'').\11\
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\10\ CEA Section 2(a)(13)(E) (``With respect to the rule providing
for the public availability of transaction and pricing data for swaps .
. . , the rule promulgated by the Commission shall contain provisions .
. . (iv) that take into account whether the public disclosure will
materially reduce market liquidity.'').
\11\ Pub. L. No. 111-203, H.R. 4173.
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Congress recognized the importance of tailored block trade
thresholds specific to an asset class and instrument.\12\ The WMBAA
advocates, as an example, a tiered solution for swap classification and
reporting. The first tier would include all ``social'' size trades,
which must be reported immediately to market participants. The second
tier would include trades that are a certain multiple of the ``social''
size, dependent on the maturity, underlying credit, and frequency of
recent transactions in the specific instrument. Each of these
transactions would be reported to a registered SDR within an
appropriate time after trade execution. This, the WMBAA believes, would
be acceptable to market participants because it would be less
disruptive to their ability to place, hedge or exit positions. Finally,
the WMBAA would suggest a third tier for trades greater than twice the
amount of the block trade threshold, reported with an indication that
an extremely large block trade was executed.
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\12\ Statement of Senator Blanche Lincoln (``The committee expects
the regulators to distinguish between different types of swaps based on
the commodity involved, size of the market, term of the contract and
liquidity in that contract and related contracts, i.e., for instance
the size/dollar amount of what constitutes a block trade in 10 year
interest rate swap, 2 year dollar/euro swap, 5 year CDS, 3 year gold
swap, or a 1 year unleaded gasoline swap are all going to be
different.''). Senate Congressional Record S. 5921, July 15, 2010.
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Such a reporting regime would ensure market participants retain a
level of transparency acceptable to successful trading. It is important
to distinguish between public reporting to market participants and
regulatory reporting through the SDR, which would be privy to complete
trade information. By identifying an appropriate social size, the
Commission would encourage additional market participants to post
prices and provide liquidity on electronic platforms. This, in turn,
would support the Commission's objective of increasing the number of
market makers and bringing greater transparency into the swaps markets.
Block Trade Calculation and Publication
Section 43.5(g) of the Proposed Rules would require registered SDRs
to calculate the appropriate minimum block size for swaps for which
such registered SDR receives data in accordance with Section
2(a)(13)(G) of the CEA. The appropriate minimum block sizes for each
swap instrument must be the greater of the resulting number derived
from the ``distribution test'' and the ``multiple test.'' If there is
only one registered SDR for a particular asset class, that registered
SDR will have to calculate the appropriate minimum block size. In the
event that there are multiple registered SDRs for an asset class, and
therefore multiple registered SDRs will accept swaps for a particular
category of swap instrument, the Commission will prescribe how the
appropriate minimum block size should be calculated in a way that
accounts for all of the relevant data.\13\
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\13\ See 75 Fed. Reg. at 76160.
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Proposed Section 43.5(h) provides that after an ``appropriate
minimum block size'' is established by either a registered SDR or by a
Commission-prescribed method, a swap market must set the ``minimum
block trade size'' for those swaps that it lists and wishes to allow
block trading, by referring to the appropriate minimum block size
(equal to or greater than the SDR threshold) that is posted on a
registered SDR's Internet website (along with the precise methodology
and complete data set used by the SDR for calculating each swap) for
the swap instrument category for such swap.
Swaps Standards Advisory Committee
The WMBAA believes that it is necessary to consider this more
complete scope of information in calculating block trade thresholds
that are truly appropriate for swap markets. The WMBAA therefore
proposes the formation of a block trade standards setting advisory
committee (the ``Swaps Standards Advisory Committee'') made up of
recognized experts and representatives of registered SDRs and SEFs to
make recommendations to the Commission for appropriate block trade
thresholds for swaps.
The WMBAA recommends that the Commission consider the role of
existing advisory committees, such as the Agricultural Advisory
Committee, Global Markets Advisory Committee, Energy and Environmental
Markets Advisory Committee, and the Technology Advisory Committee, as a
model for receiving market participant input and recommendations
related to regulatory and market issues concerning block trades on
swaps. Recent Commission rulemakings in agricultural commodities \14\
and co-location \15\ have benefitted greatly from industry input on
these advisory committees. While the Commission is authorized under the
Dodd-Frank Act to establish block trade standards on its own, and
possesses the requisite knowledge and experience in futures markets,
the WMBAA believes that a Swaps Standards Advisory Committee, similar
to the above-referenced advisory committees, could provide the
Commission with meaningful statistics and metrics from a broad range of
contract markets, SDRs and SEFs to be considered in any ongoing
rulemakings in this area.
---------------------------------------------------------------------------
\14\ See Agriculture Commodity Definition, 75 Fed. Reg. 65586
(October 26, 2010).
\15\ See Co-Location/Proximity Hosting Services, 75 Fed. Reg. 33198
(June 11, 2010).
---------------------------------------------------------------------------
The Swaps Standards Advisory Committee would work with the
Commission to establish and maintain written policies and procedures
for calculating and publicizing block trade thresholds for all swaps
reported to the registered SDR in accordance with the criteria and
formula for determining block size as specified by the Commission. The
Swaps Standards Advisory Committee would also undertake market studies
and research at its expense as is necessary to establish such
standards. This arrangement would permit SEFs, as the entities most
closely related to block trade execution, to provide essential input
into the Commission's block trade determinations and work with
registered SDRs to distribute the resulting threshold levels to SEFs.
Further, the proposed regulatory structure would reduce the burden on
SDRs, remove the possibility of miscommunication between SDRs and SEFs,
and ensure that SEFs do not rely upon dated or incorrect block trade
thresholds in their trade execution activities.
The WMBAA supports the notion that the Commission should require
registered SDRs to self-certify determinations of the appropriate
minimum block size for swap instruments. SDRs should be subject to
certification by the Commission (or the Swaps Standards Advisory
Committee) and be required to display on their website the precise
calculation of every block size (including the complete data set used
for the calculation).
The WMBAA also believes it is important for the Commission to
recognize the potential for abuse of the block trade calculation by an
SDR that operates an affiliated SEF or designated contract market. The
WMBAA believes that the Commission must authorize a Swaps Standards
Advisory Committee to insure that the block facility serves the public
interest and is not abused to serve one or more narrow commercial
interests.
Further, as the Commission recognizes, if there is more than one
registered SDR for an asset class, it may prove difficult for the
Commission to ensure that all registered SDRs calculate the same block
trade thresholds for the same swap instruments. In comparison, one
common regulatory organization responsible for facilitating SEF
compliance with core principles will be uniquely situated to prevent
the problem posed by multiple SDRs, which becomes further exacerbated
if there are multiple registered SDRs in the same asset class, each
with individual market data feeds that need to be aggregated to
calculate block trade thresholds.
The determination of whether a swap transaction is a block trade
should reflect a risk-weighted analysis, calculated on an instrument-
by-instrument basis. This threshold should be updated at an appropriate
time interval, taking into account the unique liquidity characteristics
and challenges of the market in which the instrument trades. Any
formulaic approach to computing the thresholds from trade size or other
population parameters should reflect the number of participants in the
market, the frequency of trading activity (daily, weekly, and monthly),
and the average trade sizes and terms of the transactions.
The established block trade threshold could be subject to gaming,
particularly if the market perceives the threshold to be arbitrarily
determined. However, if the block threshold accurately captures the
risk and liquidity parameters related to trading activity, then gaming
would be ineffective and less likely to occur.
With respect to inter-affiliate transactions or trades resulting
from portfolio compression, the WMBAA believes that if the block
thresholds are appropriately calculated, market participation will
increase, resulting in additional transparency and markets that better
serve the public interest. The allocation or compression of trades that
have already occurred are not open market transactions, and it would be
misleading if they were reported as open market transactions, giving
the illusion of more liquidity than exists. These transactions should
be reported as compression trades or allocations, so as not to be taken
into account in any type of market liquidity or block trading
equations.
Reporting of Block Trades
The Proposed Rules provide that a reporting party for any block
trade must report the block trade transaction and pricing data pursuant
to the rules of the swap market that makes that swap available for
trading. Such reporting must occur as soon as technologically
practicable after execution of the block trade and pursuant to the
rules of the swap market. The Proposed Rules define the term ``as soon
as technologically practicable'' to mean as soon as possible, taking
into consideration the prevalence of technology, implementation, and
use of technology by comparable market participants. The Commission
recognizes that what is ``technologically practicable'' for one party
to a swap may not be the same as what is ``technologically
practicable'' for another party to a swap. The swap market that accepts
the block trade must immediately send the block trade transaction and
pricing data to a real-time disseminator, which must not publicly
disseminate the swap transaction and pricing data before the expiration
of the time delay described in Proposed Section 43.5(k).
As noted in previous letters, the WMBAA is supportive of trade
reporting for all trades as soon as technologically practicable. The
Association believes that all trade reporting, regardless of size,
should be reported to the SDR. The WMBAA members each possess the
technological capabilities to provide regulators with real-time
electronic trade information for transactions executed in multiple
financial markets.\16\
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\16\ See, e.g., Comments from Shawn Bernardo, Tullett Prebon
Americas Corp., representing Wholesale Markets Brokers Association,
(``All of the brokers have the capability to report trades to the
regulators in a timely fashion . . . as far as TRACE is concerned, we
have a track record of reporting those trades efficiently, and we have
the systems in place to do that, along with the various means . . . we
can do that voice, we can do it electronically, we can do it as hybrid
as far as the execution, but we send those trades electronically to
them in a timely fashion.'') Roundtable Transcript at 227-228.
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While the WMBAA believes that posting the full details of SEF-
executed transactions to market participants should be at the core of
the SEF obligations, the reporting obligations of the SEF should
reflect the information that the SEF possessed at the time of the
transaction. The SEF should not have the primary reporting obligations.
The SEF may not necessarily be privy to all of the terms required to be
reported in accordance with the Proposed Rules, such as, but not
limited to: (i) contingencies of the payment streams of each
counterparty to the other; (ii) the title of any master agreement or
other agreement governing the transaction; (iii) data elements
necessary to calculate the market value of the transaction; and (iv)
other details not typically provided to the SEF by the customer, such
as the actual desk on whose behalf the transaction is entered.
Moreover, and quite critical, a SEF would not be in a position or
necessarily have the capabilities to report lifecycle event
information. Indeed, even if a SEF were required to report the
transaction details as the Proposed Rules require, something the
Association does not think is advisable, it would likely take at least
30 minutes to gather and confirm the accuracy of that information.
Additionally, requiring the post trade reporting requirements to be
``as soon as technologically practicable'' may have a negative effect
on liquidity, particularly with respect to larger transactions.
The reporting of larger transactions will likely cause participants
to refrain from entering the market in situations where they might
otherwise have entered, which will adversely impact the ability of the
parties to the large transaction to mitigate the risks of that
transaction by entering into separate, offsetting transactions. This
could affect a party's ability to hedge its risks, and the exposure of
that legitimate hedge will be diminished, resulting in fewer
transactions and potentially widening spreads, which in turn will
increase end-user costs.
Nevertheless, the WMBAA believes that trading counterparties with
reporting obligations should be able to contract with a SEF to handle
the reporting process without transferring their reporting obligations.
This will put smaller counterparties with limited trade reporting
technology in a less disadvantaged trading position to larger trading
counterparties.
Real-Time Public Reporting of Block Trade Information
Time Delay
Section 43.5(k) of the Proposed Rules provides that the time delay
for block trades must be no later than 15 minutes after the time of
execution (the time that that a swap market receives the swap
transaction and pricing data from a reporting party). After the 15
minute time delay has expired, the registered SDR or the swap market
(through a third-party service provider) must immediately disseminate
the swap transaction and pricing data to the public. By comparison, the
SEC's proposed Regulation SBSR requires the immediate dissemination of
most of the block trade data, with delayed dissemination for the
trade's notional size and the transaction ID at a designated delayed
time.
Based on the experiences related to the implementation of the
Financial Industry Regulatory Authority's Transaction Reporting and
Compliance Engine (``TRACE''), the WMBAA advocates a gradual
implementation of the 15 minute delayed reporting requirement. When the
TRACE reporting system was first introduced in 2002, there was a 75
minute delay for block trades. This time delay was reduced to 45
minutes the next year, and then reduced to current standard of 15
minutes in 2005. For the same reasons that the TRACE system required a
delayed implementation period, the WMBAA would recommend the CFTC
consider a similar phased-in approach to this requirement.
Further, the WMBAA would suggest that the CFTC consider fashioning
a more flexible time delay regime that takes into account the block
trade's asset class, the type of swap instruments, and the actual trade
size. The time delay should not be an arbitrary period of time, but
rather should reflect the period of time reasonably needed to hedge the
block trade position without distorting the market. Each asset class
will have varying regular trade frequency and block size thresholds.
Accordingly, if implemented, the Commission may find that 15 minutes is
too long of a time delay for markets which trade actively, and too
short of a time delay for markets with see infrequent trading. To this
end, an approach that factors in the relative size of a transaction
compared to average trading volume and transaction activity for that
specific asset class might be more appropriate to achieve the stated
goals for the time delayed reporting provisions.
Information Publicly Reported
Section 43.5(l) of the Proposed Rules provides that all information
in the data fields described in Section 43.4 and Appendix A to the
Proposed Rules must be disseminated to the public for block trades and
large notional swaps. The Proposed Rules list 23 data fields, which
include date stamp, time stamp, whether the trade is cleared or
uncleared, an indication of a block trade, the execution venue, the
asset class, contract type, underlying asset, price notation, the
unique product identifier, and the notional currency.
The WMBAA suggests that disseminating the specific notional amount
of a block trade could jeopardize the anonymity of the counterparties
to such trades, making counterparties less willing to engage in
transactions of size. Further, the effect of having no delay, or only a
short dissemination delay, for a block trade report that includes the
full notional size will discourage market makers from committing
capital and providing liquidity to the broader market. From a market
perspective, there is little gained from disseminating full notional
size information. Consistent with the experiences from the
implementation of TRACE, which provides regulators with full trade
information and publicly disseminates trades within a size range, the
WMBAA believes the Commission should implement a similar public
reporting methodology. This benefits market participants without
exposing a trade's notional size, which protects counterparty
anonymity, and preserves liquidity and price competition in the
market.\17\ The Swaps Standards Advisory Committee would formulate and
recommend to the Commission methodology for determining appropriate
transaction information to be reported to the public. For example, the
Swaps Standards Advisory Committee could recommend that amounts under
block size were reported as soon as practicable while blocks were
reported only as ``block size+'' after the appropriate delay for that
particular instrument. As with block size itself, the amount reported
to the public would be based on the observed number of bids and offers
in a given instrument, the number of market participants, the amount of
retail participation (if any), and the volume of trades executed.
---------------------------------------------------------------------------
\17\ See 75 Fed. Reg. at 76161. (``The Commission also considered
the standards used by TRACE in setting its minimum threshold for block
trades. In that regard, for trades with a par value exceeding $5
million for investment grade bonds or $1 million for non-investment
grade bonds (e.g., high-yield and unrated debt), TRACE publicly
disseminates the quantity as ``5MM+'' and ``1MM+'', respectively.'')
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Additionally, market participants will be wary of committing to
larger sized transactions after knowing the rapidity in which other
participants will gain knowledge of these trades, leading to less
liquidity for the dealer market, and ultimately for end-user
participants. The WMBAA also believes that the public dissemination of
block trades, as proposed, will allow some market participants to infer
the identity of the parties to the transaction and materially reduce
market liquidity.
If a liquidity provider perceives greater danger in supplying
liquidity, it will step away from providing tight spreads and leave
those reliant on market maker liquidity with poorer hedging
opportunities. From a market structure standpoint, liquidity ``takers''
benefit from liquidity providers acting in a competitive environment.
The liquidity providers compete with each other, often deriving very
small profits per trade from a large volume of transactions. By relying
on their ability to warehouse trades and post capital to make markets
and using their distribution and professional know-how to offer
competitive prices to their customer base, market makers provide
liquidity essential to fulfill the need of hedgers. For these reasons,
having either no delay or a short dissemination delay will actually
erode price discovery and the level of price efficiency in the market.
Conclusion
The WMBAA thanks the Commission for the opportunity to comment on
the Proposed Rule. Please feel free to contact the undersigned with any
questions you may have on our comments.
Sincerely,
The Chairman. Thank you, Mr. Bernardo.
I appreciate that.
We now go to Bill Bullard, Chief Executive Officer of R-
CALF, Billings, Montana.
Mr. Bullard.
STATEMENT OF WILLIAM T. BULLARD, Jr., CHIEF EXECUTIVE OFFICER,
R-CALF USA, BILLINGS, MT
Mr. Bullard. Thank you, Chairman Conaway, Ranking Member
Boswell, and Members of the Subcommittee, for this opportunity
to testify on the Dodd-Frank Wall Street Reform and Consumer
Protect Act that I will refer to as the Wall Street Reform Act.
R-CALF USA, of which I am the CEO, my name is Bill Bullard,
is a national nonprofit cattle association representing the
interest of farmers and ranchers who raise and sell live
cattle. Unlike our counterpart, the National Cattlemen's Beef
Association, that has meat packers seated on their governing
board and tries to represent the entire beef supply chain, R-
CALF USA does not represent packers. We exclusively represent
the interests of the actual farmers and ranchers that are
raising and selling cattle.
R-CALF is the largest organization in the United States
representing cattle producers, again exclusively regarding the
economic interests of the actual cattle farmers and ranchers of
this country.
It is critically important for this Subcommittee to
understand that there is a clear demarcation point between the
live cattle industry and the beef production industry, the beef
packing industry. And that demarcation point is so profound
that often there is an inverse relationship between the
economic prosperity in the cattle industry and the economic
price prosperity in the beef processing industry.
That competition between the live cattle industry and the
beef industry over the price of cattle is fierce, or so it
should be in a free market system. But today it isn't, and that
is because a handful of concentrated packers have all but
captured the marketplace for live cattle. And that is why we
are here today, to discuss the necessity of implementing the
significant regulatory reforms under the Wall Street Reform Act
to restore robust, if not fierce, competition in the cattle
market that is today largely controlled by the four dominant
packers.
As a result of the meet packers' control, we have seen that
our cattle industry is in a severe state of crisis. And for the
benefit of this Subcommittee, we looked at the 16 states that
are represented by the 24 Members of this Subcommittee and
realized that over the past 10 years, where data are available,
the 16 states have lost 49,850 cattle producers. During that 10
year period, the size of the beef cow herd in those 16 states
has been reduced by 1.3 million head, and the production of
cattle and calves in those states has been reduced by 935
million pounds.
Nationally, this same fate is being suffered by cattle
producers all across the country.
This unprecedented long-term contraction of our industry is
occurring even while domestic consumption of beef has actually
increased and reached a 40 year high in 2007 and 2008. A
shrinking industry that is unable to keep pace with growth and
domestic consumption is an industry with a severe problem, a
problem that can be addressed with the Wall Street Reform Act.
Today I want to provide evidence showing that the dominant
beef packers are engaging in practices that are destroying the
price discovery and the risk-management function of the cattle
futures markets, practices that the Wall Street Reform Act can
address.
In February of 2006, four of the largest meat packers
engaged in a coordinated action of withdrawing from the cash
market for an unprecedented 2 week period. Industry analysts at
the time said the packers did this to gain control over cattle
prices, which they did. Cash prices fell $3 a hundredweight
during their boycott, and live cattle futures markets fell to
multi-month lows during the period.
The effect of this coordinated action was to destroy
completely the price discovery function and the risk-management
function of the cattle futures market. And this caused direct
financial harm to cattle producers that were selling cattle all
across the country. In 2008, we testified before Congress and
said if this type of attack isn't--attack on our marketplace is
not addressed immediately by Congress, we would witness this--
experience this type of a problem again in the near future. And
we didn't have to wait long before our prediction materialized.
On the last trading day in October 2009, the cattle futures
market fell to $81.65 a hundredweight. There were no underlying
market forces that would warrant this break in the market.
Suggesting that a dominant market participant had shorted the
market, the cash price at the time was $87.50, and we viewed
this as the worst convergence in a long time in the cattle
futures market.
On February 7, the CFTC ordered a trader Newedge to pay a
penalty of over $220,000 for activities, unlawful activities
that occurred in October 2009. The CFTC found that in October,
Newedge exceeded the contract speculative limit for trading
cattle over 4,000 contracts, which contracts it had purchased
from JBS, the world's largest packer, and then Newedge then
sold JBS an over-the-counter swap in live cattle. The CFTC took
this action in part under the--pursuant to the Wall Street
Reform Act.
Ladies and gentlemen, we believe firmly that we must
immediately implement the Wall Street Reform Act, support the
CFTC's rulemaking process, fund it completely in order to
ensure that we restore for independent cattle producers across
this country an open robust marketplace that is functional in
terms of discovery price and the marketplace that provides them
with a risk-management tool.
Thank you.
[The prepared statement of Mr. Bullard follows:]
Prepared Statement of William T. Bullard, Jr., Chief Executive Officer,
R-CALF USA, Billings, MT
Good afternoon, Chairman Conaway, Ranking Member Boswell, and
Members of the Subcommittee. I am Bill Bullard and I thank you for the
opportunity to provide testimony regarding the Subcommittee's review of
the implementation of title VII of the Dodd-Frank Wall Street Reform
and Consumer Protection Act (``Wall Street Reform Act'').
I am here today representing the cattle-producing members of R-CALF
USA, the Ranchers-Cattlemen Action Legal Fund, United Stockgrowers of
America. R-CALF USA is a membership-based, national, nonprofit trade
association that represents United States farmers and ranchers who
raise and sell live cattle. We have thousands of members located in 46
states and our membership consists of seed stock producers (breeders),
cow/calf producers, backgrounders, stockers and feeders. The
demographics of our membership are reflective of the demographics of
the entire U.S. cattle industry, with membership ranging from the
largest of cow/calf producers and large feeders to the smallest of cow/
calf producers and smaller, farmer-feeders. Our organization's mission
is to ensure the continued profitability and viability for all
independent U.S. cattle producers.
R-CALF USA does not represent the entire U.S. beef supply chain.
Rather, R-CALF USA exclusively represents the live cattle segment of
the beef supply chain, meaning it represents the farmers and ranchers
located across the U.S. who breed, birth, and raise live cattle for
breeding purposes and beef production. These live cattle are
subsequently marketed to beef packers that transform live cattle into
the commodity beef, which beef is then further processed and/or
marketed to other entities within the beef commodity industry (e.g.,
beef processors, beef wholesalers and distributors, and beef
retailers).
It is critically important that the Subcommittee recognize that the
live cattle industry is a distinct industry segment within the U.S.
beef supply chain and that a clear demarcation point exists between the
live cattle industry and the beef commodity industry--a demarcation
point so profound that often there is an inverse relationship between
economic prosperity in the live cattle industry and economic prosperity
in the beef commodity industry.\1\
---------------------------------------------------------------------------
\1\ See, e.g., Sparks Companies Inc., ``Potential Impacts of the
Proposed Ban on Packer Ownership and Feeding of Livestock,'' A Special
Study, (March 18, 2002) at 24 (``Vertical integration [of the live
cattle industry and the beef commodity industry] often attracts
investors because of the negative correlation between profit margins at
the packing stage [beef commodity stage] and the feeding stage [live
cattle stage].'').
---------------------------------------------------------------------------
I. Introduction
The United States cattle industry is in prolonged state of severe
crisis. For the benefit of the Subcommittee, in just the most recent 10
year periods where data are available, the 16 states represented by
this Subcommittee's 24 members collectively lost 49,850 beef cattle
businesses from their respective rural economies (1988-2007),\2\
representing a rate-of-loss of nearly 5,000 beef cattle business
operations per year. In addition, the combined size of the U.S. beef
cow herd in those 16 states declined during the most recent 10 year
period (2002-2011) by over 1.3 million cows.\3\ And, the volume of
production of cattle and calves in those 16 states declined during this
period (2000-2009) by over 935 million pounds.\4\
---------------------------------------------------------------------------
\2\ See Cattle and Calves: Number of Operations by State and United
States, 1997-1998, Cattle, U.S. Department of Agriculture, Agricultural
Statistics Board, National Agricultural Statistics Service, January
1999, at 12; see also Farms, Land in Farms, and Livestock Operations
2008 Summary, U.S. Department of Agriculture, Agricultural Statistics
Board, National Agricultural Statistics Service, February 2009, at 18.
\3\ See Cattle and Calves: Number by Class, State, and the United
States, January 1, 2002-2003, Cattle, U.S. Department of Agriculture,
Agricultural Statistics Board, National Agricultural Statistics
Service, January 2003, at 5; see also Cattle Inventory by Class--States
and United States: January 1, 2010 and 2011, Cattle, U.S. Department of
Agriculture, Agricultural Statistics Board, National Agricultural
Statistics Service, January 2003, at 6.
\4\ See Cattle and Calves: Production and Income by State and the
United States, Revised 2000, Meat Animals Production, Disposition, and
Income 2001 Summary, U.S. Department of Agriculture, Agricultural
Statistics Board, National Agricultural Statistics Service, April 2002,
at 4: see also Cattle and Calves: Production and Income by State and
the United States, 2009, Meat Animals Production, Disposition, and
Income 2009 Summary, U.S. Department of Agriculture, Agricultural
Statistics Board, National Agricultural Statistics Service, April 2010,
at 7.
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Data clearly show that the geographic segment of the U.S. cattle
industry represented by the 16 states represent by the Members of this
Subcommittee is declining rapidly in terms of the number of beef cattle
operations, the size of the beef cow herd, and the volume of cattle and
calf production. Nationally, the number of U.S. cattle operations has
declined 40 percent since 1980,\5\ the size of the U.S. cattle herd is
now the smallest since 1958,\6\ and the production of U.S. beef has
declined since 2000.\7\
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\5\ The size of the U.S. cattle industry, as measured by the number
of cattle operations in the U.S., declined from 1.6 million in 1980 to
983,000 in 2005 and further declined to 967,400 in 2007. See Fed. Reg.
Vol. 72, No. 152, Wednesday, August 8, 2007, at 44681, col. 2.
\6\ See Cattle, U.S. Department of Agriculture, National
Agricultural Statistics Service, January 28, 2011.
\7\ See Beef: Supply and disappearance (carcass weight, million
pounds) and per capita disappearance (pounds), Livestock, Dairy, and
Poultry Outlook: Tables, U.S. Department of Agriculture, Economic
Research Service (Total production declined from 26.89 billion pounds
in 2000 to 26.07 billion pounds in 2009), available at http://
www.ers.usda.gov/publications/ldp/LDPTables.htm.
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These factors indicate an industry in severe crisis, particularly
when one considers that this ongoing, rapid contraction was rapidly
occurring even while domestic consumption of beef, as measured by its
disappearance from the market, was increasing significantly and reached
40 year highs in both 2007 and 2008,\8\ before beginning a decline due
to the United States' recent economic downturn. Even though per capita
beef consumption decreased over the past few decades, the considerable
growth in U.S. population fostered a long-term increase in total
domestic beef consumption that the U.S. cattle industry has been unable
to satisfy.
---------------------------------------------------------------------------
\8\ See id. (Total disappearance (i.e., consumption) of beef
increased to a over 28 billion pounds in both 2007 and 2008, which are
record-setting highs since USDA began reporting disappearances in
1970).
---------------------------------------------------------------------------
A shrinking industry unable to keep pace with domestic consumption
is, undeniably, an industry in serious trouble--the kind of serious
trouble that warrants sweeping remedial reforms such as those Congress
passed in the Wall Street Reform Act.
A principal factor driving the rapid contraction of the U.S. cattle
industry is a dysfunctional cattle market that lacks robust competition
and adequate transparency, which results in a marketplace that is
subject to manipulation and distortion.
II. The Cash and Futures Markets in the Cattle Industry Are Prone To
Manipulation and Distortion
A. The Live Cattle Production Chain and Its Relation To Markets
The U.S. cattle industry is unique in that it raises an animal with
the longest biological cycle of any farmed animal. This is the
characteristic that created the historical phenomenon known as the
cattle cycle. According to the U.S. Department of Agriculture
(``USDA''), the cattle cycle ``arises because biological constraints
prevent producers from instantly responding to price.'' \9\ It takes
approximately 15 to 18 months to rear cattle to slaughter weight and
cattle consume considerable volumes of forage (i.e., from grazing) for
much of this time. After cattle reach approximately 1 year of age on
forage, and weigh approximately 800 pounds, they then become adaptable
to a more concentrated production regime (i.e., they can be finished in
concentrated feedlots).
---------------------------------------------------------------------------
\9\ Cattle: Background, Briefing Room, USDA, ERS, updated June 7,
2007, available at
http://www.ers.usda.gov/Briefing/Cattle/Background.htm.
---------------------------------------------------------------------------
Because of the long biological cycle and the diminishing forage
requirements as cattle intended for slaughter grow to maturity, the
cattle production chain is segmented. Typically, the farmer or rancher
that maintains a beef-cow herd births new calves each year and those
calves are raised at their mothers' side on milk and forage for their
first several months of life. At approximately 6 months of age the
calves are typically weaned from their mothers and placed in a
backgrounding lot where they are fed a growing ration of forage and
grain, or they may be weaned and turned back out on forage such as
pasture. At approximately 1 year of age and weighing approximately 800
pounds, the calves will have matured sufficiently to be placed in
feedlots and fed a fattening grain ration for approximately 4 to 5
additional months before they become slaughter-ready.
The approximately 1 year-old cattle that weigh approximately 800
pounds and are ready to be placed in a feedlot correspond to the
``Feeder Cattle'' category of the commodity futures market. The feeder
cattle that are subsequently fed in a feedlot for 4 to 5 months and are
ready to be sold to the beef packer to be slaughtered correspond to the
``Live Cattle'' category of the commodity futures market and are
referred to as fed cattle.
Due to the segmented production chain in the cattle industry,
calves are often first sold by those who raised them--the cow/calf
producer--then sold to those that background them or turn them back to
pasture--the backgrounder or stocker--who in turn sells them to those
that feed them to slaughter weight--the feedlot. From the moment a
newborn calf hits the ground, its value is based on the expected future
value of that calf when it is mature and ready for slaughter. Thus, the
value of a calf weaned today at approximately 6 months of age is the
expected value of that calf when it is sold for slaughter approximately
1 year into the future. This explains why it is so vitally important to
the entire cattle industry to ensure that the market for slaughter-
ready cattle--the price discovery market--is robustly competitive and
transparent. Any manipulation or distortion of the price for cattle
that are ready for slaughter permeates throughout the entire cattle
industry and can translate into lower prices for everyone within the
cattle industry (which includes 753,000 cattle farmers and ranchers
throughout the United States),\10\ regardless of what segment of the
production chain they specialize in.
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\10\ See Farms, Land in Farms, and Livestock Operations 2009
Summary, USDA, National Agricultural Statistics Service (hereafter
``NASS''), Feb. 2010, at 14, available at http://
usda.mannlib.cornell.edu/usda/current/FarmLandIn/FarmLandIn-02-12-
2010.pdf.
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The entire cattle industry can thus be visualized as a pyramid as
depicted below in which the nation's feedlots comprise the top sections
of the pyramid and the nation's hundreds of thousands of cattle
producers occupy its base. Importantly, it is the price negotiated at
the pyramid's apex between the feedlots and the highly concentrated
beef packers that determines whether the cattle industry as a whole
remains profitable. Economists have long expressed grave concerns
regarding the unprecedented concentration in the beef packing industry.
For example, as early as 2001, Oklahoma State University Economist
Clement E. Ward described the concentration level in the U.S.
meatpacking industry as among the highest of any industry in the United
States, ``and well above levels generally considered to elicit non-
competitive behavior and result in adverse economic performance.''\11\
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\11\ A Review of Causes for and Consequences of Economic
Concentration in the U.S. Meatpacking Industry, Clement E. Ward,
Current Agriculture Food and Resource Issues, 2001, at 1.
This characteristic severely reduces the pricing power of fed cattle
sellers who often are relegated to take whatever price is offered by
the beef packer, regardless of whether it is a legitimate price or a
distorted price.\12\ See GIPSA Livestock and Meat Marketing Study,
January 2007, Volume 3, at 5-4, available at http://
archive.gipsa.usda.gov/psp/issues/livemarketstudy/LMMS_Vol_3.pdf.
---------------------------------------------------------------------------
The cash market for slaughter-ready or fed cattle is the price
discovery market for the entire cattle industry. The cattle futures
market was intended to compliment the price-discovery function of the
cash market by projecting it out into future months, thus serving as a
risk-management tool for cattle producers that raise and sell cattle
intended for slaughter and for beef packers that purchase and slaughter
the fed cattle for human consumption. Unfortunately, the cash market
for fed cattle, to which the futures market is intrinsically tied, has
become too thin to function as an accurate indicator of the fair market
value of fed cattle.
The USDA reports that the national-average volume of fed cattle
sold in the cash market has shrunk from 52 percent in 2005 to 37
percent in 2010.\13\ The volume of cash cattle in the Texas, Oklahoma,
and New Mexico marketing region is now down to less than 22 percent
\14\ and the Colorado region is now down below 20 percent.\15\ With
such a small volume of cattle actually sold in the cash market today,
the cash market can no longer function as an accurate price discovery
market. With an overwhelming number of cattle committed to the beef
packers outside the cash market at undisclosed prices and terms on any
given day (which cattle are referred to as the beef packers' captive
supply), the actual fair market price for fed cattle is difficult, if
not impossible, to determine. This is why, in addition to supporting
the ongoing rulemaking by the Commodity Futures Trading Commission
(``CFTC'') that will increase transparency in the futures market, R-
CALF USA also supports the USDA Grain Inspection, Packers and
Stockyards Administration (``GIPSA'') rulemaking that will increase
transparency in the fed cattle market.
---------------------------------------------------------------------------
\13\ See National Breakdown by Purchase Type, 2005-2010 Fed Cattle
Summary of Purchase Types, USDA Market News.
\14\ See Texas-Oklahoma-New Mexico Breakdown of Volume by Purchase
Type, 2005-2010 Fed Cattle Summary of Purchase Types, USDA Market News.
\15\ See Colorado Breakdown of Volume by Purchase Type, 2005-2010
Fed Cattle Summary of Purchase Types, USDA Market News.
---------------------------------------------------------------------------
In addition to the reduced volume of cattle sold in the cash
market, the trades that do occur in the cash market are too infrequent
to function as a viable price discovery tool. Anecdotal evidence from
numerous cattle feeders indicate that beef packers' exposure to the
cash market is now so limited that the current bidding practice often
involves an offer by the beef packer once per week, and oftentimes
within only about a fifteen minute timeframe. If the beef packers are
short bought (i.e., they have insufficient cattle numbers even with
their captive supplies), this fifteen minute window may occur on a
Thursday, or perhaps even on a Wednesday. However, if the beef packer
is long-bought (i.e., has more than enough captive supply cattle), the
fifteen minute marketing opportunity may not occur until late Friday
afternoon, after the close of the futures markets. This extremely
narrow window of opportunity to market cattle places cattle feeders at
a distinct disadvantage as there is insufficient time to make calls to
other beef packers after an offer is made--it is essentially a take-it
or leave-it offer that, if refused, means the cattle feeder must
continue feeding for another week, even if the cattle have already
reached their optimal weight, in hopes of a more realistic offer the
next week. This limited and infrequent bid window affords the beef
packers with tremendous market power that gives them the ability to
leverage down the price discovery market.
B. Empirical Evidence of Behaviors That Manipulate and Distort the Cash
and Futures Market
Empirical evidence shows that the U.S. cattle market is already
susceptible to coordinated and/or simultaneous entries and exits from
the cash market that negatively affect the futures market. In February
2006, all four major beef packers--Tyson, Cargill, Swift, and
National--withdrew from the cash cattle market in the Southern Plains
for an unprecedented period of 2 weeks. On February 13, 2006, market
analysts reported that no cattle had sold in Kansas or Texas in the
previous week.\16\ No cash trade occurred on the southern plains
through Thursday of the next week, marking, as one trade publication
noted, ``one of the few times in recent memory when the region sold no
cattle in a non-holiday week.'' \17\ Market analysts noted that ``[n]o
sales for the second week in a row would be unprecedented in the modern
history of the market.'' \18\ During the week of February 13 through
17, there were no significant trades in Kansas, western Oklahoma, and
Texas for the second week in a row.\19\ Market reports indicated that
Friday, February 17, 2006, marked 2 full weeks in which there had been
very light to non-existent trading in the cash market, with many
feedlots in Kansas, Oklahoma, and Texas reporting no bids at all for
the past week.\20\ The beef packers made minimal to no purchases on the
cash market, relying on captive supplies of cattle to keep their plants
running for 2 weeks and cutting production rather than participating in
the cash market. The beef packers reduced slaughter rates rather than
enter the cash market. Cattle slaughter for the week of February 13-17
was just 526,000 head, down from 585,000 the previous week and 571,000
at the same time a year earlier.\21\ According to one analyst, the
decision to cut slaughter volume indicated ``the determination by beef
packers to regain control of their portion of the beef price
pipeline.'' \22\ Another trade publication noted that the dramatic drop
in slaughter was undertaken in part to ``try and get cattle bought
cheaper.'' \23\ At the end of the second week of the buyers'
abandonment of the cash market, one market news service reported, ``The
big question was whether one major [packer] would break ranks and offer
higher money. That has often occurred in the past, said analysts.''
\24\
---------------------------------------------------------------------------
\16\ ``Packers Finally Seriously Cut Kills,'' Cattle Buyers Weekly
(Feb. 13, 2006).
\17\ ``Classic Standoff Continues Through Thursday,'' Cattle Buyers
Weekly (Feb. 20, 2006).
\18\ ``Classic Standoff Continues Through Thursday,'' Cattle Buyers
Weekly (Feb. 20, 2006).
\19\ Curt Thacker, ``Cash Cattle Quiet 2-20,'' Dow Jones Newswires
(Feb. 20, 2006).
\20\ Lester Aldrich, ``Cash Cattle Standoff 2-17,'' Dow Jones
Newswires (Feb. 17, 2006).
\21\ Curt Thacker, ``Cash Cattle Quiet 2-20,'' Dow Jones Newswires
(Feb. 20, 2006).
\22\ Jim Cote, ``Today's Beef Outlook 2-17,'' Dow Jones Newswires
(Feb. 17, 2006).
\23\ ``Classic Standoff Continues Through Thursday,'' Cattle Buyers
Weekly (Feb. 20, 2006).
\24\ ``Classic Standoff Continues Through Thursday,'' Cattle Buyers
Weekly (Feb. 20, 2006).
---------------------------------------------------------------------------
As a result of the beef packers shunning the cash market, cash
prices fell for fed cattle, replacement cattle, and in futures markets.
Sales took place after feedlots in Kansas and the Texas Panhandle
lowered their prices to $89 per hundredweight, down $3 from the $92 per
hundredweight price reported in the beginning of February.\25\ The same
day, February 17, live and feeder cattle futures fell to multi-month
lows.\26\ Replacement cattle prices also dropped in response to buyer
reluctance.\27\ In Oklahoma City, prices for feeder cattle dropped as
much as $4 per hundredweight.\28\
---------------------------------------------------------------------------
\25\ Curt Thacker, ``Cash Cattle Quiet 2-20,'' Dow Jones Newswires
(Feb. 20, 2006).
\26\ Jim Cote, ``Live Cattle ReCap--2/17/2006,'' Dow Jones
Newswires (Feb. 17, 2006).
\27\ ``The Markets,'' AgCenter Cattle Report (Feb. 18, 2006),
available on-line at http://www.agcenter.com/cattlereport.asp.
\28\ ``The Markets,'' AgCenter Cattle Report (Feb. 18, 2006),
available on-line at http://www.agcenter.com/cattlereport.asp.
---------------------------------------------------------------------------
Whether the beef packers' simultaneous boycott of the cash market
was deliberately coordinated or not, it was a highly unusual event that
required simultaneous action in order to effectively drive down prices,
which it did. As market analysts observed, the major question in
markets during the second week of the buyers' strike was whether or not
any one of the major beef manufacturers would ``break ranks'' to
purchase at higher prices than the other beef manufacturers. No buyer
did so until prices began to fall. In fact, beef packers were willing
to cut production rather than break ranks and purchase on the cash
market.
Abandonment of the cash market in the Southern Plains by all major
beef manufacturers for 2 weeks in a row resulted in lower prices and
had an adverse effect on competition. Cattle producers in the Southern
Plains cash markets during those two weeks were unable to sell their
product until prices fell to a level that the buyers would finally
accept. The simultaneous refusal to engage in the market did not just
have an adverse effect on competition--it effectively precluded
competition altogether by closing down an important market for sellers.
The simultaneous boycott of cash markets in the Southern Plains was,
however, a business decision on the part of the beef packers that did
not conform to normal business practices and that resulted in a marked
decline in cattle prices. At the time, market analysts interpreted the
refusal to participate in the cash market as a strategy to drive down
prices, and purchases only resumed once prices began to fall.
The coordinated/simultaneous action in February 2006 was not
isolated and was soon followed by a second, coordinated/simultaneous
action. During the week that ended October 13, 2006, three of the
nation's four largest beef packers--Tyson, Swift, and National--
announced simultaneously that they would all reduce cattle slaughter,
with some citing, inter alia, high cattle prices and tight cattle
supplies as the reason for their cutback.\29\ During that week, the
packers reportedly slaughtered an estimated 10,000 fewer cattle than
the previous week, but 16,000 more cattle than they did the year
before.\30\ Fed cattle prices still fell $2 per hundredweight to $3 per
hundredweight and feeder prices fell $3 per hundredweight to $10 per
hundredweight.\31\
---------------------------------------------------------------------------
\29\ See ``National Beef Cuts Hours at Two Kansas Plants (Dodge
City, Liberal),'' Kansas City Business Journal (October 10, 2006)
attached as Exhibit 17; ``Update 1--Tyson Foods to Reduce Beef
Production,'' Reuters (October 10, 2006), attached as Exhibit 18;
``Swift to Stay with Reduced Production at U.S. Facilities,''
Meatpoultry.com (October 10, 2006), attached as Exhibit 19.
\30\ See ``Livestock Market Briefs, Brownfield Ag Network,''
(October 13, 2006), attached as Exhibit 20.
\31\ See id.
---------------------------------------------------------------------------
By Friday of the next week, October 20, 2006, the beef packers
reportedly slaughtered 14,000 more cattle than they did the week before
and 18,000 more cattle than the year before--indicating they did not
cut back slaughter like they said they would.\32\ Nevertheless, live
cattle prices kept falling, with fed cattle prices down another $1 per
hundredweight to $2 per hundredweight and feeder cattle prices were
down another $4 per hundredweight to $8 per hundredweight.\33\
---------------------------------------------------------------------------
\32\ See ``Livestock Market Briefs, Brownfield Ag Network,''
(October 20, 2006), attached as Exhibit 21.
\33\ See id.
---------------------------------------------------------------------------
The anti-competitive behavior exhibited by the beef packers'
coordinated/simultaneous market actions caused severe reductions to
U.S. live cattle prices on at least two occasions in 2006. This
demonstrates that the exercise of abusive market power is manifest in
the U.S. cattle industry.
In testimony to the U.S. Senate Judiciary Subcommittee on
Antitrust, Competition Policy, and Consumer Rights, R-CALF USA informed
Congress on May 7, 2008, that the potential for a recurrence of this
type of anti-competitive behavior that caused the manipulation and
distortion of both the cash market and the futures market was
considerable and constitutes an empirically demonstrated risk that
would likely become more frequent, more intense, as well as extended in
duration unless Congress took decisive, remedial action.
R-CALF USA did not have to wait very long before evidence surfaced
that indicated the beef packers were once again involved in
manipulating and distorting the cash/futures market relationship. As
discussed more fully below, R-CALF USA immediately recognized the
symptoms of the unlawful market manipulation that occurred in the
cattle futures market in October 2009 and formally notified Federal
regulatory officials of the disastrous consequences to U.S. livestock
producers resulting from that manipulation. At that time, R-CALF USA
witnessed a severe break in the cattle futures market, likely
indicating that a dominant market participant had shorted the market,
causing the futures market to fall the limit. However, R-CALF USA had
no knowledge at that time regarding which dominant market participant
was involved. Below are actions R-CALF USA initiated in its attempts to
address this incidence of obvious market manipulation:
Soon after the close of the October 2009 live cattle futures
contract month, on Dec. 9, 2009, R-CALF USA Marketing Committee
Chairman Dennis Thornsberry submitted a formal complaint/affidavit to
GIPSA in which he stated:
I have used the Chicago Mercantile Exchange to hedge cattle for
the purpose of managing the risk associated with marketing my
cattle. However, the problems in the cash cattle market are
mirrored in the futures market as it too is subject to undue
influence by the dominant corporate packers and feedlots. For
example, on the last trading day before the October futures
contract expired, some outside force broke the October board,
causing it to fall by the full $3.00 limit to $81.65 per cwt.
However, the live cattle trade was at $87.50. This was among
the worst convergences that I have seen in the futures market
for a long time. It is unlikely that the futures market can
attract sufficient long positions to add the needed liquidity
to the futures market for determining the value of cattle when
the market remains vulnerable to those who would exercise
speculative short selling to effectively drive down the futures
price. Given that this type of volatility cannot be attributed
to market fundamentals (but, according to market analysts can
be triggered by a $50 million infusion, which is not beyond the
means of hedge funds and perhaps the dominant beef packers),
small to mid-sized producers would not have the financial
wherewithal to cover the margin calls associated with such a
volatile market. This, I believe, plays directly into the hands
of the large corporations that use the markets daily to gain an
advantage over the small to mid-sized producer. And, the
volatility in the futures market caused by manipulative
practices has rendered it incapable of serving as a risk
management tool for the small to mid-sized producer and is
contributing to the exodus of these producers from the
industry.
Later, in its formal comments submitted December 31, 2009, to both
the U.S. Department of Justice (``Justice Department'') and USDA
regarding the two agencies' joint investigation on Agriculture and
Antitrust Enforcement Issues in Our 21st Century Economy, R-CALF USA
provided the same evidence that indicated that the beef packers'
manipulation of the cash market is mirrored in the futures market where
they also exercise abusive market power. R-CALF USA stated:
R-CALF USA is concerned that beef packers are able to
significantly influence the commodities futures market,
rendering it unsuitable for managing the risks of independent
cattle producers. Practices such as shorting the market to
drive down both cash and futures prices, particularly on the
last trading day of the month before futures contracts expire
are a form of market manipulation. The October 2009 futures
board, e.g., broke the limit down on the last trading day in
October, causing an unprecedented number of live cattle
deliveries to occur. Based on information and belief, the
manipulative practices by the beef packers in the commodities
futures market has created a disinterest among speculators who
would otherwise participate in long speculative positions in
the market. The lack of speculative long positions in the
market may well be depressing the cash and futures market by
several dollars per hundredweight and reducing the utility of
the commodity futures market as a risk management tool for
cattle producers. R-CALF USA urges the Department of Justice
and USDA to investigate the beef packers' activities in the
commodities futures market.
Later, on April 26, 2010, R-CALF USA submitted formal comments to
the CFTC concerning its proposed Federal speculative position limits
under the Wall Street Reform Act and informed the agency of R-CALF
USA's concern that dominant beef packers were manipulating the cattle
futures market to lower the price of live cattle. R-CALF USA provided
the CFTC with the information that originated in Mr. Thornsberry's
complaint/affidavit to GIPSA to substantiate R-CALF USA's concern that
dominant market participants were manipulating the cattle futures
market:
Evidence, albeit anecdotal, that the cattle futures market is
subject to undue influence by dominant market participants
includes market events that occurred in October 2009. On the
last trading day before the October 2009 futures contract
expired, some outside force broke the October board, causing it
to fall by the full $3.00 limit to $81.65 per cwt. However, the
live cattle trade was at $87.50, resulting in an unexplained
convergence that is suggestive of direct manipulation.
Just last Monday, on Feb. 7, 2011, the CFTC issued an announcement
stating it had ordered Chicago-based futures commission merchant
Newedge USA, LLC (``Newedge'') to pay more than $220,000 for violating
speculative position limits in live cattle futures trading.\34\ In its
announcement, the CFTC stated that one of the nation's largest beef
packers, JBS USA, LLC (``JBS''), was involved in the transaction that
led to the CFTC's remedial sanction.
---------------------------------------------------------------------------
\34\ See CFTC Orders Chicago-Based Futures Commission Merchant
Newedge USA, LLC to Pay More than $220,000 for Violating Speculative
Position Limits in Live Cattle Futures Trading, U.S. Commodity Futures
Trading Commission, Release PR5981-11, Feb. 7, 2011, available at
http://www.cftc.gov/PressRoom/PressReleases/pr5981-11.html.
---------------------------------------------------------------------------
According to the CFTC order issued in this matter, Newedge
purchased 4,495 October 2009 live cattle futures contracts on the CME
from their client JBS, and then Newedge sold JBS an over-the-counter
swap (OTC) in live cattle on Oct. 9, 2009--a transaction that caused
Newedge to exceed the 450 contract speculative limit for trading live
cattle by 4,045 contracts.\35\ The CFTC order further states of the
transaction: ``On Friday, October 9, 2009, Newedge and JBS, a live
cattle end-user, agreed that JBS would sell Newedge 4,495 contract long
October 2009 live cattle futures position. Newedge would hedge the
purchase with a short position in an underlying swap in live cattle and
sell JBS a live cattle swap.'' \36\ The CFTC order also stated that
Newedge earned $80,910 in total profit and commissions on related
transactions with JBS.\37\
---------------------------------------------------------------------------
\35\ See CFTC Docket No: 11-07, Order Instituting Proceedings
Pursuant to Section 6(c) and 6(d) of the Commodity Exchange Act, Making
Findings and Imposing Remedial Sanctions, U.S. Commodity Futures
Trading Commission, Feb. 7, 2011, available at http://www.cftc.gov/ucm/
groups/public/@lrenforcementactions/documents/legalpleading/
enfnewedgeorder020711.pdf.
\36\ Ibid.
\37\ Ibid.
---------------------------------------------------------------------------
We applaud the CFTC for taking this enforcement action, which,
according to the CFTC's order in this matter, was taken pursuant to the
Commodity Exchange Act, the Food, Conservation, and Energy Act of 2008,
the new Wall Street Reform Act, and CFTC regulations. The CFTC has
taken decisive steps to ensure that dominant market participants are
not exercising abusive market power to manipulate and distort the
cattle futures market. Though three Federal agencies were informed
about this incident, to our knowledge only the CFTC took the initiative
to investigate and enforce this unlawful action. R-CALF USA believes
the October 2009 live cattle futures market transaction that involved
both Newedge and JBS, and in which Newedge was known to have engaged in
unlawful activity, was a significant, contributing cause for the
manipulation of the cattle futures price and resulting harm to U.S.
cattle producers. Further, and based on the available information, we
believe JBS' involvement in this transaction constitutes a direct
violation of the Packers and Stockyards Act of 1921 (``PSA'') that
prohibits beef packers from engaging in any course of business or do
any act for the purpose or with the effect of manipulating or
controlling prices.\38\ For those reasons, R-CALF USA has formally
requested GIPSA and the Justice Department to immediately initiate a
PSA enforcement action against JBS for its role in the debilitating
cattle futures market transaction that occurred in October 2009.
---------------------------------------------------------------------------
\38\ See 7 U.S.C. 192(e).
---------------------------------------------------------------------------
III. The Dire Need for Sweeping Futures Market Reform
R-CALF USA is a member of the Commodity Markets Oversight Coalition
(``CMOC''), which is an independent, non-partisan and nonprofit
alliance of groups that represent commodity-dependent industries,
businesses and end-users, including American consumers, that rely on
functional, transparent and competitive commodity derivatives markets
as a hedging and price discovery tool. The CMOC strongly supported
Congressional reforms to the commodity futures market and is actively
involved in the CFTC's rulemaking process to fully and expeditiously
implement the Wall Street Reform Act.
R-CALF USA is particularly concerned with the practice whereby
large beef packers, which are legitimate hedgers for a certain volume
of cattle, enter the commodity futures markets also as speculators with
the intent and effect of manipulating the futures (and hence the cash
price) of cattle. These beef packers should not be entitled to the end-
user exception for speculative trades beyond their physical needs for
slaughter cattle.
R-CALF USA has urged the CFTC to use its rulemaking authority to
fully restore the cattle futures market to its original purpose of
affording U.S. cattle producers a useful risk-management marketing tool
void of distortion and manipulation by certain speculators and other
dominant market participants (i.e., beef packers). As previously
mentioned, United States cattle producers sell their cattle into one of
the most highly concentrated marketing structures in the U.S. economy.
Inherent to this high level of market concentration is substantial
disparity between the economic power of the hundreds of thousands of
disaggregated U.S. cattle producers (i.e., cattle sellers) and the
economic power wielded by very few beef packers (i.e., cattle buyers).
A. The Futures Market for Live Cattle Is Fundamentally Broken
R-CALF USA believes the commodities futures market is fundamentally
broken and no longer functionally capable of serving as an effective,
economic risk management tool for U.S. cattle producers. Rather than to
provide true price discovery, the live cattle futures market has become
a device that enhances the ability of dominant market participants to
manage and manipulate both live cattle futures prices and cash cattle
prices.
Evidence that the live cattle futures market is no longer
functionally capable of serving as an effective risk management tool
for U.S. cattle producers includes data that show the physical hedgers
share of the long open interest in the feeder cattle futures market and
the live cattle futures market declined from 52.4 percent and 67.6
percent, respectively, in 1998 to only 17 percent and 11.7 percent,
respectively, in 2008.\39\ Such a drastic decline in the physical
hedgers open interests in just a 10 year period in these commodities
show either or both that commercial (i.e., bona fide hedgers) interests
are now avoiding the futures market (which they would not do if the
market served an economically beneficial function) and/or speculator
interests have now besieged the markets once dominated by actual
sellers and buyers of the commodities.
---------------------------------------------------------------------------
\39\ See The Accidental Hunt Brothers: How Institutional Investors
Are Driving Up Food and Energy Prices, Michael W. Masters and Adam K.
White, CFA, Table 10: Commodities Futures Markets--Long Open Interests
Composition, July 31, 2008, at 34, available at http://
accidentalhuntbrothers.com/wp-content/uploads/2008/09/accidental-hunt-
brothers-080731.pdf.
---------------------------------------------------------------------------
The consolidation and concentration that already has occurred in
the beef packing industry is now occurring at a rapid rate in the
feedlot sector of the U.S. cattle industry, thereby exacerbating the
ongoing thinning of the numbers of bona fide hedgers participating in
the cattle futures market. For example, the numbers of U.S. feedlots
that purchase feeder cattle and sell fed cattle have declined
drastically in recent years. Today just 58 of the 2,170 feedlots with
capacities of more than 1,000 head feed approximately seven million of
the approximately 26 million cattle fed and marketed, representing over
\1/4\ of all the fed cattle in 2008.\40\ As shown below, the number of
smaller U.S. feedlots, those with capacities of less than 1,000 head,
has declined sharply over the past 13 years, with nearly 30,000
feedlots having exited the industry since 1996.\41\
---------------------------------------------------------------------------
\40\ See Cattle on Feed, USDA, NASS, Feb. 20, 2009, at 14.
\41\ See Cattle, Final Estimates, various reports, 1996-2008, USDA,
National Agricultural Statistics Service (hereafter ``NASS''); see also
Cattle on Feed, USDA, NASS, Feb. 20, 2009.
---------------------------------------------------------------------------
Decline in Numbers of U.S. Feedlots
1996-2008
As a result of the worsening economic disparity caused by the
ongoing consolidation and concentration of the U.S. cattle market, the
remaining cattle producers, some of whom continue to rely on futures
markets to offset price risk, are vulnerable to any market distortions
caused by beef packers that may not only participate in the futures
market as physical hedgers, but as significant speculators as well. The
cattle futures market is susceptible to downward price movements--in
contradiction of supply/demand fundamentals, when, e.g., beef packers,
who may hold a physical hedging position in the market, also engage in
substantial speculative short selling of the market. The effect of the
beef packers' speculative short selling is to lower not only the
futures market price, but also the cash spot market price, which is
intrinsically tied to the futures market.
Another troubling development in the U.S. cattle market is that the
same concentrated beef packers, who are the dominant purchasers of fed
cattle, are fast becoming dominant purchasers of feeder cattle through
their expanded feedlot holdings. Of the nations four largest feedlot
companies, JBS Five Rivers Ranch Cattle Feeding; Cactus Feeders, Inc.;
Cargill Cattle Feeders, LLC; and, Friona Industries, LP,\42\ two,
including the largest, are owned by two of the largest beef packers,
JBS and Cargill. Thus, the beef packers' ongoing infiltration into the
cattle feeding industry means that dominant participants in both the
feeder cattle futures market and the live cattle futures market now
have an economic interest in lowering both feeder cattle prices and fed
cattle prices.
---------------------------------------------------------------------------
\42\ See Recent Acquisitions of U.S. Meat Companies, Congressional
Research Service, 7-5700, RS22980, March 10, 2009, at 2.
---------------------------------------------------------------------------
It is R-CALF USA's belief that futures market prices directly and
significantly influence prices for all classes of cattle, including fed
cattle, feeder cattle, stocker calves, and breeding stock, regardless
of whether or not these cattle are included under any futures contract.
For this reason, it is imperative that the futures market be protected
from unfair, manipulative, and speculative practices that effectively
distort the U.S. cattle market.
B. The Cattle Futures Market Must Be Protected From Manipulation by
Speculators With a Vested Interest in the Prices for Cattle
R-CALF USA believes the ongoing distortions to and manipulation of
the cattle futures markets, particularly those that we believe are
perpetrated through speculative short selling by one or more dominant
beef packers and/or other concentrated/dominant traders, can be
rectified within the CFTC's rulemaking by prohibiting traders holding
positions pursuant to a bona fide hedge exemption from also trading
speculatively.\43\ To be effective, this provision would need to apply
to any subsidiary, affiliate, or other related entity of the bona fide
hedger, particularly with respect to a dominant beef packer.
---------------------------------------------------------------------------
\43\ See 75 Fed. Reg. 4159.
---------------------------------------------------------------------------
C. The Cattle Futures Market Must Be Protected From Distortions Caused
by Excessive Speculation
Like other commodity futures markets, the futures market for live
cattle is highly susceptible to market distortion should excessive
liquidity be introduced in the form of excessive speculation. The
remaining participants in the U.S. live cattle industry, whose numbers
have already been reduced by an alarming 40 percent since 1980,\44\
operate on slim margins and are highly vulnerable to even small changes
in cattle prices.\45\ As a result, cattle producers are particularly
susceptible to financial failure caused by both market volatility and
market distortions created by excessive speculation that can swing
prices low, even for short periods, as they are operating in an
industry already suffering from a long-run lack of profitability. In
addition, small to mid-sized cattle producers do not have sufficiently
deep pockets to cover margin calls associated with market volatility
caused by excessive speculation, which, we believe, has rendered the
cattle futures markets incapable of serving as an effective risk
management tool for the small to mid-sized producer and is contributing
to the ongoing exodus of these producers from the U.S. cattle industry.
---------------------------------------------------------------------------
\44\ The size of the U.S. cattle industry, as measured by the
number of cattle operations in the U.S., declined from 1.6 million in
1980 to 983,000 in 2005 and further declined to 967,400 in 2007. See
Fed. Reg. Vol. 72, No. 152, Wednesday, August 8, 2007, at 44681, col.
2.
\45\ See A Review of Causes for and Consequences of Economic
Concentration in the U.S. Meatpacking Industry, Clement E. Ward,
Current Agriculture Food and Resource Issues, 2001, at 2 (``[E]ven
seemingly small impacts on a $/cwt. basis may make substantial
difference to livestock producers and rival meatpacking firms operating
at the margin of remaining viable or being forced to exit an
industry.'').
---------------------------------------------------------------------------
R-CALF USA believes the ongoing distortions to the cattle futures
market, particularly those we believe are created by excessive
speculation, can be rectified within the CFTC's rulemaking with a
provision that would limit speculative positions by index funds and
other trading entities that have no specific interest in the underlying
commodity and bear no risk relative to the commodity's production or
consumption. To achieve the goal of effectively preventing excessive
speculation, which is known to facilitate abrupt price movements and
price distortions in other futures markets,\46\ we are inclined to
agree with the recommendation made by Michael W. Masters:
---------------------------------------------------------------------------
\46\ See, e.g., 75 Fed. Reg. 4148, col. 3.
As a general rule of thumb, speculators should never represent
more than 50% of open interest, because at that level, they
will dominate the price discovery function, due to the
aggressiveness and frequency of their trading. The level I
recommend is 25%; this will provide sufficient liquidity, while
ensuring that physical producers and consumers dominate the
price discovery function.\47\
---------------------------------------------------------------------------
\47\ Testimony of Michael W. Masters, Managing Member/Portfolio
Manager, Masters Capital Management, LLC, before the Commodities
Futures Trading Commission, March 25, 2010.
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D. The Cattle Industry Must Be Protected From Distortions in Feed Grain
Prices Caused Also by Excessive Speculation
Because feed grains are a major component of production costs for
fed cattle, the price of feed grains is a major consideration by bona
fide hedgers when formulating expectations for future cattle prices. If
feed grain prices are expected to rise--thus increasing the cost of
cattle production--without a corresponding expectation that beef prices
also will rise, cattle feeders will attempt to offset the expectation
of higher feed grain prices by purchasing feeder cattle at lower
prices. The relationship between feed grain prices and cattle-feeder
profitability has long influenced pricing decisions by bona fide
hedgers. If, however, feed grain prices are themselves subject to non-
market forces such as excessive speculation, as they were during the
2008 commodity bubble, the profitability of cattle feeders can be
immediately affected. And, this lack of profitability, or reduced
profitability, immediately translates into a perception that feeder
cattle must be purchased at lower prices to offset the resulting
increase in production costs. Thus, distortions in futures feed grain
prices result in distortions to cattle futures prices and must be
eliminated. R-CALF USA believes that effective speculative position
limits imposed on all feed grain commodities markets would alleviate
the transference of market distortions from the feed grains futures
market to the cattle futures market.
E. The CFTC Should Consider Additional Reforms To Protect the Integrity
of the Cattle Futures Market
R-CALF USA has urged the CFTC to ensure that the cattle futures
market is always dominated by bona fide hedgers. In addition, it has
urged the CFTC to strictly curtail the practice of allowing passive
speculation in the commodities futures market by entities that hold
large market positions without any interest in the underlying commodity
and without any risk relative to the commodity's production or
consumption. R-CALF USA further believes it important that the CFTC
recognize the two types of excessive speculation that has invaded the
cattle futures market: (1) the excessive speculation by one or more
dominant market participants with market shares sufficient to engage in
market manipulation (this can include dominant beef packers acting
speculatively as discussed above or any other concentrated/dominant
speculator), and (2) the excessive speculation by those without any
vested interest in the underlying commodity and without any risk
relative to the commodity's production or consumption (including both
active and passive speculators). Both of these types of excessive
speculation contribute to market distortions that are harmful to bona
fide market participants, as well as to consumers who ultimately
consume products derived from these commodities.
To achieve an optimal level of liquidity provided by speculators,
it would be important that the actual speculative position limits for
one or more concentrated/dominant speculators and the overall actual
limit of speculation in the cattle futures market be established by
bona fide hedgers in the futures market and adjusted by them from time-
to-time as conditions may warrant. Further, the CFTC should restore
daily market price limits to levels that minimize market volatility.
The previous daily market limit in the cattle futures market of $1.50,
which could still be adjusted upward following extended periods of
limit movement, resulted in far less volatility than the current $3.00
daily market limit. Finally, R-CALF USA seeks reform to the practice of
allowing cash settlements on futures contracts in lieu of actual
delivery of the commodity, a practice that effectively lowers the
cattle futures price on the day of contract expiration.
IV. Like Cattle Producers, Consumers Are Being Harmed by the
Dysfunctional Cash and Futures Markets in the U.S. Cattle
Industry
The USDA Economic Research Service (``ERS'') states that the price
spread data it reports can be used to ``measure the efficiency and
equity of the food marketing system,'' \48\ and ``increasing price
spreads can both inflate retail prices and deflate farm price.'' \49\
According to ERS, ``[h]igher price spreads translate into lower prices
for livestock,'' \50\ innovative technologies can reduce price spreads
and economic efficiency increases when price spreads drop,\51\ and
``[b]oth consumers and farmers can gain if the food marketing system
becomes more efficient and price spreads drop.'' \52\ Thus, if U.S.
cattle markets were functioning properly and the ongoing concentration
and consolidation of U.S. cattle markets were creating efficient
economies of scale, then the spread between cattle prices and consumer
beef prices would be expected to narrow over time. However, this is the
opposite of what has occurred within the present marketing system. As
shown below, the price spreads between ranch gate prices (i.e., cattle
prices) and retail prices (i.e., prices paid by consumers) have been
steadily increasing over time.
---------------------------------------------------------------------------
\48\ Beef and Pork Values and Price Spreads Explained, U.S.
Department of Agriculture, Economic Research Service, at 3.
\49\ Id. at 2.
\50\ Id. at 8.
\51\ Id. at 3.
\52\ Ibid.
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Consumers' Retail Beef Prices Compared To Cattle Prices
Jan. 1980-May 2010
It is clear that both consumers and producers are being harmed by
the current marketing structure that is creating increased price
spreads, which means the marketplace is becoming less innovative and
less inefficient. USDA found in 2004 that ``the total price spreads
show a weak upward trend when corrected for inflation,'' \53\ and this
upward trend has only worsened since 2004. The ever-increasing price
spread between ranch gate prices for cattle and retail prices for beef
is further evidence of the broken cash and futures markets in the U.S.
cattle industry where price discovery occurs. R-CALF USA believes this
market anomaly is caused by the unrestrained exercise of market power
by dominant industry participants and results in the exploitation of
both consumers and producers.
---------------------------------------------------------------------------
\53\ See Beef and Pork Values and Price Spreads Explained, U.S.
Department of Agriculture, Economic Research Service, at 10.
---------------------------------------------------------------------------
V. Conclusion
R-CALF USA encourages Congress to continue its efforts to implement
sweeping changes that will improve market transparency and eliminate
manipulation and other anti-competitive practices that have caused
artificial price distortions in the commodities futures market and
relegated the cattle futures market to an ineffective tool for price
discovery and risk management for U.S. cattle producers. We urge
Congress to support CFTC's rulemaking as well as to ensure that the
agency has sufficient funding to effectively carry out the new
responsibilities Congress mandated in the Wall Street Reform Act.
The integrity of the cattle futures market will depend on Congress'
and CFTC's ability to impart the greatest transparency possible into
the cattle futures market and on a sincere effort by both Congress and
the CFTC to address the causes of volatility in the cattle futures
market that are unrelated to underlying commodity fundamentals. We
firmly believe that Congress and the CFTC are on the right track for
restoring the cattle futures market to its original purpose of
providing buyers and sellers with both a risk management tool that also
can serve an important price discovery function by reflecting the
legitimate market signals of supply and demand.
Respectfully,
The Chairman. We will now go to Stuart Kaswell, General
Counsel, Managed Funds Association, Washington, D.C.
Mr. Kaswell, 5 minutes.
STATEMENT OF STUART J. KASWELL, EXECUTIVE VICE
PRESIDENT, MANAGING DIRECTOR, AND GENERAL
COUNSEL, MANAGED FUNDS ASSOCIATION, WASHINGTON, D.C.
Mr. Kaswell. Thank you very much, Chairman Conaway, Ranking
Member Boswell, Members of the Subcommittee.
I am Stuart Kaswell. I am the General Counsel of the
Managed Funds Association, and we appreciate the opportunity to
provide our views on the implementation of Title VII of the
Dodd-Frank Wall Street Reform and Consumer Protection Act. MFA
commends the Subcommittee for its diligent oversight of the new
OTC derivatives framework.
MFA is the voice of the global alternative investment
industry and is the primary advocate for professionals in hedge
funds, fund to funds, and managed futures funds as well as
industry service providers. Our members primarily help
pensions, university endowments and other institutions
diversify their investments, manage risk, and generate reliable
returns to meet their obligations to their beneficiaries.
MFA's members are active participants in the OTC
derivatives markets. As such, we have a strong interest in
promoting the integrity and proper functioning of these markets
through increased transparency and systemic risk mitigation. In
seeking to accomplish these goals, it is important to ensure
that the implementation of Title VII proceeds in a thoughtful,
logical fashion that strengthens the derivatives markets and
does not impair market participants' ability to mitigate risks
through swaps.
We support the implementation of a thoughtful regulatory
framework that will protect the public while fostering
legitimate economic activity. Therefore, we believe regulators
should gather data and complete more empirical analysis before
adopting new rules. We think regulators can accomplish this in
a quick and efficient manner that properly balances the desire
to move forward toward central clearing--sorry--to move
promptly towards central clearing with a need to develop rules
through a deliberative process.
We also ask that regulators continue to coordinate to
ensure consistent implementation and harmonization. MFA
supports policymakers' efforts to reduce systemic risk by
requiring central clearing and data gathering about swaps. We
believe that central clearing will play an essential role in
reducing systemic, operational and counterparty risk, and will
enhance market transparency, competition and regulatory
efficiencies.
Since the beginning of this important debate, MFA has
supported central clearing, and we urge regulators to move with
alacrity to implement it.
The success of central clearing and data gathering will
depend on the structured governance and financial soundness of
derivatives clearing organizations, data repositories, swap
execution facilities, and designated contract markets. We
strongly believe that there is a need for those entities to
have transparent, irrevocable risk models that enable fair and
open access, incentivize competition and reduce barriers to
entry.
We also believe that it is important to have customer
representation on the governance and risk committees of
derivatives clearing organizations and for no one group to
constitute a controlling majority.
In addition, MFA believes several other Title VII
provisions can further protect against the risk of future
systemic events. Among those measures is segregation of
customer collateral for swaps. We believe that the right to
elect individual segregation of customer initial margin on
commercially reasonable terms is essential for effective OTC
derivatives regulation.
For non-cleared swaps, we support the CFTC's efforts to
require segregation of customer collateral using tri-party
arrangements. While some customers have individually been able
to negotiate these types of agreements, we believe all
customers should have the right to this protection, which can
help avoid the type of systemic event we witnessed with the
collapse of Lehman Brothers.
For cleared swaps, MFA supports complete segregation of
customers' initial margin at both the futures commission
merchant and the central counterparty levels. We think this
level of segregation provides the greatest protection of
customer assets and provides for portability in the event of a
default.
We are concerned that the CFTC appears to be moving away
from complete segregation for customer collateral posted on
cleared swaps. We encourage policymakers to recommend that the
CFTC conduct or sponsor an independent comparative cost study
that thoroughly examines the direct and external costs of
segregation before adopting any rule.
Last, the CFTC and SEC recently issued a joint proposed
rule intended to further clarify which entities meet this major
swap participant definition, a new category created by the
legislation. Because entities that become MSPs will be subject
to significant regulatory obligations, including new capital
requirements, as well as a number of business conduct and other
requirements, we would appreciate additional details to support
the SEC and CFTC's proposal in order to ensure that market
participants are clear on whether they need to register as an
MSP.
MFA appreciates the opportunity to testify before the
Subcommittee, and I am happy to answer any questions.
[The prepared statement of Mr. Kaswell follows:]
Prepared Statement of Stuart J. Kaswell, Executive Vice President,
Managing Director, and General Counsel, Managed Funds Association,
Washington, D.C.
Managed Funds Association (``MFA'') is pleased to provide this
statement in connection with the House Agriculture Subcommittee on
General Farm Commodities and Risk Management's hearing, ``[t]o review
implementation of title VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act [(the `Dodd-Frank Act')], Part II'' held on
February 15, 2011. MFA represents the majority of the world's largest
hedge funds and is the primary advocate for sound business practices
and industry growth for professionals in hedge funds, funds of funds
and managed futures funds, as well as industry service providers. MFA's
members manage a substantial portion of the approximately $1.9 trillion
invested in absolute return strategies around the world.
MFA's members are among the most sophisticated institutional
investors and play an important role in our financial system. They are
active participants in the commodity, securities and over-the-counter
(``OTC'') derivatives markets. They provide liquidity and price
discovery to capital markets, capital to companies seeking to grow or
improve their businesses, and important investment options to investors
seeking to increase portfolio returns with less risk, such as pension
funds trying to meet their future obligations to plan beneficiaries.
MFA members engage in a variety of investment strategies across many
different asset classes. The growth and diversification of investment
funds have strengthened U.S. capital markets and provided investors
with the means to diversify their investments, thereby reducing overall
portfolio investment risk. As investors, MFA members help dampen market
volatility by providing liquidity and pricing efficiency across many
markets. Each of these functions is critical to the orderly operation
of our capital markets and our financial system as a whole.
In addition, MFA members are active participants in the OTC
derivatives markets, where they use swaps to, among other things, hedge
risk. For example, an asset manager that has investments denominated in
foreign currencies may engage in a currency swap to hedge against the
risk of currency fluctuations and protect its portfolio from such
related losses. As active participants in the derivatives markets, MFA
members also play a critical role in enabling commercial and other
institutional market participants to reduce their commercial or balance
sheet risk through the use of swaps. For example, corporate end-users
may purchase a credit default swap from a dealer to protect themselves
from the default of another corporation, or a pension fund may purchase
a variance swap from a dealer to protect against stock market
volatility and to ensure that it can meet its future obligations to
pensioners. In such scenarios, dealers generally look to balance their
books by purchasing offsetting protection from market participants who
may be better positioned to manage such risk, such as hedge funds.
Dealers would be limited in the amount of protection they could offer
their customers if there were no market participants willing to
purchase or sell protection to mitigate a dealer's risk.
MFA members depend on reliable counterparties and market stability.
As such, we have a strong interest in promoting the integrity and
proper functioning of the OTC derivatives markets, and in ensuring that
new regulations appropriately address counterparty and systemic risk,
and protect customers' collateral by requiring a clearing organization
to hold, and a swap dealer to offer to hold, customer funds in
individually segregated accounts, which are protected in the event of
bankruptcy. MFA is fully supportive of policymakers' goals to improve
the functioning of the markets and protect customers by promoting
central clearing of derivatives, increasing transparency and
implementing other measures intended to mitigate systemic risk. MFA
believes that smart regulation will improve efficiency and
competitiveness in the OTC derivatives markets, reduce counterparty and
systemic risk, and help regulators identify cases of market
manipulation or other abuses.
MFA appreciates the Committee's review of the implementation of
Title VII of the Dodd-Frank Act. We provide a number of comments, which
we believe are consistent with the Committee's public policy goals and
will further enhance the benefits of OTC derivatives regulation. We
would like to work with the Subcommittee, the CFTC and any other
interested parties in addressing these issues and are committed in
working towards regulations that will restore investor confidence,
stabilize our financial markets, and strengthen our nation's economy.
Protecting the Integrity of the Regulatory Process
MFA recognizes that the Dodd-Frank Act mandates regulators to
promulgate a record number of new regulations within 360 days of its
enactment, and commends regulators for their diligence and dedication
to implementing a new OTC derivatives regulatory framework.
Nevertheless, we offer a few recommendations to further encourage the
Committee, in its oversight role, to ensure and protect the integrity
of the regulatory process.
The OTC derivatives markets play an important role in our economy
because OTC derivatives have become an important tool for market
participants to mitigate risk. MFA supports a formal OTC derivatives
regulatory framework as we believe smart regulation will reduce
systemic and counterparty risk, and enhance market efficiency,
competition and investor protection. We are concerned however, that at
times the current regulatory process has been overly focused on
quantity over quality of regulations.
In order to establish a regulatory framework that achieves the
goals of policymakers, it is important to ensure that the
implementation of Title VII proceeds in a thoughtful, logical fashion
that strengthens the derivatives markets and does not impair market
participants' ability to mitigate risk through swaps. In this respect,
we note, as an example, that it has been a challenge responding to
proposals on the regulatory requirements of certain entities prior to
understanding how the specific entities are proposed to be, or will be,
defined.
MFA also respectfully urges the Committee to encourage regulators
to enhance coordination and consistency of their regulations, where
applicable, and reduce duplicative regulation. The reality of more and
more market participants diversifying their trading strategies and
business ventures is that more entities will find that they need to
register with both the Commodity Futures Trading Commission (``CFTC'')
and Securities and Exchange Commission (``SEC''). Inconsistent
regulations will be costly, burdensome and, in some cases, impossible
for market participants to comply with both regimes. We believe
regulators should also work together to reduce duplicative regulation.
This would be a more efficient use of government resources, as well as
reduce the regulatory costs and burdens on market participants and
their customers.
Central Clearing and Access To Clearing Significant Entities
MFA supports policymakers' efforts to reduce systemic risk through
proliferating central clearing and enhancing transparency. We believe
that central clearing will play an essential role in reducing systemic,
operational and counterparty risk. While we expect a bilateral market
to remain for market participants to customize their business and risk
management needs, we believe that mandatory clearing and gathering of
data by swap data repositories (``SDRs''), to the extent practicable,
are key first steps that will offer increased regulatory and market
efficiencies, greater market transparency and competition. Therefore,
it is important to move with alacrity towards central clearing.
As customers, we recognize that the success of central clearing and
the gathering of data will depend on the structure, governance and
financial soundness of derivatives clearing organizations (``DCOs''),
SDRs, swap execution facilities (``SEFs'') and designated contract
markets (``DCMs''). Accordingly, we emphasize the need for DCOs,
wherever applicable, to have transparent and replicable risk models and
to enable fair and open access in a manner that incentivizes
competition and reduces barriers to entry. Thus, from a customer
protection perspective, we believe it is important to have customer
representation on the governance and risk committees of DCOs because
given the critical decisions such committees will make (e.g., decisions
about which classes of swaps the DCO is permitted to clear), they will
benefit from the perspective of such significant and longstanding
market participants. We also believe that to completely effectuate fair
representation and balanced governance, it is critical that the CFTC
adopt regulations that prohibit any group from constituting a
controlling majority of DCO boards or risk committees.
With respect to DCOs, DCMs and SEFs, MFA appreciates that the CFTC
has proposed rules intended to ensure that these crucial entities are
governed in a manner that prevents conflicts of interest from
undermining the CFTC's mission to reduce risk, increase transparency
and promote market integrity within the financial system. We very much
appreciate that the proposed rules reflect the CFTC's detailed
appraisal of market concerns, and we believe the rules are a critical
step towards mitigating conflicts of interest at DCOs, DCMs and SEFs
while preserving their competitiveness and ability to provide the best
possible services to the markets.
With respect to SDRs, we emphasize that their role as data
collectors is critical to providing transparency and greater
information about the financial markets. We believe that the data
received by SDRs and shared with regulators will form an essential
component of the regulatory process by providing regulators with the
information necessary to refine their regulations and to effectively
oversee the markets and market participants.
Segregation of Customer Collateral
MFA supports measures aimed at increasing protections for customer
assets posted as collateral for swaps. Therefore, with respect to
uncleared swaps, we support the legislation's requirement that swap
dealers (``SDs'') offer their customers the option to segregate initial
margin in a custodial account, separate from the assets and other
property of the SD. Similarly, we support indications from the CFTC
that they intend to require segregation of customer collateral for
uncleared swaps be pursuant to custodial agreements where the SD or
MSP, custodian and customer are all parties (i.e., tri-party
agreements). It is essential that counterparties have the right to
elect individual segregation of initial margin for uncleared swaps on
commercially reasonable terms because it not only protects customer
property in the event of an SD or MSP default, but also ensures the
stability and integrity of the OTC derivatives markets.
While the CFTC's proposed rule for uncleared swaps seems to imply
that an SD or MSP is required to offer segregation of initial margin to
its counterparty in the form of a tri-party agreement, policymakers
should recommend that the CFTC explicitly clarify that use of a tri-
party agreement is required. Many of our largest members have already
negotiated tri-party agreements with respect to their initial margin
for uncleared swaps, but we believe all counterparties should have the
right to these protections, which will help to prevent harm to
counterparties and the markets.
However, we recognize that tri-party agreements are only one of
several arrangements through which counterparties might protect their
collateral delivered as margin for uncleared swaps. As a result, we
appreciate that the CFTC has retained the flexibility for
counterparties to accept a less secure form of segregation. We agree
that market participants' should have the freedom to use any form of
negotiated collateral arrangement they so choose.
For cleared swaps, MFA applauds policymakers' decision in the
legislation to prohibit futures commission merchants (``FCMs'') from
treating a customer's margin as its own and from commingling their
proprietary assets with those of their customers. We agree that
segregation of assets is a critical component to the effective
functioning of the mandatory clearing regime and necessary to ensure
that customer assets are protected in the event of the FCM's
insolvency. Because we support the protection of customers, we are
concerned that the CFTC appears to be moving away from requiring the
use of individual customer segregated accounts for cleared swaps.
The comment period recently closed on a CFTC advanced notice of
proposed rulemaking, where the CFTC solicited comment on four potential
segregation models for collateral posted on cleared swaps. Out of the
CFTC's four proposed models, we believe that only the full segregation
model offers strong protections for customer collateral in the event of
an FCM default and allows for efficient transfer of customer positions
and collateral in the event of an FCM default.
MFA recognizes that other market participants have provided the
CFTC with conflicting views on the expense of the proposed segregation
models. We believe current cost estimates associated with the use of
the full physical segregation model may be overstated. To determine
which proposed model best accomplishes the goals of the legislation and
the CFTC, we strongly urge policymakers to recommend that the CFTC
conduct or sponsor an independent, comparative cost study of each
segregation option before adopting any particular model, and require
the CFTC to provide market participants sufficient time to evaluate the
study results and respond. If the study concludes that adopting full
physical segregation for cleared swaps would not impose inordinate
costs on customers, we strongly urge adoption of this model in order to
best protect customer assets and allow for the transfer of customer
accounts and related assets.
Definition of Major Swap Participant
The legislation provides a definition for a new category of market
participant called ``major swap participants'' (``MSPs''). Because
entities that become MSPs will be subject to significant regulatory
obligations, including new capital requirements as well as a number of
business conduct and other requirements, the way in which this
important term is defined will significantly affect the evolving
markets for swaps and the conduct of participants in these markets. MFA
believes that the MSP designation should capture systemically
important, non-dealer market participants whose swap positions may
adversely affect market stability. In addition, we strongly support the
need for enhanced market standards and consistency to prevent anomalous
and dangerous practices, such as AIG's, and which mitigate the
excessive build-up of counterparty and systemic risk.
The legislation gives the CFTC, jointly with the SEC, (together
with the CFTC, the ``Commissions''), the authority to define certain
important terms that form part of the MSP definition, such as
``substantial position'', ``substantial counterparty exposure'' and
``highly leveraged''. Recently, the CFTC and SEC jointly issued a
proposed rule providing different tests and threshold levels for these
terms in order to clarify which entities are MSPs.
MFA supports the Commissions' general approach to the MSP
definition and the tests for the different terms. However, we think it
would be useful for the Commissions first to conduct an informal survey
to determine which types of market participants will likely meet the
definition and whether the proposed definitional thresholds are
appropriate as proposed. We think such a survey can be conducted
without incurring significant costs or delaying the progression of the
regulations. In addition, we would appreciate more clarity around the
tests, such as the effects of over-collateralization or cleared swap
positions on the calculations, to ensure that there is a bright line
where market participants have certainty as to whether they need to
register as an MSP. Lastly, to be effective going forward, the
Commissions need to ensure that their proposed rules take into account
reasonable projections about market activity and growth, so that the
rules capture the intended market participants.
Capital and Margin Requirements
For market participants that must register as MSPs, the legislation
requires that the CFTC impose capital and margin requirements on
entities that are subject to regulation as non-bank SDs or MSPs. We are
concerned, however, about what capital requirements the CFTC may
impose.
Unlike banks, our members do not hold capital, but instead manage
assets on behalf of their investors, who have the right to redeem them
subject to the terms of their contractual agreements. Accordingly,
instead of holding capital, our members post margin to secure their
obligations to their counterparties and our members are generally
comfortable with margin requirements consistent with current market
levels. Moreover, our members posting of margin serves a risk
mitigation purpose functionally equivalent to the role that capital
serves for banks (i.e., protecting our counterparties and the financial
system against our default).
As a result, requiring our members to hold capital would be
inconsistent with their business structures and would materially
increase the cost for them to enter into OTC derivatives contracts.
Furthermore, imposing capital requirements over and above the margin
that our members post could have significant, unintended consequences,
including potentially precluding them from participating in the market
altogether. Accordingly, given our members' business model, we believe
that in setting capital requirements for non-bank MSPs, the CFTC should
count margin posted by such non-bank MSPs towards any capital
requirements to which they may be subject.
Position Limits
MFA recognizes that the Dodd-Frank Act expanded the CFTC's
authority to set position limits, as appropriate, to deter and prevent
excessive speculation, market manipulation, squeezes and corners.
Academic and governmental studies and real world examples show that
policies restricting investor access to derivatives markets impair
commercial participants' ability to hedge and restrict the use of risk
management tools. We do not believe position limits have proven to be
effective at reducing volatility or market manipulation.
As a general matter, MFA believes that position limits should only
be imposed for physically-delivered commodities and only where the
deliverable supply of the commodity is limited and, thus, subject to
control and manipulation. Even then, regulators need to consider the
right size for such limits to accommodate a market's unique depth and
liquidity needs. On the other hand, where there is a nearly
inexhaustible supply of the underlying commodity, concerns related to
control and manipulation are largely irrelevant, making position limits
an unnecessary and costly interference in markets.
Nevertheless, if the CFTC is determined to impose position limits,
we believe it is critical for the CFTC to conduct a study on
commodities markets for purposes of assessing the appropriateness of
setting position limits, and, if appropriate, the level at which limits
should be set. Regulation should be based on appropriate findings, and
the CFTC should have data on the size of the markets before considering
imposing position limits. We also believe it is critical for any
position limits regulation to provide market participants with a bona
fide hedging exemption, consistent with CFTC Regulation 1.3(z), and
independent account controller exemptions. In this way, position limits
regulation is less likely to unintentionally reduce market liquidity
and the ability of market participants to appropriately diversify and
hedge risk. Accordingly, we recommend that the Subcommittee encourage
the CFTC to conduct a study of the commodities markets, including the
size and number of market participants in related or equivalent OTC
derivatives markets, prior to imposing position limits.
Swap Execution Facilities
The legislation defines a ``swap execution facility'' (a ``SEF'')
as ``a trading system or platform in which multiple participants have
the ability to execute or trade swaps by accepting bids and offers made
by multiple participants in the facility or system, through any means
of interstate commerce, including any trading facility, that--(A)
facilitates the execution of swaps between persons; and (B) is not a
designated contract market.'' However, we are concerned that the CFTC
is interpreting the definition too narrowly because its proposed rule
requires that to qualify as a SEF a company must offer a ``many-to-
many'' quote platform (i.e., a trading platform where a market
participant must transmit a request for a buy or sell quote to no less
than five market participants).
MFA believes that each SEF trading platform needs to be appropriate
for the product type it will execute, as the characteristics and
corresponding trading needs vary. In addition, we believe that
permitting the broadest range of swap trading platforms (subject to the
requirements under the legislation) would benefit investors, promote
market-based competition among providers, and enable greater
transparency over time and across a variety of products. Therefore, we
would appreciate it if policymakers could provide guidance to the CFTC
on Congress's intended interpretation of the definition, so that the
CFTC's final rules will preserve flexibility and opportunity for
variety and organic development among SEF trading platforms to the
benefit of all market participants and consistent with the approach in
other markets.
MFA is still reviewing and analyzing the CFTC's proposal and we
would appreciate the opportunity to provide our written comment letter
to the Committee as an addendum to our testimony once it is complete.
Conclusion
MFA appreciates the Subcommittee's review of the implementation of
Title VII of the Dodd-Frank Act. As discussed, MFA believes that OTC
derivatives regulation has the potential benefits of reducing systemic
and counterparty risk, and enhancing market efficiency, competition and
investor protection. We recommend that the Subcommittee encourage the
CFTC in implementing the Dodd-Frank Act to work with market
participants to consider and adopt meaningful and cost-effective
regulations in a logical, thoughtful and timely manner. To the extent
practicable, regulation of OTC derivatives by the CFTC and SEC should
be streamlined, consistent, and take into consideration the economic
fundamentals of the product, as well as the likelihood that an entity
will need to register with both agencies. We believe that smart
regulations that parallel market practice will enhance oversight and
compliance, support the risk management needs of market participants
and further promote innovation and competition.
MFA is committed to working with Members and staff of the
Subcommittee and regulators to restore investor confidence, enhance our
regulatory system, stabilize our financial markets, and strengthen our
nation's economy. Thank you for the opportunity to appear before you
today. I would be happy to answer any questions that you may have.
The Chairman. Thank you.
Now the President of the Futures Industry Association in
Washington, D.C., John Damgard.
Five minutes, sir
STATEMENT OF JOHN M. DAMGARD, PRESIDENT, FUTURES INDUSTRY
ASSOCIATION, WASHINGTON, D.C.
Mr. Damgard. Thank you very much, Chairman Conaway, Ranking
Member Boswell, ladies and gentlemen of the Committee.
I am John Damgard, President of the Futures Industry
Association and am pleased to be here today. Many Members of
the Subcommittee are new, and I would like to take a minute to
explain who we are.
FIA is the principal spokesman for the commodity futures
and options industry, and our regular membership is comprised
of approximately 30 of the largest futures commission merchants
in the United States. And among FIA's associate members are
representatives from virtually all other segments of the
industry, both national and international, and we estimate that
among our members, probably 80 to 85 percent of the public
customer transactions executed on futures exchanges are done by
our member firms.
As the principal clearing members of the U.S. derivatives
clearing organizations, our members' firms play a critical role
in the reduction of systemic risk in the our financial system.
Our member firms commit a substantial amount of our own capital
to guarantee the futures and options transactions that our
customers submit for clearing. We take justifiable pride that
the U.S. futures markets operated extremely well throughout the
financial crisis. No FCM failed, and no customer lost money as
a result of the failure of the futures regulatory system.
And I should say this Committee deserves a lot of credit
for that. You created the CFTC in this very room some 45 years
ago, and you have created an agency that has done a tremendous
job of protecting the public and at the same time nurturing an
industry that has grown by something like 6,000 or 7,000
percent, as measured by the volume of trades.
Today I would like to highlight four major concerns about
the Dodd-Frank rulemaking process.
First, some of the proposed rules have gone well beyond the
intent of Congress. Given the intense pressure that we all face
in bringing down the level of government spending, it would
make more sense to focus on the regulatory requirements that
are mandated by Congress and set aside other initiatives for a
future date.
Second, the rules have been published for comment in an
order and at a pace that makes meaningful analysis and comment
very difficult, if not impossible. We encourage both Congress
and the Commodity Futures Trading Commission to take the time
necessary to fully analyze all of the costs and benefits of the
proposed rules and allow sufficient time for the
implementation.
Third, the cost of complying with Dodd-Frank will
discourage participation in the markets and force certain firms
out of business. You have already heard similar concerns from
many groups that represent the end-users of derivatives. I
would only add that the potential costs could lead to a loss of
competition among clearing firms and also liquidity providers.
Fourth, I encourage Congress to consider the international
dimensions of rulemaking process. In particular, FIA believes
that the Commission should use its exemptive authority to avoid
duplicative and perhaps conflicting regulatory requirements for
activities that take place outside the United States.
Let me turn to the rulemaking process.
Our member firms believe that the CFTC should implement the
reforms envisioned by Dodd-Frank in a deliberate and measured
way. We recognize that the CFTC and its staff are working day
and night to comply with the very tight time frames set out in
the Act, and we also appreciate that the Commission has
repeatedly invited affected parties to provide input into the
rulemaking. And we have responded.
As of today, we filed comment letters on 17 proposed
rulemakings with many more to come. We have participated in
three CFTC roundtables, and we have met with CFTC staff on many
occasions to discuss matters of particular concern. I regret to
say, however, that providing meaningful analysis and comment is
extraordinarily difficult due to the tremendous number of rules
that have been proposed in such a short period of time.
To give you one example, the Commission has proposed a
myriad of rules that taken together would completely overhaul
the record keeping and reporting requirements for clearing
member firms. These proposals include the advanced notice of
proposed rulemaking, core principles, and other requirements
for designated contract markets, risk management requirements,
information management requirements, position limits for
derivatives, core principles, and many other requirements for
swap execution facilities.
All of the pending rulemaking and reporting requirements
must be evaluated collectively, not individually. Otherwise, it
is impossible to determine whether the pending rules are
complimentary or conflicting, nor is it possible to calculate
the financial and operational burdens these proposals will
impose on the industry and customers.
FIA also believes that some of the Commission's proposed
rules go way beyond Congressional intent. And an example is the
rulemaking on governance and ownership of clearing
organizations, contract markets, and swap execution facilities.
Although the House version of the financial reform legislation
contained provisions that set specific limits, these provisions
were removed when the legislation reached the conference
committee. And the Dodd-Frank Act in its final form simply
authorized the Commission to adopt a rule with respect to
ownership and governance.
Furthermore, the Act states that any such rule should be
adopted only after the Commission first determines that such
rules are necessary or appropriate to improve the governance,
mitigate systemic risk, promote competition, or mitigate
conflicts of interests. Although the Commission has not made
the required determination, the Commission nonetheless has
proposed specific rules on governance and ownership that
effectively would implement the very provisions that were
removed.
It has been suggested that the Commission should move
forward with rules adopting Dodd-Frank Act time frames but set
selective dates that will afford participants sufficient time
to come into compliance. Although this is certainly one
alternative, we believe the better choice is to delay adopting
final rules until all affected participants have a reasonable
opportunity to fully analyze and understand the scope of the
complex and far-reaching regulatory regime that the Commission
has proposed.
Furthermore, it is our view that the Commission should be
encouraged to use its exemptive authority to ensure the market
participants and transactions taking place outside the United
States are not subject to duplicative regulations.
We urge the Subcommittee to take whatever actions it deems
necessary to encourage the Commission to shift regulatory
obligations to the NFA, through the NFA and to other self-
regulatory organizations. As discussed above, for example, the
Commission could delegate to the NFA the responsibility to
adopt rules for chief compliance officers.
Thanks again for the opportunity to appear before you
today. I am happy to answer any questions.
[The prepared statement of Mr. Damgard follows:]
Prepared Statement of John M. Damgard, President, Futures Industry
Association, Washington, D.C.
Chairman Conaway, Ranking Member Boswell, Members of the
Subcommittee, I am John Damgard, President of the Futures Industry
Association (FIA). On behalf of FIA, I want to thank you for the
opportunity to appear before you today.
As the Subcommittee is aware, the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act) substantially rewrote the
Commodity Exchange Act (CEA) to: (i) establish a comprehensive regime
for swaps, including the mandatory clearing of swaps; (ii) grant
important new authority to the Commodity Futures Trading Commission
(Commission); and (iii) impose significant, new obligations on futures
industry participants, in particular, the futures commission merchants
(FCMs) that FIA represents.
Because Congress gave the regulatory agencies, including the
Commission, broad discretion in adopting rules to implement provisions
of the Dodd-Frank Act, it is essential that the Committee on
Agriculture, as the Committee of jurisdiction with respect to matters
relating to the CEA, monitor carefully the Commission's implementation
of the Dodd-Frank Act and provide additional guidance when appropriate.
We, therefore, welcome these hearings and are pleased that Chairman
Lucas and Chairman Conaway have indicated that they intend to conduct
regular oversight hearings with respect to the Dodd-Frank Act.
We have had an opportunity to review the testimony presented by the
Chicago Mercantile Exchange and the International Swap Dealers
Association at the full Committee hearing last Thursday and share some
of the concerns they expressed.
Futures Industry Association: Who We Are
Since many of the Members of the Subcommittee are new, I would like
to take a minute to explain who we are. FIA is a principal spokesman
for the commodity futures and options industry. FIA's regular
membership is comprised of approximately 30 of the largest futures
commission merchants in the United States. Among FIA's associate
members are representatives from virtually all other segments of the
futures industry, both national and international. Reflecting the scope
and diversity of its membership, FIA estimates that its members effect
more than eighty percent of all customer transactions executed on
United States contract markets.
As the principal clearing members of the U.S. derivatives clearing
organizations (DCOs), our member firms play a critical role in the
reduction of systemic risk in the financial markets. We commit a
substantial amount of our own capital to guarantee our customers'
transactions cleared through the DCO and, through contributions to the
DCO's guarantee fund, guarantee the obligations of other clearing
members to the DCO, in the unlikely event of a clearing member's
default. As a result, our member firms, along with the DCOs of which
they are members, take seriously their responsibility to manage
carefully the significant financial risks that they assume on a daily
basis.
We take justifiable pride that throughout the financial crisis, the
futures markets operated well; no FCM failed and no customer lost money
as a result of a failure of the futures regulatory system.
The FIA Principal Traders Group. This past year, we welcomed the
FIA Principal Traders Group (FIA PTG) as a new division of FIA. The FIA
PTG is comprised of firms that trade their own capital in exchange-
traded markets. Members of the FIA PTG engage in automated, manual and
hybrid methods of trading and are active in a variety of asset classes,
such as futures, equities, foreign exchange, and fixed income. They are
a critical source of liquidity in the exchange-traded markets, allowing
those who use these markets to manage their business risks, to enter
and exit the markets efficiently.
Depending on the eventual market structure of the swaps market,
some of the firms that are members of the FIA PTG may choose to provide
liquidity to the developing cleared swaps markets. They currently are
active participants in the over-the-counter markets operated by ICE and
the New York Mercantile Exchange, both of which may be required to be
registered as swap execution facilities, and would expect to continue
trading these products under the Dodd-Frank regulatory regime. These
firms' willingness and ability to do so, however, will depend on a
number of factors, including the costs associated with complying with
requirements applicable to cleared swaps, as well as the absence of
other barriers to entry to the swaps market.
Implementation of the Dodd-Frank Act: The Rulemaking Process
The success of the futures model understandably led Congress to
require a comparable model for the swaps markets. What may have seemed
like a simple solution in concept to address systemic risk in the
bilateral swaps market, however, has proved to be tremendously complex
in implementation. While swaps and futures may serve similar risk
management purposes, the manner in which they trade and are priced and,
consequently, the financial risks they pose to DCOs and clearing
members when cleared, are substantially different.
As clearing member FCMs will be most directly affected by the
failure of a customer or other clearing member to meet its financial
obligations with respect to cleared swaps, our member firms believe it
is essential that the reforms envisioned by the Dodd-Frank Act be
implemented in a deliberate, measured way to assure that the risks
associated with the clearing of swaps are properly identified and
managed. A ``Big Bang'' approach threatens simply to shift systemic
risk to DCOs and their clearing members, to the potential detriment of
both futures market participants and swaps market participants.
We do not underestimate the challenges facing the Commission, and
we recognize that the Commission and its staff are working hard to
comply with the very tight timeframes set out in the Dodd-Frank Act. We
also appreciate that the Commission has made an effort to solicit the
views of affected parties.
In this regard, FIA member firms have committed significant time
and resources to provide their views and assist the Commission in
developing the rules to implement this regulatory regime. Our members
have made available more than 200 professional staff with risk
management and operational expertise to help FIA in this effort. Member
firm representatives have participated in three roundtables conducted
by Commission staff and have met with the staff on other occasions to
discuss matters of particular concern. Moreover, to date, FIA has filed
comment letters on 17 rule proposals.
Insufficient Time To Analyze and Comment Meaningfully
Although FIA has supported several of the Commission's proposals,
as a general matter, rules have been published for comment in an order
and at a pace that makes meaningful analysis and comment difficult, if
not impossible.
The Commission has published for comment a myriad of proposed
rulemakings that, collectively, contemplate a complete overhaul of the
record-keeping and reporting requirements to which FCMs, U.S. exchanges
and clearing organizations are subject. These proposals include: (i)
the advance notice of proposed rulemaking regarding the protection of
cleared swaps customers before and after commodity broker bankruptcies;
(ii) core principles and other requirements for designated contract
markets; (iii) risk management requirements for derivatives clearing
organizations; (iv) information management requirements for derivatives
clearing organizations; (v) position limits for derivatives; (vi) core
principles and other requirements for swap execution facilities; and
(vii) swap data record-keeping and reporting requirements.
These various rulemakings cannot be considered in isolation. All of
the pending record-keeping and reporting requirements, and the
estimated costs and benefits of each, must be analyzed and evaluated
collectively, not individually. In the absence of such a coordinated
analysis, it is impossible to determine whether the pending rules are
complementary or conflicting. Neither is it possible to calculate the
aggregate financial and operational burdens these various proposals
will have on the industry.
The Ownership and Control Rules. Record-keeping and reporting
requirements have real costs. The Commission's proposed rules requiring
designated contract markets and other reporting entities to submit
weekly ownership and control reports (OCR) to the Commission
demonstrate this point. It is important to note that the OCR rules not
required under the Dodd-Frank Act and are in addition to the list of
rules above.
The pending OCR rules would require each reporting entity to
provide the Commission detailed information, consisting of
approximately 28 separate data points, with respect to each account
reported in its trade register. The proposed data points include
detailed information on beneficial owners and account controllers,
account numbers and dates on which account numbers were assigned.
Because the OCR rules would require FCMs to collect and report a
substantial amount of information that either is not collected in the
manner the Commission may anticipate or is not collected at all, the
proposed rules would require a complete redesign of the procedures,
processes and systems pursuant to which FCMs create and maintain
records with respect to their customers and customer transactions. To
obtain and maintain the required information, an FCM would be required
to: (i) re-negotiate all active customer agreements to require
customers to provide and routinely update the necessary data points;
(ii) build systems to enter the data; (iii) manually enter the data for
each active account; (iv) put in place resources and processes to
maintain the data; (v) provide it to the reporting entity on a weekly
basis; and (vi) monitor changes daily in order to update the database.
To prepare our comment letter on the proposed OCR rules, FIA formed
an OCR Working Group, comprised of individuals with significant
experience in operations from (i) 16 FCMs, both large and small, with
both retail and institutional customers, (ii) the several U.S.
exchanges, (iii) the principal back office service providers, and (iv)
other experts to analyze their potential impact.
FIA received cost estimates for building and maintaining an OCR
database from 12 FIA member firms, both large and small. These firms
carry more than 500,000 customer accounts and hold in excess of $83.8
billion of customer funds, or approximately 62 percent of customers'
segregated funds (as of July 31, 2010, according to monthly financial
reports filed with the Commission). We found that the median firm would
face total costs of roughly $18.8 million per firm, including
implementation costs of roughly $13.4 million, and ongoing costs of
$2.6 million annually. These costs, combined with the unwarranted
structural change in the conduct of business among U.S. futures markets
participants the proposed rules would require, could force a number of
FCMs to withdraw from the business and the barrier to entry for
potential new registrants will be raised.
In its comment letter, FIA presented an alternative OCR proposal
which we believe would achieve the essential regulatory purposes of the
Commission's proposed rules. The cost of the alternative OCR was
considerably less than the estimated cost of implementing the OCR
rules, but they are substantial nonetheless. We must emphasize that
this alternative was not developed within the 60 day comment period
originally proposed by the Commission. It took several months of
detailed analysis by industry representatives who otherwise perform
critical operational and risk management responsibilities in their
firms.
Rules Go Beyond Congressional Intent
The Commission has also proposed rules (or published an advance
notice of proposed rulemaking) that we believe go well beyond
Congressional intent in the Dodd-Frank Act. In doing so, the Commission
has moved away from the principles-based regulation, which has
facilitated growth and innovation in the exchange-traded markets over
the past decade, and has proposed a far more prescriptive regulatory
regime.
Conflicts of Interest. The rules regarding conflicts of interest
for FCMs, swap dealers and major swap participants provide one example
where we believe the Commission has gone beyond the requirements of the
Dodd-Frank Act. Among other things, these provisions, found in 4s(j)(5)
and 4d(c) of the CEA, require firms to establish informational barriers
among the different business units within the firm to assure that the
research and analysis unit and the unit responsible for clearing are
not subject to pressure from the swap dealer unit that might bias their
judgment or supervision.
The Commission's proposed rules go far beyond the principles
established in these provisions of the CEA and require absolute bans on
communications in many instances. They would prohibit any employee of a
swap dealer or major swap participant business unit from participating
in any way with the provision of clearing services and related
activities by the FCM. The rules would restrict routine contacts
between trading and clearing personnel, which we believe would work to
the detriment of customers, and call into question other forms of
completely benign and beneficial conduct. Moreover, these proposed
rules could impair a firm's ability to follow established risk
management best practices. We believe the Commission needs to revise or
even reissue these rules for comment.
Governance and Ownership. Proposed rules on governance and
ownership of clearing organizations, contract markets and swap
execution facilities is another example of the Commission's decision to
propose rules that go beyond the Dodd-Frank Act and, in this case,
would impose restrictions that Congress specifically rejected. Although
the House version of the financial reform legislation contained
provisions that set specific ownership limits for these entities, they
were rejected in the Dodd-Frank Act, which simply authorizes the
Commission to adopt rules with respect to ownership and governance, but
only after completing a review, and only if it first determines ``that
such rules are necessary or appropriate to improve the governance of,
or to mitigate systemic risk, promote competition, or mitigate
conflicts of interest.'' Although the Commission conducted no review
and did not make the required determination, the Commission nonetheless
proposed rules that would effectively implement provisions that were
removed by the Conference Committee.
Chief Compliance Officer. The proposed rules relating to chief
compliance officers provide another. The Dodd-Frank Act sets out
specific responsibilities that chief compliance officers of swap
dealers and major swap participants must meet, but simply requires
chief compliance officers of FCMs to ``perform such duties and
responsibilities as shall be set forth in regulations to be adopted by
the Commission or rules to be adopted by a futures association.''
Notwithstanding these differences, the Commission elected to
propose that FCMs be subject to the same rules as swap dealers and
major swap participants. Although there may be advantages in creating
uniform rules for entities under its jurisdiction, we are concerned
that, in so doing, the Commission has ignored the model for compliance
that FCMs have long followed.
In a detailed comment letter that FIA filed jointly with the
Securities Industry and Financial Markets Association, we explained
that the proposed rules would establish a compliance framework that is
significantly different from that currently in place in the financial
services industry under the regulations promulgated by other Federal
regulators, including the Securities and Exchange Commission (SEC) and
the several banking regulators, as well as the compliance model adopted
by the Commission itself as recently as September 2010.
Among other things, the proposed rules would fundamentally change
the role of chief compliance officers by requiring them to perform
supervisory duties. Traditionally, the chief compliance officer acts as
an independent advisor to the firm's business-line supervisors, who
have the authority to supervise the firm's business activities and are
ultimately responsible for the firm's compliance with applicable law.
By eliminating the separation between supervision and compliance, the
proposed rules would eliminate the independence necessary to perform
the chief compliance officer function effectively and would undermine
the long-standing regulatory principle that the supervisory
responsibility in the firm rests with the business managers, not the
chief compliance officer.
Particularly troublesome is the Commission's statement that chief
compliance officers may be subject to criminal liability as a result of
carrying out their duties, although there is no indication that
Congress intended that chief compliance officers would be subject to
criminal liability under the applicable sections of the Dodd-Frank Act.
Criminal liability is not specifically a part of the existing financial
services compliance model, and potential criminal liability will make
it much more difficult, if not impossible, for firms to hire competent
employees who will be willing to serve as chief compliance officers.
Moreover, imposition of criminal liability on chief compliance officers
would create a duplicative, inconsistent, burdensome and unpredictable
regulatory environment in many registrants that are subject to and have
implemented the existing financial services compliance model.
In lieu of these proposed rules, we believe the Commission should
exercise the authority that Congress specifically provided in the Dodd-
Frank Act and delegate to the National Futures Association (NFA) the
responsibility to adopt rules for chief compliance officers. NFA has
considerable experience in this area and such delegation would be
consistent with the policy followed by the SEC, which has delegated
this responsibility to FINRA.
The Potential Costs Are Not Well-Understood
The Commission has acknowledged that its proposed rules will
increase the costs of effecting transactions in swaps, but believes
that the benefits outweigh any additional costs that may be imposed on
customers. We believe the Commission may well have underestimated
certain costs. Again, however, we simply have not had the time, and in
certain cases lack the information necessary, to make a meaningful
analysis in the time provided.
Moreover, these additional costs will not be imposed solely on swap
participants. They are certain to affect participants in the exchange-
traded markets as well. In this regard, we are concerned by Chairman
Gensler's announcement in his testimony last week that the Commission
has established a rulemaking team to develop ``conforming rules'' to
update the Commission's existing rules to take into account the
provisions of the CEA. To the extent this rulemaking team recommends
imposing the proposed rules for swaps on the exchange market, costs are
certain to rise. As a result, as discussed earlier, a number of FCMs
could be compelled to withdraw from registration and the barrier to
entry for potential new registrants will be raised which will
negatively affect competition. In any event, FCMs will have little
choice but to pass these costs on to their customers.
Essential Decisions Have Been Deferred
As important, the Commission has not yet made decisions on critical
issues that will determine the Commission's view of the full scope of
its jurisdiction. The basic definitions of a ``swap dealer'', ``major
swap participant'' and ``swap'' have not been adopted. Similarly, rules
relating to capital and margin requirements have not been proposed. As
a result, many swap market participants may not be aware, or may be
uncertain, whether they will be required to be registered with the
Commission in some capacity or otherwise be affected by the proposed
rules. Therefore, they may not have had an opportunity to, or reason to
believe that they should, comment on the proposed rules.
The Commission has also offered no guidance on the extent to which
it may seek to assert its jurisdiction over entities located, or
transactions that take place, outside of the United States, but which
touch the U.S. in some way. Because swaps have not previously been
entered into on organized exchanges or other trading facilities, the
swaps market is truly international in scope. For example, the U.K.
branch of a U.S. bank and a French bank may enter into an interest rate
swap, which is governed by New York law.
The Dodd-Frank Act provides that its provisions should not apply to
activities that take place outside of the United States, unless those
activities have a ``direct and significant connection with activities
in, or effect on, commerce of the United States.'' Further, the
Commission is authorized to exempt from regulation foreign derivatives
clearing organizations and swap execution facilities that are subject
to comparable, comprehensive supervision and regulation in their home
country. As the Members of the Subcommittee may be aware, the European
Union (EU) is developing a comprehensive regulatory regime for swaps,
including clearing through EU clearing organizations. The Commission
should be encouraged to use its exemptive authority to assure that
transactions and participants that do not have a ``direct and
significant connection with activities in, or effect on, commerce of
the United States'' are not subject to duplicative, and perhaps
conflicting, regulatory requirements.
The Commission has a successful model for the regulation of
international transactions that could serve as an starting point for
exempting participants and transactions from its jurisdiction. Under
the Commission's Part 30 rules, governing the offer and sale of futures
and options traded on foreign exchanges, the Commission has granted
exemptions from registration to non-U.S. firms that deal with U.S.
customers and that the Commission determines are subject to comparable
regulation in their home country. On the same basis, the Commission has
also authorized certain foreign boards of trade to permit direct access
from the U.S. In each case, the exemption is made subject to
appropriate information sharing agreements and all affected
participants must consent to the jurisdiction of the Commission and
Department of Justice to be certain that the Commission and the
Department of Justice are able to obtain information when necessary.
Delay in Adopting Final Rules
It has been suggested that the Commission should move forward with
adopting final rules within the Dodd-Frank Act timeframes, but set
effective dates that will afford participants sufficient time to come
into compliance. Although this is certainly one alternative, we believe
the better choice is to delay adopting final rules until all affected
participants have a reasonable opportunity to analyze fully and
understand the scope of the regulatory regime the Commission has
proposed.
Responsibilities Should Be Delegated to the National Futures
Association
In closing, I want to note that we were pleased that Chairman
Gensler has indicated that he intends to rely more heavily on the
National Futures Association. Self-regulation has worked extremely well
in the futures markets, and we see no reason why the success of these
programs cannot be transferred to the swaps markets.
When Congress amended the CEA in 1974 to establish the Commission,
it included a provision for an industry-wide self-regulatory
organization such as NFA. Since NFA began operations in 1982, Congress
has demonstrated its confidence in NFA by amending the CEA three times
to provide it with additional responsibilities.
As a self-regulatory organization, NFA is subject to the ongoing
oversight of the Commission. Our experience is that NFA and the
Commission have a very close and cooperative working relationship. The
Subcommittee can be confident, therefore, that NFA will use its broad
authority to achieve the regulatory goals that Congress sought in
enacting the Dodd-Frank Act. Importantly, NFA is funded entirely by
futures market participants, thereby relieving additional strain on the
Federal budget.
We urge the Subcommittee to take whatever action it deems
appropriate to encourage the Commission shift many of the regulatory
obligations that it has assumed for itself under the proposed rules to
NFA and, through NFA, to the other industry self-regulatory
organizations. As discussed above, for example, the Commission could
delegate to NFA the responsibility to adopt rules for chief compliance
officers.
Thank you again for the opportunity to appear before you today. I
would be happy to answer any questions you may have.
The Chairman. Thank you, Mr. Damgard.
Votes have been called. If we could go through Mr.
McMahon's testimony, and then we will recess real quickly, go
vote and come back.
Ms. Sanevich, we will come back to visit with you about
your testimony.
Mr. McMahon.
STATEMENT OF RICHARD F. McMAHON, Jr., VICE PRESIDENT OF ENERGY
SUPPLY AND FINANCE, EDISON ELECTRIC
INSTITUTE, WASHINGTON, D.C.; ON BEHALF OF AMERICAN PUBLIC POWER
ASSOCIATION; ELECTRIC POWER SUPPLY ASSOCIATION
Mr. McMahon. Chairman Conaway, Ranking Member Boswell, and
Members of the Subcommittee. Thank you for the opportunity to
discuss the role of over-the-counter derivatives markets in
helping energy companies insulate our customers from the
volatility of commodity price risk as well as some of the key
implementation issues of the Dodd-Frank Act.
I am Richard McMahon, Vice President of Energy Supply and
Finance for the Edison Electric Institute. I am testifying
today on behalf of EEI, APPA and EPSA. Together our members
serve most of our nation's electric consumers. The goal of our
members is to provide our customers with reliable electric
service at affordable and stable rates. Therefore, it is
essential to manage the significant price volatility inherent
in wholesale commodity markets for natural gas and electricity.
The derivatives market is an extremely effective tool in
insulating our customers from this price volatility. Utility
and energy companies are financially stable and highly credit
worthy. As a result, utilities and their customers get a
significant cost-benefit from little or no collateral
requirements for their OTC derivative swaps from exchanges, and
clearinghouses, on the other hand, are generally blind to the
financial help of our participants and demand cash margin
requirements from us.
We support the goals of Dodd-Frank to bring greater
transparency and oversight to the derivatives markets and to
address the systemic risk to the economy. However, a margin
requirement on all utility OTC swaps would have an average
annual cash flow impact of between $250 million and $400
million per company.
If our members are forced to post margin on all of their
OTC transactions, we will have three equally undesirable
choices: One, redirect dollars from our core infrastructure
capital spending programs to margin accounts at clearinghouses;
or borrow the money to post in margin accounts and pass the
costs of borrowing through to our customers in rates; or
curtail our derivatives hedging programs and pass the commodity
price volatility in natural gas and electric power through to
our customers.
We were pleased to hear CFTC Chairman Gary Gensler testify
last week that proposed rules on margins shall focus on
transactions between financial entities rather than those
transactions involving non-financial end-users. It is essential
that this approach be fully implemented. It was the clear
intent of Congress, as confirmed in the letter drafted by
Senators Dodd and Lincoln as part of the conference, to fully
exempt end-users from margin and burdensome CFTC compliance
obligations.
The Dodd-Frank Act left many important issues to be
resolved by regulators and set impractical, tight deadlines on
rulemakings. To further complicate matters, many of the complex
issues raised by scores of rulemakings are interrelated. As a
result, interested parties are unable to comment on the
proposed rules in a meaningful way because they cannot know the
full effect of the complete universe of the proposed rules.
For instance, the CFTC has not yet issued proposed rules on
the definition of a swap. This definition is critical to many
of the current rulemakings of Dodd-Frank and could
significantly expand the reach and impact of these regulations.
In the end-user clearing exemption provision of Dodd-Frank,
Congress gave our members the flexibility to elect, not to
clear, swaps that they use to hedge commercial risk. The CFTC's
proposed rulemaking implementing this provision would require
an end-user to report roughly a dozen items of information to
CFTC every time it elects to rely on the end-user clearing
exemption for a swap. The CFTC does not need such
representations from end-users about every one of their non-
cleared swaps to prevent abuse of the end-user clearing
exemption. End-users understand that knowingly providing the
CFTC with inaccurate information is a very serious violation of
the Commodity Exchange Act.
We request that the Subcommittee emphasize to CFTC that it
can implement the end-user clearing exemption consistent with
Congress' intent, by streamlining their proposed requirements
in the following ways: By requiring end-users to represent once
that they will only rely on the end-user exemption for swaps
that hedge commercial risks; and by informing the Commission
once how they generally meet their financial obligations
associated with entering into non-cleared swaps, of course
coupled with an obligation to provide notice of any material
change; and in the case of publicly traded companies, by
maintaining a record showing that an appropriate committee of
the board of directors has reviewed and approved their overall
decision not to clear.
We also have serious concerns about the CFTC's plans to
define swap dealer. The CFTC's proposed rule includes very
extensive language, expansive language about the types of
activity that CFTC views as dealing. At the same time, the
Commission has proposed to implement the ``not as part of the
regular business'' and de minimis exceptions in a very
restrictive manner. The result could be that commercial end-
users are inappropriately miscast as swaps dealers.
We appreciate your role in helping to ensure that energy
end-users can continue to use OTC derivatives to help to
protect and insulate our nation's consumers from volatile
wholesale gas and wholesale power commodity prices in a cost-
effective way.
I am happy to answer any questions you may have.
[The prepared statement of Mr. McMahon follows:]
Prepared Statement of Richard F. McMahon, Jr., Vice President of Energy
Supply and Finance, Edison Electric Institute, Washington, D.C.; on
Behalf of American Public Power Association; Electric Power Supply
Association
Chairman Conaway and Members of the Subcommittee, thank you for
this opportunity to discuss the role of over-the-counter (OTC)
derivatives markets in helping utilities and energy companies insulate
our customers from the volatility of commodity price risk, as well as
some of the key issues we see in the implementation of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (Dodd-Frank).
I am Richard McMahon, Vice President of Energy Supply and Finance
for the Edison Electric Institute (EEI). EEI is the trade association
of U.S. shareholder-owned electric utilities, with international
affiliates and industry associates worldwide. EEI's U.S. members serve
95 percent of the ultimate electricity customers in the shareholder-
owned segment of the industry, and represent approximately 70 percent
of the total U.S. electric power industry.
I also am testifying on behalf of the American Public Power
Association (APPA) and the Electric Power Supply Association (EPSA).
APPA represents the nation's more than 2,000 community-owned electric
utilities. EPSA is the national trade association representing
competitive power suppliers, including generators and power marketers.
Utilities and Energy Companies Hedge Risk
Wholesale natural gas and electric power are, and have been
historically, two of the most volatile commodity groups. Our members
use natural gas extensively as a fuel to generate electric power, as
well as distribute natural gas to consumers in their homes.
Additionally, utilities purchase wholesale electricity from generators
and marketers to meet consumer demand.
The goal of our members is to provide their customers with reliable
service at affordable and stable rates. Therefore, it is essential to
manage the price volatility inherent in wholesale commodity markets for
natural gas and electric power. Our members purchase fuel and sell
power at thousands of delivery points throughout the U.S. They need the
ability to use OTC swaps because existing futures contracts cover
limited natural gas and electricity delivery points. The derivatives
market has proven to be an extremely effective tool in insulating our
customers from this risk and price volatility. Utilities and energy
companies use both exchange traded and cleared and OTC swaps for
natural gas and electric power to hedge commercial risk. About \1/2\ of
our gas swaps and about \1/3\ of our power swaps are traded on-
exchanges.
Why the Margin Issue is Critically Important
Utilities and energy companies are financially stable and highly
creditworthy. On average EEI's members are rated BBB. As a result,
utilities and their customers get a significant cost-benefit from low
or no collateral requirements for their OTC derivatives transactions.
In some cases, our members provide a letter for credit or a lien on
assets as collateral to support their obligations on swaps. Exchanges
and clearinghouses are generally blind to the financial health of their
participants and demand cash margin deposits, both initial and
variation margin.
Our industry is in the midst of a major capital spending program to
enhance the electric grid, make our generation fleet cleaner and bring
new technologies to our customers. Last year, shareholder-owned
electric utilities' capital expenditures (CAPEX) were $83 billion, and
we expect this pace of capital investment to continue throughout the
decade. The capital investments of all of our members are contributing
to our nation's economic recovery and job growth.
A margin requirement on all utility OTC swaps would have an average
annual cash flow impact of between $250 million-$400 million per
company. This ``dead capital'' tied up in margin accounts at
clearinghouses would need to be funded by our customers.
If our members are forced to post margin on all of our OTC
transactions, we have three equally undesirable choices:
Re-direct dollars from our core infrastructure capital
spending programs to margin accounts at clearinghouses;
Borrow the money to post in margin accounts and pass that
cost through to our customers in rates; or
Curtail our derivatives hedging programs and pass the
commodity price volatility in gas and electric power through to
our customers.
Because of these undesirable consequences, the National Association
of Regulatory Utility Commissioners (NARUC) passed a resolution in
support of the industry's goal of maintaining our ability to use OTC
derivatives without cash margining requirements (see attached).
We were very pleased to hear Commodity Futures Trading Commission
(CFTC) Chairman Gensler's testimony last week before the full House
Agriculture Committee in which he stated, ``Proposed rules on margin
shall focus on transactions between financial entities rather than
those transactions that involve non-financial end-users.'' It is
essential that this now unambiguous direction from the CFTC Chairman be
carried through fully in implementation of the Dodd-Frank Act. We
believe this was the clear intent of the Congress, and it was confirmed
in the Dodd-Lincoln letter, which was drafted as part of the conference
committee to fully clarify the intent of the Congress to fully exempt
end-users from margining and burdensome CFTC compliance obligations.
(see attached)
Need for a Proper Sequencing and Implementation Timetable
We support the overarching goals of the Dodd-Frank Act to bring
greater transparency and oversight to derivatives markets and to
address systemic risk to the economy. Additionally, we compliment the
CFTC Chairman, Commissioners and staff for their hard work and openness
in seeking input from different market participants during the
implementation process.
However, the Dodd-Frank Act left many important issues to be
resolved by regulators and set impractical, tight deadlines on
rulemakings by the agencies charged with implementation. To further
complicate matters, many of the complex issues raised by scores of
rulemakings are interrelated. As a result, interested parties are
unable to comment on the proposed rules in a meaningful way, because
they cannot know the full effect of the complete universe of proposed
rules. For example, it is difficult to comment on the proposed swap
dealer definition, position limits, and record-keeping and reporting
rules for swaps before the proposed definition of a swap has been
issued.
Concerns Regarding Implementation Burdens on End-Users
In a provision of the Dodd-Frank Act known as the ``end-user
clearing exception,'' Congress gave our members and other end-users of
swaps the flexibility to elect not to clear swaps that they use to
hedge commercial risk.
The CFTC's proposed rule implementing this provision would require
an end-user to report roughly a dozen items of information to the CFTC
every time it elects to rely on the end-user clearing exception for a
swap. The required information for each swap includes representations
that:
it is a non-financial entity,
the swap is hedging commercial risk,
it has certain credit arrangements in place, and
in the case of publicly-traded companies like most of our
members, that an appropriate committee of the board of
directors (or equivalent body) has reviewed and approved its
decision not to clear.
The CFTC does not need such representations from our members and
other end-users about every one of their non-cleared swaps to prevent
abuse of the end-user clearing exception. Our members and other end-
users understand that knowingly providing the CFTC with inaccurate
information is a very serious violation of the Commodity Exchange Act
(CEA). That is more than sufficient incentive for end-users to rely on
the end-user clearing exception only when they are authorized to do so.
We request that the Subcommittee emphasize to the CFTC that it can
implement the end-user clearing exception, consistent with Congress's
intent, by requiring end-users to:
represent once that they will only rely on the end-user
clearing exception for swaps that hedge commercial risk;
inform the Commission once how they generally meet their
financial obligations associated with entering into non-cleared
swaps (coupled with an obligation to provide notice of material
changes); and
in the case of publicly-traded companies, maintain a record
that shows that an appropriate committee of the board of
directors (or equivalent body) has reviewed and approved their
decision not to clear.
In addition to our concerns about the CFTC's proposed
implementation of the end-user clearing exception, we have serious
concerns about how the CFTC plans to define ``swap dealer.'' The CFTC's
proposed rule includes very expansive language about the types of
activity--including ``accommodating'' the demand of third parties for
swaps--that the CFTC views as dealing activity. At the same time, the
Commission has proposed to implement the ``not as part of a regular
business'' and ``de minimis'' exceptions to the definition of ``swap
dealer'' in a very restrictive manner. The result could be that
commercial end-users are inappropriately miscast as swap dealers. If
our members, which primarily engage in hedging activities, are caught
within the definition of ``swap dealer,'' not only will they face the
costs of margin requirements, but they also will be subject to
additional capital and collateral requirements (not yet defined by the
CFTC), cost of IT systems for additional reporting, and other costly
requirements not appropriate for end-users.
The CEA, prior to the passage of the Dodd-Frank Act, excluded
physical forward transactions from the CFTC's jurisdiction over futures
contracts. The definition of swap in the Dodd-Frank Act includes
options on physical commodities, but excludes ``any sale of a non-
financial commodity . . . so long as the transaction is intended to be
settled.'' The CFTC has issued proposed rules on swap position
reporting and on agricultural swaps which indicate that the CFTC
intends to regulate options on physical commodities as swaps or
``swaptions.'' The end-user community is concerned about the CFTC's
proposal because many contracts for the delivery of power in the
electric industry, such as capacity and requirements contracts, include
price, volume or other optionality. Including these end-user to end-
user contracts in the definition of swap would greatly expand the scope
of the CFTC's regulation over the electric utility industry and
potentially would subject end-users to a number of burdensome
regulatory requirements. We urge Congress to restrain CFTC's regulatory
authority in this critical area of our business.
Conclusion
Thank you for your leadership and interest in implementation of the
Dodd-Frank Act. We appreciate your role in helping to ensure that
utilities and energy companies can continue to be able to use OTC
derivatives to cost-effectively help protect our nation's consumers
from volatile wholesale natural gas and power commodity prices.
Attachments
National Association of Regulatory Utility Commissioners
Resolution on Financial Reform Legislation Affecting Over-the-Counter
Risk Management Products and Its Impacts on Consumers
Whereas, There is a diverse group of end-users, consisting of
electric and natural gas utilities, suppliers, customers, and other
commercial entities who rely on over-the-counter (``OTC'') derivative
products and markets to manage electricity and natural gas price risks
for legitimate business purposes, thereby helping to keep rates stable
and affordable for retail consumers; and
Whereas, The United States Congress is considering financial reform
legislation with the goal of ensuring that gaps in regulation,
oversight of markets and systemic risk do not lead to economic
instability; and
Whereas, Previous NARUC resolutions support Federal legislative and
regulatory actions that fully accommodate legitimate hedging activities
by electric and natural gas utilities; and
Whereas, The proposed legislation would, among other things,
provide the Commodity Futures Trading Commission (CFTC) with oversight
of OTC risk management products, including mandatory centralized
clearing and exchange trading of all OTC products; and
Whereas, Mandatory centralized clearing of all OTC contracts will
increase expenses associated with hedging activity, and ultimately end-
user prices, due to increased margin requirements; and
Whereas, A report by the Joint Association of Energy End-Users
stated that the effect of margin requirements resulting from mandatory
clearing for electric utilities would have the unintended effect of
reducing or eliminating legitimate hedging practices and could
jeopardize or reduce investments in Smart Grid technology; and for
natural gas utilities and production companies could reduce capital
devoted to infrastructure and natural gas exploration; and
Whereas, The laudable goals of reform that ensure market
transparency and adequate regulatory oversight can be accomplished by
means other than mandatory clearing of OTC risk management contracts
and the anticipated extra expense. For example, a requirement that
natural gas and electric market participants engaging in legitimate
hedging report all OTC derivative transactions to a centralized data
repository, like the CFTC, provides sufficient market transparency
without the costs associated with mandatory clearing; and
Whereas, Proposed reforms would cause regulatory uncertainty with
regard to the oversight of Regional Transmission Organizations (RTOs)
and Independent System Operators (ISOs), where such uncertainty and/or
overlapping jurisdiction can lead to negative impacts on liquidity,
market confidence and reliability; and
Whereas, The Federal Energy Regulatory Commission (FERC), and the
Public Utility Commission of Texas (PUCT) for Texas/ERCOT, as the
regulators with the necessary expertise and statutory mandates to
oversee electricity and natural gas markets to protect the public
interest and consumers, should not be preempted by the financial reform
legislation from being able to continue exercising their authority to
ensure reliable, just and reasonable service and protect consumers; and
Whereas, Energy markets currently regulated by FERC or the PUCT
(for Texas/ERCOT) under accepted tariffs or rate schedules should
continue to be subject to FERC's and the PUCT's (for Texas/ERCOT)
exclusive Federal jurisdiction, including jurisdiction over physical
and financial transmission rights, and market oversight; and should
themselves not be subject to CFTC jurisdiction as a clearinghouse due
to the financial and other settlement services they provide those
transacting in regional electricity markets; now, therefore be it
Resolved, That the Board of Directors of the National Association
of Regulatory Utility Commissioners, convened at its 2010 Winter
Committee Meetings in Washington, D.C., supports passage of financial
reform legislation ensuring that electric and natural gas market
participants continue to have access to OTC risk management products as
tools in their legitimate hedging practices to provide more predictable
and less volatile energy costs to consumers; and be it further
Resolved, That new financial legislation being considered by
Congress should weigh the costs of potential end-user utility rate
increases versus the benefits of new standards for the clearing of OTC
risk management contracts used by natural gas and electric utilities
for legitimate hedging purposes; and be it further
Resolved, That any Federal legislation addressing OTC risk
management products should provide for an exemption from mandatory
clearing requirements for legitimate hedging activity in natural gas
and electricity markets; and be it further
Resolved, That any exemption to the mandatory clearing requirement
for OTC derivatives be narrowly tailored as to not allow excessive
speculation in natural gas and electricity markets; and be it further
Resolved, That the FERC, and the PUCT for Texas/ERCOT, charged with
the statutory obligation to protect the public interest and consumers,
should continue to be the exclusive Federal regulators with authority
to oversee any agreement, contract, transaction, product, market
mechanism or service offered or provided pursuant to a tariff or rate
schedule filed and accepted by the FERC, or the PUCT for Texas/ERCOT;
and be it further
Resolved, That NARUC authorizes and directs the staff and General
Counsel to promote with the Congress, the Commodity Futures Trading
Commission and other policymakers at the Federal level, policies
consistent with this statement.
Sponsored by the Committee on Gas, Consumer Affairs, and
Electricity Adopted by the NARUC Board of Directors February
17, 2010.
______
June 30, 2010
Hon. Barney Frank,
Chairman,
House Committee on Financial Services,
Washington, D.C.
Hon. Collin C. Peterson,
Chairman,
House Committee on Agriculture,
Washington, D.C.
Dear Chairmen Frank and Peterson:
Whether swaps are used by an airline hedging its fuel costs or a
global manufacturing company hedging interest rate risk, derivatives
are an important tool businesses use to manage costs and market
volatility. This legislation will preserve that tool. Regulators,
namely the Commodity Futures Trading Commission (CFTC), the Securities
and Exchange Commission (SEC), and the prudential regulators, must not
make hedging so costly it becomes prohibitively expensive for end-users
to manage their risk. This letter seeks to provide some additional
background on legislative intent on some, but not all, of the various
sections of Title VII of H.R. 4173, the Dodd-Frank Act.
The legislation does not authorize the regulators to impose margin
on end-users, those exempt entities that use swaps to hedge or mitigate
commercial risk. If regulators raise the costs of end-user
transactions, they may create more risk. It is imperative that the
regulators do not unnecessarily divert working capital from our economy
into margin accounts, in a way that would discourage hedging by end-
users or impair economic growth.
Again, Congress clearly stated in this bill that the margin and
capital requirements are not to be imposed on end-users, nor can the
regulators require clearing for end-user trades. Regulators are charged
with establishing rules for the capital requirements, as well as the
margin requirements for all uncleared trades, but rules may not be set
in a way that requires the imposition of margin requirements on the
end-user side of a lawful transaction. In cases where a Swap Dealer
enters into an uncleared swap with an end-user, margin on the dealer
side of the transaction should reflect the counterparty risk of the
transaction. Congress strongly encourages regulators to establish
margin requirements for such swaps or security-based swaps in a manner
that is consistent with the Congressional intent to protect end-users
from burdensome costs.
In harmonizing the different approaches taken by the House and
Senate in their respective derivatives titles, a number of provisions
were deleted by the Conference Committee to avoid redundancy and to
streamline the regulatory framework. However, a consistent
Congressional directive throughout all drafts of this legislation, and
in Congressional debate, has been to protect end-users from burdensome
costs associated with margin requirements and mandatory clearing.
Accordingly, changes made in Conference to the section of the bill
regulating capital and margin requirements for Swap Dealers and Major
Swap Participants should not be construed as changing this important
Congressional interest in protecting end-users. In fact, the House
offer amending the capital and margin provisions of Sections 731 and
764 expressly stated that the strike to the base text was made ``to
eliminate redundancy.'' Capital and margin standards should be set to
mitigate risk in our financial system, not punish those who are trying
to hedge their own commercial risk.
Congress recognized that the individualized credit arrangements
worked out between counterparties in a bilateral transaction can be
important components of business risk management. That is why Congress
specifically mandates that regulators permit the use of non-cash
collateral for counterparty arrangements with Swap Dealers and Major
Swap Participants to permit flexibility. Mitigating risk is one of the
most important reasons for passing this legislation.
Congress determined that clearing is at the heart of reform--
bringing transactions and counterparties into a robust, conservative
and transparent risk management framework. Congress also acknowledged
that clearing may not be suitable for every transaction or every
counterparty. End-users who hedge their risks may find it challenging
to use a standard derivative contracts to exactly match up their risks
with counterparties willing to purchase their specific exposures.
Standardized derivative contracts may not be suitable for every
transaction. Congress recognized that imposing the clearing and
exchange trading requirement on commercial end-users could raise
transaction costs where there is a substantial public interest in
keeping such costs low (i.e., to provide consumers with stable, low
prices, promote investment, and create jobs.)
Congress recognized this concern and created a robust end-user
clearing exemption for those entities that are using the swaps market
to hedge or mitigate commercial risk. These entities could be anything
ranging from car companies to airlines or energy companies who produce
and distribute power to farm machinery manufacturers. They also include
captive finance affiliates, financials that are hedging in support of
manufacturing or other commercial companies. The end-user exemption
also may apply to our smaller financial entities--credit unions,
community banks, and Farm Credit institutions. These entities did not
get us into this crisis and should not be punished for Wall Street's
excesses. They help to finance jobs and provide lending for communities
all across this nation. That is why Congress provided regulators the
authority to exempt these institutions.
This is also why we narrowed the scope of the Swap Dealer and Major
Swap Participant definitions. We should not inadvertently pull in
entities that are appropriately managing their risk. In implementing
the Swap Dealer and Major Swap Participant provisions, Congress expects
the regulators to maintain through rulemaking that the definition of
Major Swap Participant does not capture companies simply because they
use swaps to hedge risk in their ordinary course of business. Congress
does not intend to regulate end-users as Major Swap Participants or
Swap Dealers just because they use swaps to hedge or manage the
commercial risks associated with their business. For example, the Major
Swap Participant and Swap Dealer definitions are not intended to
include an electric or gas utility that purchases commodities that are
used either as a source of fuel to produce electricity or to supply gas
to retail customers and that uses swaps to hedge or manage the
commercial risks associated with its business. Congress incorporated a
de minimis exception to the Swap Dealer definition to ensure that
smaller institutions that are responsibly managing their commercial
risk are not inadvertently pulled into additional regulation.
Just as Congress has heard the end-user community, regulators must
carefully take into consideration the impact of regulation and capital
and margin on these entities.
It is also imperative that regulators do not assume that all over-
the-counter transactions share the same risk profile. While uncleared
swaps should be looked at closely, regulators must carefully analyze
the risk associated with cleared and uncleared swaps and apply that
analysis when setting capital standards for Swap Dealers and Major Swap
Participants. As regulators set capital and margin standards on Swap
Dealers or Major Swap Participants, they must set the appropriate
standards relative to the risks associated with trading. Regulators
must carefully consider the potential burdens that Swap Dealers and
Major Swap Participants may impose on end-user counterparties--
especially if those requirements will discourage the use of swaps by
end-users or harm economic growth. Regulators should seek to impose
margins to the extent they are necessary to ensure the safety and
soundness of the Swap Dealers and Major Swap Participants.
Congress determined that end-users must be empowered in their
counterparty relationships, especially relationships with swap dealers.
This is why Congress explicitly gave to end-users the option to clear
swaps contracts, the option to choose their clearinghouse or clearing
agency, and the option to segregate margin with an independent third
party custodian.
In implementing the derivatives title, Congress encourages the CFTC
to clarify through rulemaking that the exclusion from the definition of
swap for ``any sale of a non-financial commodity or security for
deferred shipment or delivery, so long as the transaction is intended
to be physically settled'' is intended to be consistent with the
forward contract exclusion that is currently in the Commodity Exchange
Act and the CFTC's established policy and orders on this subject,
including situations where commercial parties agree to ``book-out''
their physical delivery obligations under a forward contract.
Congress recognized that the capital and margin requirements in
this bill could have an impact on swaps contracts currently in
existence. For this reason, we provided legal certainty to those
contracts currently in existence, providing that no contract could be
terminated, renegotiated, modified, amended, or supplemented (unless
otherwise specified in the contract) based on the implementation of any
requirement in this Act, including requirements on Swap Dealers and
Major Swap Participants. It is imperative that we provide certainty to
these existing contracts for the sake of our economy and financial
system.
Regulators must carefully follow Congressional intent in
implementing this bill. While Congress may not have the expertise to
set specific standards, we have laid out our criteria and guidelines
for implementing reform. It is imperative that these standards are not
punitive to the end-users, that we encourage the management of
commercial risk, and that we build a strong but responsive framework
for regulating the derivatives market.
Sincerely,
Christopher Dodd,Chairman,
Senate Committee on Banking, Housing, and Urban Affairs;
Blanche L. Lincoln,Chairman,
Senate Committee on Agriculture, Nutrition, and Forestry.
The Chairman. Thank you.
We will stand in recess. In the good old days, we could
count on 30 minutes for that first vote, but we have a new
sheriff in town. So we will be right back.
So thank you.
[Recess.]
The Chairman. The Committee will come back into session,
and we will now hear from Ms. Sanevich, 5 minutes please.
STATEMENT OF BELLA L.F. SANEVICH, GENERAL COUNSEL, NISA
INVESTMENT ADVISORS, L.L.C., ST. LOUIS, MO; ON
BEHALF OF AMERICAN BENEFITS COUNCIL; COMMITTEE ON INVESTMENT OF
EMPLOYEE BENEFIT ASSETS
Ms. Sanevich. Good afternoon and thank you and welcome
back.
My name is Bella Sanevich, and I am the General Counsel of
NISA Investment Advisors. NISA is an investment advisor with
over $60 billion under management for over 100 clients, the
majority of which are private and public retirement plans.
I am testifying today on behalf of the American Benefits
Council and the Committee on Investment of Employee Benefit
Assets, which are two of the leading employee benefit trade
associations in the country. Together, their members provide
benefits directly or indirectly to over 100 million
participants. We very much appreciate the opportunity to
address the swap-related issues raised by Dodd-Frank for
private retirement plans governed by ERISA, and we applaud the
Subcommittee for holding a hearing on this critical set of
issues.
We believe that the CFTC and the SEC have been working hard
to provide guidance in this area. Nevertheless, there is one
issue that is dwarfing all others--timing. The agencies are
attempting to perform a complete restructuring of a nearly $600
trillion market with rules developed over only a few months. It
is simply not possible to do that in a way that takes into
account all relevant factors. It is inevitable that the rules
will have unintended and unforeseen consequences that could
adversely impact the retirement security of millions of
Americans, and cost our country billions of dollars and
countless jobs.
ERISA pension plans use swaps to manage the risk resulting
from the volatility inherent in the present value of a pension
plan's liability, as well as to manage regulatory plan funding
obligations. If swaps were to become materially less available
by reason of rules developed too quickly, funding volatility
and cost would increase substantially, putting Americans'
retirement assets at greater risk and forcing companies to
reserve billions of additional dollars to satisfy possible
funding obligations. Those greater reserves would have an
enormous effect on the working capital that would be available
to companies to create new jobs and for other business
activities that promote economic growth. The greater funding
volatility could also undermine the security of participant
benefits.
Accordingly, we strongly urge you to adopt legislation that
would provide that each provision of Title VII shall become
effective as of the later of January 1, 2013, or 12 months
after the publication of final regulations implementing such
provision.
I also want to describe three critical problems in the
proposed regulations as they relate to pension plans.
The first issue involves the business conduct standards.
Although several aspects of the business conduct standards are
problematic, one of the biggest problems is that the proposed
CFTC rules, when combined with those recently proposed by the
DOL relating to fiduciaries, will either cause an illegality to
occur, which is a prohibited transaction in ERISA language, or
will prevent an ERISA plan from entering into a swap
transaction altogether. The two sets of results are
irreconcilable in their current form.
The next issue involves required clearing of swaps by
pension plans. Business end-users, such as operating companies,
have the right to decide whether to clear a swap, this is the
end-user exemption, but not the plan sponsored by those
companies. To our knowledge, there is no substantive reason for
this distinction. In fact, like operating companies, pension
plans have an inherent risk to hedge which is interest rate
risk. Plans need the flexibility to structure their swaps in a
manner to protect and best serve their beneficiaries. Requiring
clearing may hamper that flexibility.
The last issue relates to real-time reporting. Although the
purpose of real-time reporting is to enhance price transparency
with the ultimate goal of reducing prices, we believe the
current proposed rules would likely have exactly the opposite
effect. In fact, we believe that if the CFTC rules were
finalized in their current form, swap transaction costs would
increase dramatically.
In conclusion, the CFTC, the SEC, and the swaps community
have an enormous challenge in working together to implement a
complete restructuring of a nearly $600 trillion market. If we
are forced to do this too quickly, it is inevitable that there
will be negative unintended consequences, costing billions of
dollars in the aggregate.
We urge Congress to modify the effective date of Dodd-Frank
to let the process proceed in an orderly and careful manner,
extend the end-user exemption to plans, and address any
problems under the regulations, such as the proposed business
conduct rules which would effectively ban all swaps with plans.
Thank you for the opportunity to present our views, and I
would be happy to take any questions you may have.
[The prepared statement of Ms. Sanevich follows:]
Prepared Statement of Bella L.F. Sanevich, General Counsel, NISA
Investment Advisors, L.L.C., St. Louis, MO; on Behalf of American
Benefits Council; Committee on Investment of Employee Benefit Assets
My name is Bella Sanevich and I am the General Counsel of NISA
Investment Advisors, L.L.C. NISA is an investment advisor with over $60
billion under management for over 100 clients, including private and
public retirement plans. I am testifying today on behalf of the
American Benefits Council, with respect to which NISA is a member, and
the Committee on Investment of Employee Benefit Assets.
The Council is a public policy organization representing
principally Fortune 500 companies and other organizations that assist
employers of all sizes in providing benefits to employees.
Collectively, the Council's members either sponsor directly or provide
services to retirement and health plans that cover more than 100
million Americans.
CIEBA represents more than 100 of the country's largest corporate
sponsored pension funds. Its members manage more than $1 trillion of
defined benefit and defined contribution plan assets, on behalf of 15
million plan participants and beneficiaries. CIEBA members are the
senior corporate financial officers who individually manage and
administer ERISA-governed corporate retirement plan assets.
We very much appreciate the opportunity to address the swap-related
issues raised by Dodd-Frank for private retirement plans governed by
the Employee Retirement Income Security Act of 1974 (``ERISA''). And we
applaud the Subcommittee for holding a hearing on this critical set of
issues.
We believe that the agencies--the Commodity Futures Trading
Commission (``CFTC''), which has jurisdiction over the types of swaps
most important to plans, and the Securities and Exchange Commission
(``SEC'')--have been working extremely hard to provide needed guidance.
Also, both agencies have been very open to input on the swap issues
from the plan community. We very much appreciate the open and frank
dialogue we have had with the agencies to date.
Timing
Implementing Dodd-Frank is an enormous undertaking. With respect to
the derivatives title of Dodd-Frank, there is one issue, however, that
is dwarfing all others: timing. The agencies are attempting to perform
a complete restructuring of a nearly $600 trillion market with rules
developed over a few months. It simply is not possible to do that in a
way that takes into account all relevant factors. It is inevitable that
the rules will have unintended and unforeseen consequences that could
adversely impact the retirement security of millions of Americans, and
cost our country billions of dollars and countless jobs.
In the pension area alone, almost no one can keep up with the
breathtaking speed at which regulations are being proposed and will
soon be finalized. The pension community barely digests one significant
proposed regulation when another significant proposed regulation is
issued. More importantly, subsequent proposed regulations can affect
the application of prior proposed regulations, making the comment
process very challenging at best and ineffective at worst. Also, the
pension community finds itself having to comment on everything, even
regulations that it hopes will not apply to ERISA plans, because of the
uncertainty regarding whether the regulations may apply.
As noted, the regulators are rushing to meet statutory deadlines.
Those statutory deadlines were aggressive at the time they were
adopted. In retrospect, given the enormity of the market, such
deadlines now appear dangerous for pension plans because, in an attempt
to meet those deadlines, regulators have proposed regulations which
could ultimately threaten pension plan participants' retirement
security.
As noted the CFTC and the SEC have opened their doors to ERISA
pension plans and we have seen our comments very helpfully taken into
account by these agencies in a number of proposed rules. But these
agencies are under extreme time constraints. And pension trade groups
are very concerned that such time constraints could result in
regulations being adopted that inadvertently harm pension plans.
Effects of staying on the current course. To stay on the current
course is to invite, if not ensure, a train wreck. In the pension area,
inadvertent adverse developments with respect to the use of swaps would
have devastating effects.
ERISA pension plans use swaps to manage the risk resulting from the
volatility inherent in determining the present value of a pension
plan's liability, as well as to manage plan funding obligations imposed
on companies maintaining defined benefit plans. If swaps were to become
materially less available or become significantly more costly to
pension plans, funding volatility and cost could increase
substantially, putting Americans' retirement assets at greater risk and
forcing companies in the aggregate to reserve billions of additional
dollars to satisfy possible funding obligations, most of which may
never need to be contributed to the plan because the risks being
reserved against may not materialize. Those greater reserves would have
an enormous effect on the working capital that would be available to
companies to create new jobs and for other business activities that
promote economic growth. The greater funding volatility could also
undermine the security of participants' benefits.
Let me explain this volatility issue further. In a defined benefit
pension plan, a retiree is promised payments in the future. The
obligations of a pension plan include a wide range of payments, from
payments occurring presently to payments to be made more than 50 years
from now. The present value of those payments varies considerably with
interest rates. If interest rates fall, the present value of
liabilities grows. So if interest rates drop quickly, the present value
of liabilities can grow quickly, creating additional risk for
participants and huge economic burdens for the company sponsoring the
plan. Swaps are used to address this risk, as illustrated in a very
simplified example below.
Assume that a plan has $15 billion of assets and $15 billion of
liabilities so that the plan is 100% funded and there is thus no
shortfall to fund. Assume that interest rates fall by one percentage
point. That alone would increase liabilities substantially. Based on a
real-life example of a plan whose interest rate sensitivity is somewhat
higher than average, we assume a 13% increase in plan liabilities to
$16.95 billion. Based on a realistic example, we assume that assets
increase to $15.49 billion. Thus, the decline in interest rates has
created a $1.46 billion shortfall. Under the general pension funding
rules, shortfalls must be amortized over 7 years, so that the plan
sponsor in this example would suddenly owe annual contributions to the
plan of approximately $248 million, starting with the current year. A
sudden annual increase in cash outlays of $248 million can obviously
present enormous business challenges as well as increased risks for
participants.
Swaps are a very important hedging tool for plan sponsors. Hedging
interest rate risk with swaps effectively would avoid this result by
creating an asset--the swap--that would rise in value by the same $1.46
billion if interest rates fall by one percentage point. Thus, by using
swaps, plan sponsors are able to avoid the risk of sudden increases in
cash obligations of hundreds of millions of dollars. If, on the other
hand, plans' ability to hedge effectively with swaps is curtailed by
the new rules, funding obligations will become more volatile, as
illustrated above. This will, in turn, increase risk for participants
and force many employers to reserve large amounts of cash to cover
possible funding obligations, thus diverting cash from critical job
retention, business growth projects, and future pension benefits.
Without swaps, some companies would attempt to manage pension plan
risk in other ways, such as through the increased use of bonds with
related decreases in returns. One company recently estimated that its
expected decrease in return that would result from the increased use of
bonds would be approximately $100 million. And this pain will be felt
acutely by individuals. Companies that lose $100 million per year may
well need to cut jobs and certainly will have to think about reducing
pension benefits.
We also note that the bond market is far too small to replace swaps
entirely as a means for plans to hedge their risks. There are not
nearly enough bonds available, especially in the long durations that
plans need. Furthermore, a flood of demand for bonds would drive yields
down, increasing the present value of plan liabilities dramatically. In
short, a shift from swaps to bonds would be costly, insufficient, and
potentially harmful for plans.
What is needed. We believe:
The agencies need more time to develop proposed rules. They
also need to sequence the rule proposals in a logical
progression.
The retirement plan community needs more time to review
those proposed rules and to provide comments to the agencies.
Given the volume of rules being proposed in such a compressed
time period, we propose that the Commission give much more than
60 days to comment.
The agencies need more time to consider the comments and
provide final rules.
The retirement plan community needs more time to prepare to
comply with an entirely new system.
Accordingly, we strongly urge you to adopt legislation that would
provide that each provision of Title VII shall become effective as of
the later of (a) January 1, 2013 or (b) 12 months after the publication
of final regulations implementing such provision.
Issues
It is important for two reasons to share with you some specific
issues arising under Title VII for plans. First, those issues will
strikingly illustrate the need for more time and the potential adverse
consequences of forcing the process to move too quickly. Second, if
additional time is not provided or if the agencies do not modify their
rules, it may be important for Congress to step in to prevent
potentially devastating results.
Business conduct standards. Under the business conduct rules, a
swap dealer entering into a swap with a plan is required to provide
counsel and assistance to the plan. The underlying rationale of these
rules was that swap dealers are more knowledgeable than plans and are
likely to take advantage of plans unless compelled to help them. By
definition, this rationale has no application to ERISA plans. By law,
ERISA plans are prohibited from entering into swaps unless they have an
advisor with an expertise in swaps. Accordingly, ERISA plans do not
have any need for any assistance or counsel from dealers. And ERISA
plans have no interest in counsel from their opposing party. So at
best, the rules have no effect. Unfortunately, the rules as proposed by
the CFTC would actually have devastating effects. Here are just two
examples, although there are other issues with respect to these
proposed rules.
Requiring actions that would make swaps impossible. The
counsel that a swap dealer is required to provide to a plan
under the CFTC's proposed rules would make the swap dealer a
plan fiduciary under regulations recently proposed by the
Department of Labor (the ``DOL''). Pursuant to the DOL's
prohibited transaction rules, a fiduciary to a plan cannot
enter into a transaction with the plan. So, if the swap dealer
is a plan fiduciary, then either no swap transaction can be
entered into or the swap is an illegal prohibited transaction
under the rules applicable to plans. Thus, the business conduct
rules would require a swap dealer to perform an illegal action
or refrain from entering into a swap with a plan. The only way
to avoid violating the law is for all swaps with plans to
cease, with the adverse results described above.
The above characterization is not just our view. To our knowledge,
it is the universal business community perspective, and
informal conversations with agencies indicate that they also
recognize this problem.
Congress clearly never intended to indirectly prohibit plans from
utilizing swaps. The CFTC must not propose conduct standards
that require a swap dealer to do the impossible--act in the
best interests of both itself and its counterparty. Even more
importantly, the CFTC and the DOL must jointly announce that
the business conduct rules will not be interpreted in a manner
that will require the swap dealer to perform an illegal act
under ERISA when trading with an ERISA plan in order to comply
with a CFTC rule under the Commodity Exchange Act. If the
agencies do not do this--and because of the time constraints
and the difficulties of inter-agency coordination it is very
possible that they will not--Congress needs to step in.
Dealers' right to veto plan advisors. Under the proposed
CFTC rules, swap dealers are required to carefully review the
qualifications of a plan's advisor and would have the ability
to veto any advisor advising a plan with respect to a swap. We
are not suggesting that a dealer would use this power, but the
fear of that result would have an enormous effect on advisors'
willingness to zealously represent plans' interests against a
dealer. Moreover, the specter of liability for not vetoing an
advisor that subsequently makes an error may have an adverse
impact on the dealers' willingness to enter into swaps with
plans; this may result in the dealers demanding additional
concessions from the plans or their advisors, or may cause the
dealers to cease entering into swaps with plans. In all of the
above cases, the effect on plans' negotiations with dealers
would be extremely adverse. This, too, was never intended by
Congress.
As stated above, placing the responsibility on the dealers to veto
advisors is not a service that would benefit plans. ERISA has a
long history of requiring plan fiduciaries to be held to the
highest fiduciary standard--that of a prudent expert.
Therefore, not only are investment advisors held to this
standard, but the plan sponsors choosing the advisors are held
to the same strict standard. It is hard to see how a
counterparty whose interests are adverse to a plan's interests
can do a better job of choosing advisors. Consistent with the
statute, a dealer should be deemed to meet the business conduct
standards relating to dealers acting as counterparties if a
plan represents that it is being advised by an ERISA fiduciary.
Required clearing. Business end-users, such as operating companies,
have the right to decide whether to clear a swap (i.e., the ``end-user
exemption''). Oddly, the plans sponsored by such companies do not have
that right. Although plans have an ``end-user exemption'' with respect
to major swap participant status, they are not eligible for the end-
user exemption from the clearing requirement. To our knowledge, there
is no substantive reason for this distinction; in fact, like operating
companies, plans have an inherent risk to hedge--interest rate risk.
Moreover, plans are required by law to be diversified, prudent, and
focused exclusively on participants' interests. Fiduciaries, acting
pursuant to the highest standard of conduct under the law, should have
the right to decide whether to clear a swap. In this regard, here are
two examples of very troubling aspects of applying the clearing
requirement to plans:
Anti-avoidance and potential loss of customized terms. Each
plan has different risks, based on the unique demographics of
its plan participants and its unique investment strategy.
Accordingly, plans have a great need to customize the terms of
their swaps to seek to most effectively hedge their unique
risks; because of the customized terms, plans' swaps may not be
generally clearable. An issue arises because Dodd-Frank
contains a section directing the CFTC to prescribe rules
precluding evasion of the clearing requirement. The problem is
that there is no clarity as to how this requirement will be
interpreted and applied, and this may cause plans and their
advisors to forego customized swaps that they think are in the
best interests of the plan and its participants, in order to
avoid inadvertently violating Dodd-Frank. It is critical that
plans not be forced to give up those customized terms. Plans
should be free to retain their customized terms and to use the
over-the-counter market if the customized terms render a swap
unclearable, without fear of violating the law.
Fellow customer risk. Unless the CFTC allows segregation of
collateral, the collateral posted by a pension plan would be
aggregated with the collateral posted by other users of the
clearing platform and thus could be subject to risks posed by
other far less secure swap market participants. For example, in
a clearing context, collateral posted by a plan could be used
to address defaults by a very risky hedge fund that uses the
same clearing platform. Prior to Dodd-Frank, plans were not
exposed to the risk of other far riskier entities. It would be
strange and ironic if Dodd-Frank were to force plans to assume
far greater risk.
We ask Congress to step in and extend the end-user exemption from
clearing to plans.
Real-time reporting. The CFTC has issued rules regarding the real-
time public reporting of swaps. The purpose of such reporting is to
enhance price transparency, with the ultimate goal of reducing prices.
But the CFTC issued rules that we believe would likely have exactly the
opposite effect. In fact, we believe that if the CFTC rules were
finalized in their current form, swap transaction costs would increase
dramatically, perhaps by as much as 100% in some cases.
The problem is that if the terms of a swap are immediately known to
the market, the dealer assuming the risk with respect to the swap will
have far more difficulty in offsetting that risk in a subsequent
transaction. Knowing that the dealer has to offset a specific risk, the
rest of the market has a large negotiating and informational advantage
over the dealer and can charge the dealer much more to offset its risk.
The dealer thus has to charge much more for the original swap.
This is a problem that can be easily solved with data regarding how
much time dealers need to offset risk with respect to different types
of swaps. Any effort to act before sufficient data are collected and
analyzed is likely to result in exactly the wrong result--cost
increases.
Plan swap terms should not be altered without plan consent. It is
essential that the CFTC and SEC adopt clear rules under which no party
involved in the reporting or clearing process has the power to modify
the terms of any swap. For example, today, it is not uncommon for a
swap data repository or an electronic confirmation service provider to
require, as a condition of using their service, the unilateral right to
modify swap terms by ``deeming'' a user to have agreed to such terms if
they use the system after notice. Today, plans can simply elect not to
use those services. But after Dodd-Frank becomes effective, plans will
be required by law to report swaps. If the swap data repository
receiving such reports or an entity providing services with respect to
such repository has the right to modify plan terms, the repository or
entity would effectively have government-type power to control swap
terms. This would be shocking and certainly not what Congress had
intended.
* * * * *
In conclusion, the CFTC, the SEC, and the swaps community have an
enormous challenge in working together to implement a complete
restructuring of a nearly $600 trillion market. This cannot, and should
not, be done in a few months. If we are forced to do this too quickly,
it is inevitable that there will be negative unintended consequences,
costing billions of dollars in the aggregate. With respect to the plan
area alone, retirement benefits would be subject to greater risk and
huge numbers of jobs and billions of dollars of participants' benefits
could be adversely affected. We urge Congress to (1) modify the
effective date of Dodd-Frank to let the process proceed in an orderly
and careful manner, (2) extend the end-user exemption from clearing to
plans, and (3) address any problems under the regulations, such as the
fact that the proposed business conduct rules would effectively ban all
swaps with plans.
Thank you for the opportunity to present our views. I would be
happy to take any questions that you may have.
The Chairman. All right. Thank you, Ms. Sanevich.
I thank all the witnesses for being here today.
I was in a meeting with a fellow who runs the NSA named
Keith Alexander who said, nothing is impossible for those who
don't have to do it. And it seems like we have asked Gary
Gensler and his team to do the impossible. Because, quite
frankly, Congress didn't have to do it. And whether the 360
days to get all of this done made sense--it certainly made
sense to those who supported this work last year. But in the
current mix of things that are going on and all of the things
that you talked about, the 360 does not make as much sense as
it does to now.
We will go on the 5 minute clock.
I would like all of the witnesses to address these
questions. If we don't have a chance to get to everybody, we
will do a second round after we have gone through everybody. So
I will just take my 5 minutes along with everyone else.
In terms of--help us understand the body of rules that are
out there. Mr. Gensler said last week that he would have most
of it done soon, and it would be in a quieter pause while they
assimilated everything they have done.
If you were Mr. Gensler, in what order would you roll out
the next round of either final rules or proposed rules or
whatever in terms of a pecking order that he would--that you
would roll those out in, and give me something a little
clearer.
Ms. Sanevich, you mentioned compliance costs would go way
up, dramatic was your word. If you could quantify those a
little better.
Mr. McMahon, you talked about hundreds of millions of
dollars in terms of margin and those kind of things, but help
us understand from a qualitative standpoint how much we are
actually talking about in terms of compliance costs.
So I will throw it open to anyone who wants to start off,
and we will come back after we have had the other speakers.
Mr. Damgard. I am happy to start off.
He has really got it backwards. We would like to know what
a definition of a swap is going to look like. We would like to
know who qualifies as a significant swap participant. We would
like to know what a SEF is. Until we have definitions of those
kinds of organizations or those definitions, there are bodies
of people out there that have no idea whether they are going to
be affected. And if they find out after the fact it is going to
be too late for them to comment.
Now I know that they are working real hard at the CFTC. I
will say my organization is totally exhausted. We face four or
five rulemakings a year historically from the CFTC, and there
are 30 pending right now. We simply are unable to do an
adequate job of making sure that what we are able to send to
the CFTC, which has historically been very helpful, is even
being properly considered.
I mean, I remember when the CFTC was created in this room.
It was created as an oversight regulator. And the exchanges
have very, very deep rule books; and they have an awful lot of
self-interest in making sure that their exchanges are seen as
good organizations. They don't want manipulation in their
markets, because people wouldn't use them.
We have a very good self-regulator called the National
Futures Association, which was also created by you guys; and
they have done an excellent job and a very efficient job.
My view is Mr. Gensler wants to change all that from being
an oversight regulator and go back to this prescriptive rules
and regulation where everybody is going to have to come to the
CFTC and ask his permission once he finalizes all these rules.
He certainly has enough economists over there to write these
rules and finalize them. Where he is going to ask for more
money is implementation and enforcement.
And my concern--and he has essentially made this threat
recently--he said, well, once I have all these regulations in
place, then if I don't have the revenues and I don't have the
resources in which to decide whether I am going to allow you to
register as a SEF, then get in line. It could take a long, long
time. So you people ought to be out there helping us get the
additional resources.
Well, whether I would like to do that or not is irrelevant.
It isn't going to happen. And I would like to see Congress
maybe go back to what we did initially; and that was, when we
created the CFTC, there were an awful lot of people that were
already in the business and that they didn't instantly have all
the resources at the CFTC to make all these approvals.
Truthfully, the year 2000 and that reauthorization was
extremely helpful to the industry; and we have seen the
industry grow dramatically because of that.
Now, it is true that--and I represent the listed markets. I
represent exchange-traded futures. And other people can make
excuses for the swaps market, but, truthfully, energy swaps,
interest rate swaps, currency swaps, all those work perfectly.
It is only when we get into the debt instruments and the CDSs,
I mean, it just seems like our whole industry is paying an
awful price for AIG.
And I see my time is almost up.
The Chairman. Ms. Sanevich.
Ms. Sanevich. I agree that the definition of who is covered
by what and who--so what is a swap, who falls under an MSP, who
is an end-user, what is required under those things have to be
sequentially addressed so that then people can process and
think through how the various other rules that are being
promulgated for all these entities will apply to that
particular entity.
And very importantly from the pension plans perspective is
that we have very similar sequencing issues and concerns. But,
on top of that, we have the Department of Labor coming out and
working with rules that will effectively shut down the use of
pension plan swaps completely. And so at a very high level for
pension plans, unless these things are coordinated and resolved
adequately, the rest of it might be moot from a pension plan's
perspective because they won't be able to use these
instruments.
The Chairman. Thank you. We will come back on the other
witnesses after everybody has had a chance.
Mr. Boswell, 5 minutes.
Mr. Boswell. Thank you, Mr. Chairman.
I know that some of the Members have meetings, so I am
going to yield to them to go down your list. Because I am going
to stay until it is over, and I will have another opportunity.
The Chairman. The gentleman from North Carolina, Mr.
Kissell.
Mr. Kissell. Thank you, Mr. Chairman. I thank everybody for
being with us here today and your patience with us during
voting and your testimony before us.
This whole idea of the derivatives was the first hearing I
came into--this is my second term in Congress--my first year I
came in here was on derivatives. And it was a back-and-forth
testimony at the time between those who felt we needed to do
something and those who said, well, no one lost any money and
everything is fine.
Mr. Damgard, you mentioned a second ago the industry is
paying a high price for AIG, and I felt that more than just the
industry paid for AIG, is gas prices went up to $4 a gallon,
and all the things that we associated with, while people may
not have lost money, per se, that were in the swaps, I felt
that we as a nation paid a pretty high price for some of the
pricing and so forth and so on. And, as Mr. Boswell said
earlier, shining a little bit of light in here, it doesn't seem
like that is an issue.
So I am curious about when you said the industry paid a
price for AIG, how would you separate the industry from AIG?
And if you could elaborate on that briefly for me, please.
Mr. Damgard. AIG is now one of my member organizations, but
I would say it is awful easy to shoot the messenger. Markets
have worked extremely well. And when gas prices go up,
truthfully, it is not the fault of the market. There are people
in the market that are buying and selling, and, yes, there are
passive longs, but the energy market, frankly, is hardly a free
market when you have OPEC controlling a large percentage of the
volume.
So when I say AIG is causing us a lot of agony, because we
weren't directly involved in any of the difficulties in the
market, and I am very proud of the fact that futures markets
all over the world worked very, very smoothly through all of
that stress. And the CFTC is now given this huge new mandate to
regulate the OTC world or the swaps world, and an awful lot of
that is, unfortunately, carrying over into the futures market.
We would like to say futures markets have worked extremely
well.
There is nothing in Dodd-Frank that says you have to go out
and totally rewrite the rule book on an industry that worked
perfectly well, and this is basically what is happening. And
some of it is inevitable. If you are going to do something in
the swaps area, it is almost impossible to necessarily
differentiate those kinds of things from the futures market.
Just in collecting data, and I won't bore you with it, but
in my----
Mr. Kissell. If I could interrupt you, and I apologize, but
I have a couple other questions I want to get to.
Mr. McMahon, you had talked about the concerns for the end-
user; and if I heard you correctly, you said, yes, they are
saying they are going to exempt the end-user. Are you satisfied
that they are and that is what they say they are going to do?
Or do you still have concerns there?
Mr. McMahon. Well, our concerns I think are two-fold.
One, as I mentioned in my statement, we want to make sure
that we are fully exempt from the margining requirements, that
commercial end-users are exempt, and also because of the $250
to $400 million per company impact of that on our companies. I
will say our companies use exchange-traded products as well as
over-the-counter products. So it is not that we don't use them.
It is just that when they are appropriate we do.
The other aspect of it, again, is the fact that the
compliance cost associated with it, it looks to us as if the
CFTC is taking more of a transactional approach to the end-user
exemption so that instead of making a declaration that we use
these products to hedge commercial risk and that being the end
of it, in addition to the reporting that would come along with
it, it appears that it looks as if we are going to have to make
a transaction by transaction disclosure so that the compliance
burden would be, we feel, pretty heavy in that sort of
approach. And we haven't computed the cost of that, but we
believe it would be pretty burdensome to do that. So I think
that is a real concern.
And, again, we are not quite sure, because the definition
of a swap hasn't been promulgated, how many of our transactions
would be affected, because utilities are subject to weather and
things like that, and that causes us to build in a lot of
optionality into our agreements for fuel and things like that.
So we are concerned that things that we would normally consider
to be derivatives or swaps, if the definition is very broad,
could be encompassed in this; and, of course, that would change
potentially the end-user status if they are using a lot of
these products that we normally wouldn't consider to be swaps.
Mr. Kissell. Thank you, sir.
Thank you, Mr. Chairman.
The Chairman. Sure. I thank the gentleman.
And the gentlelady from Alabama, Terri Sewell, quite the
comedienne from the other night. I was in the audience. I heard
that activity. You are recognized for 5 minutes.
Ms. Sewell. Thank you, Mr. Chairman.
To our panelists, thank you so much for coming in and
enlightening us on this topic.
My question, everyone on the panel seemed to say that the
lawmaking should not go into effect in July, that it is too
onerous, that there is just not enough time. So my question
really is--and this is to anyone who wants to answer it--are
you saying that the market should go unregulated, that somehow
we shouldn't put regulations on swaps and on these derivatives?
And if you are not saying that, then when is the timeline?
Give me a timeline that would be acceptable to the marketplace.
Mr. Bullard. Congresswoman, we believe that these
regulations should be implemented as swiftly as possible. We
have already identified dysfunctionality within the futures
market. We need to restore that market as quickly as possible
so it is a used and useful tool to discover price in tandem
with the cash market, which is also a price discovery market in
our industry, as well as to provide producers a legitimate and
genuine risk management tool that is unavailable when the
market is prone to manipulation and distortion, as we
witnessed.
Mr. Kaswell. If I may, we would not say don't do anything.
We are not trying to deliver that message. I think we are
trying to say we respectfully think it should be done
selectively. And we think that moving forward on things like
central clearing, that is very important to us, segregation of
collateral, that is very important to us. But, in other cases,
it is a matter of sequencing; and I think this is where it gets
back to the Chairman's question.
We also would like to know what a major swap participant is
before we know what those responsibilities entail. It is
similar to comments made about the definition of a swap, and
the sequencing and the clarity to know where we stand so then
we will understand, if you are in this category, what does that
mean.
There are also some things that the CFTC is proposing that
we are troubled about, which is they are proposing to take away
one of the exemptions for CPOs, commodity pool operators, which
will in effect require those organizations to be duly regulated
by the SEC and the CFTC with potentially conflicting
regulations. We don't think that is an effective use of
regulatory resources at a time when we understand the pressures
that everyone is under.
Thank you.
Mr. Damgard. And I am not here to apologize for the OTC
world, but I do think they make a good case. Ag swaps worked
just fine. People trusted their counterparties, and for the
most part so did interest rate swaps and the others.
One example is the energy market. We have a very fine
energy market in New York, and that is called--belongs to the
CME. It is the WTI. It is called the West Texas Intermediate.
That is the benchmark trade.
Now the oil is not coming from west Texas, with all due
respect. The oil is coming from the Middle East. We are losing
that market share. We are losing it every day to the Brent.
Because, to the extent that there are going to be position
limits in the energy market, any dealer that has customers all
over the world may run the risk of exceeding what that position
limit may be at any given moment.
Someone mentioned that somebody just got fined the other
day, and it was not an intentional--but firms will go to a
market where they don't run that risk, and the Brent market is
an extremely good market. It is called the International
Petroleum Exchange. So we are not only losing market share to
foreign markets, we may lose those markets altogether, and the
Brent will soon be the benchmark that people will trade.
And I just hate to see the United States lose a business,
lose an industry, for the wrong reasons. If we are being out-
competed, that is one thing. But if we go overboard and we see
the pendulum swing way over to one side, then it is going to be
very damaging to business in the United States.
Mr. Bernardo. Just to add to that, I think that the
regulatory transparency should be and could be done quickly,
but the regulators need to understand the markets that they are
regulating.
Ms. Sanevich. This is a very diverse market. You can see by
the different entities represented here. And at least from our
perspective, we are very concerned about unintended--no one
meant for a bad consequence to happen, but because everything
has to be promulgated so quickly not only is it hard for the
regulators to think through a very complicated market but for
those who are directly impacted to actually digest and respond
and to raise issues. These are very complex issues that are
very interrelated. And that is the angst in our case. There is
different regulatory agencies now that are in direct conflict.
The Chairman. Thank you.
Now, Mr. Welch, you are up next for 5 minutes.
Mr. Welch. Thank you very much, Mr. Chairman.
As I listened to your testimony and read your testimony,
the conflict that seems to be the problem inherent in this is
that, on the one hand, you have the physical hedgers, the ones
buying the product; and the statistics that you gave, Mr.
Bullard, that the futures markets declined from 52 percent and
67 percent respectively for the futures market and in the live
cattle market in 1998 to 17 percent and 11.7 percent shows that
the participation rate by the physical hedgers has obviously
declined.
On the other hand, Mr. Damgard, what you are concerned
about, and rightly so, is that if there are rules and
regulations that interfere with the work that you are doing for
the overall market, then we will lose a good industry.
But what may be good for one end of the futures market,
which is essentially the financial transactions, some people
would use the term speculation which plays a role in liquidity,
the interests of that segment of the market really do seem to
be in some conflict with the small feedlot operators who needed
this market for a very simple, straightforward hedging
position.
And I don't know how we thread that needle. That to me is
the question. Because I think we have to have a futures market
that protects the folks that Mr. Bullard works for and
obviously wants the jobs that your activity represents. And I
am just going to ask each of you to tell me what your
recommendations are about how to resolve that conflict so we
don't hammer the cattle and feedlot dealers and destroy jobs
that might go overseas.
I will start are with you, Mr. Bullard.
Mr. Bullard. Congressman, the futures commodity market is a
market that supports an entire underlying industry with those
who are, as you indicated, physical hedgers. And what has
transpired as a result of the excessive speculation by the
index funds and the hedge funds that have entered these markets
is that the market has become less and less capable of
discovering the fair market value. As a result, we no longer
have a market that is actually providing the price discovery
function that it should be that would normally occur if you had
the majority of physical hedgers in the market.
And our concern also is with the industry itself, the
industry that has become so dominated by just four large
packers that now control over 80 percent of all the fed steer
and heifer slaughter. You have on one side of that physical
market essentially four participants and all the rest are the
independent feeders who are trying to sell to them. That market
has to be protected, and we have already seen that we have
severe problems in the market. So that is why we support
strongly reductions on the number of speculators that are
involved in the market.
And we also believe that it is improper for a packer who
may be a physical hedger to step out of the role of a physical
hedger and suddenly become a speculator in order to try to
manage the direction of the market, and we believe that that
has been ongoing for a number of years.
Mr. Welch. Thank you.
Mr. Damgard, I will ask you to basically try to, for me,
let me understand how we could accomplish what you want without
destroying what Mr. Bullard represents, or is it impossible?
Mr. Damgard. In defense of the futures markets, let me just
say that these markets have grown just exponentially. And I
would agree that the CFTC has done an excellent job of--I mean,
you don't hear about the Hunt brothers anymore. If there is
manipulation in the market, you pay a very, very dear price. So
if somebody is manipulating the market, I believe the CFTC is
the right place to determine whether that manipulation has
taken place, and to the extent that it does take place people--
--
Mr. Welch. Let me just address that. Because I don't think
that Mr. Bullard is talking about manipulation so much as if
the market has gone from essentially something that serves
physical hedgers to one that serves financial players, it works
differently; and that is I think the dilemma that we are in.
Mr. Damgard. I am a corn grower and soybean grower in
central Illinois. I use the markets all the time. I decided
that at $4.50 that was a pretty good price. That covered my
cost and gave me a profit. So I sold a lot of corn at $4.50.
Today, it is $7.
Now the real problem for the cattle feeders, in my
judgment, is you can't feed animals $7 corn and make any money.
So what is happening is you see the herds declining, fewer
animals; the price of the animal is more expensive; you are
going to pay a whole lot more for a steak; and my ability to
grow corn next year and sell it at a good price is going to be
limited by the lack of demand from the cattle industry.
Now, we can get into ethanol, but we can also get into the
fact that China is a huge buyer of U.S. agricultural products.
Most of the corn that I grow today in central Illinois that
used to go down the river gets on a train and goes out to
Portland, Oregon. Because the bottoms are in short demand, and
it is shorter to go from Portland to Beijing or wherever.
My own view is that there may be markets that get so thin
that they are no longer useful for the people using those
markets. And if that is the case, it is the exchange's problem.
I think the exchange went to great lengths to try to change the
terms of the cotton contract last year because a lot of people
were concerned that the cotton market wasn't working properly.
But to blame the whole thing on the lack of regulation is a
terrible mistake. We don't want that.
Mr. Welch. My time is up, but I thank you for your answer.
Thank you, Mr. Chairman.
The Chairman. Thank you.
Mr. Scott from Georgia, 5 minutes.
Mr. David Scott of Georgia. Thank you, Mr. Chairman.
Mr. Kaswell, both last week at the full Committee's
hearing, and then this morning at Financial Services, I
questioned Chairman Gensler regarding the CFTC's advance notice
of proposed rulemaking on margin segregation. And I would kind
of like to explore that with you but particularly on the cost
versus benefits of regulation and how it relates to this issue.
I have heard from dealers, I have heard from some
clearinghouses that margin segregation could dramatically
increase costs for everyone involved and will produce only
marginal gains in risk protection. Listening to you, you seem
to dispute my position and assertion. Is that correct?
Mr. Kaswell. I disagree with that position. I hate to
disagree with you, sir.
Mr. David Scott of Georgia. Let me ask you this. Have your
members been able to quantify what their additional costs may
be and how much additional risk mitigation they may receive
from a margin segregation regulatory requirement?
Mr. Kaswell. I think we don't know the cost, but I don't
think anyone knows the cost, and I think that is part of the
concern that we have.
The statute has a preference for segregation of collateral
for cleared swaps, complete segregation. We think that reduces
systemic risk and provides the greatest stability for the
trading system and for the public at large. We know there will
be costs in building these clearing systems.
What I think is the fair question is not that it will be
expensive but what will be the marginal cost of providing that
additional level of protection?
And we think that before we say we can't afford it, even
though it would prevent repetitions of problems like Lehman
Brothers, we think that we should have a better sense of what
those costs are. And once we know that, then I think we will be
in a better position to say, yes, we actually think this is not
going to be too bad and we can get those benefits, or them to
say maybe it is too expensive. But I think those who argue that
we don't need the protection and notwithstanding that the
statute expresses a preference for it, admittedly with
exceptions, that we should look to fully explore it before we
discard that option.
Mr. David Scott of Georgia. It is true that the Dodd-Frank
Act doesn't even require the CFTC to explore this issue.
Mr. Kaswell. Well, I don't think it directs a rulemaking on
it, but it does require in the provision for section 724 that
it says, for cleared swaps, segregation is required. And it
says commingling is prohibited. And then it goes on to create
some exceptions so that we can have the range of possibilities
that the CFTC has proposed. And so I am not saying that the
statute forecloses a discussion on this, but we think it
expresses a preference for full segregation.
One of the issues that you face is that if I am a customer
in an FCM and I have no ability to know who the other customers
are at that FCM, I can't do due diligence. If my good friend
John Damgard is another customer, I can't know--I mean, I know
he is a great guy. You are good for it. But there is no way I
can do due diligence on that. And if his failure could
jeopardize that FCM, which could then jeopardize the system, my
position as a solvent participant could be harmed and my
ability to move my collateral from one FCM to another, or from
one clearing entity to another would be compromised and we
could be in the soup that we saw with Lehman in Europe.
Mr. David Scott of Georgia. Just to clear up, given that we
don't require this margin segregation for futures
clearinghouses, I would be interested to know why. The question
is, why do you think they are looking into this? Did someone
come to the CFTC to request this? What was the origination for
this? I am just simply--it wasn't required in the law. It is
clear that there have been complaints about the expensiveness
and the cost and minimal benefits.
Mr. Kaswell. I think you would have to ask the CFTC, but I
do know the CFTC has proposed at least four options in the
notice. The one that we think makes the most sense is the
first, which is the complete segregation of collateral, but
they have they laid out various other alternatives.
Mr. David Scott of Georgia. And is it not true that perhaps
they have undertaken their own investigation to determine
whether or not this is a rule they will pursue?
Mr. Kaswell. Well, I believe there is a notice of proposed
rulemaking, but I really think these questions are better
directed at the CFTC.
Mr. David Scott of Georgia. You do not believe that
future--just one little bit here--God bless you. I thank you so
much.
The Chairman. You are the only guy to do it so far.
Mr. David Scott of Georgia. You are a good man.
Shouldn't futures clearinghouses and derivative
clearinghouses be treated the same? And, in general, are your
members supportive of this effort of the CFTC and are they all
of one mind to do, or do some of them feel that this is not
necessary?
Mr. Kaswell. We are strongly in support of the idea of
segregation of collateral at the FCM and the clearinghouse
level. We think that is the optimal answer.
We understand there are questions and there should be
thoughtful inquiry into that. But, again, we think that, before
rejecting that which we see is the best alternative, we think
we should conclude that the marginal cost is too high and not
worth it. And we don't think anybody has made that case, and
so, therefore, we think we should pick the best option because
it provides the greatest amount of protection for the system
and will allow us to avoid problems that have occurred in the
past.
Mr. David Scott of Georgia. Thank you very much, Mr.
Chairman, for your kindness and generosity.
The Chairman. The gentleman yields back.
Mr. Hultgren from Illinois, 5 minutes.
Mr. Hultgren. Thank you, Mr. Chairman; and thank you all
for being here. Thank you for your testimony. Sorry for the
busy day we have going here, but I really appreciate your being
here on some very important issues that we are going to be
facing, going forward.
I do have a couple of questions to Ms. Sanevich.
First, from your testimony, from the written testimony, you
made a point under the proposed CFTC rule swap dealers will be
required to provide counsel to pension plans that would then
make them fiduciaries under the DOL rules. Also, under DOL
rules, fiduciaries cannot trade with pension plans so that CFTC
results would essentially shut pension plans out of the market
altogether. Am I misreading that?
Ms. Sanevich. Combined with the DOL rules, that is
absolutely correct. Pension plans will not be able to engage in
swaps if the two rules are promulgated as proposed currently.
Mr. Hultgren. Is that your sense? Is that the direction it
is going? Have you heard anything different on that?
Ms. Sanevich. The CFTC has been very open to hearing our
issues and concerns. It is hard for me to tell where this might
be going. But I can tell you that, without very clear
statements jointly from both agencies, that the two rules do
not conflict in a manner that people tend to read them. It will
cause enormous disruptions and will shut pension plans out of
the swaps market in the future.
Mr. Hultgren. I think you started to address this already,
but will your counterparties be subject to new liability under
Dodd-Frank? And what impact may this have in your ability to
engage in the swap markets?
Ms. Sanevich. Yes, certainly dealers, as was intended in
part, will be subject to additional responsibilities; and we
are certainly not saying, don't do that. The problem is that a
lot of the responsibilities that are contemplated are in direct
conflict with how pension plans invest. They already have
fiduciaries at many levels acting as prudent experts for the
investment in pension plans, so imposing this duty on dealers
is not only kind of irrelevant because the pension plans
already have lots of layers of prudent experts, but is quite
problematic and potentially will shut pension plans out of the
market. So, yes.
Mr. Hultgren. I wonder if you could just briefly describe
the real-time reporting rules. They were intended to enhance
price transparency and also to reduce costs, but I wonder if
you can explain how they might have exactly the opposite
impact.
Ms. Sanevich. Sure. And in this case it is really a
question of very much lack of information in connection with a
proposed rule. So our concern is that real-time reporting to
everyone in the market, for every trade, will increase
transaction costs for everyone. The dealers will pass them on
ultimately to the other side of the trade and the concern is
that these transaction costs will be material. They may differ
from different kinds of swaps, but they will increase
transaction costs.
And what we have suggested is the agencies should collect
the data for a year--there is certainly no problem with them
receiving the data--analyze it, and then promulgate rules that
will not disrupt the markets and will not have the perverse
effect of increasing transaction costs when the whole intent is
to decrease the costs.
Mr. Hultgren. It seems so oftentimes here where intended
results arrive at unintended consequences.
Ms. Sanevich. That is the concern here, is that these
unintended consequences--these are some of the ones we happen
to have thought of; and lots of very busy, smart people are
thinking about these things, including the CFTC and the SEC.
But this is such a vast undertaking that there may be many
negative unintended consequences that we just can't foresee.
Mr. Hultgren. One last question, pension plans, from your
perspective, how would you encourage them to protect themselves
from risks posed by their counterparties.
Ms. Sanevich. Well, pension plans right now, because their
investment advisors are subject to the highest fiduciary
standards, they already do that now. Most pension plans
certainly are client based, and others we know have lots of
termination events. If a counterparty's credit rating declines,
they require daily posting of collateral. Many require
segregation of their collateral so that it is kept by an
independent third party.
And so many plans use any of these tools in combination
currently so that, in fact, when Lehman did go under, at least
from our experience, to the extent plans lost anything, it was
.001 percent of the plan or two or three percentage points of a
trade, really insignificant amounts. Because plans already have
a lot of these protections embedded in their documents.
Mr. Hultgren. Mr. Chairman, I see my time is up. Can I ask
one more quick question? Would that be all right?
The Chairman. In fairness to Mr. Scott, yes.
Mr. Hultgren. Following up on that, basically, to what
degree during the financial crisis did pension plans suffer
losses due to swap activities? Just briefly.
Ms. Sanevich. Yes, the losses that we tend to think because
of the financial crisis was losses from a Lehman or an AIG
going down. And as I mentioned, at least in our experience and
from those of others that we have informally talked to, they
were really miniscule percentages on a trade and as a
percentage of a plan, really nothing, .001, or whatnot percent.
Mr. Hultgren. Well, thank you so much.
Thank you, Mr. Chairman.
And I do want to thank you all of you for your part. We
need your help and involvement as we work through this, the
implications of what was passed last year. So thank you very,
very much.
Thank you, Mr. Chairman.
The Chairman. The gentleman yields back.
The gentleman from Massachusetts, Mr. McGovern.
Mr. McGovern. I want to thank the Chairman.
I should preface my remarks by saying I am new here on the
Agriculture Committee. I have the very last seat in the front
row when the full Committee is here. And I apologize for
missing most of your testimony. I was handling the rule on the
continuing resolution. But from the give and take, I just have
a couple of questions for clarification.
I get the fact that there are a lot of concerns about how
we are proceeding here and what is going on in the CFTC and
that you want to make sure that they don't overreach. On the
other hand, it seems most people agree that doing something is
not necessarily a bad thing, but we have to figure out what
that right thing to do is.
I am on the Rules Committee, so I am anticipating whatever
might come before the Rules Committee. One of our colleagues,
Michele Bachmann, introduced a bill to totally repeal Dodd-
Frank. And I would just like to see a show of hands here. How
many people support the outright repeal?
Mr. Damgard. We can think of parts of it that we would like
to get rid of.
Mr. McGovern. But nobody here is advocating an outright
repeal.
Now I just came from the floor. We are dealing with a
continuing resolution. I heard a number of concerns about
making sure that everyone's comments are properly assessed,
that the data that needs to be gathered is properly analyzed.
They want to analyze the reported swap data that will take more
infrastructure and technology is going be necessary. And we
were warned that the Commission is estimated to run out of data
storage by October of this year.
The continuing resolution that we are dealing with on the
House floor right now would reduce the Commission's budget to
Fiscal Year 2008 levels. Now when the Chairman was here last
week, he talked about the need that they need to expand their
staff and their technology in order to do this right, to get it
right. And I think, Mr. Damgard, I was hearing you say that
they were trying to get you guys to come on board and advocate
for an appropriate budget, which seems to me, no matter whether
you have concerns about some of the things that are going on or
not, would be the right thing to do.
What I am worried about is, are decisions being made
without the proper analysis? I am worried about when things get
put into place a review of applications taking a long time
because there is not the proper staff.
I would think, no matter what your concerns on this, that
you would be a little bit concerned about what we are doing on
the floor today.
Any response you have I would appreciate listening to.
Mr. Damgard. As I pointed out earlier, I am a big believer
in self-regulation; and I think self-regulation has worked
extremely well in the futures markets. The question that the
Congressman asked, how much money did pension funds lose as a
result of Dodd-Frank? Futures customers didn't lose anything
because of the segregation of the funds. Even Lehman Brothers
customers, when Lehman went down, those customers got their
money back.
Mr. McGovern. That is not my question. My question is
whether or not, given the fact that none of you are on record
as calling for the outright repeal of Dodd-Frank, which means
that the CFTC has a lot of work to do, I was asking about
whether you agreed with the fact that they need to have
additional resources to be able to better do their job.
Mr. Damgard. And what I said was I think the NFA can
relieve an enormous amount of their burden without them needing
a lot more money.
Mr. McGovern. So the answer to that is no?
Mr. Damgard. It is not no----
Mr. McGovern. I am looking for kind of straight answers
here. Because, again, we are dealing with a cut today going
down to Fiscal Year 2008 levels. I am wondering whether that is
a good idea from your perspective or whether or not you think
there are additional resources, cutting back would be a bad
idea.
Mr. Damgard. You mean I should decide whether or not we
should go to 2008 levels or what is in the President's budget?
I would say somewhere in the middle.
Mr. McGovern. Well, whatever. Today, we are going back to
Fiscal Year 2008 levels. I am wondering whether you think that
is a good idea or not. That means less resources.
Mr. Damgard. I am not qualified to say that the CFTC is
expending all their finances and resources, so I am not
qualified to answer the question.
Mr. McGovern. I am making a suggestion that if, in fact, we
want to get this right, it is going to require the proper
analysis, which means that I do think they are going to need
more resources to be able to do that.
Mr. Damgard. If the CFTC decides to take it all upon
themselves and not delegate to the NFA, it is clearly going to
take more resources.
Mr. McGovern. Thank you, Mr. Chairman.
The Chairman. The gentleman yields back. Thank you.
Mrs. Ellmers from North Carolina 5 minutes.
Mrs. Ellmers. Yes. Thank you. Thank you, Mr. Chairman.
For Mr. McMahon, how would you respond to claims that
clearing and exchange trading is in the best interest of the
end-users, because it prevents swap dealers from charging
higher prices to engage in OTC transactions?
Mr. McMahon. As I mentioned a little bit earlier, we do use
exchange and clear transactions on the gas side for about half
of our transactions and about a third of our power
transactions, and where it is possible it does make sense in
some of our transactions. But in a lot of cases, because of the
customized nature, particularly on the power side, and the fact
that we are very creditworthy entities and we have a benefit
because of that creditworthiness of not having to post margin
and tie up that capital in such a way, it benefits our
customers not to have to clear those transactions, and we don't
get any real net risk reduction in the overall transaction
because of not having to post margin.
So forced margining and forced clearing would have a huge
negative impact on our industry and result in us having to tie
up a lot of capital that we are using right now to enhance the
grid to deploy cleaner technologies and do those things and put
it into margin accounts, and we just do not see any benefit at
all coming back to our customers. And a lot of our OTC swaps
are done with long-standing relationships with people we have
been trading with for a long time, so we don't really see any
benefit to our customers for those swaps.
Mrs. Ellmers. Thank you. So, in the end, basically, this is
going to be more costly, more cumbersome for your particular
customers?
Mr. McMahon. Yes. Any requirement along those lines would
be. And, as I said, when it makes sense and the standardized
swaps meet our needs, we use them. But for the ones that we
don't, we just don't have that option.
Mrs. Ellmers. And from a business standpoint, would you say
that this then is going to be an increase in costs to you to do
these transactions?
Mr. McMahon. Yes. I think that it comes down to if we are
required to clear these transactions--and some of them are so
customized that they probably couldn't be cleared. But if you
assume that they could be cleared, it would be a significant
increase in costs to our companies; and, ultimately, that cost
would either need to be borne by our customers or else we would
need to probably do less hedging and pass that volatility to
our customers, neither of which is a good option.
Mrs. Ellmers. Thank you very much.
I yield back the remainder of my time.
The Chairman. The gentlelady yields back.
The Ranking Member, Mr. Boswell, for 5 minutes.
Mr. Boswell. Thank you.
Interesting discussion. I thank you for being here again.
Mr. Bullard, you talked quite a bit about the discovery
process. Is it working? In the sense--and, Mr. Chairman, you
join in if you want to, because we had some interesting side
discussion here. But I have producers out there that have a
couple, three feedlots of cattle and they want to sell them and
they don't really know what the price is, at least up to date.
I suggest if they went to the auction the day before they might
know that. But I don't think that is good enough in today's
deal. So I just wanted you to talk about that a little bit.
Mr. Bullard. Price discovery in the cattle market is
extremely difficult, and it is because there are so many
various options with which to sell cattle. You have formula
contracts, forward contracts. You have premiums. You have
discounts. You have premiums for certain breeds. You have
transportation premiums that are factored in.
And you have a cash market that has become so thin in the
cattle industry where, in 2005, we had 52 percent of the volume
of cattle were sold on the cash market. By 2010, that volume
had shrunk to about 37 percent. In some markets like in
Colorado, we are down below 20 percent.
So you now have a minority of the cattle that are sold in
the cash market where the price discovery occurs; and then all
of the other cattle, whether it be on a forward contract, a
marketing agreement, the base price is all tied to that thin
cash market that hasn't discovered the true market value of
cattle.
The same is occurring in the futures market where you are
now dominated not by the physical hedgers in the market but
rather by speculators.
So we are having an extremely difficult time to ascertain
what is the fair market value of cattle at any given point in
time because of the complex nature of the industry and the
thinning of the markets that have historically been used for
price discovery.
Mr. Boswell. It brings to what you just said much better
than I could have. That is my point. You made my point. It
seems like we are just running as fast as we can go on the
cattle side to see if we can get vertical integration to the
point we don't have a cash market.
Mr. Bullard. We have already seen that, Congressman, in the
hog industry. The hog industry has essentially lost its cash
market. And we saw a reduction in the number of hog producers
fall over about 90 percent. We had 667,000 independent hog
producers in the United States back in 1980. We now have about
67,000. We eliminated 90 percent of the producers. That means
that the rural communities that were supported by these hog
producers are now no longer receiving the economic vitality
that these producers brought, and that is why we are seeing a
hollowing out in rural communities all across the U.S.
Mr. Boswell. Well, it has a lot to do with it. And one of
the things we have heard here in this room over and over with
the rural development, and as I see this happening where I come
from and some of the other places I have traveled, I think you
are hitting a very salient point. And I don't know what we can
do about it.
Maybe somebody else would have some idea at the table
there. But is this a concern or is this just something for a
few of us? Is it a concern for others? Anybody?
Mr. Damgard. I was in the hog business in Illinois, and we
had a marketing problem when they closed down Joliet. All the
hogs were being sent down to North Carolina. So I just got out
of the hog business and went straight to grain. Turns out it
was pretty good idea.
Mr. Bullard. Congressman, I would like to add, too, and
that is exactly what is happening in the cattle industry. We
can't let the cattle industry, which is the single largest
segment of American agriculture, go the way of the hog
industry. Illinois used to be one of the top hog-producing
states in the nation. Back in 1980, it was among the top three
states. And then the meat packers, having vertically controlled
the industry, decided to uproot from the Midwest and move to
North Carolina. Illinois got booted out of the status of having
among the largest hog-producing states of the United States.
And this is the result of lack of competition and anti-
competitive practices that are occurring as a result of the
dominance by the meat packers who are essentially unrestrained,
unrestrained in the futures market and unrestrained in the cash
market.
Mr. Boswell. Well, you are making a point that I am
concerned about.
I don't know, Mr. Chairman, is there something that we can
look at further down the road or whatever? But it seems like it
is happening, and I have been worried over this now for a
number of years, and it seems like the pace is keeping up. And
I have seen that happen to the hog market, and we have heard
some testimony just here now. And it seems like we are at a
fast pace of it happening to the cattle market. So I guess we
can talk some more on that. But I am concerned.
My time is up. I yield back.
The Chairman. Thank you, Mr. Boswell.
And I am not sure if you can blame it all on--things
change. At some point in time, somebody built the latest,
greatest, best buggy whip manufacturing facility known to man,
and times change. I don't know how much a differential that is.
But back to the broader point, from a sequencing
standpoint, if the CFTC does, in fact, roll out a swaps
definition rule, which surely they have to do, and your
comments from the folks about if they did the definitions first
and rolled those out so that you then knew for sure you were
either a major swap participant or the transactions you were
doing were swaps or whatever, how much time would you need to
turn around your comments back to the CFTC to absorb what the
new definitions are and then look at what the regulatory
umbrella looks like once we understand what the definitions
are? Is there a time step you can help us understand?
Mr. Damgard. I would say historically when rules are rolled
out, we have taken an awful lot of time to implement them to
make sure that it wasn't disruptive to the market.
And there is no set time table, depending on how
complicated that rule might be. But I think discretion is the
important thing to consider here. I mean, we really need to
take our time and get it right. I have heard Mrs. Shapiro say
that. I have heard Gary Gensler say that. And rushing these
things through to meet these arbitrary deadlines, which are
unreasonable, is not the way to go.
The Chairman. Other comments?
Mr. Kaswell. I think there are some things that we feel
need to move more quickly than others, and I think I have
mentioned that. But the sequencing on these definitions that
you have addressed, Mr. Chairman, I think those are of great
concern, and I think that would make the process move much more
logically so that we come out to a set of rules that we all
feel we can work with and play by.
The Chairman. Last week we had the Chairman in. He said he
had all of the authority he needs. While he has a statutory
limit of 360 days to get the rules finalized, he has extensive
authority to pace the rollout and/or the implementation over a
much longer period of time.
Do you all think he has that authority to do that
implementation issue over a more reasonable approach than he
has in terms of developing the rules themselves?
Mr. Damgard. There are issues of whether he has the
authority to do a number of things.
For instance, position limits, in the legislation, he has
the authority to put in position limits subject to the CFTC
making a determination that somehow position limits were part
of the problem. And they made no such effort to do that.
So my sense is that the last thing we want to do is attract
a lot of lawsuits that would tie things up for much, much
longer. I mean, Mr. Kaswell, mentioned the fact that for 70
years, segregation has been segregating the customer's money
from the firm's money. And it worked very well. It has worked
well for 70 years. To go a step beyond that may or may not be
allowed without some sort of change either in the bankruptcy
law or the Commodity Exchange Act and lawyers are going to
argue about that one way or the other.
I would hate to see this being stalled 2 or 3 years while
we wait for a legislative solution. And as a result, I think
that the industry is looking for more time to figure out what
these costs are going to mean, whether or not there are
unintended consequences that we should worry about.
But yes, there will be legal challenges to some of these
things based on what some of the lawyers have said to me.
Mr. Kaswell. I think on full segregation, I think there is
pretty good clarity, with all due respect. But I think that--
but again, on some of the definitions, the sequencing is very
important.
The Chairman. All right. Comments from others?
Ms. Sanevich. Well, I have two quick points to make.
It is really that certainly there will need to be some time
after the rules are finalized to give everyone time to put
processes in place to implement. I mean, there are lots of
different aspects to it. But even in thinking through the rules
as to who comments on what, I mean, that is an important
sequencing aspect as well. No one knows what a swap may be or
an MSP or, in our case, what the DOL is going to do. And so it
is very hard to seek to wrap your head around everything that
may or may not apply because you are not quite sure how it will
affect you.
And importantly from the pension plans perspective, both as
it relates to the DOL issue and others, uncertainty in the
market as to whether we may be covered by this or not covered
by that, or whether we are going to get hit with an anti-
avoidance issue because our swaps are not--are customized and
maybe they should have been cleared, those are huge issues. And
any uncertainty in the market will significantly hamper a
pension plan's ability and maybe others as well to engage in
these kinds of instruments.
The Chairman. All right.
Mr. Bullard. Mr. Chairman?
The Chairman. Yes.
Mr. Bullard. From our perspective, we think the most
important thing here is to bring transparency to the opaque
markets, like the swaps and the over-the-counter trades. And so
we think the priority for Mr. Gensler should be to implement
those as quickly as possible, because it is one thing for an
industry to change because of competitive forces; it is quite
another for another industry to be fashioned because of the
anti-competitive conduct that is occurring in the market and we
don't know about it.
So we need transparency so the regulators can see with
certainty what involvement the dominant participants are having
in marketplaces that are as important to the cattle industry as
is the cattle futures market.
The Chairman. Thank you.
Any Members have other questions?
Anybody else?
Well, I want to thank the panel.
One of the things that was said to Chairman Gensler last
week was he put on the record the extensive work he and his
team have done to reach out to you and your colleagues and any
interested party in the deal, all of the participants, and the
feedback he has gotten, the thousands of this and the hundreds
of those and these kinds of things.
And what I asked him to do was--we have to propose rules.
You have had all of this public help. I am hopeful that they
will be able to look at the final rules and see meaningful
improvements from the proposed rule to the final rule and that
the funnel that is getting created by the tyranny of time by
the hard date in the legislation doesn't in fact create some
sort of a de facto fallback to the proposed rule because they
run out of time and they just kind of roll that back.
So any insight that you can help us with that to see where
we all listen but whether or not you change what you were going
to do based on what I said is the bigger point.
So anybody else have a comment before we adjourn.
Okay. This is our first Subcommittee hearing. So we are a
little disjointed.
Under the rules of the Committee, the record for today's
hearing will remain open for 10 calendar days to receive
additional material and supplementary written responses from
the witnesses to any questions posed by a Member.
This hearing on the Subcommittee on General Farm
Commodities and Risk Management is adjourned.
Thank you.
[Whereupon, at 3:28 p.m., the Subcommittee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Statement by Hon. K. Michael Conaway, a Representative in
Congress from Texas; on Behalf of Hon. Glenn English, CEO, National
Rural Electric Cooperatives Association
Mr. Chairman, Ranking Member Boswell, and Members of the
Subcommittee. Thank you for holding this hearing to address the role of
over-the-counter (OTC) derivatives in helping electric cooperatives
keep electric rates affordable for our consumer-members.
The National Rural Electric Cooperative Association (NRECA) is the
not-for-profit, national service organization representing over 900
not-for-profit, member-owned, rural electric cooperative systems, which
serve 42 million customers in 47 states. NRECA estimates that
cooperatives own and maintain 2.5 million miles or 42 percent of the
nation's electric distribution lines covering \3/4\ of the nation's
landmass. Cooperatives serve approximately 18 million businesses,
homes, farms, schools and other establishments in 2,500 of the nation's
3,141 counties. Our member cooperatives serve nearly 1.5 million member
owners in Congressional Districts represented on this Subcommittee.
Cooperatives still average just seven customers per mile of
electrical distribution line, by far the lowest density in the
industry. These low population densities, the challenge of traversing
vast, remote stretches of often rugged topography, and the increasing
volatility in the electric marketplace pose a daily challenge to our
mission: to provide a stable, reliable supply of affordable power to
our members--including constituents of many members of the Committee.
That challenge is critical when you consider that the average household
income in the service territories of our member co-ops lags the
national average income by over 14%.
Mr. Chairman, the issue of derivatives and how they should be
regulated is something with which I have a bit of personal history
going back twenty years in this very Subcommittee. Accordingly, I am
grateful for your leadership, in pursuing the reforms necessary to
increase transparency and prevent manipulation in this marketplace.
From the viewpoint of the rural electric cooperatives, the over-
the-counter or ``OTC'' derivatives market can be boiled down to a
single, simple concern that I know you have heard me articulate before:
affordability.
NRECA's electric cooperative members, primarily generation and
transmission members, need predictability in the price for power, fuel,
transmission, financing, and other supply resources if they are to
provide stable, affordable rates to their members. As not-for-profit
entities, we are not in the business of making money. Rural electric
cooperatives use derivatives to keep costs down by reducing the risks
associated with those inputs. It is important to understand that
electric co-ops are engaged in activities that are pure hedging, or
risk management. We DO NOT use derivatives for speculation or other
non-hedging purposes. We are in a difficult situation, but OTC
derivatives are an important tool for managing risk on behalf of our
members.
Most of our hedges are bilateral trades on the OTC market. Many of
these trades are made through a risk management provider called the
Alliance for Cooperative Energy Services Power Marketing or ACES Power
Marketing, which was founded a decade ago by many of the electric co-
ops that still own this business today. Through diligent credit risk-
management practices, ACES and our members make sure that the
counterparty taking the other side of a hedge is financially strong and
secure.
Even though the financial stakes are serious for us, rural electric
co-ops are not big participants in the derivatives markets. This market
is estimated at $600 trillion dollars. Our members have a miniscule
fraction of that sum at stake and are simply looking for an affordable
way to manage risk and price volatility for our consumers. Because many
of our co-op members are so small, and because energy markets are so
volatile, legislative or regulatory changes that would dramatically
increase the cost of hedging or prevent us from hedging all-together
would impose a real burden. If this burden is unaffordable, then these
price risks will be left unhedged and will be passed on to the
consumer, where they are unmanageable.
Electric cooperatives are owned by their consumers. Those consumers
expect us, on their behalf, to protect them against volatility in the
energy markets that can jeopardize their small businesses and adversely
impact their family budgets. The families and small businesses we serve
do not have a professional energy manager. Electric co-ops perform that
role for them and should be able to do so in an affordable way.
Our concerns with implementation of the Dodd-Frank Act are as
follows:
The Definition of ``Swap''
The most important term in the Dodd-Frank Act--because it defines
the scope of the CFTC's regulatory authority--is ``swap.''
Unfortunately, however, after over 40 ``swap'' rulemakings to date, the
CFTC has not yet explained what transactions it believes constitute
swaps. NRECA is concerned that if the CFTC defines that term too
broadly, it could bring under the CFTC's jurisdiction numerous
transactions that cooperatives and others in the energy industry have
long used to manage electric grid reliability and to provide long-term
price certainty for electric consumers. It is our belief that the CFTC
must acknowledge in its rules that a ``swap'' does not include physical
forward commodity contracts, ``commercial'' options that settle
physically, or physical commodity contracts that contain option
provisions, including full requirement contracts that even the smallest
cooperatives use to hedge their needs for physical power and natural
gas. Further, CFTC should acknowledge that a ``swap'' excludes long-
term power supply and generation capacity contracts, reserve sharing
agreements, transmission contracts, emissions contracts or other
transactions that are subject to FERC, EPA, or state energy or
environmental regulation.
These instruments are non-financial contracts between non-financial
entities that have never been considered ``derivatives'' or employed
for speculative purposes. They protect the reliability of the grid by
ensuring that adequate generation resources will be available to meet
the needs of consumers and do not impose any systemic risk to the
financial system. Yet, if they were to be regulated by the CFTC as
``swaps,'' it could impose enormous new costs on electric consumers and
could undermine reliability of electric service if the costs forced
utilities to abandon these long-term arrangements.
In the Dodd-Frank Act, Congress excluded from the definition of
``swap'' the ``sale of a non-financial commodity . . . so long as the
transaction is intended to be physically settled.'' NRECA asks Congress
to insist that the CFTC read this language as it was intended to
exclude from its regulation these kinds of contracts utilities use to
meet the needs of consumers.
Margin and Clearing Requirements
In general, co-ops are capital constrained. We and our members
would prefer that cash remain in our members' pockets rather than
sitting idle in large capital reserve accounts. At the same time, we
have significant capital demands, such as building new generation and
transmission infrastructure to meet load growth, installing equipment
to comply with clean air standards, and maintaining fuel supply
inventories. Maintaining 42% of the nation's electrical distribution
lines requires considerable and continuous investment.
Congress respected those constraints in Dodd-Frank by establishing
an ``end-user exemption'' that exempted those entities--like
cooperatives--that use swaps solely to hedge commercial risk
obligations, may choose to forgo the requirements to trade their swaps
on regulated exchanges or to pay ``margin'' (collateral) on those
swaps. If properly implemented by regulation, that exemption would
leave millions of dollars in electric consumers' pockets that might
otherwise sit in margin accounts or be paid in fees to financial
institutions.
I want to remind you that we are NOT looking to hedge in an
unregulated market. NRECA DOES want swaps markets to be transparent and
free of manipulation.
The problem is that requiring cooperatives' hedges to be centrally
cleared or subjected to margin requirements contracts would be
unaffordable for most co-ops and would provide no value to the markets
or to the nation. That is because our hedging transactions do not
impose any of the systemic risk Dodd-Frank was intended to address, yet
any ``initial margin'' or the ``working'' or ``variance'' margin
requirements on our transactions under broad CFTC rules could force our
members to post hundreds-of-millions of dollars in idle collateral that
our consumers cannot afford to provide.
If the CFTC implements Dodd-Frank's end-user exemption too
narrowly, the resulting clearing and margining requirements could force
cooperatives to postpone or cancel needed investment in our
infrastructure, borrow to fund margin costs, abandon hedging, or
dramatically raise rates to consumers to raise the capital. Of course,
whatever choice co-ops made would lead to the same result: increased
electric rates for cooperative members.
Reporting Requirements
Mr. Chairman, the Dodd-Frank Act quite properly requires the CFTC
to require reporting of those swaps traded on regulated exchanges. That
information is critical to providing transparency to those markets.
Unfortunately, the CFTC is proposing to move far beyond the reporting
requirements in the Act to also require utilities to report a
significant volume of information for those end-user transactions that
Congress exempted from Dodd-Frank's central clearing requirements. In
our energy markets, many utility-to-utility transactions are entered
into between two end-users, and there are no swap dealers or major swap
participants to bear the reporting burdens that these types of dealer
entities are accustomed to.
I encourage the Subcommittee to urge the CFTC to reduce this
reporting process burden, as provided for in the law. We are requesting
that the CFTC adopt a ``CFTC-lite'' form of regulation for non-
financial entities like the cooperatives. The CFTC should let us
register, keep records and report in a less burdensome and less
frequent way--not as if we were swap dealers or hedge funds. For
example, it should be sufficient to require end-users to make a single
representation that they will rely on the end-user exemption
exclusively to hedge commercial risk, and once they have made that
representation, they should not have to report those transactions any
more frequently than is now required by the Federal Energy Regulatory
Commission.
As explained above, these transactions represent a miniscule
fraction of the swap market and pose no systemic risk to that market,
making more frequent reporting unnecessarily expensive.
Exemptions for FERC-Regulated and 201(f) Transactions
Congress recognized in the Dodd-Frank Act that elimination of the
Commodity Exchange Act's exemption for energy transactions could lead
to duplicative and potentially conflicting regulation of transactions
now subject to FERC regulation and could lead to unnecessary and
expensive regulation of transactions between non-public utilities.
Accordingly, it directed the CFTC to exempt those transactions from its
regulation if it found such an exemption to be in the public interest.
No entity has yet sought such an exemption because the rules from
which they would be seeking exemption have not yet been written.
Because the industry does not yet know what the CFTC will consider to
be a ``swap'' or whether utility hedging efforts will be exempted from
central clearing and margining requirements as end-user transactions,
it does not yet know how critical it will be to pursue these additional
avenues for relief. We certainly hope that the CFTC will choose to
write its rules in a manner that minimizes potential conflicts with
FERC regulation and that minimizes potential costs for transactions
between cooperatives or municipal utilities.
Nevertheless, should it become necessary to pursue additional
exemptions, NRECA hopes that the CFTC will recognize that Congress
intended in Dodd-Frank to address systemic risk in financial markets
without disrupting existing markets for electricity, and that the CFTC
will entertain the industry's applications for further exemptions if
and or when they are submitted.
Treatment of Cooperative Lenders
Rural electric cooperatives banded together four decades ago to
form their own financing cooperative to provide private financing to
supplement the loan programs of the US Department of Agriculture's
Rural Utilities Service. Today, this nonprofit cooperative association,
the National Rural Utilities Cooperative Finance Corporation (CFC),
provides electric cooperatives with private financing for facilities to
deliver electricity to residents of rural America, and to keep rates
affordable. In this context, CFC, which is owned and controlled by
electric cooperatives, uses OTC derivatives to mitigate interest rate
risks, and tailor loans to meet electric cooperative needs. CFC does
not enter into derivative transactions for speculative purposes, nor is
it a broker dealer. CFC only enters into derivatives necessary to hedge
the risks associated with lending to electric cooperatives. If CFC is
unnecessarily swept up in onerous new margining and clearing
requirements, electric cooperatives will likely have to pay higher
rates and fees on their loans, and those costs will ultimately be
passed on to rural consumers.
We ask that CFC's unique nature as a nonprofit cooperative
association owned and controlled by America's consumer-owned electric
cooperatives be appropriately recognized. Electric cooperatives should
not be burdened with additional costs that would result by subjecting
their financing cooperative, CFC, to margining and clearing
requirements.
Conclusion
Mr. Chairman, at the end of the day, we are looking for a
legitimate, transparent, predictable, and affordable device with which
to hedge risk and volatility for our members. If we are to do that, the
CFTC must define ``swap'' narrowly to exclude those pure hedging
transactions the industry uses to preserve reliability and manage long-
term power supply costs; must give meaning to Dodd-Frank's end-user
exemption; must limit unnecessary reporting costs for end-users; and
must limit duplicative and unnecessary regulation of cooperatives and
other electric utilities.
Rural electric cooperatives are not financial entities, and
therefore should not be overburdened by new regulation or associated
costs as if we were financial entities. We believe the CFTC should
preserve access to swap markets for non-financial entities like the co-
ops who simply want to hedge commercial risks to provide affordable
power to its consumers.
I thank you for your leadership on this important issue. I know
that you and your committee are working hard to ensure these markets
function effectively. The rural electric co-ops hope that at the end of
the day, there is an affordable way for the little guy to effectively
manage risk.
Thank you.
______
Submitted Letter by Hon. K. Michael Conaway, a Representative in
Congress from Texas; on Behalf of Bill Donald, President, National
Cattlemen's Beef Association
February 15, 2011
Hon. K. Michael Conaway,
Chairman,
Subcommittee on General Farm Commodities and Risk Management, House
Committee on Agriculture,
Washington, D.C.
Dear Chairman Conaway:
As you prepare for today's Subcommittee hearing to review
implementation of title VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, I wanted to give you some perspective from the
cattle industry. Futures markets originated with agricultural
commodities as a way to establish value. For more than 100 years, these
markets have provided a mechanism to discover value, and more
importantly, have provided a tool to help cattle producers manage the
inherent risk that comes with marketing cattle.
As the Subcommittee looks at the Act, it is important to ensure
that implementation of the Act's provisions are done in a thorough and
methodical fashion. Rushing to implement this Act could result in
unintended consequences that could actually harm or hinder the
marketplace. Cattle producers are already being harmed by the
unintended consequences of other regulatory actions such as dust
enforcement by the Environmental Protection Agency (EPA) and the
proposed Grain Inspection Packers and Stockyards Administration's
(GIPSA) marketing rule. We cannot afford to let another rulemaking
further hamper our ability to stay in business.
Commodity markets work and have provided risk management tools
benefiting U.S. producers. The commodity markets have not forced
producers out of our industry. On the contrary, their risk management
products have provided non-government program safety nets that have
protected producers. Transparency and regulation of the market is
needed, but not to the extent that it actually hampers trade and
distorts the most efficient means of price discovery in agricultural
markets.
We ask you to thoroughly review the regulatory actions taken by the
Obama Administration to implement this Act in order to maintain our
ability to use the commodity markets as a beneficial tool in managing
ever increasing risks in agricultural marketing.
Sincerely,
______
Submitted Letter by Hon. K. Michael Conaway, a Representative in
Congress from Texas; on Behalf of National Corn Growers Association and
Natural Gas Supply Association
February 9, 2011
Hon. Frank D. Lucas,
Chairman,
House Committee on Agriculture,
Washington, D.C.;
Hon. Collin C. Peterson,
Ranking Minority Member,
House Committee on Agriculture
Washington, D.C.
Subject: Dodd-Frank Wall Street Reform and Consumer Protection Act,
Implementation of Swap Dealer Definition
Dear Chairman Lucas and Ranking Member Peterson:
The Commodity Futures Trading Commission's (CFTC) implementation of
title VII of the Dodd-Frank Wall Street Reform and Consumer Protection
Act of 2010 (Dodd-Frank Act) is critical to maintaining the economic
protections provided by the Dodd-Frank Act to end-users.
The National Corn Growers Association (NCGA) and the Natural Gas
Supply Association (NGSA) were active participants in the shaping of
the Act during its passage and are taking an active role in the Act's
successful implementation through participation in the CFTC's
rulemaking process.
Financial reform must not come at the expense of America's energy
and commodity producers, consumers, and ultimately, the entire U.S.
economy. Absent careful CFTC implementation of the swap dealer
definition, the practical effect of the Dodd-Frank Act could be
mandatory clearing for many commercial end users. Imposing a clearing
requirement on commercial end-users does not further the goal of
ensuring financial system integrity, and instead, centralizes risk that
would have otherwise been diversified, increasing systemic risk and
unnecessarily removing productive capital from the economy.
Mandatory clearing of derivatives transactions will drain the
economy of more than $650 billion * in capital. Keeping U.S. industry's
capital at work in a recovering economy through the sound
implementation of the end user protections in the Dodd-Frank Act will
help create jobs, energy and products for U.S. consumers without
compromising the integrity of the U.S. financial system.
---------------------------------------------------------------------------
* Estimate based on the U.S. portion of global credit exposure that
is not already collateralized. Data sources include the Bank for
International Settlements, Monetary and Economic Department OTC
Derivatives Market Activity Report, ``Cross-border derivatives
exposures: how global are derivatives markets?'' by Sally Davies of the
Division of International Finance, Board of Governors of the Federal
Reserve System, and Country Exposure Report that shows U.S. banks'
exposure from derivatives. For the detailed calculation methodology,
please contact the Natural Gas Supply Association at [Redacted].
---------------------------------------------------------------------------
A primary purpose of CFTC regulation of the ``over-the-counter''
(OTC) markets is to protect consumers from systemic risk. The CFTC's
definition of Swap Dealer should balance the goals of protecting
consumers from systemic risk and ensuring no unnecessary harm to the
economy. Thus, the CFTC must carefully scope the definition of Swap
Dealer because an unnecessarily broad definition will sweep in end-
users, limiting one of the key protections for the economy incorporated
into the Dodd-Frank Act.
In November 2010, NCGA and NGSA offered the following pre-proposal
comments to the CFTC, outlining what we believe is a workable solution
to the implementation of the swap dealer definition. NCGA and NGSA
intend to provide further comments to the CFTC on this issue later this
month but believe that the approach to the definition of Swap Dealer
might be also be helpful in your review of the implementation of Title
VII of the Dodd-Frank Act later this week.
Trading in Swaps Should Not Make a Company a Swap Dealer. The CFTC
should implement the Swap Dealer definition by ensuring that both the
law's general exception and the de minimis exception are properly
applied. The general exception applies to entities entering into swaps
for their own account (e.g., traders). The de minimis exception allows
for the exclusion from a Swap Dealer designation of entities that
engage in a de minimis quantity of swap transactions ``with or on
behalf of'' their customers. These two exceptions are essential because
they allow entities that use swaps to hedge or mitigate commercial
risks, such as those risks that stem from the production of energy and
agricultural commodities, to avoid being designated as Swap Dealers, a
designation that would preclude eligibility for the end-user clearing
exception. Entities designated as Swap Dealers would be required to
transact their swaps on an exchange or to clear such transactions,
subjecting them to costly margin and clearing expenses and draining the
economy of billions of working capital dollars.
The CFTC Should Use the Concept of ``Intermediation'' to Define
Swap Dealer. To achieve Congressional goals, the CFTC should use a two-
step process based on the Securities Exchange Act and the concept of
intermediation (transacting to satisfy a customer order or, simply put,
acting on behalf of a customer) to first implement the general
exception and then implement the de minimis exception in the Swap
Dealer definition. The Securities and Exchange Commission (SEC)
precedent on the designation of a dealer provides a comprehensive way
to distinguish trading from dealing. Central to the SEC case law that
distinguishes ``dealing'' from ``trading'' is the concept of
intermediation. To implement the two exceptions, the CFTC should use
the concept of intermediation as the basis for filtering dealers from
traders, many of whom use swaps to hedge business risk. This approach
will ensure that financial entities engaging in swaps with or on behalf
of customers remain in the regulatory purview of the CFTC without
diminishing the integrity of the end-user clearing exception.
---------------------------------------------------------------------------
Vol. 15, Broker-Dealer Regulation, David A. Lipton, Section 1:6
at 1-42. 11, n. 4.
---------------------------------------------------------------------------
Step one: Use the SEC model for distinguishing between ``dealers''
and ``traders'' to implement the general exception. Built into the Swap
Dealer definition is a general exception excluding ``persons that enter
into swaps for that person's own account, either individually or in a
fiduciary capacity, but not as a part of a regular business''--from
designation as a Swap Dealer. Put another way, the general exclusion
establishes that only an entity trading swaps that are not for its own
account (e.g., done in an intermediary capacity) is a Swap Dealer. In
securities markets, the SEC and the courts have identified a number of
characteristics for dealing activity. While the securities market
activities do not translate precisely to the commodity swaps market,
the concept of ``intermediation'' does translate. (See inset below.)
The concept of intermediation can be used to implement the general
exception as the starting point for sorting dealers from traders so
that the integrity of the economic protection provided by the general
exclusion can be maintained.
Step two: Implement the de minimis exclusion by considering the
level of ``dealing'' transactions relative to total swap transaction
activities. An entity would not qualify for the general exception if it
both trades and deals. While not universal, many commercial entities
with
------------------------------------------------------------------------
-------------------------------------------------------------------------
Securities Market Intermediation Concept Translates to Commodity
Swaps Market Swap Dealer Characteristics
performing an intermediary role in swaps
markets by engaging in swap transactions
with customers;
remaining essentially neutral to price move-
ments with respect to the swap and under-
lying commodity;
quoting a two-sided market for swaps and
standing ready to take the opposite side of
customer orders; and
providing financially-related, ancillary dealer
activities (e.g., advising on investments).
------------------------------------------------------------------------
astute trading capabilities also enter into transactions with their
traditional customers that may ultimately resemble dealing. Often this
``dealing'' is the result of the customer's interest in transacting
financial hedges with a counterparty that has physical assets and a
history in bringing physical product to market. This is where the de
minimis exception plays a critical role. For entities that trade swaps
and engage in this limited form of dealing, the CFTC should design the
de minimis exception so that the level of dealing (defined by using the
concept of intermediation as reflected in the SEC regulations) is
compared to their total swap transactions (e.g., trading and dealing).
If the level of dealing relative to the total is small, in other words,
if the entity primarily trades swaps, the de minimis exception is
satisfied.
The right Swap Dealer approach works for consumers and the economy.
Using the concept of intermediation to implement the general and de
minimis exceptions will allow the CFTC to sort true swap dealers from
those entities that trade swaps to hedge commercial business risk. This
approach is consistent with existing case law and the Congressional
goal of avoiding unnecessary harm to the economy. Finally, the solution
provides the CFTC with a practical and valid way to regulate Swap
Dealers that buy and sell swaps to satisfy customer orders, without the
harm to the economy that would result from avoidable and unnecessary
increases in business risk management costs. Appropriate implementation
of the Swap Dealer definition is essential to maintaining the integrity
of the end-user protection provisions that were central to the passage
of the Dodd-Frank Act.
Founded in 1957, NCGA is the largest trade organization in the
United States representing 35,000 dues-paying corn farmers nationwide
and the interests of more than 300,000 growers who contribute through
corn checkoff programs in their states. NCGA and its 48 affiliated
state associations and checkoff organizations work together to create
and increase opportunities for their members and their industry.
Established in 1965, NGSA represents integrated and independent
companies that produce and market approximately 40 percent of the
natural gas consumed in the United States.
Please do not hesitate to contact Sam Willett, Senior Director of
Public Policy for NCGA at [Redacted] or Jenny Fordham, Vice President,
Markets for NGSA at [Redacted], if we can provide any additional
information. Thank you for your review of the implementation of title
VII of the Dodd-Frank Act.
Sincerely,
National Corn Growers Association;
Natural Gas Supply Association.
______
Submitted Questions
Questions Submitted by Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Response from John M. Damgard, President, Futures Industry Association
Question 1. CFTC Commissioner Dunn, in various public comments,
appears to be making the argument that the CFTC's budgetary uncertainly
could lead the agency to put forth a rules-based regulatory regime as
opposed to a principles-base regime. Do any of you agree with his
comments?
Answer. We respectfully disagree with Commissioner Dunn. With the
enactment of the Commodity Futures Modernization Act of 2000 (CFMA),
which replaced the overly prescriptive regulatory structure that
previously had so restricted the conduct of designated contract markets
(DCMs) and derivatives clearing organizations (DCOs) with the core
principles, Congress confirmed that the CFTC's appropriate role is as
an oversight agency, with direct supervisory responsibility exercised
by the several self-regulatory organizations, NFA and the DCMs.
The CFMA facilitated a period of unprecedented growth and
innovation in the futures industry, without requiring any significant
increase in CFTC staff. A rules-based regulatory regime, on the other
hand will require additional staff, as staff would be required to
review and approve virtually all DCM and DCO proposed rules to assure
that they fall within the four corners of the CFTC-prescribed rules. A
rules-based regulatory regime will also stifle innovation, which is
essential to promote competition in the market for cleared swaps, which
is in its initial stages. The CFTC's proposed rules are already highly
prescriptive and are based primarily on current market practices. DCMs
and DCOs will not be able to respond to changes in the international
market in a timely manner in a rules-based regulatory regime.
Question 2. Your testimony states that FIA has presented an
alternative ownership and control rule which would achieve the same
purposes as the CFTC's proposed rules at less cost. Can you explain
your proposal in more detail and tell us your estimate of the cost
differences?
Answer. A copy of our comment letter on the CFTC's proposal, which
describes our alternative in detail, is attached for your review. As
explained in the appendix to the letter, we estimate that, compared
with the CFTC's proposal, the FIA alternative would result in an
average first-year cost savings of approximately $18.8 million. As
described in the charts at the end of the appendix, the first year
costs of the CFTC's proposal is four times greater than the median
costs incurred by FCMs under the FIA alternative.
We recently met with the CFTC staff on this proposal and responded
to questions they had.
Question 3. Your testimony mentions the CFTC should delegate some
responsibilities to the National Futures Association, a self-regulatory
organization that already performs several oversight functions for the
CFTC. What responsibilities do you believe should be delegated to the
NFA and which ones should the CFTC retain?
Answer. As described above, we believe the CFTC should be an
oversight agency, with primary responsibility for supervising CFTC
registrants vested in NFA and the exchanges. Chairman Gensler has
already announced that NFA will process registration applications for
swap dealers and major swap participants. Since NFA currently processes
all other CFTC registration applications, this is not only appropriate,
but necessary. It is not clear that the CFTC has the necessary
infrastructure any longer to process applications.
Primary responsibility for the oversight of FCMs and other
intermediaries is currently allocated among NFA and the exchanges in
accordance with the Joint Audit Plan. There is no reason why these SROs
could not perform the same activities with respect to swap dealers. Our
understanding, however, is that the CFTC has only recently begun to
talk with NFA about the role NFA can play in implementing the
regulatory program for swaps.
NFA should also be responsible for developing and enforcing rules
regarding the obligations of chief compliance officers of registrants
and, more generally, business conduct rules governing swap dealers,
major swap participants and other CFTC registrants. As we noted in our
comment letter, FINRA has this responsibility on the securities side,
and the CFTC proposal conflicts in several significant ways with the
FINRA rules. Since most FCMs are also registered with the SEC as
broker-dealers and are FINRA members (and we expect that most swap
dealers will also be security-based swap dealers), it is critical that
these firms not be subject to conflicting business conduct and other
rules.
SROs also have enforcement authority and should have primary
responsibility for taking enforcement action against members that
violate SRO rules. These rules also require their members to comply
with applicable provisions of the Commodity Exchange Act and CFTC
regulations. Of course, the CFTC also has an important role to play in
enforcing the CEA. However, the CFTC has recently begun to take over
enforcement investigations which had been initiated against market
participants by an exchange and which could properly have been resolved
there. This results in a duplication of effort and an unnecessary
demand on CFTC enforcement staff resources. (It may also significantly
increase costs on respondents.)
Question 4. In mentioning that the CFTC should delegate some
responsibilities to the National Futures Association, you state that
the NFA is funded entirely by its participants. Given that the CFTC is
not funded directly by the participants in the markets it oversees, but
by taxpayers, wouldn't direct NFA oversight place a greater cost on the
industry than direct CFTC oversight?
Answer. The industry does not object to paying fees to support the
regulatory activities of NFA, because the industry believes it is
appropriate to share the cost of assuring market integrity. The current
regulatory regime strikes the appropriate balance, with the industry
assuming responsibility for direct supervision of market participants,
and taxpayers assuming responsibility for oversight of NFA, DCMs and
DCOs.
attachment
By Electronic Mail Revised
December 23, 2010
David A. Stawick,
Secretary,
Commodity Futures Trading Commission,
Washington, D.C.
Re: Account Ownership and Control Report, 75 Fed. Reg. 41775 (July 19,
2010)
Dear Mr. Stawick:
This letter supplements and replaces the October 7, 2010 letter
that the Futures Industry Association (``FIA'')\1\ filed in response to
the Commodity Futures Trading Commission's (``Commission's'') request
for comment on its proposed rules requiring designated contract markets
and other ``reporting entities,'' as defined in the proposed rules,\2\
to submit certain ownership and control reports (``OCR'') to the
Commission weekly (``OCR Rules''). The OCR Rules would require each
reporting entity to provide the Commission detailed information,
consisting of approximately 28 separate data points, with respect to
each account reported in its trade register. ``The OCR will necessitate
each reporting entity to collate and correlate these and other data
points into a single record for trading accounts active on its trading
facility, and to transmit such record to the Commission for regulatory
purposes.'' \3\
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\1\ FIA is a principal spokesman for the commodity futures and
options industry. FIA's regular membership is comprised of
approximately 30 of the largest futures commission merchants (``FCMs'')
in the United States. Among FIA's associate members are representatives
from virtually all other segments of the futures industry, both
national and international. Reflecting the scope and diversity of its
membership, FIA estimates that its members effect more than eighty
percent of all customer transactions executed on United States contract
markets.
\2\ A ``reporting entity'' is defined as ``any registered entity
required to provide the Commission with trade data on a regular basis,
where such data is used for the Commission's trade practice or market
surveillance programs.'' Reporting entities include, but are not
limited to, designated contract markets and exempt commercial markets
with significant price discovery contracts. Proposed Commission Rule
16.03(a). In addition, the Commission anticipates that it would also
collect ownership and control information from swap execution
facilities and foreign boards of trade operating in the U.S. pursuant
to staff direct access no-action letters, provided such letters are
conditioned on the regular reporting of trade data to the Commission.
FIA is concerned that efforts to extend the OCR Rules to foreign boards
of trade may conflict with the laws and regulations of the jurisdiction
of that board of trade. Significantly, the definition does not
contemplate that FCMs would be designated as ``reporting entities.''
\3\ 75 Fed. Reg. 41775, 41776, fn. 1 (July 19, 2010).
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As the Commission further explains in the Federal Register release
accompanying the proposed OCR Rules:
The OCR will serve as an ownership, control, and relationship
directory for every trading account number reported to the
Commission through reporting entities' trade registers. The
data points proposed for the OCR have been specifically
selected to achieve four Commission objectives. These include:
(1) identifying all accounts that are under common ownership or
control at a single reporting entity; (2) identifying all
accounts that are under common ownership or control at multiple
reporting entities; (3) identifying all trading accounts whose
owners or controllers are also included in the Commission's
large trader reporting program (including Forms 40 and 102);
and (4) identifying the entities to which the Commission should
have recourse if additional information is required, including
the trading account's executing firm and clearing firm, and the
name(s) of the firm(s) providing OCR information for the
trading account.\4\
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\4\ 75 Fed. Reg. 41775, 41783 (July 19, 2010).
Broadly, the Commission asserts that the information collected
will: (i) enhance market transparency; (ii) increase the Commission's
trade practice and market surveillance capabilities; (iii) leverage
existing market surveillance systems and data; and (iv) facilitate the
Commission's enforcement and research programs.
Although reporting entities would be responsible for submitting the
OCR, the Commission acknowledges that these entities do not currently
collect a significant amount of this information. The ``root sources''
for much of the information required rests instead with others. As
discussed below, clearing member FCMs will be the primary source of
this information. They, in turn, will be required to rely on their
customers to provide, and keep current, the required information.\5\
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\5\ In the Federal Register release accompanying the OCR Rules, the
Commission implies that it would expect a reporting entity to prohibit
members from trading on or through the entity, unless the member
complies with any applicable reporting requirements the reporting
entity may impose: ``Successful implementation of the OCR will require
reporting entities to offer their services only on the condition that
ownership and control information be provided upon request by the
relevant party in possession of such information.'' Id. at 41785.
Presumably, member FCMs, in turn, would be prohibited from carrying
accounts on behalf of customers that fail to provide, and keep current,
the information required with respect to each account. As discussed
below, FCMs must rely almost entirely on customers to provide and keep
current, information with respect to data such as: (i) beneficial
owners; (ii) account controllers; (iii) dates of birth; (iv) primary
residence addresses; and (v) date accounts are assigned to current
controllers. Although FCMs can advise customers of the information
required and contract with their customers to provide such information,
FCMs cannot be placed in the position of being guarantors of the
information that their customers provide, or fail to provide.
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In our October 7, 2010 letter, we advised the Commission that, to
assure that both the feasibility of the proposed OCR Rules and their
potential impact on the industry were properly assessed, FIA had formed
an OCR Working Group, comprised of individuals with significant
experience in operations from (i) 16 FCMs, both large and small, with
both retail and institutional customers, (ii) the several U.S.
exchanges, (iii) the principal back office service providers, and (iv)
other experts.\6\ The group carefully analyzed each of the data points
to be collected under the OCR Rules and identified: (1) the required
data that is currently collected; (3) the required data that is not
collected; and (3) the required data that would be difficult, if not
impossible, to collect. The group then estimated the cost of
implementing and maintaining the proposed database.
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\6\ Several members of the group participated in the Commission's
September 16, 2010 roundtable on the proposed OCR Rules.
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After fully analyzing the Commission's proposal, the OCR Working
Group concluded that the financial and operations burdens imposed by
the OCR Rules would be overwhelming. In addition, the OCR Rules would
force an unwarranted structural change in the conduct of business among
U.S. futures markets participants, especially among clearing member and
nonclearing member FCMs, foreign brokers, and their respective
customers. In particular, the proposed requirement that clearing member
FCMs know and report to the relevant clearing organization the identity
of each customer that comprises an omnibus account and their respective
positions will disrupt, if not destroy, the regulatory and operational
synergies among market participants that have developed over decades
and are essential to the efficient operation of the markets.
Equally important, the OCR Rules would impose on such FCMs
substantial increased regulatory and concomitant financial obligations.
As a result, a number of FCMs could be compelled to withdraw from
registration and the barrier to entry for potential new registrants
will be raised. In addition, a significant number of foreign customers
will effectively be denied access to U.S. markets.
Consequently, we advised the Commission that we cannot support the
adoption of the OCR Rules as currently proposed. We further advised the
Commission, however, that the OCR Working Group was working on an OCR
alternative that we would submit to the Commission for its review.
Since the proposed OCR Rules were published in July, and since we
undertook to submit an OCR alternative, the regulatory landscape has
shifted dramatically. The Commission has published (or shortly will
publish) for comment a myriad of proposed rulemakings that,
collectively, contemplate a complete overhaul of the recordkeeping and
reporting requirements to which FCMs, U.S. exchanges and clearing
organizations are subject. These proposals include: (i) the advance
notice of proposed rulemaking regarding the protection of cleared swaps
customers before and after commodity broker bankruptcies; (ii) core
principles and other requirements for designated contract markets;
(iii) risk management requirements for derivatives clearing
organizations; (iv) information management requirements for derivatives
clearing organizations; (v) position limits for derivatives; (vi) core
principles and other requirements for swap execution facilities; and
(vii) swap data recordkeeping and reporting requirements.
We respectfully submit that these various rulemakings cannot be
considered in isolation. All of the pending recordkeeping and reporting
requirements, and the estimated costs and benefits of each, must be
analyzed and evaluated collectively, not individually. In the absence
of such a coordinated analysis, it is impossible to determine whether
the pending rules, including the OCR Rules and alternative set out
herein, are complementary or conflicting. Neither is it possible to
calculate the aggregate financial and operational burdens these various
proposals will have on the industry.\7\
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\7\ Among other burdens, these various proposal, if promulgated,
are likely to severely strain the resources of FCMs' information
technology staffs as well as the staffs of the principal back-office
software vendors.
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In order to assure an efficient and competitive futures industry,
it is essential that the financial and operational burdens imposed by a
revised recordkeeping and reporting system are necessary and
proportionate to benefits realized. In this regard, therefore, we are
prepared to expand both the charter and the composition of the OCR
Working Group to undertake the necessary analysis. We encourage the
participation of the Commission staff in any manner the Commission
deems appropriate.
In light of the foregoing, the OCR alternative included herein at
Appendix A and Appendix B should not be viewed as an industry-approved
alternative, but solely as a basis for further discussions among the
Commission, the futures industry and other interested parties.
Consistent with the Commission's request, the estimated costs of
implementing this OCR alternative are also set out in Appendix A.
Although these costs are significantly less than the estimated costs of
implementing the OCR Rules, they are substantial nonetheless (even
without taking into account the other rule proposals summarized above)
and emphasize the importance of analyzing the Commission's proposed
recordkeeping and reporting requirements as integrated parts of a
single unit rather than distinct requirements.
For the convenience of the Commission, set out below, with certain
non-substantive revisions, is the body of our October 7, 2010 letter on
the OCR Rules.
The OCR Rules Would Impose Substantial Costs on FCMs
Because the OCR Rules would require FCMs to collect and report a
substantial amount of information that either is not collected in the
manner the Commission may anticipate or is not collected at all, the
proposed rules would require a complete redesign of the procedures,
processes and systems pursuant to which FCMs create and maintain
records with respect to their customers and customer transactions. Such
redesign would take far longer and be far more expensive than the
Commission suggested in the Federal Register release accompanying the
proposed rules.
In this latter regard, we respectfully submit that the Commission
erred in basing its cost analysis under the Paperwork Reduction Act
only on anticipated costs to be incurred by registered entities.\8\
FCMs are the root source of approximately \1/2\ of the data points the
Commission is proposing to collect. The cost to FCMs of building an OCR
database, collecting the required information and transmitting it to
the relevant exchange will be substantially greater than the
Commission's estimate of the costs that will be incurred by the
exchanges alone. Such costs will be particularly burdensome on smaller
FCMs, which frequently carry a proportionately higher number of
accounts, comprised of non-institutional hedgers and individual
traders.\9\
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\8\ We take no view on the analysis presented in the Federal
Register release of the costs to be incurred by exchanges. We
anticipate that the designated contract markets will submit comments in
this regard.
\9\ Implementation of the OCR Rules would also place smaller
exchanges and potential new exchange entrants at a significant
disadvantage.
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We are concerned that the cost of opening and maintaining these
smaller accounts in compliance with the OCR Rules may result in certain
FCMs withdrawing from registration, raising the bar to entry, and
denying certain customers, including certain non-institutional hedgers,
access to the futures markets. To obtain and maintain the required
information, an FCM would be required to: (i) re-negotiate all active
customer agreements to require customers to provide and routinely
update the necessary data points; (ii) build systems to enter the data;
(iii) manually enter the data for each active account; (iv) put in
place resources and processes to maintain the data; (v) provide it to
the reporting entity on a weekly basis; and (vi) monitor changes daily
in order to update the database.
FIA received cost estimates for building and maintaining an OCR
database from 12 FIA member firms. The cost analysis included:
operational costs, such as notifying beneficial owners and
account controllers, collecting and recording data;
technology costs of building databases, developing user
interfaces, storing additional data, and developing a
transmission mechanism; and
legal costs of client notification, and re-executing client
agreements.
These cost estimates do not include rebuilding systems/processes to
manage account numbers, including vendor costs, which will be passed on
to each FCM. They also do not include the cost of tracking beneficial
owner and account controller information through the omnibus chain.
Our sample of 12 firms represents approximately 16 percent of the
approximately 70 FCMs that execute and clear customer accounts. These
firms handle in excess of $83.8 billion of customer funds, or
approximately 62 percent of customers' segregated funds (as of July 31,
2010, according to monthly financial reports filed with the
Commission). We found that the median firm would face total costs of
roughly $18.8 million per firm, including implementation costs of
roughly $13.4 million, and ongoing costs of $2.6 million annually. On a
per account basis, the median cost would be $623 per account.\10\
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\10\ We understand that the Commission requested that cost data be
presented with respect to specific firms and not on an aggregate basis.
However, because this cost data constitutes confidential business
information, the firms that provided the data have not been identified
by name.
FCMs' CFTC Proposed Rule Cost Estimates 1
----------------------------------------------------------------------------------------------------------------
Total Start-up and First-Year
Affected Start-up Ongoing Ongoing/First-Year Costs Per
Accounts Costs Account
----------------------------------------------------------------------------------------------------------------
Firm A 90,000 $49,280,000 $6,768,844 $56,048,844 $623
Firm B 75,300 $13,395,600 $2,625,500 $16,021,100 $213
Firm C 50,000 $28,000,000 $3,000,000 $31,000,000 $620
Firm D 2 39,979 N/A N/A $18,208,863 $455
Firm E 34,700 $22,000,000 $3,750,000 $25,750,000 $742
Firm F 3 30,000 $10,000-$35,000 $540,000 $560,000-$575,000 N/A
Firm G 19,473 N/A N/A $50,000,000 $2,568
Firm H 14,000 N/A N/A $21,525,000 $1,538
Firm I 250 $50,000+ $150,000+ $200,000+ $800+
Firm J * 130,000 $2,000,000-$2,500,000 $200,000 $2,200,000-$2,700,000 $19
Firm K * 40,000 $2,900,000 $280,000 $3,180,000 $80
Firm L * 550 $3,600,000 $1,150,000 $4,750,000 $8,636
----------------------------------------------------------------------------------------------------------------
Notes:
1 The 12 firms in the sample handle in excess of $83.8 billion, or almost 62% of customers' segregated funds (as
of July 31, 2010, according to monthly financial reports filed with the CFTC).
2 Total cost estimate is based on estimate for affected accounts and average cost per account.
3 Firm's estimates exclude IT costs.
* Firm did not provide cost estimates for the Industry Solution.
Cost Analysis
FCMs' CFTC Proposed Rule Cost Estimates
Based on the foregoing, we submit that the cost of building and
maintaining a database to comply with the OCR Rules is overly
burdensome for FCMs and some reporting entities. This is particularly
true, since FIA found that the size of the FCM had little to do with
the projected costs. As noted earlier, smaller FCMs may have a large
number of retail accounts, i.e., non-institutional hedgers and
individual traders. Taking into consideration today's extremely low
commission rates, it could take years for firms to recoup the cost of
OCR implementation and maintenance. Most firms will certainly elect to
pass on those costs to end-users. FCMs may avoid smaller accounts
altogether, since the commissions earned would be far less than the
cost of establishing and maintaining the account.
In addition, although the costs for a reporting entity may not seem
significant for the larger, well-established exchanges, they are
significant for the smaller exchanges and other entities such as swap
execution facilities that the Commission has indicated may be required
to be reporting entities. At a time when legislators and regulators are
trying to encourage transparent execution venues and centralized
clearing, the scope of the OCR seems counterproductive.
The Commission and the Industry Must Work Together
Notwithstanding the foregoing, and as noted earlier, FIA supports
the Commission's goals. We are committed to working with the Commission
and the other futures market participants to develop a meaningful
alternative to the proposed OCR Rules. To this end, FIA is submitting
herein for the Commission's review an alternative proposal that has
been developed by FIA's OCR Working Group.\11\
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\11\ As discussed above, the OCR Working Group that FIA formed
includes (i) 16 FCMs, both large and small, representing retail and
institutional customers, (ii) exchanges, (iii) back office service
providers and (iv) other experts.
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The alternative seeks to maximize the use of existing data;
automate and enhance the current, largely manual, large trader
reporting system; \12\ provide the Commission with an efficient means
of monitoring trading behavior based on volume thresholds; and linking
ownership data to the trade registers. The large trader reporting
system already provides the Commission the ability to aggregate certain
customer activities across clearing firms. In addition to automating
the large trader system, the OCR Working Group's alternative would
enhance this system, in part, by extending reporting requirements to
traders that engage in a certain volume of transactions without regard
to their open positions. As under the proposed rules, the Commission
would remain responsible for linking accounts across exchanges and
FCMs.
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\12\ Currently, once an account becomes reportable, the carrying
FCM assigns it a ``special account number'' and submits ownership and
control data to the Commission and the exchanges on Commission Form
102. This form is submitted by facsimile or e-mail, and the Commission
staff then enters the information into its systems. (We understand that
some exchanges, but not all, enter this information into an exchange
database.) At the request of the Commission, a customer may be required
to file a separate report effectively confirming and supplementing the
information provided on the Form 102. This Statement of Reporting
Trader, Commission Form 40, is also filed with the Commission by
facsimile or e-mail. The carrying FCM frequently does not receive a
copy of the Form 40.
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The OCR alternative would achieve the essential regulatory purposes
underlying the proposed OCR Rules, while reducing the regulatory,
operational and financial costs that would be imposed by the OCR
Rules.\13\ Importantly, these costs would be distributed more fairly
across the industry, thereby easing the potentially adverse competitive
impact of the OCR Rules.
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\13\ To the extent the OCR Working Group alternative would not
provide the Commission the full scope of information contemplated under
the proposed OCR Rules, the Commission would be able to use its special
call authority to obtain such information.
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The alternative represents our best collective efforts to date.
However, we must emphasize here, as we did at the staff roundtable on
September 16, the importance of Commission participation in this
project. We submit that nothing is gained by the Commission and the
industry working on parallel yet separate tracks. Without the active
participation of Commission staff, the industry runs the considerable
risk of expending substantial time and resources developing an
alternative that the Commission will ultimately conclude does not
achieve its goals. FIA, therefore, encourages the Commission to
authorize the staff to meet with industry representatives (and other
participants as the Commission may select) to develop a mutually
acceptable alternative to the OCR Rules or, at the very least, to
provide necessary feedback to the industry's initiative.\14\
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\14\ FIA has no objection to opening these meetings to the public,
if the Commission were to determine that it would be necessary or
appropriate to do so.
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Proposed Data Points
The balance of this letter will first discuss each of the data
points that the proposed OCR Rules would require FCMs and reporting
entities to collect and maintain. We will describe (i) the data that is
currently collected, (ii) the data that is not currently collected, and
(iii) the data that the OCR Working Group has concluded would be
difficult, if not impossible, to collect.\15\ We conclude with a
discussion of the tremendous structural changes the OCR Rules would
impose.
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\15\ The information with respect to the proposed data points is
based in substantial part on information that was provided to FIA by 13
of its member FCMs. In the aggregate, these FCMs carry approximately
530,000 accounts. As noted earlier, the number of accounts carried by
an FCM is not necessarily proportional to the FCM's size, i.e., its
adjusted net capital. Several smaller FCMs carry significantly more
accounts on behalf of noninstitutional hedgers and individual traders.
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In general. Because FCMs, not reporting entities, establish and
maintain the customer relationship, much of the information that would
be required to be collected and reported under the OCR Rules would be
collected in the first instance by FCMs. Of the approximately 28 data
points listed in OCR Rules, FCMs are the root source for 10-12.
Exhibit A, set out on the following page, identifies the data
points that the Commission is proposing to be collected and reported in
the OCR for which FCMs would be the root source. The exhibit identifies
the data points that currently: (i) are captured electronically; (ii)
are captured in hard copy; and (iii) are not captured at all. To the
extent these data points are currently captured, they reside in a
variety of systems and formats. Importantly, no system consolidates
this information in a single location, where it can be easily reported
to an exchange. Rather, FCMs use mapping tables and a variety of
reconciliation tools to manage the accounts they carry or for which
they act as an executing broker.
In order to collect the information as proposed in the OCR Rules,
therefore, an FCM would have to overhaul completely its existing
procedures, processes and systems. As noted earlier, an FCM would be
required to: (i) re-negotiate all active client agreements to require a
customer to provide and routinely update the necessary data points;
(ii) build systems to enter the data; (iii) manually enter the data for
each active account; (iv) put in place resources and processes to
maintain the data; (v) provide it to the reporting entity on a weekly
basis; and (vi) monitor changes daily in order to update the database.
Exhibit A
Proposed OCR Data Elements
Account numbers. Account numbers are the key to identifying trading
activity but present significant challenges in tying account ownership
and control information to the trade register, as proposed in the OCR
Rules. Account numbers assigned by FCMs when the account is opened are
not standardized across the industry. The field that carries account
numbers varies from system to system, firm to firm and exchange to
exchange. Some fields allow six characters; others allow nine
characters. Some justify left; others justify right. Some recognize
spaces; others do not.
In addition, a customer may have multiple account numbers,
representing various trading strategies, funds, or traders. For
example, FIA understands that one major fund manager has 1,500 account
numbers at a single FCM. Further, certain customers may have their own
account numbers, which they provide to their carrying FCM. The FCM
assigns an account number that follows the FCM's account number
conventions, which it then maps to the customer provided account
number.
Critically, the account numbers reflected in the trade register
will not always match the account numbers assigned by the carrying FCM.
Among other reasons, these differences arise from the use of: (i) give-
up transactions; (ii) short codes; and (iii) average pricing. Give-up
transactions and average price transactions, for example, are often
allocated to suspense accounts using short codes, pending completion of
the trade and allocation among the receiving customers and carrying
FCMs.\16\ FCMs use mapping tables and reconciliation tools extensively
to manage account numbers.
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\16\ The use of short codes is consistent with Commission Rule
1.35(a-1), which does not require that an FCM record the customer's
account number when submitting an order for execution. The rule simply
requires that the order include an account identification.
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In many cases, of course, the ownership information can be tied to
the trade register through the account number (Diagram 1). ``Trade
Order Routing Flow'' shows at a high level how orders are initiated
from a customer or trader, either directly or through an executing
broker, and are processed through the various systems in the trade
management chain of systems. An account identifier is used by the
executing firm and clearing firm to identify the customer account
associated with the individual trades/positions. The account identifier
is entered into trade management systems by the customer or traders
(directly), or by the executing broker trading on behalf of the
customer. The account identifier is captured in trade management
interfaces, passed through to the exchange trading platforms and is
stored in the exchange/clearinghouse clearing systems. These same
account identifiers are reported to regulatory agencies through trade
register files.
There are several instances, however, when the account identifiers
recorded on the trade register do not reflect the actual customer or
traders (Diagrams 2-4). In these instances, the account identifiers on
the trade register cannot be used to identify trade account ownership.
In Diagram 2, Client A places an order with the executing broker.
The executing broker enters the order using account identifier
``12345,'' which represents the company making the trade and not the
individual executing the trade. The order is given up to the clearing
broker, which assigns the account identifier ``ABCDE,'' which is a
short code that allows the clearing broker to tie the trade back to the
individual trader at Client A. The clearing broker converts the short
code to the Client A settlement account identifier in its internal
system. The trade register contains the short codes used by both the
executing and clearing brokers, but not the client's settlement account
number (123-ABCDE).
Diagram 3 describes how the use of ``short codes'' adversely
impacts the ability of the trade register to identify account
ownership. In this diagram, the customer/trader executes a trade using
the short code ``ABCDE''. The executing broker also executes a trade
for a client using the short code ``UVXYZ.'' The clearing broker
receives both the client executed trade (ABCDE) and the broker-executed
trade (UVXYZ) for Client A. The clearing broker then converts both
short codes to Client A's settlement account 123-ABCDE. As in the
previous example, the trade register does not contain Client A's
settlement account identifier.
Diagram 4 shows processing for average priced transactions executed
by one firm and given-up to the carrying FCM. Average priced trades
represent transactions traded as a group with an average price applied
to them. In many cases, they are given up using an account identifier
for the average priced group. In the diagram, an average priced trade
for account ``APS12'' is executed. The trade is then given up to the
clearing broker using the clearing broker's short code 123-APS12. The
clearing broker subsequently allocates the trades into Client A's
settlement account 123-ABCDE, which is not represented on the executing
firm's records or on the trade register.
Ultimate beneficial owners. An FCM currently collects only limited
information on certain ultimate beneficial owners of an account. This
information is obtained only when the account is opened and is
generally not updated. For example, when an account is opened for a
managed fund (e.g., a commodity pool), the FCM generally will ask the
fund manager for the identity of any investor that holds more than a 10
percent interest in the fund. The FCM employs its customer
identification program to verify the identity of these investors.
However, FCMs have no means to independently verify the fund's
beneficial owners and rely completely on the fund manager to identify
these investors.
Moreover, investors may increase or decrease their investment
throughout the life of the fund (or may withdraw entirely), and new
investors will be accepted on a regular basis. FCMs generally do not
receive information with respect to changes in the composition of the
investors in a fund once an account is opened. Although FCMs will ask
for a copy of the fund's annual report, this report does not reflect
changes in the composition of investors.
When a corporate account is opened, FCMs will obtain information on
the parent company, if any, and on the individual or entity that
controls the trading in the account. However, once the account is
opened, FCMs generally do not monitor the customer for changes in its
organizational structure and relies on the customer to inform the FCM
of any changes. As a practical matter, FCMs do not receive updates to
this information on a regular basis.
Owner's Name. While an individual account owner's name is certainly
kept within a firm's books and records, it can be difficult to compare
names across systems. One firm may enter a customer name in full while
another may use a version of the customer name. For example, the name
for John Smith could be entered in an FCM's records as follows: (i)
John Smith; (ii) John R. Smith; (iii) John Ronald Smith; (iv) John R
Smith; (v) J R Smith; or (vi) J. R. Smith. Each variation of this name
refers to the same individual account owner. However, because of manner
in which names are stored electronically, electronic systems cannot
detect that each of the six names refers to the same account owner.
The same is true for accounts that are owned by entities. For
example, when setting up a database for give-up agreements, FIA found
52 versions of the name ABN Amro.
Date of birth. An FCM generally does not record the date of birth
of a customer or account controller that is an individual. An FCM may
be required to confirm the age/date of birth of the customer for
purposes of NFA Compliance Rule 2-30 \17\ or compliance with anti-money
laundering rules, but neither rule requires an FCM to capture that
information in its systems. Therefore, an individual's date of birth
generally is not stored electronically. When it exists in the records
maintained by the FCM, it is stored in the form of a paper copy of a
driver's license or passport.\18\
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\17\ NFA Compliance Rule 2-30, Customer Information and Risk
Disclosure, requires NFA member firms to obtain certain information
about its customers who are individuals, including the customer's
approximate age. The rule does not require member firms to pierce
through a customer that is an entity and collect information regarding
the beneficial owners of the customer. Further, a customer may decline
to provide certain information.
Effective January 3, 2011, NFA Compliance Rule 2-30, has been
amended to provide, in relevant part: ``For an active customer who is
an individual, the FCM Member carrying the customer account shall
contact the customer, at least annually, to verify that the information
obtained from that customer under Section (c) of this Rule [i.e., name,
address, occupation, estimated income and net worth, approximate age,
and previous investment experience] remains materially accurate, and
provide the customer with an opportunity to correct and complete the
information.''
\18\ FIA further understands that it is considered a violation of
privacy to ask for date of birth in certain countries, including
Germany and Canada. We understand that privacy laws in foreign
jurisdictions generally may prevent the routine disclosure of other
proposed data points relating to individuals.
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Primary residence. An FCM may collect the residential address of
its individual customers. However, in some cases this information is
subject to data privacy laws. Further, residential address information
is not routinely updated, particularly when customer statements are
delivered electronically). Moreover, if the beneficial owner
participates in a fund or is part of an omnibus account, FCMs would not
have the individual's primary residence address. In any event, primary
address information is entered in a free form field in the FCM's system
and is not standardized. Therefore, to the extent this information is
collected to meet the OCR Rules, it would have to be re-entered in a
standardized format.
NFA identification number. Not all entities or individuals are
registered with the Commission and members of NFA. Subject to NFA Bylaw
1101, FCMs generally do not request or record this information. If the
Commission were to insist on this data point, an FCM would be required
to separately confirm with NFA whether each account owner, beneficial
owner or account controller had an NFA identification number (or
whether the number provided was accurate).
Account controllers (who must be natural persons). Our comments
with respect to the difficulty in obtaining and maintaining records
with respect to name, address, date of birth and NFA identification
number of account owners (and beneficial owners) of accounts apply
equally to account controllers. More important, the broad definition of
an account controller is troubling. The OCR Rules define an account
controller as ``a natural person, or a group of natural persons, with
the legal authority to exercise discretion over trading decisions by a
trading account, with the authority to determine the trading strategy
of an automated trading system, or responsible for the supervision of
any automated system or strategy.'' \19\
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\19\ The authority to exercise discretion is sufficient, regardless
of whether such authority is actually exercised. Proposed Rule
16.03(c).
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This definition cuts too broad a swath and would require
information on individuals that never actually exercise trading
authority over an account but, because of their position with the
customer, as a owner or officer, would be deemed to have this
authority.\20\ FCMs do not collect information on officers or employees
of a customer who place orders for the customer's account.\21\
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\20\ Although certain exchanges have adopted programs that require
customers afforded direct access to the exchange trading platform be
identified to the exchange (e.g., CME Tag 50), the individual
responsible for data input may not be the account controller.
Correspondingly, account controllers are not always identified through
such programs.
\21\ At one point, FCMs collected this information but stopped this
practice many years ago after finding that a customer's authorized
traders changed frequently, but customers advised FCMs of such changes
infrequently, if at all. As a result, FCMs were placed in the untenable
position of either refusing to accept an order from an individual that
was not on the approved traders list, potentially adversely affecting
the customer's trading strategy, or accepting a trade from an
individual with apparent authority, potentially exposing the FCM to
liability for accepting an order from an unauthorized individual. FCMs
generally concluded that the responsibility for maintaining control of
an account belonged to the customer, not the FCM.
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FIA believes the definition of an account controller should be
consistent with the Commission's definition of control as set out in
Commission Rule 1.3(j) and generally applied at exchanges. That is,
unless a customer specifically provides discretionary trading authority
to a third party that is either registered with the Commission as a
commodity trading advisor or is excluded or exempt from registration,
the account controller should be deemed to be the owner of the account.
Date account is assigned to the current controller. This
information is not captured by FCMs. The cost of capturing this
information would outweigh the regulatory benefit.
Designation of the manner in which the trade is executed. FCMs do
not currently capture information with respect to whether a trade is
executed by a natural person, automated trading system or both. We
believe any effort to do so would be difficult at best. Many account
controllers, as broadly defined in the OCR Rules, input orders in a
variety of ways for a variety of reasons. Simply because an account
controller generally executes trades through an automated trading
system does not mean that certain trades will not be executed manually.
Special account number. Special account numbers associated with an
account are generally assigned by an FCM's compliance or operations
department. The number is not included with the customer information
that is submitted with a trade and, therefore, is not included on the
trade register. Rather, the special account number is added to the
position file at the end of the day.
Date the account becomes reportable. FCMs currently do not record
when an account becomes reportable, since this information appears to
be of limited regulatory value.\22\
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\22\ Since the alternative described below will effectively
automate the Form 102, information with respect to all reportable
accounts will be provided to the Commission weekly.
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Omnibus accounts. Although FCM systems identify accounts as omnibus
accounts, the name of the account may be different at each carrying
FCM, making it difficult to compare names across systems.
Name of the executing firm and its unique identifier reported in
the reporting entity's trade register. This information is not included
in the trade register. A customer may use a variety of executing
brokers and the carrying firm does not record this information at the
account level.
Name of the clearing firm for the trading account and its unique
identifier reported in the reporting entity's trade register. This
information is contained in the trade register and carried at the
account level.
Name of root data source. Providing the reporting entity with
information with respect to the trading account. This point needs
additional clarification. The root data source is typically the
beneficial owner or account controller. The FCM, however, would provide
the data to the reporting entity. This data point appears to be
unnecessary and would add complexity to the OCR database.
Reporting entity. Name of the reporting entity would be added when
submitted to the Commission.
OCR transmission date. The OCR transmission date would be added
automatically upon transmission of the data to the Commission.
The OCR Rules Would Force a Structural Change in the Conduct of
Business
As we noted at the outset of this letter, implementation of the OCR
Rules would force an unwarranted structural change in the conduct of
business among U.S. futures markets participants, especially among
clearing member and non-clearing FCMs, foreign brokers, and their
respective customers. Because the proposed rules would require clearing
member FCMs to know and report to the relevant clearing organization
the identity of each customer that comprises an omnibus account and
their respective positions, the ability to maintain omnibus accounts
would be significantly impaired, if not eliminated.
Omnibus accounts, which are treated as the account of a single
customer for all purposes on the books and records of the carrying FCM
or clearing organization, have been an integral part of the futures
markets since well before the Commission was created in 1974. Foreign
brokers and FCMs that are not members of a particular clearing
organization maintain omnibus accounts with clearing members; clearing
member FCMs, in turn, maintain omnibus accounts with the relevant
clearing organization.
Omnibus accounts serve both a practical and regulatory purpose.
FCMs, whether clearing members or non-clearing members of a particular
clearing organization, compete for customers.\23\ Non-clearing FCMs,
therefore, do not want to disclose the names of their customers to the
FCM that clears their customers' accounts. The same practical
considerations lead foreign brokers to open customer omnibus accounts
with the FCMs that clear their customers' positions.\24\
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\23\ An FCM may choose to become, or elect not to become, a member
of a particular clearing organization for a number of reasons. For
example, the cost of becoming a member of a clearing organization may
be too high or the volume of business that the FCM would clear through
the clearing organization may not justify the operational and financial
costs.
\24\ The Commission's recognition of the essential purpose of
omnibus accounts was described in a 1984 exchange of correspondence
between the Commission's Division of Trading and Markets (now the
Division of Clearing and Intermediary Oversight) and the Federal
Deposit Insurance Corporation (``FDIC''), in which the FDIC confirmed
that, provided that the books and records of bank and the relevant FCMs
properly indicate that the funds in the account are being held in a
custodial capacity, FDIC insurance would be afforded each ultimate
customer's interest in an omnibus account in which the transactions of
two or more persons are carried by a carrying FCM in the name of an
originating FCM. Interpretative Letter No. 84-14, [1984-1986 Transfer
Binder] Comm. Fut. L. Rep. 22,311.
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For their part, clearing member FCMs may not want to incur the
operational expense of maintaining an extensive branch office network.
They rely instead on non-clearing FCMs that are often physically closer
to their customers and, as result, are better able to serve them and
evaluate more fully any credit risk they may pose.\25\ In these
circumstances, the non-clearing FCM is the clearing member FCM's
customer, and the clearing member FCM will conduct due diligence on the
non-clearing FCM to be certain that it understands the nature of the
business in which the non-clearing FCM is engaged, the types of
customers that non-clearing FCM serves and the non-clearing FCM's risk
management practices. Because non-clearing FCMs stand between their
customers and the clearing member FCM, the clearing member FCM has to
consider only the credit of the non-clearing FCM.
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\25\ For these same reasons, a customer may prefer to deal with a
non-clearing FCM that is able to provide more personal service and make
an informed judgment concerning the credit risk the customer may pose.
Alternatively, an institutional customer holding positions cleared
through a smaller clearing organization may prefer to have its trades
carried by a non-clearing FCM that has substantially greater capital
than a clearing member FCM of that clearing organization.
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From a regulatory perspective, omnibus accounts facilitate the
conduct of business by a clearing member FCM, in particular, in
connection with customers located outside of the U.S. A clearing member
FCM's ability to carry an omnibus account of a foreign broker allows
the FCM to carry the accounts of foreign customers without having to be
registered in the home jurisdiction of each customer.
The Commission historically has taken the position that a firm
acting in the capacity as an FCM is required to be registered as such
if either the firm is located in the U.S. or the firm's customers are
located in the U.S. Under the Commission's Part 30 rules, the only
exception to this requirement the Commission has made is with respect
to foreign firms that carry a customer omnibus account on behalf of a
U.S.-registered FCM.\26\
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\26\ Commission Rule 30.4(a).
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Foreign jurisdictions generally take the same position. That is, a
U.S. FCM would be prohibited from soliciting or accepting orders
directly from a foreign person for execution on a U.S. contract market,
unless the FCM were properly registered in the foreign person's home
jurisdiction. A U.S. FCM, however, may carry the customer omnibus
account of a foreign broker without being so registered.
More generally, because the omnibus account is treated as a single
customer, a clearing member FCM's rights and responsibilities under the
Act and Commission rules are solely with respect to the omnibus
account. The clearing member FCM has no obligation to pierce through
the omnibus account to know the identity of each of the customers that
comprise the omnibus account.
Thus, the omnibus account is treated as a single account for
purposes of compliance with: (i) the provisions of section 4d(a)(2) of
the Act and Commission Rules 1.20-1.30, including the investment of
customer funds under Rule 1.25; (ii) the early warning requirements
under Rule 1.12(f)(3); (iii) the provisions of Rule 1.33 regarding
confirmations and monthly statements; (iv) the provisions of Rule 1.35
regarding records of futures and options on futures transactions; (v)
the provisions of Rule 1.36 regarding records of securities and
property received from customers; (vi) the provisions of Rule 1.37
regarding the name, address and occupation of customers; (viii) the
large trader reporting requirements of Part 17; and (ix) the provisions
of Rule 166.3, which require an FCM to supervise diligently the
handling of all commodity interest accounts carried, operated, advised
or introduced by the FCM and all other activities relating to its
business as a Commission registrant. Significantly, the omnibus account
also is treated as a single account for purposes of compliance with the
PATRIOT Act, including an FCM's anti-money laundering and suspicious
activity reporting requirements.
If the Commission were to require clearing member FCMs to know and
report to the relevant clearing organization the identity of each
customer that comprises an omnibus account and their respective
positions, the carefully crafted provisions of law and rules that have
governed the conduct of omnibus accounts for decades would be
destroyed. We do not believe--and more importantly, do not believe that
the Commission has ever taken the position--that an FCM can know the
identity of customers in an omnibus account, as well as the positions
that are attributable to such customers, with incurring the concomitant
obligations of treating those customers as customers of the FCM for all
purposes.
In the absence of a Commission rule to the contrary,\27\ which
would specifically relieve a clearing member FCM of such obligations,
once the FCM knows the identity of such customers, the FCM would have
to assume that it would have the obligation with respect to each such
customer, individually: (i) under Rule 166.3, to supervise the handling
of each customer's accounts; (ii) under section 4d(a)(2) of the Act and
Commission Rules 1.20-1.30, to segregate each customer's funds; (iii)
under Rule 1.33, to provide each such customer with a confirmation of
each trade and a monthly statement; (iv) under Rule 1.35, to make a
record of each customer's transactions; (v) under Rule 1.36, make a
record of the securities and property received from each customer; (vi)
under Rule 1.37, record the name , address and occupation of each
customer; and (vii) under Part 17, file a large trader report with
respect to each customer.
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\27\ The Treasury would also have to grant relief from the
applicable PATRIOT Act requirements.
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The clearing member FCM would have no choice but to restructure
completely the way in which it conducts business. It would be required
to make each customer within the omnibus account a direct customer,
thereby negating any need or reason for maintaining a relationship with
the nonclearing member FCM. The result would be a further contraction
of the number of FCMs able to compete for customer business. Further,
without the intermediation of a non-clearing member FCM willing to
assume the credit risk of customers not known to the clearing member
FCM, those customers would probably not be able to maintain a trading
account.
The abolition of omnibus accounts could have potentially serious
effects as well on smaller exchanges and their affiliated clearing
organizations. As noted earlier, an institutional customer holding
positions cleared through a smaller clearing organization may prefer to
have its trades carried by a non-clearing member FCM that has
substantially greater capital than a clearing member FCM of that
clearing organization. If the institutional customer is required to
open an account directly with the smaller clearing member FCM, it may
simply decline to trade on that smaller exchange.
Perhaps most severe could be the potential impact on the ability of
foreign customers to trade on U.S. markets. If U.S. FCMs were required
to be registered in the home country of each foreign customer whose
account it carried, the FCM would be subject to potentially conflicting
regulatory requirements. Even if the conflicting regulatory
requirements could be managed, the operational and financial burdens
would be such that only the most highly capitalized FCMs could even
contemplate conducting business on behalf of foreign customers. The
more likely result would be that foreign customers would be effectively
shut out of the U.S. markets.
Unique Account Identifier
The Commission has invited comment on how the futures industry
could develop and maintain a system to assign unique account
identification numbers (``UAIN'') to all account owners and account
controllers. We do not believe such a project is feasible. On the
surface, assigning each customer a unique identifier that would be used
by all firms and exchanges would appear to solve many of the issues
with creating an OCR database. However, UAINs would require a massive
change in all systems in the trading cycle. Every system in the
industry would have to be modified, including all front-end systems,
customer order entry systems, middleware and back-end systems, as well
as exchange trading and clearing systems. We have not computed this
cost. The addition of a UAIN also adds data/risk to the clearing
systems which are already facing capacity issues.
Conclusion
For all of the above reasons, FIA regrets that we cannot support
the OCR Rules as proposed. We nonetheless appreciate the deliberative
manner in which the Commission has approached this project, and we look
forward to having the opportunity to work with the Commission and staff
in developing an OCR database and reporting system that will achieve
the Commission's goals in an effective and efficient manner. In the
meantime, if the Commission has any questions concerning the matters
discussed in this letter, please contact Barbara Wierzynski, FIA's
Executive Vice President and General Counsel.
Sincerely,
President.
Honorable Gary Gensler, Chairman;
Honorable Michael Dunn, Commissioner;
Honorable Jill E. Sommers, Commissioner;
Honorable Bart Chilton, Commissioner;
Honorable Scott O'Malia, Commissioner;
Division of Market Oversight:
Richard Shilts, Acting Director;
Rachel Berdansky, Deputy Director;
Sebastian Pujol Schott, Associate Deputy Director;
Cody J. Alvarez, Attorney Advisor.
APPENDIX A
Ownership and Control Reports Proposed OCR Alternative
The Futures Industry Association (``FIA'') hereby submits for the
Commission's review the following OCR alternative, in lieu of the
ownership and control reporting requirements that the Commission has
proposed to impose on ``reporting entities.'' 75 Fed. Reg. 41775 (July
19, 2010) The OCR alternative was developed by the OCR Working Group,
which was formed by FIA and is comprised of a broad cross-section of
the futures industry. Its members include representatives from (i) 16
FCMs, both large and small, serving retail and institutional customers,
(ii) the several U.S. exchanges, (iii) back office service providers,
and (iv) other experts. By no means perfect, the OCR alternative
nonetheless presents a more cost effective and practical mean to create
an OCR database, which is user-friendly and familiar to the Commission
staff and investigators. It should not be viewed as an industry-
approved alternative, but solely as a basis for further discussions
among the Commission, the futures industry and other interested
parties.
Based on the Commission's large trader reporting system, the OCR
alternative may be implemented more effectively across multiple
exchanges. The alternative integrates the existing trade register data
generated by the exchanges with the fundamental OCR data collected by
FCMs, thereby allowing the Commission to access the data more quickly
and aggregate account-level information across multiple exchanges.
Although the OCR alternative would require clearing-member FCMs to make
significant changes in the collection, storage and transmission of
customer and trade-related data, the alternative would be less costly
and could be implemented more quickly. As important, the alternative
would achieve the essential regulatory purposes underlying the proposed
OCR Rules, as outlined in the Federal Register release accompanying the
proposed rules.
Specifically, the OCR alternative would: (i) help integrate data
found in the Integrated Surveillance System and the Trade Surveillance
System by linking individual transactions reported on exchange trade
registers with aggregate positions reported in large trader data; (ii)
identify small and medium-sized traders whose open interest does not
reach reportable levels, but whose intra-day trading may aversely
affect markets during concentrated periods of intra-day trading; (iii)
reduce the time-consuming process of requesting and awaiting
information from outside the Commission to identify the entity
associated with the account number and aggregate all identified
entities that relate to a common owner; (iv) link traders' intra-day
transactions with their end-of-day positions; (v) calculate how
different categories of traders contribute to market-wide open
interest; and (vi) categorize market participants based on their actual
trading behavior on a contract-by-contract basis, rather than on how
they self-report to the Commission (e.g., registration type or
marketing/merchandising activity on Commission Form 40).
At a high level, the alternative proposes that clearing firms will
provide a weekly OCR file to exchanges and the Commission that will
facilitate the linking of trading activity to owners and controllers
across firms and exchanges. This file would be provided for each
trading account exceeding an agreed upon volume threshold. Much of the
data currently collected on Form 102 would be included in the OCR file,
thereby automating the Form 102 process.
In developing this proposal, the OCR Working Group was guided by
the principle that, to the extent practicable, the alternative should:
extract certain data from existing systems to create and
maintain an OCR file;
rely on data currently available in existing systems;
minimize new data recording requirements; \28\
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\28\ The new data required to be collected would be limited to the
short codes employed in exchange trade registers and customer e-mail
addresses.
confine collection of the data to the clearing-member FCM;
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and
use volume thresholds to determine the accounts that should
be subject to OCR.
The OCR alternative contains the following assumptions:
The definition of ``control'' would be limited to that which
is currently used for purposes of the large trader reporting
system (i.e., a person other than the account owner will be
deemed to ``control'' an account only if the person is a third
party with discretionary authority to trade the account; the
account owner's employees will not be deemed to ``control'' the
owner's account).
Non-disclosed omnibus accounts would report the name of the
omnibus account only; disclosure of all accounts within the
omnibus will not be required.
OCR data would be captured for end-of-day cleared accounts
at the carrying broker level.\29\
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\29\ Executing brokers do not usually have, and should not be
required to provide, account ownership and control information.
The Commission will acquire additional information required
for OCR that is not currently captured or stored by clearing
member FCMs directly from account owners/controllers (i.e.,
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through Form 40 reporting).
The OCR Working Group would work with the Commission to
determine an appropriate volume threshold. For purposes of
estimating costs, however, the OCR Working Group limited the
number of accounts that would be reported to accounts that
traded more than 250 contracts weekly.\30\
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\30\ The OCR Working Group also discussed pegging the volume
threshold to current large trader position reporting levels.
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Account Ownership Data
As indicated above, the alternative would leverage and automate the
Form 102, which FCMs file with the Commission whenever a customer
exceeds the large trader reporting thresholds.\31\ Form 102 would be
updated to reflect the current trading environment, in particular,
significant intraday trading activity, and collect information with
respect to accounts that exceed either position or volume thresholds.
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\31\ The Form 102 provides essential information about the account:
(1) type of account, e.g,, house, customer omnibus, corporation,
limited liability company, individual: (2) name of account owner; (3)
address; (4) registration category, if any; (5) commodities hedged, if
any; and (6) identity of account controller, if any. Certain
information currently collected on the Form 102 would not be collected
under the OCR alternative.
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Although Form 40 provides more detail regarding account owners and
account controllers, if any, this form is completed by customers and,
in most cases, is forwarded directly to the Commission. FCMs generally
do not receive a copy of the Form 40 and, in any event, do not record
the information electronically. We appreciate that the Commission may
want to amend the Form 40 to enhance the information that the
Commission receives. However, the OCR alternative does not contemplate
any change in the current procedures regarding the Form 40.
The OCR Alternative
The OCR alternative would require each FCM to develop and maintain
an electronic reporting system containing the following fields of
information. Appendix B hereto summarizes the data to be collected and
identifies whether the information currently resides in FCM back-office
systems or the Form 102.
Trading Account Number. Account numbers are the key to linking
account ownership and control information to the information contained
in the exchange trade registers. The OCR alternative overcomes the
problems described earlier in our comment letter by providing the means
to relate the trading account and short codes to the ownership and
control information.
Special Account/Reportable Account Number. This field contains the
large trader reportable position account number that the FCM assigns,
if applicable.
Short Code. Exchange trade registers contain the account numbers
submitted by both executing and carrying firms for each transaction
executed on the relevant exchange. Although these account numbers can
be used to identify account owners, as explained earlier, the account
number in the trade register is often a ``short code'', or proxy
number, that does not tie directly to the account owner. FCMs maintain
internal mappings for these account schemes, but these ``short codes''
are not always in the firm's account reference file. Middleware systems
are used to translate short codes to actual account numbers for firms'
internal books; these translation rules can be leveraged to create
mapping tables for matching trades to the OCR. The alternative would
require firms to include the short code mappings in the back-office
identification of the account ownership and control information.
Owner Name. This field will include owner first name and last name,
and middle name as available, if the owner is a natural person.
Owner Organization. This field would include the name of the
entity, if the owner is not a natural person.
Owner Address. Multiple address fields would include the street
address, city, ZIP Code and country for the account owner.
Owner E-mail Address. This field would include the e-mail address
of the owner, if a natural person. E-mail addresses hold promise as a
unique identifier for customer accounts. However, implementation and
maintenance would have operational challenges as well as financial
costs. At present, some FCMs have no robust process for collecting and
maintaining customers' e-mail addresses and would need to upload (and
update) e-mail addresses manually. Therefore, the customer's e-mail
address initially would be a non-mandatory data field.
Controller Name. This field would include the first and last name
of the controller, if the controller is a natural person.
Controller Organization. This field would include the name of the
business or organization that controls the account if the controller is
not a natural person.
Controller Address. Multiple address fields would include the
street address, city, ZIP Code and country for account controller.
Controller E-mail Address. This field would include the e-mail
address of the account controller.
Controller Type. This field would indicate whether the customer
represents a fund or a CTA/CPO.
FCM Identification Number. This field would includes the number
assigned to the clearing FCM by the Commission.
Omnibus Flag. This field would indicate whether the account is an
omnibus account.
Trading Account Effective Date. This field would include the date
on which the account was established in the clearing FCM's back office
accounting system.
OCR Construction Work Effort
Although the alternative would use data that is currently stored in
existing systems, those systems would be required to be modified to
extract, report, and transmit OCR-related information. In addition, it
would be necessary to build certain databases to support the OCR.
Firms would be required to supply information to build the OCR
file. Firms would need to:
modify systems to build an OCR file for daily or weekly
submission to the Commission;
create processes to identify trading accounts that exceed
volume thresholds;
acquire ownership and control information for the initial
construction of the OCR file; and
create operational processes to maintain the OCR file on an
ongoing basis.
Cost Analysis of OCR Alternative
The OCR Working Group estimates that, compared with the
Commission's proposal, the OCR alternative would result in an average
first-year cost saving of approximately $18.8 million. As described in
the charts at the end of this Appendix, the first year costs of the
Commission proposal is four times greater than the median costs
incurred by FCM's under the alternative.
The first-year cost estimates were collected from a sample of 12
FCMs.\32\ Three of the FCMs that responded to this survey were not
among the 12 firms that provided estimates of the costs of implementing
the Commission's proposed OCR Rules and the assumptions underlying one
firm's estimates were inconsistent with the assumptions of the
remaining nine FCMs. For comparison purposes, therefore, we used only
the estimates provided by the eight FCMs that responded to both surveys
applying comparable assumptions. The cost of building an OCR file
containing the data elements identified above and in Appendix B ranges
from $400,000 to $14,500,000, with the average estimated cost per firm
being $4,647,292. The estimated ongoing costs associated with operating
and maintaining the OCR data files ranges from $125,000 to $7,000,000
on an annual basis, averaging $1,337,292 per firm.
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\32\ According to the FCM Financial Data reported on the Commission
website, as of July 31, 2010, the 12 firms surveyed held segregated
customer funds in excess of $96.4 billion, approximately 71 percent of
all customer funds.
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Each FCM's estimated costs would depend on the number of accounts
for which the OCR data must be collected, with larger firms facing
greater costs but also realizing economies of scale in implementation.
Small FCMs that carry fewer than 250 accounts and would rely
exclusively on vendors to implement the alternative may not realize
economies of scale.
Although the total costs small FCMs would incur appear reasonable,
their first-year cost per account would be significantly greater than
the FCMs that are able to rely to a lesser extent on vendors for
developing the OCR. The average estimated first year cost for smaller
FCMs is $1,850 per account, while the average cost for other firms
would be $205 per account.\33\ However, it is important to note that
these estimates are not firm quotes on cost by the vendors, and the
actual cost would depend on the size of the business, optional modules
utilized, number of connectors from either vendor or third party back/
middle office systems and whether or not the service is hosted by the
vendor or deployed in-house at each firm.
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\33\ While this amount is high, the estimated cost per account
under the Commission's proposal was also on an order of magnitude
greater than most other FCMs. These FCMs are largely dependent on the
vendors and have used cost estimates provided by the vendors to
formulate their estimates.
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Most FCMs found that adopting a volume threshold of 250 contracts
per week would decrease significantly the costs of implementing the
alternative, by reducing the amount of data required to be processed
and the associated cost of transmitting large amounts of data to the
exchanges and the Commission. The average estimated cost of populating
the OCR database using a volume threshold of 250 contracts per week is
$1,783,750. In contrast, the estimated total cost for initially
populating the OCR file based on a volume threshold that includes all
accounts (referred to in our survey as option 1) is $2,134,375.
Some FCMs suggested that a volume threshold could increase the cost
of implementing the alternative initially. This is because processes
would have to be developed to identify when customers exceed the
threshold and logic code would have to be developed to pull the OCR
data for transmission to the Commission. Regardless of the impact on
the cost burden placed on the FCMs, however, a volume threshold would
introduce efficiencies in processing and transmission, and will help
avoid data overload for both the FCMs and the Commission.
As we found with the Commission's OCR proposal, the effort to
automate the processes and develop the database would be challenging.
However, most firms felt that the alternative would be a much more
robust process and could be implemented within the 18 month timeframe
envisioned by the Commission.
The end result of the developing the alternative system could
ultimately save the firms (and the Commission) significant time and
money by automating the current manual process for filing out and
submitting Form 102 information. Implicit in the Working Group proposal
and the related cost estimates is the assumption that the weekly OCR
change files would replace the manual process of submitting Form 102 by
hard copy. As we previously noted, these forms currently are updated as
requested by the Commission, generally, annually or upon request. With
OCR automation, FCMs would be providing weekly feeds that would include
updated information on each account meeting the threshold (e.g.,
changes in the customer's address and e-mail address, as well as
changes in the identity of the account controller).
Once implemented, the average cost savings associated with
automating the Form 102 was estimated to be $33,300 per firm on an
annual basis. This efficiency would also be realized by the Commission
because of the decreased reliance on data entry, manual processing,
recordkeeping, and document management in the current system of
collecting and storing manual Forms 102.
Conclusion
For all of the above reasons, the OCR alternative described herein
would achieve the essential regulatory purposes underlying the proposed
OCR Rules and forms a basis for further discussion on the proper
structure of an OCR report. As noted earlier, however, these
discussions cannot take place in a vacuum. All of the pending
recordkeeping and reporting requirements, and the estimated costs and
benefits of each, must be analyzed and evaluated collectively, not
individually. The OCR Working Group is anxious to work with the
Commission and staff in developing and implementing an effective and
efficient recordkeeping and reporting program.
FCMs' Industry Solution Cost Estimates 1
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Total Start-up
Affected and Ongoing/ First-Year
Accounts Start-up Ongoing First-Year Costs Per
Costs Account
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Firm A 90,000 $7,500,000 $7,000,000 $14,500,000 $161
Firm B 75,300 $8,370,000 $225,000 $8,595,000 $114
Firm C 50,000 $2,935,000 $3,000,000 $5,935,000 $119
Firm D 39,979 $135,000 $600,000 $735,000 $18
Firm E 34,700 $2,000,000 $500,000 $2,500,000 $72
Firm F 30,000 $3,950,000 $1,080,000-$1,095,000 $5,037,500 $168
Firm G 19,473 $5,135,000 $2,550,000 $7,685,000 $395
Firm H 14,000 $5,050,000 $125,000 $5,175,000 $370
Firm I 250 $100,000 $300,000 $400,000 $1,600
Firm M * 10,000 $3,500,000-$4,000,000 $500,000 $4,250,000 $425
Firm N * N/A $650,000-$850,000 $50,000-$150,000 $850,000 N/A
Firm O * 50 $45,000 $60,000 $105,000 $2,100
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Notes:
1 The 12 firms in the sample handle in excess of $96.4 billion, or nearly 71% of customers' segregated funds (as
of July 31, 2010, according to monthly financial reports filed with the CFTC).
* Firm did not provide cost estimates for the CFTC Proposed Rule.
FCMs' OCR Implementation Cost Estimates
CFTC Proposed Rule vs. Industry Solution
APPENDIX B
Proposed OCR File
Below is a summary of the fields in the proposed OCR File that
would be sent weekly from the clearing FCM to the Commission and/or
exchanges. The file includes information that exists in current systems
and on the Form 102.
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Exists in
Firm Back- Description and
Field Name Office Form 102 Comments Values Format Size
Systems
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Trading Account X Account for which trade Alphanumeric ID that AN 20
Number was executed identifies the
customer(s) on the
associated trade record
Special Account/ X Large Trader reportable Alphanumeric ID used to AN 12
Reportable position account, if aggregate trading
Account assigned. accounts for large
trader position
reporting.
Short Code Account identifier used Alphanumeric ID that AN 20
Short codes must upon execution that is identifies the
be accompanied by translated into a customer(s) on the
a trading account trading account number associated trade record
number but may by back office systems.
not have a
special account
number.
Owner Last Name X Last name of account Smith AN 30
(Person) owner, if the owner is
a natural person.
Owner First Name X First name of the James AN 30
(Person) account owner, if the
owner is a natural
person.
Owner Name X Name of the business or Proprietary Trading Firm AN 60
(Organization) organization that owns Inc.
the account, if the
owner is not a natural
person.
Owner Address 1 X Primary address of the 123 Main St. AN 40
account owner
Owner Address 2 X Primary address of the #500 AN 40
account owner
Owner Address 3 X Primary address of the AN 40
account owner
Owner City X City of the owner's Chicago AN 25
primary address
Owner State/ X State or province IL AN 5
Province abbreviation for the
owner's primary
address.
Owner ZIP/Postal X ZIP Code or postal code 60601-9999 AN 10
Code for the owner's primary
address.
Owner Country X Country code for the U.S. AN 2
owner's primary address
Owner E-mail E-mail address of the James.Smith@tradingfirm. AN 100
Address (Person) account owner, if the com
account is owned by a
natural person.
Controller Last X Last name of account Smith AN 30
Name (Person) controller, if the
controller is a natural
person.
Controller First X First name of the James AN 30
Name (Person) account controller, if
the controller is a
natural person.
Controller Name X Name of the business or Proprietary Trading Firm AN 60
(Organization) organization that Inc.
controls the account,
if the controller is
not a natural person.
Controller Address X Primary address of the 123 Main St. AN 40
1 account controller
Controller Address X Primary address of the #500 AN 40
2 account controller
Controller Address X Primary address of the AN 40
3 account controller
Controller City X City of the owner's Chicago AN 25
primary controller
Controller State X State or province IL AN 5
abbreviation for the
controller's primary
address.
Controller ZIP X ZIP Code or postal code 60601-9999 AN 10
Code for the controller's
primary address.
Controller Country X Country code for the U.S. AN 2
controller's primary
address
Controller E-mail X E-mail address of the James.Smith@tradingfirm. AN 100
Address (Person) account controller, if com
the account is
controlled by a natural
person.
Controller Type X Describes the type of F--Fund AN 1
controller(s) listed on C--CTA/CPO
the respective account.
CFTC Firm ID X CFTC provided firm AN 3
identifier assigned to
the firm.
Omnibus Account X Yes or No indicator to Y--Omnibus AN 1
Flag denote the type of N--Not Omnibus
account
Trading Account X X The day account was YYYYMMDD--Date on which N 8
Effective Date established in the the trading account is
firm's back office effective
system.
Trading Account Expiration date/end date YYYYMMDD--Date on which N 8
Expiration Date of the trading account. the trading account has
Could have a default of expired
99991231, denoting no
expiration.
EFS Owner Exchange For member accounts, the CME--Could optionally AN 5
exchange at which the use ISO MIC.
account owner holds a
membership.
EFS Non-Member Indicator to denote if Y--Indicates account is AN 1
Owned Indicator the account is fully a joint account between
member owned or if non- a member and nonmember
members are joint N--Non-members do not
owners on the account. exist on the account
EFS Main Account Description of the group Contains company name, AN 40
Description of accounts which often trading group,
includes the legal name partnership, etc.
of the 100% owned
subsidiary. This is
often referred to as
``Account Title''.
EFS Main Account Grouping/roll up account Alphanumeric ID that AN 20
Number that associates all identifies the Fees
trading accounts with grouping account.
the same account
owners(s) and
controller(s)
EFS Owner Type Describes the type of I--Individual AN 1
owner(s) listed on the N--Non-Member
respective account. F--Firm
J--Joint Account
EFS Owner Middle X Middle name or middle R AN 15
Name (Person) if initial of the account
available owner, if the owner is
a natural person.
EFS Controller X Middle name or middle R AN 15
Middle Name initial of the account
(Person) if controller, if the
available controller is a natural
person.
EFS Exchange X Exchange Acronym AN 5
CBT--Could optionally
use ISO MIC.
EFS Clearing Firm X Clearinghouse assigned 999--Existing 3-5 AN 5
Number clearing firm number/ character firm code.
firm number
EFS Clearing Firm X Clearing Firm Name Name of the clearing AN 60
Name firm
EFS Main Account Effective date/start YYYYMMDD--Date on which N 8
Effective Date date of the main the main account is
account. Could effective
potentially be derived
from the reporting of
the change record.
EFS Main Account Expiration date/end date YYYYMMDD--Date on which N 8
Expiration Date of the main account. the main account has
Could have a default of expired
99991231, denoting no
expiration.
EFS Owner Effective date/start YYYYMMDD--Date on which N 8
Effective Date date of the owner the owner was
relationship to the associated with the
account. Could account
potentially be derived
from the reporting of
the change record.
EFS Owner Expiration date/end date YYYYMMDD--Date on which N 8
Expiration Date of the owner the owner relationship
relationship to the has expired.
account.
EFS Controller X Effective date/start YYYYMMDD--Date on which N 8
Effective Date date of the controller the controller was
relationship to the associated with the
account. Could account
potentially be derived
from the reporting of
the change record.
EFS Controller Expiration date/end date YYYYMMDD--Date on which N 8
Expiration Date of the controller the controller
relationship to the relationship has
account. expired.
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