On April 26, 2018, Commodity Futures Trading Commission (CFTC) Chairman J. Christopher Giancarlo and Chief Economist Bruce Tuckman published a white paper on potential reforms to the CFTC’s swaps trading rules.^[1]

Consistent with longstanding concerns raised by Chairman Giancarlo, the white paper proposes a series of changes to rules relating to transactions on swap execution facilities (SEFs). Accompanying statements note that Commission staff is expected to propose a formal rulemaking in this area this summer. The white paper also examines and makes general proposals in several other areas, including the regulation of central counterparties (CCPs), swaps reporting rules, swap dealer capital and the scope of the end-user exception. It is not clear yet whether or when changes in these areas may be forthcoming.

Background

Chairman Giancarlo has over the past several years voiced a number of concerns with the CFTC’s swaps market rules implemented under Title VII of the Dodd-Frank Act, which he views as having veered off the course charted by their congressional mandate. In 2015, then-Commissioner Giancarlo penned a white paper proposing an alternative swaps trading platform,^[2] which he argued was necessitated by the fact that the CFTC’s swaps regulatory framework failed to take into account the liquidity and trading dynamics of the global swaps market, artificially fragmented swaps market segments and put U.S. swaps market participants at a distinct disadvantage to their global counterparts.

Since his appointment as CFTC Chair, Giancarlo has remained a vocal advocate for CFTC swaps market regulatory reform. He has repeatedly argued that the time passed since the regulations’ implementation has provided the CFTC with sufficient experience, improved data and constructive feedback from market participants from which to draw upon when considering new rulemakings.^[3] He has also argued that the CFTC was too heavy-handed in its implementation of the rules and that the CFTC regulations have unintentionally inhibited swaps trading liquidity and pushed trading away from SEFs,^[4] counter to the goals of Title VII.^[5]

White Paper

In the white paper, titled “Swaps Regulation Version 2.0,” Giancarlo and Tuckman liken their proposed reforms to a software upgrade, necessary to maintain the relevancy and applicability of the CFTC’s regulations. They break these suggested improvements down into five sections, including: (1) swaps execution rules; (2) swaps CCPs; (3) swaps reporting rules; (4) swap dealer capital; and (5) the end-user exception.

Swaps Execution Rules

The white paper states that the CFTC’s SEF rules, as they are currently written, fail to achieve the goals set out by Congress under Title VII. Despite Congress’s intention to move swaps trading onto SEFs, Giancarlo and Tuckman believe the CFTC’s current SEF rules instead disincentivize price discovery and liquidity formation on SEFs by (1) limiting the execution methods for swaps subject to the rules’ trade execution requirement; and (2) limiting the number of products traded on SEF by adopting an overly narrow “made available to trade” (MAT) definition. Other adverse consequences of the CFTC’s SEF rules, according to the authors, include market fragmentation, additional costs under the order book requirement and leakage of information stemming from the requirement to send a request-for-quote to three or more unaffiliated parties.

To remedy these concerns, Giancarlo and Tuckman believe updated CFTC SEF rules should eliminate the order book requirement for MAT transactions and permit more flexible means of execution for all swaps subject to the trade execution requirement. Under their proposed approach, swaps listed on SEFs could be traded “through any means of interstate commerce,” as intended by Congress. They also suggest revamping the MAT process by making it part of the clearing determination, such that all swaps subject to mandatory clearing would have to be traded on a SEF or designated contract market (DCM), unless the product is not offered by a SEF or DCM. Additionally, they recommend enhancing swaps execution by imposing requirements on licensure, testing and professional conduct.

This aspect of the white paper echoes many of the concerns and proposals in Chairman Giancarlo’s 2015 white paper. It seems these proposals have gained some momentum at the CFTC, and it is fair to assume that at least several of these suggestions will be incorporated into an official CFTC proposal in the coming months.

Swaps CCPs

While recognizing the benefits of the growth of swaps clearing, Giancarlo and Tuckman believe there are challenges that remain to ensuring a CCP’s safety in extreme scenarios. For example, they see potential issues related to liquidity of margin and prefunded resources, the possibility of correlated defaults and contagion effects, properly sizing margin levels to cover liquidation costs (particularly for new products) and whether default waterfall design (including a CCP’s own “skin-in-the-game” contributions) provides incentives to achieve an optimal level of risk taking at a CCP. They also argue that greater transparency and predictability of CCP recovery plans is necessary; however, they caution that regulators should not be overly prescriptive in the implementation of these plans. In the context of potential resolution of a CCP, they also note the importance of coordination between regulators (including the CFTC and the Federal Deposit Insurance Corporation, which is responsible for resolution under the “Orderly Liquidation Authority” of Title II of the Dodd-Frank Act).

Swaps Reporting Rules

Although they acknowledge that the implementation of the CFTC’s swaps data reporting regime under Dodd-Frank has achieved significant progress in terms of clarifying reporting requirements and coordinating with international regulators, Giancarlo and Tuckman believe there is still additional work to be done. The CFTC’s 2017 Roadmap to Achieve High Quality Swaps Data (Roadmap) has been one of Giancarlo’s major initiatives since being named chairman.^[6] The white paper suggests that following on the Roadmap, the CFTC should consider updating requirements for swap data repositories (SDRs) to verify the accuracy and completeness of reported swaps data and adding a requirement that SDRs validate data as it is received. Additionally, the white paper argues that the CFTC should consider changes to Part 45 of CFTC Regulations in order to streamline swaps data reporting by better defining and standardizing data fields. Giancarlo and Tuckman also argue that the one-size-fits-all reporting requirements across products, asset classes and trade size are inefficient and that further research should be conducted with an eye towards balancing liquidity and transparency.

Going forward, they believe new technologies could play a large role in shaping swaps data reporting. For example, Giancarlo and Tuckman speak to the possibilities of developing “regulator nodes” on distributed ledgers to assist with cross-border recordkeeping and the use of blockchain and distributed ledger technology (DLT) to standardize information and improve market oversight. These suggestions reflect the increased focus at the CFTC recently on FinTech and similar initiatives. However, as noted by Giancarlo and Tuckman, subjecting distributed ledgers to uniform standards faces a number of hurdles.

It will be interesting to monitor what specific steps LabCFTC, the CFTC’s FinTech initiative, takes in implementing these suggestions and other emerging technologies into the CFTC’s swaps data reporting regime.

Swap Dealer Capital

Giancarlo and Tuckman argue that the current bank capital regime maintains a bias against swap activities as it fails to consider inherently risk-reducing elements of transactions. They focus in particular on the treatment of margin and netting arrangements. The white paper further notes that some requirements focus on the notional amount of the swap transaction, which grossly overestimates the risk of the trade. Some bank capital requirements, such as the supplementary leverage ratio, also include cash margin from customers as part of total expenses, which therefore increases required capital for swaps businesses despite the risk-reducing benefits of such margin.

In response, Giancarlo and Tuckman suggest further refining standardized capital models to be more appropriately risk sensitive or providing greater leeway and improving monitoring systems with respect to firms’ internal models. However, they acknowledge drawbacks to both potential solutions and decline to take any definitive stance on the matter (which is, in any event, largely outside of the purview of the CFTC).

The End-User Exception

The white paper argues that Dodd-Frank and the current regulations impose undue costs on end users in light of the limited risk they pose to the financial system. While Giancarlo and Tuckman think the CFTC has taken steps in the right direction, they believe the CFTC can do more, such as codifying no-action relief from the clearing requirement issued to small bank holding companies and savings and loan holding companies with consolidated assets of less than $10 billion,^[7] among other measures to reduce burden on these market participants.

Giancarlo and Tuckman also believe the treatment of financial end users under clearing and margin rules should be reconsidered, particularly for financial end users with relatively simple business models that more closely resemble commercial end users than large financial institutions. They focus in particular on the potential costs of clearing and margin requirements for such entities. One potential change is to rethink the material swaps exposure (MSE) threshold used in determining whether initial margin requirements apply. They propose using an alternative metric when calculating the MSE threshold that would better account for risk-reducing trades and the size of a firm’s swaps positions relative to the size of its business, as opposed to the notional calculations used currently. They also suggest creating exceptions from providing variation margin for entities that do not meet the MSE threshold and argue that a similar threshold should be considered in the context of the clearing requirement.

Giancarlo and Tuckman argue more generally that current uncleared margin requirements are overly prescriptive, and have in turn led to the unintended consequence of pushing the industry to converge on a single, global margin model for swaps, which they believe is a source of systemic risk. They suggest that regulators should instead take a less prescriptive approach by allowing market participants to design their own business-specific models that would require regulatory approval and encouraging third-party vendors of margin models.

Comment

CFTC Division of Market Oversight Director Amir Zaidi said the CFTC hopes to publish proposed updated SEF regulations as soon as July 2018. However, Chairman Giancarlo has said the CFTC has no plans for forthcoming rulemakings on any of the white paper’s other topics. As a result, it remains to be seen whether, and when, other aspects of the white paper may find their way into actual proposed regulations. It is likely that even in the absence of new regulations, the CFTC and its staff will pay increased attention to the other areas identified in the white paper as part of their ongoing supervision of the derivatives markets.