Chairman Giancarlo declares the new agenda is “market focused.”
CFTC Chairman J. Christopher Giancarlo
Swaps regulatory reform is the focus of a recent white paper/report, “Swaps Regulation Version 2.0: An Assessment of the Current Implementation of Reform and Proposals for Next Steps,” co-authored by CFTC Chairman J. Christopher Giancarlo and CFTC Chief Economist Bruce Tuckman.
The report was unveiled at the annual meeting of the International Swaps and Derivatives Association (ISDA).
“This white paper is economy-focused,” Giancarlo said at the ISDA meeting. “And our role at the CFTC is to bring a market-focused approach. Our focus is what’s in the best interest of the markets. Our mission is market integrity and market health,” he adds.
“I’m committed to a process in rule writing which is ‘ready, aim, fire,’” Giancarlo replied to a question at the meeting regarding the paper’s implementation timeline. “I’m committed to a deliberative process and getting back to regular order at the agency. We’re not in the wake of a crisis right now — we need to take the time to get this right. We have an ambitious timetable, and we will get this done, but we will do this right. We will move forward in regular order and in good order — we will get this done.”
The report relies on a “range of academic research, market activity and the agency’s regulatory experience with implementing current swaps reform, to assess the agency’s implementation of swaps reform, determine its strengths and deficiencies and recommend improvements to the current swaps market reform framework,” the CFTC says in a statement. which notes that Giancarlo and Tuckman “seek to optimize the CFTC’s implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 … so as to strike a balance between systemic safety and stability and market vibrancy and economic growth.”
According to the CFTC’s statement, Giancarlo and Tuckman “explain that financial regulators have a duty to apply the policy prescriptions in ways that enhance markets and their underlying vibrancy, diversity and resiliency. That duty also includes the responsibility to review past policy applications continuously to confirm they remain improved for the purposes intended. It further includes anticipating changing market dynamics and the impact of technological innovation.”
“Of all the swaps reforms to emerge from the financial crisis, visibility into counterparty credit risk of major financial institutions was perhaps the most pressing,” the full report observes. “The regulatory failure to complete it is certainly the most disappointing.
“As with swaps trade execution, Dodd-Frank got much right in requiring that swaps trades be reported to swap data repositories (SDRs). Yet, despite the hard work and effort that has gone into establishing SDRs and supplying them with swaps data, a decade after the financial crisis, SDRs still cannot provide regulators with a complete and accurate picture of counterparty credit risk in global swaps markets.”
According to the full Giancarlo/Tuckman report, “the problem has [partly] been faulty implementation and ineffective project management by regulators, including the CFTC. Unlike its overly prescriptive approach to swaps execution, the CFTC’s initial approach to swaps reporting provided insufficient technological detail and specification. Instead, it relied on industry participants to utilize standardized nomenclature and data protocols, assuming the existence of a similar degree of standardization of swaps market data that exists in futures markets.”
The Giancarlo/Tuckman report focuses on five areas:
Swaps Central Counterparties (CCPs)
Swaps clearing is probably the most “far-reaching and consequential” of the swaps reforms adopted under Title VII of Dodd-Frank, the report observes, calling the CFTC’s implementation of Dodd-Frank’s clearing mandate “highly successful, significantly increasing the volume of swaps cleared by CCPs.”
The CCPs and the CFTC have made “substantial progress to ensure that CCPs are safe and sound under extreme but plausible scenarios and have credible recovery plans to remain viable without government assistance,” the report adds, calling for “[c]ontinued vigilance and improvement …with respect to ensuring the liquidity of prefunded resources; understanding network effects; estimating the liquidation costs of defaulted positions; and enhancing the transparency and predictability of recovery plans.”
However, the FDIC and CFTC “have much to do in formulating resolution plans, which would guide government intervention in the most dire of eventualities,” according to the report.
Swaps Reporting Rules
The data reporting mandate was important to regulators who were tasked with “measuring the counterparty credit risk of swaps by large financial institutions,” the report notes. “Yet, ten years after the crisis, the reporting structure is still incomplete,” and its “initial implementation was flawed and ineffective, providing insufficient technical specificity.”
Since that initial implementation, the CFTC has “laid out a more detailed and clear path forward under its July 2017 ‘Roadmap to Achieve High Quality Swaps Data,’” the report notes, referring to an earlier Giancarlo initiative.
The report notes that the CFTC also co-chairs the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions Harmonization Group, which has “issued final guidance regarding unique transaction identifiers (UTIs) and unique product identifiers (UPIs).”
Real-time reporting requirements like those, the report observes, “should be tailored to the liquidity profiles of the associated swaps products in order to yield value of transparency to market (e.g. price discovery, confidence) without introducing trading risk.”
In addition, the CFTC should “look to collaborate with other authorities to cultivate the development of ‘regulator nodes,’ on distributed ledgers,” the report recommends.
Swaps Execution Rules
Congress mandated that “swaps transactions be traded on regulated platforms called swap execution facilities (SEFs)” and executed by “any means of interstate commerce,” according to the report, which criticizes the initial, “incorrectly implemented” CFTC “execution mandate,” which “arbitrarily confining swaps execution to two methodologies and adopting trading rules from highly liquid futures markets, the wrong model for swaps that trade in more episodically liquid markets.”
The “adverse consequences” of that incorrect implementation of restrictive execution methods has been “global fragmentation of swaps markets and pushing swaps liquidity formation and price discovery away from the SEF platforms, contrary to Congressional intent,” according to the report, which calls on the CFTC to “encourage a greater amount of swaps trades to take place on regulated SEFs by making the ‘Made Available to Trade’ requirement synonymous with the clearing requirement.”
In summary, the report declares that “instead of trying to determine SEFs’ swaps execution business model, the CFTC should focus on raising standards of conduct for swaps trading.”
Swap Dealer Capital
Some elements of “today’s bank capital regime overestimate the risks of swaps,” the report states, specifying that the “conceptual problems are relying on swap notional amount to measure risk; failing to sufficiently recognize offsetting swap positions; and failing to sufficiently acknowledge the risk mitigation of posted margin.”
According to the full report, “many parts of the current regime are biased against swaps,” and the problems of “standardized, regulatory capital models arise from inappropriately relying on swap notional amount to measure risk; from not sufficiently recognizing offsetting swap positions between pairs of counterparties; and from not sufficiently acknowledging the risk-mitigation of posted margin. These appear to be unintended consequences of swaps market reform, and should be corrected.”
End User Exception
And finally, the report notes that “Dodd-Frank intended a robust end user exception from clearing and margin requirements and did not intend margin rules to favor cleared products.”
Therefore, “to reduce the burdens on end users that are not sources of systemic risk, and, in some cases, to reduce their liquidity risk, material swaps exposure thresholds should be established, below which entities would be excepted from clearing and margin requirements,” the report concludes, adding that “[r]ules governing uncleared initial margin should be reworked to be less prescriptive and to be unbiased with respect to cleared and uncleared products.”
The full, 103-page “Swaps Regulation Version 2.0” report is available here.
Perhaps significantly, the full report begins with the following disclaimer:
While this paper was produced in the authors’ official capacity, and while the CFTC seal is reproduced on the cover, the views expressed herein are those of the authors and do not necessarily reflect the views of the Commodity Futures Trading Commission or its staff.
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