Senate Agriculture Committee Discusses Derivatives Regulation
AT TODAY’S SENATE AGRICULTURE COMMITTEE HEARING, lawmakers discussed the impact of Dodd-Frank derivatives regulation with Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler; Robert Cook, Director of the Securities and Exchange Commission’s (SEC) Division of Trading and Markets; and industry stakeholders. Major issues of discussion focused on the CFTC’s and SEC’s approach to cross border application of Dodd-Frank rules, the sequencing and implementation of such rules, and the CFTC’s response to the recent misappropriation of customer funds by futures commission merchants (FCMs).
Testimony
In his opening statement, Gensler discussed the CFTC’s progress in finalizing Dodd-Frank rulemakings and provided an overview of the Commission’s involvement in the recent Libor manipulation investigation and the misappropriation of customer funds at Peregrine, a FCM overseen by the National Futures Association (NFA) and the CFTC. Gensler noted a number of customer protection enhancement rules that he believes the Commission should adopt, including: providing self-regulatory organizations (SROs) and the Commission with direct electronic access to FCMs’ bank and custodial accounts for customer funds without asking the FCM’s permission; providing futures customers access to information about how their assets are held; and additional rules laying out the SROs’ requirements for conducting examinations and audits.
In his opening statement, Cook provided an overview of the SEC’s progress in implementing Title VII regulations. He said the SEC expects to complete the last core elements of the proposal phase as well as release its cross border proposal in the near term. He said the “publication of a single proposal addressing the international implications of Title VII is intended in part to give investors, market participants, foreign regulators, and other interested parties an opportunity to consider as an integrated whole our proposed approach to the registration and regulation of foreign entities engaged in cross-border transactions involving U.S. parties.” He said the proposal will likely be published before rules addressed in the proposal are finalized so that “comments received can be taken into account in drafting the final rules.”
In his opening statement, Robert Pickel, CEO of the International Swaps and Derivatives Association, discussed how the process of implementing Dodd-Frank has been problematic and provided four recommendations for easing the process, including: prioritizing the finalization and implementation of rulemakings to focus on those that are most systemically important; analyzing and assessing the most systemically important rulemakings to ensure their implementation is properly sequenced; ensuring international consistency in substance and timing of new regulations after sequencing is completed; and engaging in fulsome cost-benefit analysis that considers the impact of the new framework on financial firms, corporations, market liquidity, and the economy.
Thomas Erickson of Bunge North America, who spoke on behalf of the Commodity Markets Council, discussed issues that are of concern to his members, including the definition of “hedging” and the five separate definitions of hedging as it relates to the Volcker rule, end users and swap dealers, which he said creates confusion for the industry. Erickson also raised concerns with regulation regarding inter-affiliate swaps, noting that such transactions may be subject to the same set of requirements that apply to swaps with external dealer counterparties, noting that the CFTC has not yet provided any clarity on the issue. In addition, Erickson discussed reporting and recordkeeping compliance concerns for his member firms as well as how many firms will be brought under the scope of the “swap dealer” definition. He said the CFTC estimates on how many swap dealers will register is too low and that many firms risk being “wrongly captured by the expansive definition.”
Larry Thompson, Managing Director and General Counsel for the Depository Trust and Clearing Corporation (DTCC), discussed DTCC’s progress in launching a global electronic database for swaps transactions. He said DTCC launched a “regulatory portal” last year to provide regulators more access to more granular trade data and that the firm is fully prepared to meet Dodd-Frank reporting requirements. He explained how the proper reporting infrastructure is in place and noted how regulators must have the proper analytic tools to understand and analyze such data and identify certain risky behaviors on an automated basis.
Dennis Kelleher, President and CEO of Better Markets, provided a comprehensive overview of the economic effects of the financial crisis and discussed the need for regulators to continue working to fully implement the Dodd-Frank Act. He said industry has been invoking the need for regulators to conduct proper cost-benefit analysis as a mechanism to slow or halt new regulation, and added that industry
complaints over the alleged costs of regulation are usually “without merit.” Kelleher also argued for the need to properly fund the agencies in charge of implementing Dodd-Frank and called the House’s FY 2013 budget proposal for the CFTC “indefensible.”
Question and Answer
FCM Use of Customer Funds, Reforms
Chairman Debbie Stabenow (D-Mich.) referenced the recent loss of customer funds by Peregrine and noted that a Committee hearing will be held on August 1 where market participants will discuss recommendations for enhancing customer protections in the futures market. She then asked Gensler what measures the CFTC has taken to bolster consumer confidence in these markets.
Gensler referenced rules the Commission finalized last week regarding the use and reporting of customer funds by FCMs. He also said recommendations that take such protections “a step further” are before the Commissioners for their consideration, and reiterated the need for SROs to have direct and daily electronic access to customer accounts.
Sen. Tom Harkin (D-Iowa) voiced his concern over the fact that Peregrine was able to fraudulently pass NFA audits for twenty years and exclaimed that “self-regulation only works with really tight controls.” He asked if the CFTC has the resources to perform adequate oversight functions if it is able to electronically access bank records on customer funds.
“Frankly, we don’t,” Gensler responded. He added that direct electronic access is “critical” but that “SROs are the first line of defense.”
Sen. Amy Klobuchar (D-Minn.) followed up by asking whether the NFA is “up to the task” of serving as a front line regulator.
Gensler said it was “great question” and added that the NFA’s responsibilities will be broadened as the CFTC continues to implement new swaps regulation under Dodd-Frank. He said the CFTC will be reviewing the SROs’ responsibilities to ensure that proper oversight capabilities exist.
Cross Border Interpretative Guidance
Stabenow pointed to the CFTC’s recent cross border interpretive guidance and asked why the SEC is moving in a different direction by offering a proposed rule and when that rule is expected to be released.
Cook said the SEC’s approach at the staff level is to provide guidance through a rulemaking that will incorporate full economic and cost-benefit analysis. He said the SEC hopes to release the rule before the end of year and shortly after rules establishing capital and margin requirements are taken up.
Ranking Member Pat Roberts (R-Kan.) followed up on the cross border issue and noted provisions in the CFTC’s interpretative guidance that allows certain foreign affiliates of U.S. firms to meet Dodd-Frank requirements through “substituted compliance” and deems foreign branches of U.S. firms a “U.S. person,” which would subject the branch to U.S. regulations. He asked where in Dodd-Frank does the authority for the CFTC to propose such requirements exist.
Gensler cited Section 722(d) of the Act which calls for the application of Title VII derivatives regulation when certain activities and entities have a “direct and significant” effect on U.S. commerce.
Roberts interjected by asking what happens when a U.S. person disagrees with its designation and questioned how the entire designation and substituted compliance process will take place as outlined in the proposed guidance. With regard to such processes, Roberts also questioned what the CFTC will do if foreign regulations are not similar in scope to U.S. rules and what country or entity will mediate disagreements. He also wanted to know if such regulations would make the U.S. vulnerable to retaliatory regulation by foreign countries and whether there will be a potential for regulatory arbitrage.
Gensler pointed to AIG and the recent trading losses by JPMorgan Chase’s London affiliate as some examples of how risk overseas can migrate back to the U.S. He said Dodd-Frank will apply to any activities or entities that “leave U.S. taxpayers exposed.” With regard to any disagreements over the designation process, Gensler noted that the Commission will be taking public comment into consideration before finalizing the guidance.
Roberts also asked if the SEC and CFTC will merge their cross border releases into one proposal.
Cook responded that no single rule is expected. He said the SEC will take into account what the CFTC has done and that any potential differences in the agencies’ approaches will have to be analyzed.
Stabenow referenced the CFTC’s proposed regulation of foreign branches of U.S. firms at the transaction level, noting that there is “significant competitive disadvantage with U.S. entities versus foreign competitors.” She asked how the CFTC will balance protecting American consumers and American investors.
Gensler reiterated the risk from foreign entities migrating back to the U.S. and warned that U.S. taxpayers would be on the hook while jobs would move overseas. “If we were to adopt fully what some in the industry have asked for, the jobs would move offshore and the risk would still be back here,” Gensler said. He added that firms have “thousands of legal entities to pick from” as it relates to jobs and markets moving to “London and elsewhere because they will go to where they can have less regulation.”
Volcker Rule, Portfolio Hedging
Sen. John Thune (R-S.D.) referenced the Volcker Rule and asked how regulators will draw the distinction between proprietary trading and hedging. He also asked Gensler whether he thinks portfolio hedging should be allowed under the rule.
Gensler called the Volcker Rule one of the most “challenging” for regulators to implement and that “very good progress is being made.” With regard to portfolio hedging, Gensler noted that statutorily, hedges for specific risks or aggregate positions are allowed. He added that portfolio hedging can “mean almost anything to anybody” and that hedges tied to specific positions, “even if there is a hundred of them” should be allowed.
Second Panel Q&A
During questioning of the second panel, Stabenow noted how the SEC and CFTC have finalized entity and product definition rules and asked if firms are ready to comply with the new sets of regulation.
Pickel said it depends on the market participant. He noted that larger dealers have always assumed they would be designated as swap dealers and have taken significant steps to comply with the new rules. Other firms, such as commodity firms, would “really have to start almost from scratch” to come into compliance, he said.
Roberts remarked that he shared Erickson’s concern regarding the CFTC’s rule sequencing process and asked Erickson if his member firms will be able to comply with the CFTC’s 60-day registration time period, which would be around October 1.
Erickson said being able to meet such compliance timeframes with regard to registering as a swap dealer and being able to collect all the necessary data globally from the position limits rules are two major concerns for commercial firms.
For testimony and a webcast of the hearing, please click here.
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AT TODAY’S SENATE AGRICULTURE COMMITTEE HEARING, lawmakers discussed the impact of Dodd-Frank derivatives regulation with Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler; Robert Cook, Director of the Securities and Exchange Commission’s (SEC) Division of Trading and Markets; and industry stakeholders. Major issues of discussion focused on the CFTC’s and SEC’s approach to cross border application of Dodd-Frank rules, the sequencing and implementation of such rules, and the CFTC’s response to the recent misappropriation of customer funds by futures commission merchants (FCMs).
Testimony
In his opening statement, Gensler discussed the CFTC’s progress in finalizing Dodd-Frank rulemakings and provided an overview of the Commission’s involvement in the recent Libor manipulation investigation and the misappropriation of customer funds at Peregrine, a FCM overseen by the National Futures Association (NFA) and the CFTC. Gensler noted a number of customer protection enhancement rules that he believes the Commission should adopt, including: providing self-regulatory organizations (SROs) and the Commission with direct electronic access to FCMs’ bank and custodial accounts for customer funds without asking the FCM’s permission; providing futures customers access to information about how their assets are held; and additional rules laying out the SROs’ requirements for conducting examinations and audits.
In his opening statement, Cook provided an overview of the SEC’s progress in implementing Title VII regulations. He said the SEC expects to complete the last core elements of the proposal phase as well as release its cross border proposal in the near term. He said the “publication of a single proposal addressing the international implications of Title VII is intended in part to give investors, market participants, foreign regulators, and other interested parties an opportunity to consider as an integrated whole our proposed approach to the registration and regulation of foreign entities engaged in cross-border transactions involving U.S. parties.” He said the proposal will likely be published before rules addressed in the proposal are finalized so that “comments received can be taken into account in drafting the final rules.”
In his opening statement, Robert Pickel, CEO of the International Swaps and Derivatives Association, discussed how the process of implementing Dodd-Frank has been problematic and provided four recommendations for easing the process, including: prioritizing the finalization and implementation of rulemakings to focus on those that are most systemically important; analyzing and assessing the most systemically important rulemakings to ensure their implementation is properly sequenced; ensuring international consistency in substance and timing of new regulations after sequencing is completed; and engaging in fulsome cost-benefit analysis that considers the impact of the new framework on financial firms, corporations, market liquidity, and the economy.
Thomas Erickson of Bunge North America, who spoke on behalf of the Commodity Markets Council, discussed issues that are of concern to his members, including the definition of “hedging” and the five separate definitions of hedging as it relates to the Volcker rule, end users and swap dealers, which he said creates confusion for the industry. Erickson also raised concerns with regulation regarding inter-affiliate swaps, noting that such transactions may be subject to the same set of requirements that apply to swaps with external dealer counterparties, noting that the CFTC has not yet provided any clarity on the issue. In addition, Erickson discussed reporting and recordkeeping compliance concerns for his member firms as well as how many firms will be brought under the scope of the “swap dealer” definition. He said the CFTC estimates on how many swap dealers will register is too low and that many firms risk being “wrongly captured by the expansive definition.”
Larry Thompson, Managing Director and General Counsel for the Depository Trust and Clearing Corporation (DTCC), discussed DTCC’s progress in launching a global electronic database for swaps transactions. He said DTCC launched a “regulatory portal” last year to provide regulators more access to more granular trade data and that the firm is fully prepared to meet Dodd-Frank reporting requirements. He explained how the proper reporting infrastructure is in place and noted how regulators must have the proper analytic tools to understand and analyze such data and identify certain risky behaviors on an automated basis.
Dennis Kelleher, President and CEO of Better Markets, provided a comprehensive overview of the economic effects of the financial crisis and discussed the need for regulators to continue working to fully implement the Dodd-Frank Act. He said industry has been invoking the need for regulators to conduct proper cost-benefit analysis as a mechanism to slow or halt new regulation, and added that industry
complaints over the alleged costs of regulation are usually “without merit.” Kelleher also argued for the need to properly fund the agencies in charge of implementing Dodd-Frank and called the House’s FY 2013 budget proposal for the CFTC “indefensible.”
Question and Answer
FCM Use of Customer Funds, Reforms
Chairman Debbie Stabenow (D-Mich.) referenced the recent loss of customer funds by Peregrine and noted that a Committee hearing will be held on August 1 where market participants will discuss recommendations for enhancing customer protections in the futures market. She then asked Gensler what measures the CFTC has taken to bolster consumer confidence in these markets.
Gensler referenced rules the Commission finalized last week regarding the use and reporting of customer funds by FCMs. He also said recommendations that take such protections “a step further” are before the Commissioners for their consideration, and reiterated the need for SROs to have direct and daily electronic access to customer accounts.
Sen. Tom Harkin (D-Iowa) voiced his concern over the fact that Peregrine was able to fraudulently pass NFA audits for twenty years and exclaimed that “self-regulation only works with really tight controls.” He asked if the CFTC has the resources to perform adequate oversight functions if it is able to electronically access bank records on customer funds.
“Frankly, we don’t,” Gensler responded. He added that direct electronic access is “critical” but that “SROs are the first line of defense.”
Sen. Amy Klobuchar (D-Minn.) followed up by asking whether the NFA is “up to the task” of serving as a front line regulator.
Gensler said it was “great question” and added that the NFA’s responsibilities will be broadened as the CFTC continues to implement new swaps regulation under Dodd-Frank. He said the CFTC will be reviewing the SROs’ responsibilities to ensure that proper oversight capabilities exist.
Cross Border Interpretative Guidance
Stabenow pointed to the CFTC’s recent cross border interpretive guidance and asked why the SEC is moving in a different direction by offering a proposed rule and when that rule is expected to be released.
Cook said the SEC’s approach at the staff level is to provide guidance through a rulemaking that will incorporate full economic and cost-benefit analysis. He said the SEC hopes to release the rule before the end of year and shortly after rules establishing capital and margin requirements are taken up.
Ranking Member Pat Roberts (R-Kan.) followed up on the cross border issue and noted provisions in the CFTC’s interpretative guidance that allows certain foreign affiliates of U.S. firms to meet Dodd-Frank requirements through “substituted compliance” and deems foreign branches of U.S. firms a “U.S. person,” which would subject the branch to U.S. regulations. He asked where in Dodd-Frank does the authority for the CFTC to propose such requirements exist.
Gensler cited Section 722(d) of the Act which calls for the application of Title VII derivatives regulation when certain activities and entities have a “direct and significant” effect on U.S. commerce.
Roberts interjected by asking what happens when a U.S. person disagrees with its designation and questioned how the entire designation and substituted compliance process will take place as outlined in the proposed guidance. With regard to such processes, Roberts also questioned what the CFTC will do if foreign regulations are not similar in scope to U.S. rules and what country or entity will mediate disagreements. He also wanted to know if such regulations would make the U.S. vulnerable to retaliatory regulation by foreign countries and whether there will be a potential for regulatory arbitrage.
Gensler pointed to AIG and the recent trading losses by JPMorgan Chase’s London affiliate as some examples of how risk overseas can migrate back to the U.S. He said Dodd-Frank will apply to any activities or entities that “leave U.S. taxpayers exposed.” With regard to any disagreements over the designation process, Gensler noted that the Commission will be taking public comment into consideration before finalizing the guidance.
Roberts also asked if the SEC and CFTC will merge their cross border releases into one proposal.
Cook responded that no single rule is expected. He said the SEC will take into account what the CFTC has done and that any potential differences in the agencies’ approaches will have to be analyzed.
Stabenow referenced the CFTC’s proposed regulation of foreign branches of U.S. firms at the transaction level, noting that there is “significant competitive disadvantage with U.S. entities versus foreign competitors.” She asked how the CFTC will balance protecting American consumers and American investors.
Gensler reiterated the risk from foreign entities migrating back to the U.S. and warned that U.S. taxpayers would be on the hook while jobs would move overseas. “If we were to adopt fully what some in the industry have asked for, the jobs would move offshore and the risk would still be back here,” Gensler said. He added that firms have “thousands of legal entities to pick from” as it relates to jobs and markets moving to “London and elsewhere because they will go to where they can have less regulation.”
Volcker Rule, Portfolio Hedging
Sen. John Thune (R-S.D.) referenced the Volcker Rule and asked how regulators will draw the distinction between proprietary trading and hedging. He also asked Gensler whether he thinks portfolio hedging should be allowed under the rule.
Gensler called the Volcker Rule one of the most “challenging” for regulators to implement and that “very good progress is being made.” With regard to portfolio hedging, Gensler noted that statutorily, hedges for specific risks or aggregate positions are allowed. He added that portfolio hedging can “mean almost anything to anybody” and that hedges tied to specific positions, “even if there is a hundred of them” should be allowed.
Second Panel Q&A
During questioning of the second panel, Stabenow noted how the SEC and CFTC have finalized entity and product definition rules and asked if firms are ready to comply with the new sets of regulation.
Pickel said it depends on the market participant. He noted that larger dealers have always assumed they would be designated as swap dealers and have taken significant steps to comply with the new rules. Other firms, such as commodity firms, would “really have to start almost from scratch” to come into compliance, he said.
Roberts remarked that he shared Erickson’s concern regarding the CFTC’s rule sequencing process and asked Erickson if his member firms will be able to comply with the CFTC’s 60-day registration time period, which would be around October 1.
Erickson said being able to meet such compliance timeframes with regard to registering as a swap dealer and being able to collect all the necessary data globally from the position limits rules are two major concerns for commercial firms.
For testimony and a webcast of the hearing, please click here.