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House Ag Cmte on Derivatives Reform

 

House
Agriculture Committee

Dodd-Frank
Turns Five: Assessing the Progress of Global Derivatives Reforms

Wednesday, July 29, 2015

 

Key
Topics & Takeaways

    CFTC Funding:
    Chairman Conaway emphasized his strong opposition to increasing funding for the
    CFTC until the institution has been reauthorized, citing the inaction of the
    Senate as a Congressional “failure” because it allows federal agencies to
    operate outside of the traditional budget process.

    Substituted
    Compliance:     CME’s Duffy said that cross-border regulations need not be
    identical, which is “unrealistic and unnecessary,” but instead “the goal is to
    adopt frameworks that lead to consistent regulatory outcomes and allow for
    appropriate substituted compliance.”

    Cross-Border Overreach:
    ISDA’s O’Malia said the CFTC “has overreached” in its application of
    cross-border rules and taken the statute “beyond its logical” application.

    CFTC Budget
    Justification:     Duffy noted that the CFTC often cites the notional value
    of the swaps market as justification for an increased budget, but said the
    number of transactions is a more important metric to look at when determining
    funding. However, he added, “the CFTC is probably underfunded to some extent.”

    Margin Requirements:
    O’Malia expressed concern with the “significant difference” that
    inter-affiliate transactions would be subject to the margin requirements in the
    U.S., but not in Japan or the EU.

 

Panelists

Opening Remarks

Michael
Conaway (R-Texas), Chairman, House Committee on Agriculture

Rep.
Conaway began his remarks
by highlighting continued global efforts after the 2008 financial crisis by the
G-20 to provide guidance for regulation of the global swaps markets that must
ultimately be implemented by national regulators. Regulators, he said, must
ensure actions support market discipline, competition, dynamism, and innovation
in the marketplace overall.

Conaway also emphasized his strong opposition to
increasing funding for the Commodity Futures Trading Commission (CFTC) until
the institution has been reauthorized, citing the inaction of the Senate as a
Congressional “failure” because it allows federal agencies to operate outside
of the traditional budget process.

Collin
Peterson (D-Minn.), Ranking Member, House Committee on Agriculture

Rep.
Peterson noted the CFTC has made significant progress in implementing
Dodd-Frank since its passage in 2010, adding that 50 of the 60 rules required
of the CFTC under Title VII have been passed. He continued that efforts to
increase central clearing, margin requirements, and greater price transparency
have made derivative markets much safer than at the time of the crisis.

Peterson
expressed support for efforts by CFTC Chairman Timothy Massad to coordinate
with foreign regulators, and emphasized the importance of improving the current
trade data reporting regime.

Panelist Testimony

Mr.
Terrence A. Duffy, Executive Chairman & President, CME
Group

Terrence
Duffy, in his testimony,
outlined the 2009 G-20 framework for derivatives reform: 1) reporting; 2)
trading on exchanges and clearing through central counterparties; and 3) higher
margin and capital requirements for uncleared over-the-counter (OTC)
derivatives.

Significant
work has been done, he said, as swaps are now traded on execution venues and
reported to trade repositories. However, he said many G-20 nations have yet to
implement the core elements the U.S. has already addressed. Duffy emphasized
that the lack of coordination creates “inconsistency, uncertainty,” and
potential harm to the efficiency of U.S. and global swaps markets.

Duffy
noted EU equivalency standards as the first area to be addressed, highlighting
the negative impact on liquidity and global competitiveness of the market as a
result of the U.S. and EU failure to mutually recognize equivalency of
clearinghouse regulatory regimes. Diminished liquidity, he said, leads to
higher hedging costs and ultimately higher commodity prices for U.S. consumers.

Duffy
stressed the importance of harmonizing the global swaps regulatory framework as
well, noting that the CFTC framework is often overly prescriptive, which could
lead to the movement of price discovery and risk management of U.S. commodities
abroad due to higher costs domestically.

The
supplemental leverage ratio (SLR), Duffy said, represents a significant failure
on the part of the Federal Reserve to recognize the risk reducing effect of
segregated margin. Duffy noted that the SLR penalizes the use of central
clearing by banks on behalf of their clients, forcing them to overstate
exposure and resulting in better treatment for higher risk products. This
policy, he expressed, is directly contrary to the G-20 commitment to increase
accessibility of clearing.

Duffy
emphasized that cross-border regulations need not be identical, which is
“unrealistic and unnecessary,” but instead “the goal is to adopt frameworks
that lead to consistent regulatory outcomes and allow for appropriate
substituted compliance.”

Mr.
Scott O’Malia, Chief Executive Officer, ISDA

Scott
O’Malia began his testimony
by highlighting the progress in global derivatives markets, noting that 75
percent of interest rate derivatives are now centrally cleared, with over half
now traded on swap execution facilities (SEFs). He also noted that universal
reporting to swap data repositories (SDRs) and margin and capital requirements
are being phased in to further mitigate risk.

O’Malia
emphasized, however, that the speed of U.S. implementation relative to global
implementation has led to “duplicative, inconsistent” rules which engender
“fractured rules, fractured markets, [and] fractured liquidity.” He noted the
importance of global regulation which provides transparent guidelines based on
broad outcomes that also provide adequate implementation timelines.

O’Malia
cited developing common initial margin methodologies, common reporting requirements
and data standards, and consistent and coherent capital requirements as areas
in which ISDA has sought to develop standards for use by the global
marketplace. He called for immediate recognition of all clearinghouses meeting
the International Organization of Securities Commissions (IOSCO) Committee on
Payments and Market Infrastructures’ (CMPI) principles and noted a need for
regulators to minimize differences in trade execution rules to increase SEF use
and facilitate cross-border trading.

O’Malia
called on Congress to evaluate the cross-border approach taken by the CFTC and
Securities and Exchange Commission (SEC), which he characterized as “not in
line” with global regulations, and questioned the regulators’ assessments of
whether certain activity has a “significant and direct effect on U.S.
commerce,” as required by Dodd-Frank.  He encouraged Congress to monitor
the finalization of the U.S. margin regime, especially in terms of
inter-affiliate trades, and called for the repeal of Section 21(d) of the
Commodity Exchange Act pertaining to the indemnification of SDRs. O’Malia
emphasized the need for continued Congressional oversight in rulemaking to
determine the impact of such rules on liquidity.

Mr.
Christopher S. Edmonds, Senior Vice President, Financial
Markets, ICE

Christopher
Edmonds, in his testimony,
highlighted increased transparency, robust risk management, enhanced compliance
mechanisms and an increase in the number of products that are centrally
cleared. He cautioned, however, that with increasingly divergent global
regulations, liquidity pools could fragment and harm could come to market participants.

Edmonds
cited heavy reliance on prescriptive rules as one area where reform is needed,
suggesting replacing prescriptive rulemakings with flexible regulatory
principles for the evolving markets.

Mr.
Larry E. Thompson, Vice Chairman and General Counsel, DTCC

Larry
Thompson, in his testimony,
noted that progress on derivatives regulation has been “steady, but slow.”
Thompson said enhanced transparency remains only partially addressed,
emphasizing 1) legal barriers to global trade sharing; 2) challenges to global
coordination; and 3) the need for consistent global data standards as areas of
concern.

Legal
barriers, Thompson said, prevent cross-border data sharing which blocks U.S.
and global regulators from having access to data across borders. Thompson urged
Senate passage of H.R. 1847,
the Swap Data Repository and Clearinghouse Indemnification Correction Act of
2015, which provides a “technical, non-controversial” fix to this problem.

Global
coordination has been hindered by the establishment of regional instead of
global reporting on trade depositories, which has fragmented global reporting,
Thompson expressed, and consistent global data standards would significantly
improve the quality of data that is reported. Efforts to identify systemic
risks, Thompson said, will not work if regulators can only see a partial
picture of the market.

Dr.
John E. Parsons, Senior Lecturer, MIT Sloan School of
Management

In
his testimony,
Dr. John Parsons focused on the issue of transparency in CFTC reporting, which
he cited as the “least contentious, most critical” aspect of the Dodd-Frank
reform to manage future crises. The CFTC, he said, issues a weekly swaps report
in which the gross notional outstanding data for commodities swaps ($1.7
trillion) has not changed in over ninety weeks of reporting. This indicates
persistent deep problems in the CFTC reporting regime, Parsons said, that need
to be addressed.

Question & Answer

Cross-Border

Conaway
began the discussion asking if the CFTC’s current cross-border guidance helps
or hurts the markets.   O’Malia replied that the CFTC “has
overreached” in is application of cross-border rules and taken the statute
“beyond its logical” application. He added that the “extra-territorial reach
test” was never validated or used. O’Malia said the implementation of trade
execution requirements has created bifurcated markets in which people do not
want to trade with U.S. participants. He said the CFTC has not done enough to
embody a substituted compliance regime and suggested that the Commission use
its workable rules under Part 30 to recognize foreign platforms.

Agriculture
Products

Peterson
asked why end-users are paying up to five times more than previously to clear
trades and why agricultural products are two times more expensive to clear than
risky credit default swaps (CDS). Duffy agreed that CDS are “much more risky”
but said they “fall out of the scope of the law” and are cheaper because of the
way that margin requirements are structured. He stressed that margin on deposit
should not “count against the balance sheet.”

CCP
Recognition

Peterson
asked if the EU was holding up recognition determinations for U.S. centralized
counterparties (CCPs) because of initial margin. Duffy explained that the EU
requires “two day net” margin calculations, while the U.S. requires “one day
gross,” and that the U.S. system results in more margin being held at CCPs. He
said this is a competitive issue and that the lack of recognition is a “slap in
the face” which will take business out of the U.S.

Price
Discovery

Rep.
Bob Gibbs (R-Ohio.) asked if price discovery has been enhanced or reduced under
Dodd-Frank, to which O’Malia said that transparency has increased, but that
there is still “a long way to go.” He noted that trade execution is “overly
restrictive” and said the individual and cumulative costs of the rules from
Dodd-Frank have not been calculated. He suggested that Congress ask financial
regulators to quantify the costs of capital rules.

CFTC Funding

Rep.
Ann Kuster (D-N.H.) asked what effect underfunding the CFTC will have on its
data collection and ability to regulate the market.  Parsons said the CFTC
is trying to “grapple with how to deal with data” and noted the enormous task
the Commission has in coping with large volumes of data.

O’Malia
said the CFTC should solve its data issues “immediately” and stated that
technology has always “come second at the Commission.”

Duffy
noted that the CFTC often cites the notional value of the swaps market as
justification for an increased budget, but said the number of transactions is a
more important metric to look at when determining funding. However, he added
that “the CFTC is probably underfunded to some extent.”

Liquidity

Rep.
Austin Scott (R-Ga.) noted that market events have raised concerns about market
liquidity and asked about the cumulative impact of regulations as a
contributing factor. Edmonds said there is uncertainty around how collateral
works, noting that Basel rules are not consistent with the U.S., specifically
in that other countries have classified U.S. Treasuries as liquid assets, while
the U.S. has not.

Rep.
Rick Allen (R-Ga.) asked whether diminished liquidity still poses a risk to the
markets. Duffy highlighted the issues in the U.S. Treasury bond market as an
example of liquidity concerns raised from the failure of the Federal Reserve to
raise interest rates and said that potential harm could result from a dramatic
rate hike. Edmonds cited the repo market as another area of concern.

Data 

Scott
asked how useful data formats are. Parsons stressed the need for good data
standards and information sharing across borders and among domestic regulators.
Thompson agreed and noted that there are currently different definitions for
various data items, including formatting for the date of a transaction.

Rep.
Alma Adams (D-N.C.) asked what resources the CFTC can use to have better
oversight. O’Malia recommended that regulators work with the industry to adopt
data standards and an appropriate taxonomy that already exists in the
marketplace, stressing the need for regulators to endorse these standards.

Rep.
Ralph Abraham (R-La.) asked where the best location to simplify data would be.
Parson noted that SDRs hold data for the public, but said that this data is
“trash” and that regulators should be more prescriptive in their data
requirements.

Rep.
Trent Kelly (R-Miss.) asked what Congress could do to facilitate the reduction
of cross-border risk and increase transparency, to which Thompson answered that
clear standards and data sets would be extraordinarily helpful. O’Malia, adding
that the European Union is in the process of developing its version of
Dodd-Frank, the Markets in Financial Instruments Directive (MiFID), said
misinformation in data reporting could result in radically different
requirements between the U.S. and EU.

Kelly
asked Parsons how significant the unchanged $1.7 trillion figure for the
commodities market reported by the CFTC is. Parsons responded that it provides
clear evidence of a problem in reporting. Kelly followed up, saying it is key
for Congress to determine how the CFTC can provide usable information in the
future
FSOC

Rep.
Rodney Davis (R-Ill.) noted that CFTC Commissioner Christopher Giancarlo has
called the Financial Stability Oversight Council (FSOC) an “unmitigated
disaster” and asked if there is another body that could coordinate
regulators.  O’Malia said the FSOC could better serve the public if it 1)
was more transparent; 2) had a more diversified participant base including
bipartisan input from all Commissioners of member agencies; and 3) followed the
Administrative Procedures Act to include cost benefit analysis and public
notice and comment for all of its rules.

Duffy
said he is not certain that another body could be a better coordinator and
Edmonds said the FSOC’s communication is “not consistently successful.”
Thompson called the FSOC a “work in progress that can only get better” and
Parsons noted that the FSOC’s “kick in the pants” to the SEC on money market
fund reforms was helpful.

Margin

In
response to a question from Abraham on CCPs, O’Malia stressed the need for
Congress to “pay attention” to margin rules for OTC derivatives. He noted that
inter-affiliate transactions would be subject to the proposal’s requirements in
the U.S., but explained that Japan and the EU do not have this requirement.
O’Malia expressed concern with this “significant difference” as well as
differences in haircutting collateral for foreign exchange transactions, and
said if regulators cannot come to agreement on this rule, then “where can
they?”

Impact
on Small Businesses

Allen
asked whether there is a disconnect between small businesses and the government
on how to regulate. Edmonds noted that with so many global moving parts,
determining the final outcome and expressing that to small businesses right now
is “dangerous” because the standards can change at any moment. Duffy provided
the example of the CFTC rule on anticipatory hedge exemptions as a rulemaking
whose tangible impact can be felt by agri-businesses.

O’Malia
added that the uncertainty largely derives from the CFTC’s failure to provide
answers, noting the cross-border rule and final registration of SEFs and SDRs
as several components yet to be determined.

For
more information on this meeting and to view an archived webcast, please click here.