United States: CFTC Chair Giancarlo Outlines Vision For Swaps Reform

CFTC Chair J. Christopher Giancarlo unveiled a plan for reforming swaps regulation in a white paper co-authored with CFTC Chief Economist Bruce Tuckman. In the paper, Mr. Giancarlo and Mr. Tuckman (the "authors") asserted that reforms should better balance systemic risk resiliency with capital markets vibrancy. The authors assessed CFTC implementation of swaps reform in the areas of clearing, data reporting, execution, dealer capital and mandatory margin in order to a map out a direction for the future. General regulation of swap dealers was not addressed.

The white paper covers areas of successes and deficiencies and contains a number of recommendations. The areas reviewed include:

  • Swaps Central Counterparties: Describing swaps clearing as "probably the most far-reaching and consequential" Dodd-Frank reform, the authors characterized reform in this area as a success. They encouraged continued progress on dealing with the challenge of enhancing CCP resiliency and recovery by: (i) ensuring the safety of CCPs under extreme conditions, (ii) establishing adequate recovery plans, and (iii) resolution by government authorities when recovery plans prove inadequate.
  • Swaps Reporting Rules: The authors acknowledged that swap data repositories ("SDRs") are still unable to "provide regulators with a complete and accurate picture of counterparty credit risk in global swaps markets." They found that the problem can be traced back to the CFTC's adoption of a principles-based approach to reporting requirements and insufficient attention to the need for specific and detailed data standards. In addition to advocating that the CFTC devote adequate time and attention in collaboration with the industry to produce granular and data standards, the authors recommended (i) revisiting timing for public dissemination of large transactions to balance transparency and liquidity, (ii) updating requirements for reporting parties and SDRS to validate data when it is reported, (iii) considering relaxation of the timing for data reporting generally to prioritize data integrity over rapid reporting, and (iv) cultivating emerging technologies (e.g., distributed ledger technology) to enhance reporting.
  • Swaps Execution Rules: The authors took prior CFTC leadership to task for "missing the mark" set by Congress and imposing "arbitrary and prescriptive requirements" on execution methods in a misguided effort to impose the market structure for futures on the swaps market. The authors made the case that prescriptive requirements for use of central order books and "RFQ-to-3" disincentivize the use of SEFs, thus reducing liquidity formation from taking place on such platforms. They proposed removing these "ad hoc constraints on methods of execution and other inapposite forms taken from futures markets." The authors also advocated expanding the category of swaps subject to the Trade Execution Requirement to include all swaps subject to the CFTC's clearing mandate.
  • Swap Dealer Capital: The authors contended that bank capital rules tend to be biased against swaps in various places where they use standardized rather than risk-based approaches. They suggested that these can be best corrected by improving oversight capacity to allow for greater use of internal risk models used by banks. In particular, the authors called out use of notional amounts for measuring swap risk, the continued use of standardized models (specifically, the Current Exposure Method) in various components of the risk regimes, the treatment of cash margin in the Supplementary Leverage Ratio, and inadequate recognition of the value of netting and initial margin.
  • End User Exception: The authors advocated exempting smaller financial end users from clearing and margin requirements through reworking the "material swaps exposure" threshold and applying it across the board, for the same reasons that commercial end users are exempt. They urged a less prescriptive approach for setting uncleared initial margin, expressly revising the approach to setting the "margin period of risk" to model the close-out period for an uncleared swaps book on more realistic and risk-based assumptions.

The paper was unveiled at ISDA's 33rd Annual General Meeting. In accompanying remarks, Mr. Giancarlo argued that the regulators had a duty to revisit reforms that were quickly adopted in the wake of the financial crisis. He emphasized that the CFTC has accumulated sufficient experience and data from the first iteration of swaps reform for a comprehensive assessment. Responding to a question about the feasibility of adopting an ambitious revamp during his remaining tenure, he stressed that it is important to adhere to regular order to get reforms right but pledged to "get this done."

Commentary / Jeff Robins

The White Paper should be required reading for regulatory reform teams at banks and swap dealers. While it is consistent with past agenda-setting efforts such as the Treasury report on capital markets reform and Mr. Giancarlo's own prior speeches and publications, it advances the policy debate significantly by providing a close look at CFTC reforms and a sustained analysis in light of post-reform research and economic insights.

In terms of recommendations for reform, the sections on SEFs and uncleared swaps margin are the most far-reaching. On SEF's, the White Paper repeats Mr. Giancarlo's critique from other publications, namely that prescriptive trading requirements adopted by the CFTC to move swap trading to look more like futures has backfired badly, resulting in market fragmentation and decreased liquidity. However, Mr. Giancarlo then takes this critique in a somewhat surprising direction. Besides advocating for repeal of restrictive trading requirements and allowing SEFs to provide flexible means of execution, Mr. Giancarlo recommends that all swaps subject to mandatory clearing be deemed "made available to trade" (provided they are traded on any SEFs). He justifies this on the basis of Congressional intent to promote trading through SEFs, which it is argued was intended to improve standards for dealer conduct as well as to increase pre-trade market transparency. In effect, Mr. Giancarlo advocates using the clearing and trading mandates to strengthen dealer oversight by SEFs. While this may be a way of squaring liberalization of the trading mandate with Dodd-Frank and the political conversation amongst regulators, it is not obvious that expanding a regulatory license to empower one set of private actors (SEFs) over another (dealers) is an optimal way to provide conduct regulation.

Regarding uncleared swaps margin, the White Paper presents a compelling case that current rules are not sufficiently risk-based and impose punitive costs on uncleared swaps trades for smaller financial end users. The impact of this critique is likely to be a bit different than other parts of the report. While recommendations for clearing, data and execution can be seen as signaling the Chairman's agenda for the CFTC, Mr. Giancarlo acknowledges that the CFTC has limited ability to implement margin reforms without the agreement of other regulators. In this, the White Paper is significant in that it opens up political and intellectual space in Washington for reform discussions that have largely been off the table until now. It also provides an opportunity to engage the CFTC and other regulators in a discussion of the risk calibration of margin (and related capital) rules that market participants will certainly want to seize upon.

Though the topic of two-way posting of margin is not addressed directly in the White Paper, the policy basis for requiring dealers to post margin to buy-siders was never adequately addressed in the original rulemaking. The requirement appears ripe for an analysis of costs and benefits in light of broader risk regulation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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