[House Hearing, 113 Congress]
[From the U.S. Government Publishing Office]
THE FUTURE OF THE CFTC: MARKET PERSPECTIVES
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HEARING
BEFORE THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED THIRTEENTH CONGRESS
FIRST SESSION
__________
MAY 21, 2013
__________
Serial No. 113-5
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Printed for the use of the Committee on Agriculture
agriculture.house.gov
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COMMITTEE ON AGRICULTURE
FRANK D. LUCAS, Oklahoma, Chairman
BOB GOODLATTE, Virginia, COLLIN C. PETERSON, Minnesota,
Vice Chairman Ranking Minority Member
STEVE KING, Iowa MIKE McINTYRE, North Carolina
RANDY NEUGEBAUER, Texas DAVID SCOTT, Georgia
MIKE ROGERS, Alabama JIM COSTA, California
K. MICHAEL CONAWAY, Texas TIMOTHY J. WALZ, Minnesota
GLENN THOMPSON, Pennsylvania KURT SCHRADER, Oregon
BOB GIBBS, Ohio MARCIA L. FUDGE, Ohio
AUSTIN SCOTT, Georgia JAMES P. McGOVERN, Massachusetts
SCOTT R. TIPTON, Colorado SUZAN K. DelBENE, Washington
ERIC A. ``RICK'' CRAWFORD, Arkansas GLORIA NEGRETE McLEOD, California
MARTHA ROBY, Alabama FILEMON VELA, Texas
SCOTT DesJARLAIS, Tennessee MICHELLE LUJAN GRISHAM, New Mexico
CHRISTOPHER P. GIBSON, New York ANN M. KUSTER, New Hampshire
VICKY HARTZLER, Missouri RICHARD M. NOLAN, Minnesota
REID J. RIBBLE, Wisconsin PETE P. GALLEGO, Texas
KRISTI L. NOEM, South Dakota WILLIAM L. ENYART, Illinois
DAN BENISHEK, Michigan JUAN VARGAS, California
JEFF DENHAM, California CHERI BUSTOS, Illinois
STEPHEN LEE FINCHER, Tennessee SEAN PATRICK MALONEY, New York
DOUG LaMALFA, California JOE COURTNEY, Connecticut
RICHARD HUDSON, North Carolina JOHN GARAMENDI, California
RODNEY DAVIS, Illinois
CHRIS COLLINS, New York
TED S. YOHO, Florida
______
Nicole Scott, Staff Director
Kevin J. Kramp, Chief Counsel
Tamara Hinton, Communications Director
Robert L. Larew, Minority Staff Director
(ii)
C O N T E N T S
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Page
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, submitted letters....................................... 59
Lucas, Hon. Frank D., a Representative in Congress from Oklahoma,
opening statement.............................................. 1
Prepared statement........................................... 2
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 3
Prepared statement........................................... 4
Witnesses
Duffy, Hon. Terrence A., Executive Chairman and President, CME
Group, Inc., Chicago, IL....................................... 5
Prepared statement........................................... 6
Sprecher, Jeffrey C., Founder, Chairman, and CEO,
IntercontinentalExchange, Inc., Atlanta, GA.................... 10
Prepared statement........................................... 11
Roth, Daniel J., President and Chief Executive Officer, National
Futures Association, Chicago, IL............................... 13
Prepared statement........................................... 14
Lukken, Hon. Walter L., President and Chief Executive Officer,
Futures Industry Association, Washington, D.C.................. 16
Prepared statement........................................... 18
O'Connor, Stephen, Chairman, International Swaps and Derivatives
Association, Inc., New York, NY................................ 21
Prepared statement........................................... 23
Dunaway, William J., Chief Financial Officer, INTL FCStone, Inc.,
Kansas City, MO................................................ 28
Prepared statement........................................... 30
THE FUTURE OF THE CFTC: MARKET PERSPECTIVES
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TUESDAY, MAY 21, 2013
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 10:18 a.m., in Room
1300 of the Longworth House Office Building, Hon. Frank D.
Lucas [Chairman of the Committee] presiding.
Members present: Representatives Lucas, Neugebauer, Rogers,
Conaway, Gibbs, Austin Scott of Georgia, Tipton, Crawford,
Noem, Fincher, LaMalfa, Hudson, Davis, Collins, Peterson,
McIntyre, David Scott of Georgia, Costa, Walz, McGovern,
DelBene, Negrete McLeod, Vela, Kuster, Nolan, Enyart, Vargas,
and Bustos.
Staff present: Debbie Smith, Jason Goggins, Josh Mathis,
Kevin Kramp, Nicole Scott, Suzanne Watson, Tamara Hinton, Caleb
Crosswhite, John Konya, C. Clark Ogilvie, Liz Friedlander, and
Riley Pagett.
OPENING STATEMENT OF HON. FRANK D. LUCAS, A REPRESENTATIVE IN
CONGRESS FROM OKLAHOMA
The Chairman. This hearing of the Committee on Agriculture
entitled, The Future of the CFTC: Market Perspectives, will
come to order. I recognize myself for an opening statement. I
apologize to the Ranking Member and the witnesses and the
Committee Members for being a little late. Life has been a
little bit challenging back home in Oklahoma in the last couple
days, and I simply note that no matter how challenging Mother
Nature may be, and no matter how sometimes our fellow citizens
suffer, it is nonetheless in a small way redeeming to see how
well in this country, whether it is in Oklahoma or on the East
Coast or the West Coast, how well we still come together after
a tragedy and how decently we treat each other, and how hard we
help those who are hurt or hurting. I thank you for your
indulgence.
And with that, let me also note that we are all here today
to discuss the reauthorization of the Commodity Futures Trading
Commission. This is the first hearing on this issue, and the
first in a series of hearings this Committee plans to hold in
advance of writing legislation. CFTC reauthorization gives the
Committee an opportunity to review the CFTC's operations,
examine the pressing issues facing the futures and swaps
markets, evaluate how regulations are impacting end-users and
the agricultural community, and determine how to best protect
consumer funds while restoring confidence in our markets. The
reauthorization also allows the Committee to take stock of past
events, such as the passage of the Dodd-Frank Act of 2010, the
ensuing rulemaking process, and the failures of MF Global, and
PFG Best.
It is impossible to discuss the CFTC and the future of the
CFTC without recognizing the impact of these events on the
agency and its response to them. Today, nearly 3 years after
the Dodd-Frank Act was enacted, numerous Main Street businesses
are still waiting to understand how new regulations affect them
and their operations. Our food producers, our manufacturers,
our technology companies, and our public power companies have
all been impacted by new financial regulations.
The agency's process for writing rules has lacked
sequencing and coordination. For example, the agency defined
swap dealer before it defined swap, which does seem to kind of
defy logic. How do you know if you are a dealer if you don't
know what you are dealing? Also, the SEC and the CFTC have
failed to coordinate on cross-border rules. So now we have two
different definitions of U.S. person for trades with foreign
counterparts.
In the wake of missing implementation deadlines, the CFTC
has also issued dozens of last-minute no action letters, which
has only contributed to a greater sense of uncertainty as
businesses try to understand how and when to comply, if ever.
It is telling that the agency has issued more no action letters
than finalized rules. It would be one thing if the CFTC missed
deadlines as the result of a thoughtful rulemaking process that
considers meaningful public comment and the unintended
consequences of its actions, but that isn't the case. Rather,
the agency has been moving in a haphazard way that defies
Congressional intent and could jeopardize the United States
competitiveness in the global marketplace.
Today, we will hear perspectives from the futures and swaps
marketplace, including the two largest derivative exchanges, a
futures commission merchant whose customers are farmers and
ranchers, and industry trade associations who represent
hundreds of companies. We hope to gain a greater understanding
of the challenges they will face.
Moving forward, we will continue our hearings with
perspectives from end-users, futures customers, and of course,
the CFTC.
[The prepared statement of Mr. Lucas follows:]
Prepared Statement of Hon. Frank D. Lucas, a Representative in Congress
from Oklahoma
Good morning.
Thank you all for being here today to discuss the reauthorization
of the Commodity Futures Trading Commission. This is the first hearing
on the issue, and the first in a series of hearings this Committee
plans to hold in advance of writing legislation.
CFTC reauthorization gives the Committee an opportunity to review
the CFTC's operations, examine the pressing issues facing the futures
and swaps markets, evaluate how regulations are impacting end-users and
the agricultural community, and determine how best to protect customer
funds while restoring confidence in our markets.
The reauthorization also allows the Committee to take stock of past
events, such as the passage of the Dodd-Frank Act of 2010, the ensuing
rulemaking process, and the failures of MF Global and PFG Best. It is
impossible to discuss the CFTC and the future of the CFTC without
recognizing the impact of these events on the agency and its response
to them.
Today, nearly 3 years after the Dodd-Frank Act was enacted,
numerous Main Street businesses are still waiting to understand how new
regulations affect them and their operations. Our food producers, our
manufacturers, our technology companies, and our public power companies
have all been impacted by new, financial regulations.
The agency's process for writing rules has lacked sequencing and
coordination. For example, the agency defined swap dealer before it
defined swap, which defies logic. How do you know if you're a dealer if
you don't even know what you're dealing? Also, the SEC and CFTC have
failed to coordinate on cross-border rules, so now we have two
different definitions of ``U.S. person'' for trades with foreign
counterparts.
In the wake of missing implementation deadlines, the CFTC has also
issued dozens of last minute ``no-action'' letters, which has only
contributed to a greater sense of uncertainty as businesses try to
understand how or when to be in compliance--if ever. It is telling that
the agency has issued more ``no-action'' letters than finalized rules.
It would be one thing if the CFTC missed deadlines as the result of
a thoughtful, rulemaking process that considers meaningful public
comment and the unintended consequences of its actions. But, that isn't
the case. Rather, the agency has been moving in a haphazard way that
defies Congressional intent and could jeopardize the United State's
competitiveness in the global marketplace.
Today, we will hear perspectives from the futures and swaps
marketplace, including the two largest derivatives exchanges, a futures
commission merchant whose customers are farmers and ranchers, and
industry trade associations who represent hundreds of companies. We
hope to gain a greater understanding of the challenges they face.
Moving forward, we will continue our hearings with perspectives
from end-users, futures customers, and of course, the CFTC.
The Chairman. With that, the chair recognizes the Ranking
Member for any opening comments he might have.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
Mr. Peterson. Thank you, Mr. Chairman, and with all due
respect, I have to take some issue with the way you
characterized how this is going, looking at the CFTC, and I do
not disagree with you that it certainly could have been a
better process, but the amount of money that has been spent by
these groups to stop these regulations and ball up the works is
phenomenal, if you look into it. It is not only focused on the
CFTC and the SEC, but focused on Congress. It is unreal the
amount of money that has been poured into stopping these
regulations, so it is no wonder that it is 3 years and we don't
have it done. It is amazing we have as much done as we have.
Why they took some of this stuff out of sequence and so
forth I am not sure, but I point out to people that you have
Republicans and Democrats on the CFTC. They haven't agreed, and
it has been a difficult process.
But, at the end of the day they listen to people. A good
example of that is a SEF rule that was completed last week
which I didn't agree with. They watered that down. Initially it
was going to be five--there had to be five calls or contacts
made to try to determine the price. That was reduced to two,
and then, I guess, three after some kind of process like that.
And they allowed for phone brokering as opposed to electronic,
which isn't going to give people that are interested in the
market making as much information. So there is an example that
they listened to all of these lobbyists and all of this
pressure. I don't agree with it, but they went ahead and moved
the process.
So, with that SEF rule out of the way now, they don't have
that much left to do, and from everything I can tell, they are
going to finish this up this summer. So again, my advice would
be that we wait. You know, we are going to have hearings.
Apparently we are going to have hearings at the Subcommittee
level. That is good. But that we wait until these rules get
completed so we know what we are dealing with, and we are not
speculating about what might or might not happen.
And to go along with that, we have the farm bill to deal
with. It is not going to be an easy thing to get that through
the Floor, and then if we get it through conference, then that
is going to take us most of June and July anyway to get the
farm bill done. And I would hope we wouldn't get distracted in
that effort by the reauthorization of the CFTC.
So I would, again, just encourage a little patience here,
and not that I am defending the CFTC and everything that they
have done, but they have had a tough job. And part of the
problem, we created that last night when we did the conference
on the Dodd-Frank bill when they required that the CFTC had to
coordinate with the SEC and when that happened, I knew this was
going to be a problem, and that bogged everything down.
Hopefully they will get this thing resolved this summer and
then we will know where we are at, and see if there is anything
that needs to be changed in the reauthorization that regards
the implementation of this Dodd-Frank rule or not.
So with that, I would yield back.
[The prepared statement of Mr. Peterson follows:]
Prepared Statement of Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Thank you Chairman Lucas.
Oversight of the CFTC and its implementation of Dodd-Frank has been
the subject of numerous Committee hearings over the last few years, and
at each of these hearings I've urged my colleagues to be patient. I'm
maybe beginning to sound like a broken record, but as we begin today's
hearing on CFTC reauthorization, I still think it's important we don't
get ahead of ourselves.
The CFTC is still in the process of implementing the reforms called
for by Dodd-Frank, and I believe we need to give them the necessary
time to get this right. In my discussions with Chairman Gensler, he
seems optimistic that they will be finished with their rule-making
sometime this summer. Again, we would be better served by exercising
caution and waiting until the rules are finalized before moving ahead
with CFTC reauthorization. Once the rules are completed, we will have a
much clearer picture and the opportunity to fix anything that we feel
needs to be fixed.
Additionally, I don't want CFTC reauthorization to distract us from
the Committee's primary task at hand--getting a 5 year farm bill across
the Floor of the House. We passed a good, bipartisan bill last week,
but we know there will be numerous challenges on the Floor. I think
we're going to need all hands on deck to keep the Committee bill
largely intact.
Once that is done, conferencing the House farm bill with the Senate
version will be another challenge. Having been through this in 2008, I
know that trying to pass another major piece of legislation could
inadvertently hurt or hinder our goal of getting a new farm bill
enacted before current law expires. I think we owe it to our farmers,
who have waited far too long, to remain focused on finishing the farm
bill.
Again, I thank the chair and welcome our witnesses.
The Chairman. The gentleman yields back the balance of his
time. The chair requests that other Members submit their
opening statements for the record so that the witnesses may
begin their testimony, and to ensure that there is ample time
for questions.
We call our first panel to the table. I would like to
welcome the witnesses. Mr. Terrence A. Duffy, Executive
Chairman and President, CME Group Incorporated, Chicago
Illinois; Mr. Jeffrey C. Sprecher, Chairman and CEO,
IntercontinentalExchange, Incorporated, Atlanta, Georgia; Mr.
Daniel J. Roth, President and CEO of National Futures
Association, Chicago, Illinois; the Honorable Walter L. Lukken,
President and CEO, Futures Industry Association, Washington,
D.C.; Mr. Stephen O'Connor, Chairman of the International Swaps
and Derivatives Association, Incorporated, New York, New York;
and Mr. William Dunaway, Chief Financial Officer of INTL
FCStone Incorporated, Kansas City, Missouri.
Mr. Duffy, please begin when you are ready, sir.
STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN AND
PRESIDENT, CME GROUP, INC., CHICAGO, IL
Mr. Duffy. Thank you, Mr. Chairman, and first, may I say
that our thoughts and prayers are with you and all the people
in Oklahoma for these tragic events that you are all suffering
through down there. It is--as a father of two young sons, I
just can't even imagine what the people of Oklahoma are going
through, so our thoughts and prayers are with you, sir.
That being said, Mr. Chairman, Ranking Member Peterson,
Members of the Committee, I want to thank you for the
opportunity to offer market perspectives on the future of the
CFTC as the Committee considers agency reauthorization.
Four critical issues to the future of the agency include
agency funding, rulemaking, market structure, and customer
protection. We support appropriate funding for the agency, but
oppose the Administration's proposal to fund any of the $315
million budget with a transaction tax for many reasons, the
main reason being a proposed tax will substantially increase
the cost of market making. For some market makers, this cost
could go up as much as 100 percent. Market making is an
essential source for market liquidity. Imposing this new tax
would increase the cost of business for all customers because
it would reduce liquidity, increase volatility, and impair
efficiency. Hedging cost for farmers, ranchers, and other
commercials will likewise increase and be passed on to the
consumers in the form of higher prices of food and other goods.
Although the Administration calls for an exemption for end-
users and some others by taxing market making liquidity pool,
their costs will go up dramatically due to the lack of
liquidity and efficiency in the market. The Commission's misuse
of Dodd-Frank to expand its role is evident in unnecessary
departure from the principal-based regulatory regime.
Regulated futures markets performed flawlessly throughout
the financial crisis. The Commission's efforts to micromanage
markets and clearinghouses is inefficient, hampers innovation,
and increases costs and budgets. The Commission's
implementation of Dodd-Frank by an uncoordinated and often
inflexible set of rules, resulted in conflicts, confusion, and
over-inclusion. Our industry would have grounded to a
standstill without dozens, as the Chairman has recognized, no
action letters. I have illustrated these concerns in my written
testimony.
We urge the Committee to direct the agency to reexamine its
rulemaking with genuine attention to a cost-benefit criteria
and a commitment to return to a principle-based regulation.
Dodd-Frank makes clear that futures and swaps are different
products and should receive similar, but not identical
regulation. Claims that futurization is leading to unfair
competition or as a means to secure more favorable margin
treatment are simply wrong. A well-run and regulated
clearinghouse, like ours, does not set margin based on the name
or label of a cleared contract. CME sets margins based on the
underlying volatility and liquidity risk of that contract. Many
of our most important futures contracts use 2 day volatility
measures in excess of the CFTC's regulatory floor. Market
participants will continue to use both customizable swaps and
standardized futures. Innovation, competition, and customer
choice among well-regulated markets is not only a positive
development for customers and the public, but it is entirely
consistent with Dodd-Frank's goals, including the goal of
reducing risk through central clearing.
I reported about the rules CME and NFA have implemented to
strengthen the protection of customers' property at FCMs,
timely access to aggregated customer balances at banks, for
example. Facilities have risk-based reviews of the FCMs. The
CFTC has proposed rules that codify our initiatives which we
support, but the proposed rules would also change how the
industry operates in fundamental ways. The industry is studying
their impact, which could be significant on smaller FCMs that
serve the agricultural community. We have urged the CFTC to let
the industry complete its work before moving forward with the
proposal. We believe that Congress could also further enhance
customer protection to amendments to the Bankruptcy Code.
Potential changes would enhance a clearinghouse's ability to
transfer positions of non-defaulting customers or facilitate
individual segregation of customer property.
With respect to the question of insurance, CME, FIA, NFA
and others are sponsoring a database study of insurance
scenarios so policymakers can determine whether insurance for
futures would be viable. The data provided in this study should
inform decisions regarding the costs and benefits of various
insurance approaches.
I want to thank you for the opportunity this morning and
look forward to your questions.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman and
President, CME Group, Inc., Chicago, IL
Good morning, Chairman Lucas, and Ranking Member Peterson. Thank
you for the opportunity to offer market perspectives on the future of
the CFTC as the Committee considers reauthorization of the Agency. I am
Terry Duffy, Executive Chairman and President of CME Group.\1\ Four
critical issues to the future of the Agency include Agency funding,
rulemaking, market structure and customer protection.
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\1\ CME Group Inc. is the holding company for four exchanges, CME,
the Board of Trade of the City of Chicago Inc. (``CBOT''), the New York
Mercantile Exchange, Inc. (``NYMEX''), and the Commodity Exchange, Inc.
(``COMEX'') (collectively, the ``CME Group Exchanges''). The CME Group
Exchanges offer a wide range of benchmark products across all major
asset classes, including derivatives based on interest rates, equity
indexes, foreign exchange, energy, metals, agricultural commodities,
and alternative investment products. The CME Group Exchanges serve the
hedging, risk management, and trading needs of our global customer base
by facilitating transactions through the CME Group Globex electronic
trading platform, our open outcry trading facilities in New York and
Chicago, and through privately negotiated transactions subject to
exchange rules.
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Agency Funding
We support adequate funding for the CFTC, but oppose the
Administration's proposal to fund the entire amount with a ``user
fee,'' which is just another name for a transaction tax. The
Administration's FY 2014 Budget proposes to increase the CFTC's budget
by $109 million to $315 million and to fund the entire amount with a
``user fee'' levied on futures and derivatives trades. Such a ``user
fee'' will impose a $315 million per year transaction tax on market
making. For some market makers, this tax could represent a 100% cost
increase. Market-making is an essential source of market liquidity.
Imposing this new tax would increase the cost of business for all
customers because it would reduce liquidity, increase volatility, and
impair the efficient use of U.S. futures markets. It will make it more
difficult and expensive for farmers, ranchers, and other end-users to
hedge commodity price risk in the market. This will force farmers and
other market participants to pass along these higher costs to consumers
in the form of higher food prices.
Moreover, the tax will change the competitive balance in favor of
foreign and OTC markets with lower transaction costs where, in an
electronic trading environment, market users can and will shift their
business; lessen the value of the information provided to farmers and
the financial services industry by means of the price discovery that
takes place in liquid, transparent futures markets with low transaction
costs; increase the cost to the government resulting from less liquid
government securities markets; and fail to actually collect the funds
anticipated when market participants choose lower cost alternative
jurisdictions and markets.
For all of these reasons, Congress should reject a transaction tax
to fund the CFTC.
Rulemaking
We have been strong advocates for the primary driver behind the
Dodd-Frank Act: bringing transparency and clearing to the opaque over-
the-counter swaps market. However, the Commission has misused the DFA
to expand its role, as primarily evidenced by its unnecessary departure
from the principles-based regulatory regime which has operated so
successfully. Regulated futures markets performed flawlessly throughout
the financial crisis. The Commission's efforts to impose unnecessary
new regulations on futures markets and clearing houses are inefficient,
hamper innovation, and ultimately increase consumers' costs.
Consequently, the use of regulated markets and clearing as risk
management tools is becoming less appealing to market participants--
increasing overall risk in complete contravention of the intention of
DFA
The Commission implemented DFA with an uncoordinated and often
inflexible set of rules resulting in conflicting rules, confusion and
over inclusion. Our industry would have ground to a standstill without
the issuance of dozens of no-action letters, most of which were issued
as deadlines approached. A look at some rulemakings affecting the U.S.
energy markets in recent months illustrates these problems.\2\
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\2\ I highlighted similar problems in my testimony before the
Committee on February 10, 2011, and its Subcommittee on General Farm
Commodities and Risk Management on April 13, 2011, respectively.
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The CFTC finalized its product definition rulemaking in the summer
of 2012, with an effective date of October 12, 2012. This effective
date triggered compliance obligations relating to products defined as
``swaps'' under many different rulemakings previously finalized by the
CFTC. However, because the CFTC had not yet completed critical
rulemakings that would clarify whether certain types of contracts used
in the energy markets were ``swaps.'', market participants,
understandably, were unclear as to their responsibilities. Ultimately,
and at the last minute before the compliance deadline, the CFTC issued
an order delaying the implementation of these compliance obligations to
allow the swaps and futures markets to continue operating without
disruption until year end.
A few months later, lack of clarity in the swap reporting
rulemaking again led to confusion in the energy markets. When the swap
data reporting obligations became effective, it was not clear to market
participants whether they were required to provide historical trade
data relating to certain energy contracts that have been listed and
regulated as futures for over a decade. Notwithstanding the fact that
this same trade data was already being reported to the CFTC under the
existing futures rules, it was not clear, and remains unclear, whether
this data was also subject to swap data reporting requirements. CME
Group has submitted to the CFTC two requests for guidance, consistent
with the CFTC's explicit indication in their proposed rulemaking that
they would provide such guidance.\3\ To date, energy market
participants still have not received clarity from the CFTC regarding
their record-keeping or reporting obligations under the new swap rules,
which for many of them will go into effect on May 29.
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\3\ In the rule proposal relating to historical data reporting
requirements, the Commission stated that it ``expects to provide
interpretive guidance concerning the determination of the reporting
counterparty in situations where a historical swap was executed and
submitted for clearing via a platform on which the counterparties to
the swap do not know each other's identity.'' 77 Fed. Reg. 35200,
35211, n. 43 (June 12, 2012).
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We ask the Committee to direct the Agency to re-examine its DFA
rulemaking with genuine attention to a cost-benefit criteria and
commitment to return to principles-based regulation.
Market Structure
As previously indicated, one of the fundamental purposes of the DFA
was to respond to the financial crisis by bringing regulatory oversight
to the previously unregulated and opaque swaps market. The DFA
accomplished this through two primary changes to the swaps market: (1)
centralized clearing, to reduce systemic risk; and (2) reporting and
trading on regulated platforms, to provide transparency. These policies
mirror, in many ways, the regulatory structure under which the U.S.
futures markets have operated for many decades.
The DFA makes clear that futures and swaps are different product
classes and should receive similar, but not identical, regulation.
Claims that ``Futurization'' is an improper effort to secure more
favorable margin treatment or other regulatory benefits are misplaced.
Margin requirements permit the clearing house that is clearing a
contract to mitigate the risk attendant to that specific contract. CFTC
rules set a floor for the amount of initial margin that clearinghouses
must collect. At a well-run and regulated clearing house, like ours,
margin is determined by risk management policies and procedures
designed to account for the actual risk profile of the product--its
underlying volatility and liquidation risk of the contract--not its
label as a swap or a future. In fact, many of our futures products
require initial margin based on a 2 day volatility measure in excess of
the CFTC's regulatory floor.
The example provided by the Lehman bankruptcy is informative. From
the time CME decided to liquidate Lehman's futures house positions
cleared by CME to complete liquidation, 6 hours elapsed. This was a
complex portfolio, across all of CME major product categories, with a
margin required on the portfolio approaching $2 billion. We used a
variety of market participants to liquidate, and did so within margin
cover. In contrast, Lehman's cleared swaps portfolio--which consisted
of ``vanilla'' swaps--was so complex that it took the clearinghouse
that liquidated them over 3 weeks to fully liquidate the portfolio.
This example illustrates that whether a swap and a future share an
economic profile is not the determinative factor to a clearing house in
setting margins. The determinative factor is the overall risk profile
of the product. And the liquidity and transparency afforded by that
product's market infrastructure is a critical element of the product's
risk profile.
It is consistent with the risk mitigation objectives of DFA to
ensure that margin requirements be tailored to address the risk
characteristics of different contracts. Market participants will
continue to use both customizable swaps and standardized futures
products. Innovation, competition and customer choice among well-
regulated markets is not only a positive development for customers and
the public as a whole, but is entirely consistent with the goals of
DFA.
Customer Protection
Industry Safeguards
I have previously testified about the rules CME Group, together
with the National Futures Association (``NFA'') and other U.S. futures
exchanges have implemented to strengthen the protection of customer
property (and its investment) at the FCM through strict and regular
reporting and on-line access to customers' balances at banks and other
depositories. They improve our work to mitigate the risk of and early
detection of the improper transfer of customer funds and the improper
reporting of customer asset balances, and to check compliance with CFTC
requirements for the investment of customer funds. Our efforts to
enhance our monitoring continue today through the use of an account
balance aggregation tool. Timely, including daily, access to this
additional information is enabling us to better direct our regulatory
resources at risk-based reviews of customer balances at clearing
members and FCMs and their activity with respect to those balances.
Moreover, the CFTC has recently proposed additional rules on
customer protection that include provisions codifying these
initiatives, which we strongly support. However, this rulemaking also
seeks to fundamentally change the way in which the futures marketplace
operates. As we explained in our comment letter, if a proposed
``protective'' measure is so expensive or its impact on market
structure is so severe that customers cannot effectively use futures
markets to mitigate risk or discover prices, the reason to implement
that measure needs to be re-examined. Among the proposed rules to
reevaluate is the rule that would require at all times an FCM's
residual interest (its own funds) in segregated accounts to exceed the
margin deficiencies of its customers. It does not appear that any
system currently exists or could be construed in the near future the
will permit FCMs to accurately calculate customer margin deficiencies,
continuously in real-time. Without access to this data, FCMs will be
required to maintain substantial residual interest in segregated
accounts or require customers to significantly over-collateralize their
accounts. We believe this will be a significant and unnecessary drain
on liquidity that will make trading significantly more expensive for
customers to hedge. We believe this rule and others could have a very
significant impact on certain sectors in the marketplace, particularly
smaller FCMs that serve the agricultural community. The industry is
conducting an impact analysis of these rules. We have urged the CFTC to
allow the industry to complete this impact analysis before proceeding
further with the rulemaking process.
Further, CME Group believes that proposed changes to Rule 1.52
threaten the viability of the current regulatory structure. This rule
governs the manner in which self-regulatory organizations (``SROs''),
such as CME and NFA, conduct their risk-based reviews of FCMs. Among
other things, the proposed rule improperly conflates the roles played
by an FCM's outside auditor and its regulatory examiners (designated
SROs or DSROs), in essence requiring SROs and DSROs to replicate the
role of an external auditor. SROs and DSROs are not staffed to play
such a role, nor should they be. One of the primary strengths of the
current regulatory scheme is that SROs and DSROs play a role distinct
from, yet complimentary to, that played by an outside auditor. Rather
than simply replicating the work performed by outside auditors, the
SROs and DSROs perform limited reviews that focus on particular areas
of regulatory concern, including the segregation of customer funds and
net capital requirements. This proposal would serve little regulatory
purpose while imposing significant costs.
Bankruptcy Code Improvements
We believe that Congress could further enhance customer protections
through amendments to the Bankruptcy Code. Potential amendments range
from fundamental changes that would facilitate individual segregation
of customer property to narrower revisions that would enhance a
clearinghouse's ability to promptly transfer positions of non-
defaulting customers. While amending the Bankruptcy Code is a
significant undertaking, CME Group believes that modification to the
bankruptcy regime in light of recent experience would benefit customers
and the market as a whole.
Insurance for Futures Study
In the wake of MF Global and Peregrine Financial, some have
advocated establishing an insurance scheme to protect futures
customers. Any such proposal must be analyzed in light of the costs and
potentially limited efficacy of such an approach due the
extraordinarily large amount of funds held in U.S. segregation.
The futures industry, led by the Futures Industry Association,\4\
is researching various insurance mechanisms in order to provide a
quantitative, data-based analysis that will enable policymakers and
market participants to determine whether insurance for futures would be
viable.
---------------------------------------------------------------------------
\4\ CME Group, the Institute for Financial Markets (``IFM'') and
the NFA are also sponsors of the study.
---------------------------------------------------------------------------
Conclusion
As Congress considers reauthorization of the CFTC, we urge the
Committee to continue its strong oversight of the CFTC to ensure that
rulemaking is efficient and consistent with the DFA; regulation
enhances the safety and soundness of futures and derivatives markets by
a principles-based regulatory regime; and the U.S. competitive stance
in the global financial marketplace is preserved. We look forward to
working with the Committee during this process.
The Chairman. Thank you, Mr. Duffy.
Mr. Sprecher, you may begin when you are ready, sir.
STATEMENT OF JEFFREY C. SPRECHER, FOUNDER,
CHAIRMAN, AND CEO, IntercontinentalExchange, INC.,
ATLANTA, GA
Mr. Sprecher. Thank you, Chairman Lucas, Ranking Member
Peterson, and Committee Members, including my colleagues from
Georgia. I am Jeff Sprecher. I am Chairman and Chief Executive
Officer of ICE, and I am grateful for the opportunity to
comment on the Commodity Exchange Act as this Committee
undertakes its reauthorization.
ICE is a leading operator of regulated global marketplaces
for futures and OTC derivatives. On December 20 of last year,
ICE announced its transaction to acquire NYSE Euronext, which
will further expand our reach across commodities and equities
markets.
My testimony today focuses on some of the issues that we
see in operating these diverse markets.
In 2009 in response to the global financial crisis, the G20
Nations met in Pittsburgh to agree on reforming the world's
financial markets. This agreement led Congress to passing the
Dodd-Frank Act. Today, the CFTC has passed the majority of
applicable rules under Dodd-Frank, and ICE's U.S. businesses
have largely implemented these new rules. We continue to
support market participants who are doing the same thing.
We are now turning towards rulemakings and implementation
in Europe and in Asia, as they finalize their financial reform
laws. As we look at the various regimes and work with global
regulators, we have concluded that contrary to the G20 goals,
global financial reform efforts are not being harmonized and
substantial differences remain between regulatory regimes. If
regulators fail to harmonize, the effects of uncertainty and
the prospect for regulatory arbitrage will be damaging.
The derivatives markets are international, and a majority
of companies that operate globally use derivatives to manage
price risk and they conduct these transactions with both U.S.
and non-U.S. counterparties. The likely outcome will be that
regulators deem other country's financial regulatory systems as
being non-equivalent, which would lead to those countries
erecting barriers to financial markets. It is crucial to
understand that if countries erect barriers, markets and market
participants will be damaged. Currently in the U.S.,
commodities markets are the home to global benchmark contracts
because Asian and European market participants have direct
access to our markets. Over the past year, ICE has been
delivering this message to domestic and international
regulators, yet regulations continue to diverge, particularly
between the U.S. and Europe. We ask the Committee in its
oversight role to impress upon the Commodity Futures Trading
Commission the importance of working with European and Asian
counterparts to harmonize their regulation and avoid creating
unintended, unpredictable impacts on our markets and our users.
Note the time for this agreement is closing, because in
June, Europe will begin the process of deeming the U.S.
equivalent or non-equivalent under its regulations, so these
issues must be solved in the next few months.
In passing the original Commodity Exchange Act, Congress
wisely added a sunshine provision to the law to make sure that
the CEA has kept pace with rapidly evolving commodities
markets. Importantly, this CEA reauthorization marks the third
anniversary of the passage of the Dodd-Frank Act. When Dodd-
Frank was passed, the financial markets were very different
than today. In reviewing the CEA, ICE believes that the
Commission should focus on two key areas.
First, given the recent FCM bankruptcies, the Committee
should focus on modifications to the bankruptcies provisions of
the CEA to ensure that customer funds are protected in future
bankruptcies. ICE has been working with other exchanges and
market participants on this issue and we look forward to
working with you and your staffs to advance this objective.
Second, the market would benefit from a clarification of
Dodd-Frank rules on position limits. Of particular concern is
Dodd-Frank's definition and limitation on bona fide hedging,
which is the exemption that is used by end-users. The narrowing
of a definition of bona fide hedging will likely hurt
commercial end-users that markets are here to serve. The
support for the bona fide hedge exemption methodology that has
been relied upon historically would bring greater certainty to
our end-users.
ICE appreciates the opportunity to work with Congress and
global regulators to address evolving derivatives markets, and
Mr. Chairman, thank you for the opportunity to share our views
with you. I will be happy to answer your questions as they may
arise.
[The prepared statement of Mr. Sprecher follows:]
Prepared Statement of Jeffrey C. Sprecher, Founder, Chairman, and CEO,
IntercontinentalExchange, Inc., Atlanta, GA
Chairman Lucas, Ranking Member Peterson, I am Jeffrey C. Sprecher,
Chairman and Chief Executive Officer of IntercontinentalExchange, Inc.,
or ICE. I am grateful for the opportunity to comment on the Commodity
Exchange Act (CEA) as this Committee undertakes reauthorization.
As background, ICE was established in 2000 as an over-the-counter
(OTC) marketplace with the goal of bringing needed transparency and a
level playing field for the opaque, fragmented energy market that
existed at the time. Since then, ICE has met that objective and
expanded its markets through organic growth as a result of innovation.
We have acquired futures exchanges and brought competition, new
products, technology, and risk management services to a centuries-old
business. Today ICE is a leading operator of regulated, global
marketplace for futures and OTC derivatives across agricultural and
energy commodities, foreign exchange, credit derivatives and equity
indexes. Commercial market participants ranging from producers to end-
users rely on our liquid, transparent markets to hedge and manage risk.
On December 20th of last year, ICE announced its transaction to
acquire NYSE Euronext. As a result of this transaction, which we expect
to close this year, ICE's range of products and our global reach will
expand even further, adding to our operations in Europe, Asia, North
America and South America across the derivatives and equities markets.
ICE's businesses are regulated by multiple regulators in multiple
jurisdictions, including the United State's Commodities Futures Trading
Commission and the Securities and Exchange Commission, among others. My
testimony today focuses on some of the issues we see in operating in
such diverse markets.
International Harmonization
In 2009, in response to a global financial crisis, the G20 nations
met in Pittsburgh to agree on reforming the global financial markets.
This agreement led to Congress passing the Dodd-Frank Wall Street
Reform and Consumer Protection Act (Dodd-Frank Act), which was passed
that same year and has been in the implementation process over the past
3 years. Appropriate regulation of derivatives is of utmost importance
to the proper functioning of the financial system. ICE believes that
increased transparency, risk management and capital sufficiency,
coupled with legal and regulatory certainty, are central to reform and
to restoring confidence to these vital markets.
Today, given that the CFTC has passed the majority of the
applicable rules under Dodd-Frank, ICE's U.S. businesses have largely
implemented the new rules, and continue to support market participants
in doing the same. We are now turning toward rule-makings and
implementation in Europe and Asia as they finalize their financial
reform laws. As we look at the various regimes and work with global
regulators, we have concluded that, contrary to the G20 goals, global
financial reform efforts are not being harmonized and substantial
differences remain between regulatory regimes.
If regulators fail to harmonize, the effects of uncertainty and the
prospect for regulatory arbitrage will be damaging. Because markets are
global and capital flows across borders, no single country or
regulatory regime oversees the derivatives market. In order to make
long-term business decisions, market participants require certainty
that their transactions will not be judged on conflicting standards.
The derivatives markets are international: the majority of companies
that operate globally use derivatives to manage price risks, and they
conduct these transactions with both U.S. and non-U.S. counterparties.
The likely outcome will be that regulators deem other countries'
financial regulatory systems as ``nonequivalent'', which would lead to
those countries erecting barriers to its financial markets. It is
crucial to understand that if countries erect these barriers, WE
markets and market participants will be damaged. Currently, the U.S.
derivatives markets are home to vital global benchmark contracts in
agriculture, energy, financial asset classes. These have become
benchmark contracts because Asian and European market participants have
direct access to U.S. markets. Importantly, the long-standing global
nature of the derivatives markets and the resulting international
competition has lead to advances in transparency, risk management, and
historically, regulatory cooperation.
Over the past year, ICE has been delivering this message to
domestic and international regulators, yet regulations continue to
diverge, particularly in the U.S. and Europe. We ask the Committee, in
its oversight role, to impress upon the Commodity Futures Trading
Commission the importance of working with European and Asian
counterparts to harmonize regulation and avoid creating unintended,
unpredictable impacts on financial markets and their users. The time
for agreement is closing. In June, Europe will begin the process of
deeming the U.S. equivalent or nonequivalent under its regulations.
These issues must be solved in the next few months.
Commodity Exchange Act Reauthorization
In passing the original Commodity Exchange Act, Congress wisely
added a sunshine provision to the law. Every few years, Congress re-
examines the CEA to make sure that the law has kept pace with the
rapidly evolving derivatives markets. Importantly, this CEA
reauthorization marks the third anniversary of the passage of the Dodd-
Frank Act. When Dodd-Frank was passed, the derivatives markets were
very different than today. Over the past 3 years, these markets have
become more standardized, transparent, and key derivative contracts are
now subject to mandatory clearing. Last week, the CFTC finalized rules
to that will lead to mandatory trading on regulated Swap Execution
Facilities. Last year, ICE itself transitioned its OTC energy contracts
to regulated futures contracts.
Given these sweeping changes, CEA reauthorization is a key
opportunity for Congress to review the law, as well as the oversight of
the CFTC, to ensure that the law and the Commission are in step with
today's derivatives markets. In reviewing the CEA, ICE believes that
the Commission should focus on two key areas. First, given the recent
Futures Commission Merchant (FCM) bankruptcies, a focus on
modifications to the bankruptcy provisions of the CEA to ensure that
customer funds are protected in future FCM bankruptcies. ICE has been
working with other exchanges and market participants on this issue and
we look forward to working with you and your staff to advance this
objective.
Second, the market would benefit from a clarification of Dodd-Frank
rules on position limits. As the U.S. District Court for the District
of Columbia stated last year, the position limit rules in Dodd-Frank
are contradictory. If position limits are applied incorrectly, markets
could be constrained in serving a price discovery function. Of
particular concern, is the Dodd-Frank Act's limitation of a bona fide
hedge, which is the exemption used by end-users. The narrow definition
of bona fide hedge will likely hurt commercial end-users that these
markets are intended to serve, and thus support the bona fide hedge
exemption relied upon historically would bring greater certainty to
end-users in executing their risk management operations.
Conclusion
ICE has always been and continues to be a strong proponent of open,
regulated and competitive markets, and appreciates the opportunity to
work with Congress and global regulators to address the evolving
derivatives markets. We will continue to engage you and your staff on
the wide variety of CEA-related issues under the Committee's
jurisdiction.
Mr. Chairman, thank you for the opportunity to share our views with
you. I would be happy to answer any questions you may have.
Mr. Conaway [presiding.] Thank you, Mr. Sprecher.
Mr. Roth for 5 minutes.
STATEMENT OF DANIEL J. ROTH, PRESIDENT AND CHIEF
EXECUTIVE OFFICER, NATIONAL FUTURES ASSOCIATION, CHICAGO, IL
Mr. Roth. Thank you, Mr. Chairman. My name is Dan Roth and
I am the President of National Futures Association.
As we begin this reauthorization process, we at NFA, like
all of you, are very focused on customer protection issues. The
fact is that for a very long time, the futures industry had an
impeccable reputation, and I might add, a well-deserved
reputation, for safeguarding the integrity of customer funds.
But in the last 2 years, we had first MF Global and then
Peregrine, and in both of those instances, customers suffered
real losses, hard losses, losses that regulators like me are
supposed to prevent.
Clearly, we had to make some dramatic improvements and I
wanted to let you know that at NFA, we have been working very
closely with the CFTC, with the CME, and other self-regulatory
organizations to bring about those changes, and I have
highlighted a number of those changes in my written testimony,
but in the limited amount of time we have here, if I could
focus on just one area, I would like to talk a little bit about
something Mr. Duffy mentioned, and that is the daily
confirmation process for segregated funds.
At NFA, we have always required FCMs to file daily reports
with us showing the amount of customer funds that they are
holding. We monitor those reports. We look at them. We are
trying to monitor not only compliance with the rules, but also
looking for trends or dramatic changes that might be troubling.
In 2012--I should mention, the confirmation process was--we
would confirm those balances that we got on the daily reports
as part of the annual examination process, and we did that
confirmation through the traditional methodology. We would send
a written confirmation request to the bank, and then the bank
would mail a written response to NFA.
In 2012, we started using an electronic confirmation
process, an e-confirmation process, and that is essentially
what uncovered the fraud at Peregrine. But even then with the
e-confirmation process, that was still being done only as part
of the annual examination, and we knew we had to do better, and
so we have done better. We have partnered with the CME and
together, we have developed and implemented a system that
requires the daily confirmation of all seg bank balances. We
still have FCMs that file reports daily with the CME and with
NFA showing the amount of customer funds that they are holding,
but now we get daily confirmation from the banks regarding
those same accounts. We are talking about over 2,300 bank
accounts which are being confirmed on a daily basis by NFA and
the CME. We then do an automated comparison between what the
FCM is saying and what the bank is showing so that we can
identify any suspicious deviations.
We are expanding that system further. We are expanding it
to cover not just banks, but other depositories holding
customer's segregated funds, such as clearinghouses and other
clearing FCMs, and that expansion should be done by the end of
the third quarter.
Mr. Chairman, I wanted to spend some time on it, because it
is a really big deal. This is a huge improvement. This is a
giant step in the way we monitor for seg compliance, and we are
a better industry because of it.
The one other topic I wanted to discuss orally has to do
with, again, a topic Mr. Duffy touched on, which is the
customer account insurance. In the wake of MF Global and
Peregrine, there have been calls for customer account insurance
in the futures industry. Some people think we need some form of
insurance to bolster public confidence. Well obviously, public
confidence is a very important ingredient. It is essential to
having the sort of liquid markets that make efficient markets,
and we recognize that. Others, though, are concerned that the
cost of the insurance would be so exorbitant that you would
actually drain liquidity out of the markets and you would be
doing more harm than good. I understand those concerns, too. In
our view at NFA, we felt this issue was too important to be
decided based on a hunch, that we needed real information and
real data, and so we, as Terry has said, we have partnered with
the CME and FIA and the Institute for Financial Markets. We
have commissioned a consultant with deep expertise in the
insurance industry and in the futures industry. He is analyzing
several different insurance scenarios, and we have been
providing him with very detailed, granular information about
the account populations at 11 different FCMs, ranging in size
from small to medium to large, and armed with that information,
he can then go out and actually get prices from people in the
insurance and reinsurance industry so that this Committee can
ultimately have real information and make a more informed
choice as to whether account insurance would work for this
industry or whether it would do more harm than good.
As this process goes forward, Mr. Chairman, we certainly
look forward to working with Congress and the Commission and
others, and try to continue the improvements that we are making
in the regulatory structure here for the futures industry, and
I would be happy to answer any questions.
Thank you.
[The prepared statement of Mr. Roth follows:]
Prepared Statement of Daniel J. Roth, President and Chief Executive
Officer, National Futures Association, Chicago, IL
Thank you, Mr. Chairman. My name is Daniel Roth and I am the
President of National Futures Association. As Congress begins the
reauthorization process, customer protection issues should be front and
center in everybody's mind. Customer protection is the heart and soul
of what we do at NFA, and for years the futures industry had an
impeccable reputation for safeguarding customer funds. Since Congress
last considered reauthorization, though, that reputation has taken a
serious hit. First at MF Global and then at PFG, customers suffered
very real harm from shortfalls in customer segregated funds, the kind
of harm that all regulators seek to prevent. Clearly, dramatic
improvements had to be made. In the wake of MF Global and PFG, NFA has
worked very closely with the CME, other self-regulatory organizations
and the CFTC to bring about those improvements. Let me start by
highlighting the steps we have already taken.
Daily Confirmation of Segregated Account Balances
For years NFA and other SROs confirmed FCM reports regarding the
customer segregated funds held by the FCM through traditional paper
confirmations mailed to the banks holding those funds. These
confirmations were done as part of the annual examination process. In
early 2012 NFA began confirming bank balances electronically through an
e-confirm process. That change led to the discovery of the fraud at
PFG, but e-confirms were still done as part of the annual examination.
We had to find a better way and we did.
We partnered with the CME and developed a process by which NFA and
the CME confirm all balances in all customer segregated bank accounts
on a daily basis. FCMs file daily reports with NFA and the CME,
reflecting the amount of customer funds the FCM is holding. Through a
third party vendor, NFA and CME get daily reports from banks for the
over 2,000 customer segregated bank accounts maintained by FCMs. We
then perform an automated comparison of the reports from the FCMs and
the reports from the banks to identify any suspicious discrepancies. In
short, Mr. Chairman, the process by which we monitor FCMs for
segregated fund compliance is now far ahead of where it was just 1 year
ago.
We are working with the CME to expand this system to also obtain
daily confirmations from other types of depositories, such as clearing
firms and clearinghouses. That expansion should be complete by the
fourth quarter of this year.
Customer Account Insurance
In light of the failures of MF Global and PFG there have been
renewed calls for some form of customer account insurance. As we begin
this discussion, we should bear in mind three points. First, customer
account insurance can take many forms. There are alternatives to the
SIPC, government sponsored model. Private insurance solutions can take
several forms in terms of who is covered and to what extent. Second,
public confidence in the markets is critical, but it is a means to an
end. The real goal is to ensure that futures markets are effective and
efficient and a benefit to the economy. Markets must therefore be
liquid and that requires public confidence. However, attempting to
bolster public confidence through insurance programs that prove to be
cost prohibitive is self-defeating and would damage the liquidity we
are trying to foster. Finally, this question is too important to be
dismissed out of hand because various forms of insurance might be too
expensive.
We need data, not hunches. We need to know what kind of insurance
we would be buying and what we would be paying for it. Only then can
Congress make an informed decision. With this in mind, NFA has joined
with the CME, FIA and the Institute for Financial Markets to commission
a detailed analysis of various alternative approaches to customer
account insurance. Armed with detailed customer account information
from small, medium and large FCMs, the study will calculate the
estimated costs of each of the alternatives studied. We hope to have
the results of the study in June.
FCM Transparency
One of the lessons we learned from MF Global is that customers
should not have to study the footnotes to an FCM financial statement to
find out how their segregated funds are invested or other financial
information about their FCMs. We had to make it easier for customers to
do their due diligence on financial information regarding FCMs. We now
require all FCMs to file certain basic financial information with NFA,
and that information is then posted on NFA's website for customer
review. The information includes data on the FCM's capital requirement,
excess capital, segregated funds requirement, excess segregated funds
and how the firm invests customer segregated funds. This information is
displayed for each FCM and includes historical information in addition
to the most current data. The display of FCM financial information on
NFA's website began in November 2012 and so far these web pages have
received over 15,000 hits.
MF Global Rule
All FCMs maintain excess segregated funds. These are funds
deposited by the FCM into customer segregated accounts to act as a
buffer in the event of customer defaults. Because these funds belong to
the FCM, the FCM is free to withdraw the excess funds, but after MF
Global, NFA and the CME adopted rules to ensure notice to regulators
and accountability within the firm. Now all FCMs must provide
regulators with immediate notification if they draw down their excess
segregated funds by 25% in any given day. Such withdrawals must be
approved by the CEO, CFO or a financial principal of the firm and the
principal must certify that the firm remains in compliance with
segregation requirements. This rule became effective on September 1,
2012.
FCM Internal Controls
NFA, CME and other SROs developed more specific and stringent
standards for the internal controls that FCMs must follow to monitor
their own compliance with regulatory requirements. NFA has drafted an
interpretive notice that contains specific guidance and identifies the
required standards in areas such as separation of duties; procedures
for complying with customer segregated funds requirements; establishing
appropriate risk management and trading practices; restrictions on
access to communication and information systems; and monitoring for
capital compliance. NFA will submit the interpretive notice to the CFTC
shortly for its review and approval.
Review of NFA Examination Procedures
NFA's Special Committee for the Protection of Customer Funds--
consisting of all public directors--commissioned an independent review
of NFA's examination procedures in light of the PFG fraud. The study
was conducted by a team from the Berkeley Research Group (``BRG'') that
included former SEC personnel who conducted that regulator's review of
the SEC's practices after the Madoff fraud. BRG's report was completed
in January 2013. The report stated that ``NFA's audits were conducted
in a competent manner and the auditors dutifully implemented the
appropriate modules that were required.'' The report, however, also
included a number of recommendations designed to improve the operations
of NFA's regulatory examinations in the areas of hiring, training,
supervision, examination process, risk management, and continuing
education. NFA has already taken a number of steps to implement BRG's
recommendations. A Special Committee appointed by NFA's Board will
oversee the timely implementation of these recommendations.
Both the PFG and MF Global bankruptcies highlighted the need for
greater customer protections to not only guard against the loss of
customer funds but also in the event of an FCM's insolvency. As
discussed above, NFA has made and continues to implement changes to
enhance the safety of customer segregated funds and guard against a
shortfall in customer funds in the event of any future FCM failures.
NFA believes, however, that Congress should consider a number of
possible changes to Bankruptcy Code provisions that govern an FCM's
liquidation that would likely strengthen customer protections and
priorities in the event of a future FCM bankruptcy. We fully recognize
that any changes to the Bankruptcy Code regarding FCM insolvency
protections will not be easy to achieve. Yet we strongly believe that
the two recent FCM failures have highlighted the need for enhanced
customer protections that can only be achieved via changes to the
Bankruptcy Code.
We are in discussions with all facets of the industry to arrive at
a consensus view on changes that should be made. Chief among NFA's
concerns in this area is removing the uncertainty over the validity of
the CFTC's definition of customer property. Other issues may include
reviewing whether it is appropriate that all joint FCM/broker-dealer
bankruptcies be administered under SIPA.
Detecting and combating fraud is central to our mission. No system
of regulation can ever completely eliminate fraud, but we must always
strive for that goal. The process of refining and improving regulatory
protections is ongoing and the initiatives outlined above do not mark
the end of our efforts. We look forward to working with Congress, the
CFTC, SROs and the industry to ensure that customers have justified
confidence in the integrity of the U.S. futures markets.
Mr. Conaway. Thank you, Mr. Roth.
Mr. Lukken for 5 minutes.
STATEMENT OF HON. WALTER L. LUKKEN, PRESIDENT AND CHIEF
EXECUTIVE OFFICER, FUTURES INDUSTRY
ASSOCIATION, WASHINGTON, D.C.
Mr. Lukken. Thank you, Mr. Chairman, Ranking Member
Peterson, and other Members of the Committee. I appreciate the
opportunity to testify today. My name is Walt Lukken. I am the
President and CEO of the Futures Industry Association. FIA is
the leading trade association for the futures, options, and
over-the-counter cleared derivatives markets. FIA's mission
since its inception has been ``to protect the public interest
through adherence to high standards of professional conduct and
financial integrity.''
As you know, clearing is an integral part of the futures
market structure. Clearing ensures that parties to a
transaction are protected from a failure by a counterparty to
perform its obligations. The FCMs that FIA represents play a
critical role in guaranteeing the transactions and ensuring
they are secured with appropriate customer margin to facilitate
the clearing process.
As you know, the failures of MF Global and Peregrine
Financial Group resulted in severe and unacceptable
consequences for futures customers and the markets generally.
The entire industry has been working collaboratively to
identify and improve procedures required to better protect the
integrity of the markets, and much has been accomplished over
the last year. FIA formed a customer protection task force in
the aftermath of these insolvencies and recommended a number of
changes that have been adopted by the regulators. Some of the
highlights include the enhancement of FCM record-keeping,
reporting, and early warning indicators, including the filing
of daily segregation balances with regulators, creating of an
automated daily verification, as Mr. Roth has mentioned, for
customer segregation balances directly with banks, and other
depository institutions, the collection and posting of
additional FCM financial information to NFA's online system,
Basic, to help customers monitor and assess the health of their
FCM, just to name a few.
The Committee may also be interested to know that, as
mentioned before, that FIA and CME, the IFM, and NFA have
joined together to fund a study of the costs and benefits of
various insurance proposals, and we look forward to sharing the
findings of this with the Committee when they are available
early this summer.
In addition to the efforts undertaken by the industry, the
CFTC has recently proposed a set of comprehensive regulations
to further enhance customer protection, and we support much of
what have been suggested in this rulemaking, including the
codification of many of FIA's recommendations. However, the
proposed change related to residual interest drastically
reinterprets the longstanding application of the statute
regarding customer margin collections, and will make trading
significantly more expensive for customers hedging their
commercial risks. Specifically, this reinterpretation would
require FCMs in collecting customer margin to assume all
customer margin call deficits are simultaneously not collected,
requiring either customers to prepay their margin or firms to
fund customer margins on their behalf. When the proposal was
released by the Commission, the Commission did not conduct a
cost-benefit analysis because it did not have adequate
information to determine the costs of this reinterpretation. As
such, FIA engaged in its own cost analysis, estimating that
this change would require an additional $100 billion in
customer margin. Many agricultural customers have expressed
strong concerns with this proposal, which will increase the
cost of hedging, cause consolidation among small FCMs, and
limit execution choices for customers. We believe this part of
the CFTC rule warrants further review before changing the
existing interpretation.
Moving to swap clearing, Congress looked to the reliability
and stability of the clearing system for futures when it
determined to extend clearing for swaps under the Dodd-Frank
Act. To date, much of the debate surrounding the implementation
of the swap clearing requirement under Dodd-Frank has been
focused on what products and entities might be subject to the
mandatory clearing requirement, rather than how the operations
and mechanics of clearing would work for swaps. Unfortunately,
the reality is that the rules being written to facilitate the
clearing for swaps are reinventing the already proven clearing
process that is familiar and well-tested for futures, thereby
creating an overly complicated web of regulations for both
swaps and futures. Even those entities in the existing futures
clearing environment are being forced to seek temporary relief
from the new regulation while they sort through compliance
issues. Without such relief, market participants face the
reality of either shutting down existing commercial activity,
or inadvertently being out of compliance as they seek to
implement ambiguous, confusing, or misaligned regulations.
Also of concern is the manner in which the needed relief is
being granted. Relief is either commonly provided at the very
last minute, causing disruption for customers in both the
futures and the swap markets, or causing tremendous resources
to be wasted while market participants prepare and wait for a
last-minute action.
While the industry appreciates the opportunity to seek
temporary relief in these circumstances, what necessitates this
relief and the manner in which this relief is granted remains
troubling.
With that, Mr. Chairman, I will end my testimony. Thank you
very much.
[The prepared statement of Mr. Lukken follows:]
Prepared Statement of Hon. Walter L. Lukken, President and Chief
Executive Officer, Futures Industry Association, Washington, D.C.
Chairman Lucas, Ranking Member Peterson, and Members of the
Committee, thank you for the opportunity to provide our perspective on
matters affecting the derivatives industry and in particular the
regulation of our markets by the Commodity Futures Trading Commission
(CFTC). As you turn your attention to reauthorizing the CFTC, the
Futures Industry Association (FIA) stands ready to assist in any way we
can. FIA is the leading trade organization for the futures, options and
over-the-counter cleared derivatives markets. It is the only
association representative of all organizations that have an interest
in the listed derivatives markets. Its membership includes derivatives
clearing firms, traders and exchanges from more than 20 countries.
FIA's core constituency consists of futures commission merchants,
commonly known as FCMs, and the primary focus of the association is the
global use of exchanges, trading systems and clearinghouses for
derivatives transactions.
As you know, clearing has long been an integral part of the futures
market structure. Clearing ensures that parties to a transaction are
protected from a failure by the opposite counterparty to perform their
obligations, and the FCMs that FIA represents play a critical role in
ensuring that transactions are secured with appropriate margin to
facilitate this clearing process.
Improving Customer Protection
I would like to take this opportunity to update the Committee on
recent efforts to improve the handling of customer funds, or what is
often called margin or collateral. As you know, the failures of MF
Global Inc. and Peregrine Financial Group resulted in severe and
unacceptable consequences for futures customers and the markets
generally. The entire industry has been working collaboratively to
identify and improve procedures required to better protect the
integrity of these markets. A number of changes are already being
implemented, many of which were recommended by FIA in the aftermath of
these insolvencies: \1\
---------------------------------------------------------------------------
\1\ See Futures Industry Association, Futures Markets Financial
Integrity Task Force--Initial Recommendations for Customer Funds
Protection: http://www.futuresindustry.org/downloads/
Initial_Recommendations_for_Customer_Funds_Protection.pdf.
The National Futures Association (NFA) and the CME Group
(CME), the industry's principal self-regulatory organizations,
have adopted rules that subject all FCMs to enhanced record-
keeping and reporting obligations. For example, chief financial
officers or other appropriate senior officers are now required
to authorize in writing and promptly notify the FCM's DSRO
whenever an FCM seeks to withdraw more than 25 percent of its
excess funds from the customer segregated account in any day--
these are funds deposited by the FCM into customer segregated
---------------------------------------------------------------------------
accounts to guard against customer defaults.
NFA and CME have begun building an automated system for the
daily monitoring of all customer segregated, secured, and
cleared swaps amounts held by FCMs. As part of this project,
NFA and CME contracted with AlphaMetrix360, a subsidiary of
AlphaMetrix Group, to aggregate the data on customer
segregated, secured, and cleared swaps amount accounts. The new
system will allow NFA and CME to run an automated comparison of
the balances in customer segregated, secured, and cleared swaps
accounts at the depositories with the daily reports they
receive from FCMs, and then quickly identify any discrepancies.
NFA is also collecting additional financial information from
FCMs and posting that information on its online Background
Affiliation Status Information Center (Basic) system, a key
step in giving customers the tools they need to monitor the
assets they deposit with their FCMs. The new service provides
the public with access to specific information about an FCM,
such as the firm's adjusted net capital, the amount of funds
held in segregated, secured, and cleared swaps accounts, and
the types of investments that the FCM is making with those
customer funds.
It is my understanding that NFA is in the process of
drafting an interpretive notice that contains specific guidance
and identifies the minimum required standards for FCM internal
controls such as separation of duties; procedures for complying
with customer segregated and secured amount funds requirements;
establishing and complying with appropriate risk management and
trading practices; restrictions on access to communication and
information systems; and monitoring for capital compliance.
A set of frequently asked questions on customer funds
protection \2\ has also been developed by FIA, which is being
used by FCMs to provide their customers with increased
disclosure on the scope of how the laws and regulations protect
customers in the futures markets.
---------------------------------------------------------------------------
\2\ See Protection of Customer Funds, Frequently Asked Questions:
http://www.futuresindustry.org/downloads/PCF-FAQs.PDF.
Additionally, FIA, CME Group, NFA, and the Institute for
Financial Markets have partnered to fund an evaluation of the
costs and benefits of various asset protection insurance
proposals. We look forward to sharing these findings with the
---------------------------------------------------------------------------
Committee when available.
In addition to the efforts undertaken by the industry, the CFTC has
recently proposed a set of comprehensive regulations to further enhance
customer protection. To a significant extent, the proposed rules build
upon and codify the recommendations that FIA made and rules that the
NFA and CME adopted in early 2012. FIA strongly endorses the regulatory
purposes underlying the proposed amendments. We nonetheless submitted
an extensive comment letter designed, in substantial part, to assist
the Commission in striking an appropriate balance among its several
proposals to assure that the producers, processors and commercial
market participants that use the derivatives markets to manage the
risks of their businesses will be able to continue to have cost-
effective access to the markets and a choice of FCMs. In particular,
the proposed change related to residual interest drastically re-
interprets the long-standing application of the statute and will result
in a tremendous drain on liquidity that will make trading significantly
more expensive for customers hedging their financial or commercial
risks, and will adversely affect the ability of many FCMs to operate
effectively. The current interpretation was essential to the
performance of the futures industry during the 2008 crisis and its
application is not related to the shortcomings identified after the
recent failures. When the proposal was released the Commission did not
have adequate information to determine the costs of the modified
residual interest requirement.\3\ As such, FIA engaged an accounting
consultant to sample FCMs on the potential costs of the residual
interest proposal; the results show that this change could require an
additional $100 billion obligation to the customer funds accounts,
beyond the sum required to meet initial margin requirements. Many of
the very customers this proposal is designed to benefit have expressed
concerns as they rightfully realize this will significantly increase
the costs of hedging and likely have the largest impact on small to
mid-sized FCMs which could potentially lead to consolidation and fewer
choices for them as customers. As previously mentioned, the FIA
supports many of the customer protection measures that the Commission
has proposed, we simply believe this one in particular warrants further
review as to why the existing statutory interpretation should be
changed.
---------------------------------------------------------------------------
\3\ See 77 FR 67916.
---------------------------------------------------------------------------
The FIA is very engaged in the development of industry and
Commission-initiated efforts to proactively address many of the issues
presented by these recent failures. While the derivatives industry is
strong, and clearing continues to be the gold standard in protecting
market participants from the unexpected failure of a counterparty, we
have learned that the collateral necessary for a robust clearing
system, and the customers who post such margin, are better protected
through enhanced disclosures, reporting, and internal controls. Our
members commit a substantial amount of their own capital to guarantee
customer transactions. We have every incentive to ensure that the
integrity of the derivatives clearing system is well-regarded as safe
and reliable.
Clearing Under the ``Dodd-Frank Act''
Under the ``Dodd-Frank Act'', Congress determined to extend
clearing beyond futures to swaps, and as such the role of the FCM has
also expanded. Because FCMs play a critical role in achieving the
newly-established clearing regime for swaps, we are happy to offer our
thoughts on the implementation of these requirements.
To date, much of the debate surrounding the implementation of the
swaps clearing requirements under the ``Dodd-Frank Act'' has been
focused on who, what, when and where, rather than how. Often, public
attention to Title VII implementation has been devoted to what products
will be subject to the clearing mandate; who will be expected to comply
with the mandate; when they will be expected to comply; and where,
within the global markets, the products and participants will be
regulated--all very important questions, but far less discussion has
been devoted to how the mechanics of clearing are being impacted. This
is probably a result of the fact that as the legislation was being
constructed there were very few questions about how the actual act of
clearing swaps would work--I believe most assumed that the process
already established for futures would simply be applied to swaps.
Certainly, the regulatory policies that have historically existed for
clearing futures can largely be applied to swaps, with the occasional
exception necessitated by the fact that swaps and futures have evolved
in different environments. Unfortunately, the reality is that the rules
being written to facilitate the clearing of swaps are in some cases re-
inventing the already proven clearing process that is familiar and
tested for futures, thereby creating an overly-complicated web of
regulations for both swaps and futures. Even those who have for many
years operated within the existing futures clearing environment are
being forced to seek temporary relief from the new regulations while
they sort through compliance options. Without such relief, market
participants face the reality of either shutting down existing
commercial activity or inadvertently being out of compliance as they
seek to implement confusing regulations.
Also of concern is the manner in which the needed relief is being
granted. Relief is commonly provided at the very last minute causing
disruptions for customers in both the futures and the swaps markets and
causing tremendous resources to be wasted while market participants
prepare and wait.
While the industry appreciates the opportunity to seek temporary
relief in these circumstances, what necessitates this relief and the
manner in which the relief is granted remain troubling. Let me be
clear, we support properly designed and effective clearing rules. Our
members provide the majority of the funds that support derivatives
clearinghouses and commit a substantial amount of their own capital to
guarantee customer transactions. We have every incentive to ensure that
the actual process of clearing derivatives--both futures and swaps--is
properly regulated.
However, at this critical juncture, when the newly required
clearing mandate for swaps is beginning to take effect, we are
concerned that so much complexity and disorder exists especially given
the existence of rules that have long governed the clearing of futures.
FCMs stand ready and willing to facilitate the clearing of swaps, just
as they have for futures, but the wide-spread confusion as to the
mechanics of clearing under these new regulations may be hindering the
process.
State of the Derivatives Industry
I want to take some time to update you on the general state of the
derivatives industry. As the swaps market developed and Congress,
through the ``Dodd-Frank Act'', determined that certain swaps are now
likely suitable for the clearing protections that have long been
required for futures, some have claimed that there is regulatory
arbitrage occurring, with futures and swaps competing against each
other. I believe that most market participants welcome the broadened
array of products available in a cleared environment and will continue
to use both swaps and futures products to meet their individual risk
management needs as appropriate. And as these products continue to
evolve, so will their demand. That is the nature of the derivatives
industry which has long been dynamic.
In 2012, the total number of futures and options contracts traded
on exchanges worldwide dropped by 15.3%. However, overall trading and
clearing volumes have risen over the past 10 years. Even before the
clearing mandate for certain swaps and swap market participants took
effect in March, the volume of swaps submitted voluntarily for clearing
was up in January:
LCH.Clearnet experienced a major surge in interest rate swap
clearing, with volume exceeding $55 trillion in notional value
in January, an all-time high.
CME Group also saw all-time highs in interest rate swap
clearing, with January volume of more than $250 billion
notional cleared and $750 billion in open interest.
The notional volume of credit default swaps cleared by ICE
Clear Credit totaled $400 billion in January.
As the clearing mandate took effect in March for swap dealers,
major swap participants and active funds the infrastructure responded
relatively well--as noted many of these entities had been engaged in
voluntary clearing efforts prior to the March date. It should be noted
that the next effective date of June 10 will bring in many more
participants and will likely present many more challenges to the new
regulatory regime. Given the timing, these implementation challenges
will likely become apparent and coincide with the Committee's
consideration of the CFTC reauthorization--I encourage you all to
continue your long-standing tradition of bipartisan oversight as you
focus on these issues absent political pressure.
I am fortunate to represent a wide array of stakeholders in the
derivatives industry--all of whom want to see this industry continue to
support the risk management needs of its customers in a productive way.
This is a goal I know the Members of this Committee share and I look
forward to working with you as you consider the CFTC's role in
achieving this mutual objective.
Mr. Conaway. Thank you, Mr. Lukken.
Now Mr. O'Connor for 5 minutes.
STATEMENT OF STEPHEN O'CONNOR, CHAIRMAN,
INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC., NEW
YORK, NY
Mr. O'Connor. Chairman Lucas, Ranking Member Peterson,
Members of the Committee, thank you for the opportunity to
testify today.
In the 5 years since the onset of the financial crisis,
significant progress has been made in building a more robust
financial system and safer, more transparent, over-the-counter
derivative markets. ISDA squarely supports these initiatives
and regulatory reforms designed to improve systemic resiliency,
and ISDA has been working hard alongside regulators to
implement those reforms.
However, improvements can and should be made the regulatory
reform process. Contrary to Congress' stated intentions, the
Dodd-Frank Act contains provisions that could actually
increase, rather than decrease, systemic risks. Such provisions
include the law's Section 716, swaps push-out provision, and
also the requirement for mandatory initial margin for OTC
derivative transactions. The rationale for and value of these
provisions are uncertain, but what is certain is that such
provisions will impose significant costs and drags on the
economy without any clear countervailing benefits.
We also have concerns with regard to the interpretation and
implementation of the Act by the CFTC and the SEC. In some
cases, sections of the law are being construed differently by
the two regulators; in others, regulators are interpreting and
implementing the laws in ways that do not reflect the intent of
Congress. For example, there are significant risks that the
goal of increased regulatory transparency is being undermined
by the fragmentation of derivatives trade reporting. U.S.
regulators and their international counterparts have failed to
reach agreements on the implementation of key regulations, and
lack of international coordination and jurisdictional overreach
has created barriers to international capital flows and to
international commerce.
Here in the United States, the CFTC and the SEC have taken
different approaches to the cross-border application of
derivative laws, which can seriously impact market liquidity
and the competitiveness of U.S. firms in the global economy.
The two U.S. regulators also have different interpretations of
the law's trade execution requirements, which could lead to
bifurcated market practices, and the law's business conduct
standards are being applied in a very prescriptive manner, not
envisioned by legislators, adding unnecessary costs and
complexity to the system. And in some instances, the cost-
benefit analysis required under the law is not being
appropriately conducted, which could result in the imposition
of rules that wind up doing more harm than good. In these and
in other areas, there is significant concern that the law will
be inconsistently and inappropriately applied.
It is vitally important that we, industry and regulators,
focus our resources on those aspects of regulatory reform that
address the most important issue: reducing systemic risk. This
includes capital, central clearing, and variation margin
frameworks as well as regulatory transparency. It is vitally
important to avoid enacting measures that harm liquidity or
reduce systemic resiliency in the very markets they are trying
to protect, resulting in a direct and harmful impact on the
economy. This is particularly critical given the slow and
uneven growth of the U.S. and the broader global economy.
Dodd-Frank is an important step forward for our country and
our markets, and the CFTC deserves our sincere appreciation and
support for its efforts in implementing wide-ranging provisions
in a relatively short period of time. It is clear, however,
that our experience over the past several years has shown that
not all of the law's provisions are appropriate and contribute
to the overriding goal of a safer financial system, and some
efforts by the regulators to implement the law are inconsistent
with the intent of Congress, are being interpreted in different
ways by different agencies, or impose costs that far exceed any
resulting benefits.
In light of these concerns and observations, ISDA
respectfully requests this Committee to, first, consistent with
H.R. 1256, stress to the CFTC the necessity of applicable,
prudent interpretation of the law, including in the area of
margin, and work closely with the industry to adopt financial
regulations that ensure the safety of markets, but regulations
that do not harm market liquidity or harm market participants,
and second, urge the SEC and the CFTC to harmonize their cross-
border approach as soon as possible so that U.S. regulators
first speak with one voice, and then engage together
proactively in the ongoing global debate on international
harmonization, since proper global coordination is essential to
ensure the competitiveness of the U.S. markets, U.S.
businesses, and the U.S. economy.
Thank you.
[The prepared statement of Mr. O'Connor follows:]
Prepared Statement of Stephen O'Connor, Chairman, International Swaps
and Derivatives Association, Inc., New York, NY
Chairman Lucas, Ranking Member Peterson, and Members of the
Committee: Thank you for the opportunity to testify today.
In the nearly 5 years since the onset of the financial crisis,
significant progress has been made in building a more robust financial
system and a safer, more transparent over-the-counter (OTC) derivatives
markets. Rule-making is effectively a two stage process. First, the
Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act)
created a legal framework for reform, and then the Commodity Futures
Trading Commission (CFTC) and the Securities and Exchange Commission
(SEC) have been charged with responsibility for creating market rules,
effectively the implementation of the Act. Through this mechanism, a
great deal of progress has been made towards a safer more robust
financial system.
However, improvements can and should be made at both stages of this
process. Contrary to Congress' stated intentions, the Dodd-Frank Act
contains provisions that could actually increase, rather than decrease,
systemic risk. This includes, for example, the law's Section 716 swaps
push-out provision and also the requirement for mandatory initial
margin for derivatives transactions. The rationale for, and value of,
these provisions are uncertain. What is certain is that such provisions
will impose significant costs and drags on the economy, without any
clear countervailing benefits.
We also have concerns with regard to stage two, the interpretation
and the implementation of the Act by the CFTC and the SEC. In some
cases, different sections of the law are being construed differently by
the different regulators. In others, regulators are interpreting and
implementing the laws in ways that do not reflect the intent of
Congress. For example:
There is a significant risk that the goal of increased
regulatory transparency is being undermined by the
fragmentation of derivatives trade reporting;
The CFTC and the SEC have taken different approaches to the
cross-border application of derivatives rules, which could
seriously impact market liquidity and the competitiveness of
U.S. firms in the global economy;
The two U.S. regulators also have different understandings
of the law's trade execution requirements, which could lead to
bifurcated market practices;
The law's business conduct standards are being applied in a
very prescriptive manner not envisioned by legislators, adding
unnecessary costs and complexity to the system; and
In some instances, the cost-benefit analysis required under
the law is not being appropriately conducted, which could
result in the imposition of rules that wind up doing more harm
than good.
In these and other areas, there is significant concern that the law
will be inconsistently and inappropriately applied. This could increase
rather than decrease risk, raise costs and prevent the sound
application of risk management practices that are essential to the
proper functioning of markets and to a healthy, productive American
economy.
I will address each of these points in more detail, but before I
do, it's important to state quite clearly: The International Swaps and
Derivatives Association squarely supports financial regulatory reform
that is designed to build a strong, safe financial system, reduce
systemic risk, decrease counterparty credit risk and improve regulatory
transparency. This, indeed, is our mission: to foster safe and
efficient derivatives markets for all users of derivatives products.
ISDA has worked for 25 years on measures such as the significant
reduction of credit and legal risk by developing a framework of legal
certainty which includes the ISDA Master Agreement and related
standardized collateral agreements. The Association has also been a
leader in promoting sound risk management practices and processes and
has for 12 years been a strong advocate of the appropriate use of
central clearinghouses
Today, ISDA has more than 800 members from 60 countries on six
continents, including corporations, investment managers, government and
supranational entities, insurance companies, energy and commodities
firms, as well as international and regional banks. In addition to
market participants, members also include key components of the
derivatives market infrastructure including exchanges, clearinghouses
and repositories, as well as law firms, accounting firms and other
service providers. The Association's broad market representation is
further reflected by the number of non-dealer firms on our board of
directors and their representation on key ISDA committees.
ISDA believes that the most effective way to achieve the goal of
greater systemic resiliency is through a regulatory framework that
includes: appropriate capital standards, mandatory clearing
requirements where appropriate, robust collateral requirements and
mandatory trade reporting obligations. We have worked actively and are
engaged constructively with policymakers in the U.S. and around the
world on these important initiatives. Great strides have been made in
all of these areas.
For example, trade repositories have been established covering
derivatives in all major asset classes--interest rates, credit,
equities, commodities and foreign exchange. Regulators around the world
now have comprehensive access to information about trading activity in
the derivatives market. Regulators will now be able to readily identify
where risk may be building up in the system as well as detect improper
behavior, observe transaction flows and identify trends in liquidity in
the OTC markets. However, as discussed in greater detail below,
significant work remains to ensure that this information is completely
visible to regulators and a major opportunity is not lost.
With regard to clearing of derivatives through central
counterparties, nearly \2/3\ of the interest rate swap market is
already centrally cleared, largely due to voluntary initiatives and
commitments by banks to global regulators in advance of the Dodd-Frank
Act required mandates. Clearing will increase significantly in the next
twelve to twenty-four months as trades between dealers and their
clients become subject to mandatory clearing, which began in the U.S.
in March 2013.
* * * * *
Let me turn briefly to what we believe are two of the most
significant areas of the Dodd-Frank Act that could benefit from action
by Congress: the swaps push-out provision and the initial margin
requirements.
Section 716 Swaps Push-Out Provision
The Dodd-Frank Act's Section 716, commonly called the ``Swap Push-
Out'' provision, requires banks to separate and segregate portions of
their derivative businesses, including equity derivatives, certain CDS
and commodity derivatives transactions, outside of entities that
receive Federal assistance, including the Federal deposit insurance
program or access to the Federal Reserve's discount window. These
activities would have to be conducted in separately capitalized
affiliates, legally apart from entities such as FDIC-insured banks. We
should also note that, due to a drafting error, certain non-U.S.-based
firms with significant U.S. operations and U.S. employees could be
harmed further, as they would not be able to take advantage of certain
statutory exemptions contained in Section 716.
While the ostensible purpose of Section 716 is to reduce risk,
forcing derivatives activities outside of a better-capitalized, better-
regulated bank into new standalone subsidiaries could actually increase
risk to the system. This perverse outcome has been noted by the FDIC,
Federal Reserve, former Treasury Secretary Geithner and even former
Federal Reserve Chairman Paul Volcker. Section 716 will also lead to
greater inefficiencies and the loss of exposure netting as it requires
firms to conduct swaps across multiple legal entities.
There are other disadvantages to Section 716 as well. It will tie
up additional capital that might better be used to support investment,
and create higher funding and operational costs for the financial
institutions that are required to implement it.
Those financial institutions currently include only firms doing
business in the U.S., as there is no similar law or regulation in place
in any major foreign jurisdiction. These firms will be at a competitive
disadvantage to their non-U.S. counterparts. American customers of
these firms would therefore face higher costs, or will seek out lower
cost non-U.S. firms to assist with their risk management initiatives
and transactions.
Customers will also need to evaluate the strength and capital of
each Section 716 subsidiary that they may do business with, rather than
that of the parent company, which will also impact these subsidiaries'
competitiveness. Section 716 also complicates the ability of financial
institutions to net their exposures and to manage their risks most
efficiently.
Due to the above noted issues, ISDA has expressed support for H.R.
992, legislation passed by this Committee and the Financial Services
Committee.
Initial Margin Requirements
The Dodd-Frank Act adds section 4s(e) to the Commodity Exchange Act
to address capital and margin requirements for swap entities.
ISDA and the industry support the intent of global policymakers to
develop a regulatory framework that improves the safety of the global
over-the-counter derivatives markets, and further recognize the need
for robust variation margin requirements, particularly for systemically
important firms. That said, we harbor grave concerns regarding Dodd-
Frank's initial margin (IM) requirements.
IM is designed to cover the replacement costs if a counterparty
defaults. It is an extra payment made between parties in excess of
amounts owed, and as such, it improves the situation of the non-
defaulting party.
While initial margin has benefits, it is important to understand
the very real and very significant costs that it would impose.
Depending on how IM requirements are developed and implemented:
The initial margin requirement has the potential to
significantly strain the liquidity and financial resources of
the posting party;
In stressed conditions, the initial margin requirements will
result in greatly increased demand for new funds at the worst
possible time for market participants; and
The initial margin requirements could cause market
participants to reduce their usage of non-cleared OTC
derivatives and: (1) choose less effective means of hedging,
(2) leave the underlying risks unhedged, or (3) decide not to
undertake the underlying economic activity in the first
instance due to increased risk that cannot be effectively
hedged.
Perhaps most importantly, we do not believe that initial margin
will contribute to the shared goal of reducing systemic risk and
increasing systemic resilience. When robust variation margin practices
are employed, the additional step of imposing initial margin imposes an
extremely high cost on both market participants and on systemic
resilience with very little countervailing benefit.
The Lehman and AIG situations highlight the importance of variation
margin. AIG did not follow sound variation margin practices, which
resulted in dangerous levels of credit risk building up, ultimately
leading to its bailout. Lehman, on the other hand, posted daily
variation margin, and while its failure caused shocks in many markets,
the variation margin prevented outsized losses in the OTC derivatives
markets.
While industry and regulators agree on a robust variation margin
regime including all appropriate products and counterparties, the
further step of moving to mandatory IM does not stand up to any
rigorous cost-benefit analysis.
We recognize that it would take Congressional action to amend the
Act and the IM requirement. In the absence of such amendment, we
believe it imperative that the regulators implement the IM requirement
in a prudent way that does not introduce overwhelming costs, reduce
liquidity and directly harm the U.S. economy.
* * * * *
Moving to further comments on implementation, as noted above, there
are challenges related to an inconsistent interpretation of the law,
and an interpretation that does not reflect the original intent of the
legislation.
Swap Data Repositories
Perhaps the most important of these issues is related to
fragmentation of trade reporting by OTC derivatives markets
participants.
One of the major lessons learned of the financial crisis is the
need for regulators and supervisors to have clear and comprehensive
access and insights into the level and type of risk exposures at
financial institutions and their counterparties. One of the most
important achievements of policymakers and market participants in the
past 5 years has been the establishment of global trade databases, or
swaps data repositories, that accomplish this goal. Such repositories
have been built for all major derivatives asset classes. The level of
information they contain is unparalleled in the global financial
markets.
This progress is now at risk. Because of current regulatory
interpretation regarding collection and reporting of cleared trades, it
seems likely that there will not be one central information warehouse
that collects all derivatives market data. This data could be
splintered into multiple warehouses. If this happens, then regulators
would essentially be forced to follow their previous, pre-crisis
practices. They would have to go from repository or repository to
collect and to attempt to aggregate exposures, just as they used to go
from firm to firm for data. Such attempts to aggregate will be near-
impossible if fragmentation really takes hold. Systemic risk would not
be reduced. Regulatory visibility and the ability to identify where
risk is building up in the system would be fatally impaired.
A fantastic opportunity will have been missed. The amount and
completeness of information that could be available to regulators is
unprecedented in global financial markets. For no other financial
instrument, in any asset class, has there ever been a way for
authorities to access a complete database of the entire global
transaction population.
Cross-Border Application of Rules
Concerns are also growing about the potential application, impact
and consistency of the U.S. regulatory framework in other
jurisdictions. This was most recently and pointedly evidenced by the
April 18 letter from finance officials representing nine of the world's
largest countries--imploring Treasury Secretary Lew to limit the cross-
border reach of Dodd-Frank Act swaps rules. These issues are raising
the prospect that market participants will be subject to duplicative
and/or contradictory regulatory mandates from the EU and other non-U.S.
jurisdictions that would impose significant costs, fragment market
liquidity and potentially create an uneven playing field. As the letter
states, ``An approach in which jurisdictions require that their own
domestic regulatory rules be applied to their firms' derivatives
transactions taking place in broadly equivalent regulatory regimes
abroad is not sustainable.''
ISDA and our members believe that a globally harmonized approach to
cross-border regulation is of paramount importance. What they face now
is considerable uncertainty. Uncertainty is never a good thing in
financial markets, as there are typically only two things to do in face
of that uncertainty. One response is to pull back and wait until such
time as greater certainty is provided. On a firm level, that means
missed opportunity. On a market level, that translates to less
efficient, less liquid and more volatile markets, material harm to
financing and investing activities and a drag on the economy in
general.
The other response is to try to anticipate various possible
results. This can lead to costly, duplicative efforts with no guarantee
that all that planning will prove effective once the rules are
finalized.
Either path runs the risk of undermining the safe, efficient
markets that ISDA, regulators and the industry all desire.
To achieve the goal of a globally harmonized framework, the CFTC
and SEC should work together to achieve consensus with global
regulators. H.R. 1256 would help the U.S. regulators to provide a
unified front when addressing the extraterritorial application of U.S.
rules and when dealing with non-U.S. regulators. Harmonization of
regulatory approaches, particularly on issues with systemic risk
implications, and a concerted program of mutual recognition of
regulatory regimes by global regulators are essential parts of the
solution to ET.
Trade Execution Requirements
The inconsistent interpretation of the law by the CFTC and the SEC
is apparent in the recently finalized CFTC swap execution facility
(SEF) requirements which mandate initially two, and later three,
requests for quotes (RFQs).
To our knowledge, no objective or empirical evidence exists as to
why multiple RFQs are beneficial to the market and no research has been
done to this effect. In fact, ISDA's members from the buy-side
community have expressed concern that a multiple-RFQ model will harm,
rather than help, their execution.
For example, the CFTC rule may result in increased transaction
costs, and in an ISDA survey of the buy-side, 70 percent of respondents
indicated they would migrate to other markets if required to post
multiple RFQs. In fact, 76 percent indicated it would have a negative
effect on liquidity.
Many buy-side firms have very serious concerns about being forced
to request a quote from more than one dealer because that can cause a
signaling effect, exposing their investment strategy to multiple market
participants. A provision that has been put forth as a benefit for end-
users is being soundly rejected by them.
In addition to these issues, the CFTC regulation for SEFs will
limit the means by which swaps can be executed to two types of
platforms: an electronic order book and an RFQ system.
Business Conduct Rules
Dodd-Frank required the development of Business Conduct rules as a
form of customer protection in the swaps market. Regulators have in the
past several years developed business conduct rules required of market
participants, particularly swap dealers. These rules are extremely
detailed and prescriptive and they impose a large compliance burden on
market participants that is well outside the scope of what Congress
apparently intended.
The rules impose significant additional requirements on swap
dealers in respect to their relationships with their customers. Since
the majority of external business conduct rules became effective May 1,
we have yet to see whether the significant compliance requirements
translate into increased customer protection.
To facilitate compliance with these requirements, ISDA has created
and managed two industry-spanning protocols directly related to Dodd-
Frank. Protocols intend to get the majority of market participants to
agree to new transaction terms that reflect the regulatory changes in
the law, by adhering to these changes through an electronic market-wide
process. The August 2012 Dodd-Frank ISDA Protocol addresses compliance
with the CFTC's External Business Conduct Rules; a second protocol
facilitates compliance with the CFTC's rules on Swap Trading
Relationship Documentation and Clearing Requirements.
Cost-Benefit Analysis
The business conduct standards rules described above, and ISDA's
work to fulfill those that have been finalized, clearly illustrate the
cost and expense related to certain Dodd-Frank provisions. What is less
clear, however, are the benefits that these and other aspects of the
law and their regulatory interpretation bring to our country's
financial system and the thousands of companies that use OTC
derivatives.
An appropriate cost-benefit analysis was both required and
desirable prior to finalization of rules; however in a number of
instances the CFTC's analysis did not comply with the regulatory
standard.
As the Jun. 2012 report by the CFTC Inspector General stated:
``. . . Generally speaking, it appears CFTC employees did not
consider quantifying costs when conducting cost-benefit
analyses for the definitions rule. As indicated in the rule's
preamble, the costs and benefits associated with coverage under
the various definitions (in light of the various regulatory
burdens that could eventually be associated with coverage) were
not addressed . . .''
The lack of an appropriate cost-benefit analysis makes it
especially important that the application and implementation of the
final rules be phased in a flexible manner. Doing so would help ensure
that rules achieve the purposes for which they are intended and do not
impose burdensome costs on the financial system. It would also help
regulators to identify and avoid unintended consequences of their
actions. And it would encourage regulators to properly allocate limited
resources.
* * * * *
In conclusion, ISDA remains committed to achieving a safer, more
efficient and more robust financial system and OTC derivatives markets.
Toward that end, it is vitally important that we, industry and
regulators, focus our resources on those aspects of regulatory reform
that address the most important issue--reducing systemic risk. This
includes appropriate capital, central clearing and variation margin
frameworks as well as regulatory transparency.
At the same time, it is vitally important that we seek to avoid
burdensome measures that do not pose any clear, tangible benefit, and
that divert resources from being allocated more efficiently elsewhere
and impede progress in more important areas. Or worse still, enacting
measures that harm liquidity or reduce systemic resiliency in the very
markets they are trying to protect, resulting in a direct and harmful
impact on the economy. This is particularly critical given the slow and
uneven growth of the U.S. and the global economy.
Dodd-Frank is an important step forward for our country and our
markets. And the CFTC deserves our sincere appreciation and support for
its efforts in implementing its wide-ranging provisions in a relatively
short period of time. It is clear, however, that our experience over
the past several years has shown that not all of the law's provisions
are appropriate and contribute to the overriding goal of a safer
financial system. Similarly, some efforts by the regulators to
implement the law are inconsistent with the intent of Congress, are
being interpreted in different ways by various agencies, or impose
costs that far exceed any resulting benefits.
In light of these concerns and observations, ISDA respectfully
requests this Committee to (1) support the amending of Section 716,
which could be done in an effective way through passage of H.R. 992 (2)
consistent with H.R. 1256, stress to the CFTC the necessity of a
flexible, prudent interpretation of the statutory provisions on margin
and work closely with the industry to adopt final regulations that
ensure the safety of the markets but do not harm liquidity and market
participants; (3) urge the SEC and CFTC to harmonize their cross-border
rules as soon as possible so U.S. regulators speak with one voice in
the ongoing global debate on extraterritoriality since this is
necessary to ensure the competitiveness of U.S. markets and the
efficient flow of capital throughout all the global markets in which
U.S. businesses operate.
Thank you.
Mr. Conaway. Thank you, Mr. O'Connor.
Mr. Dunaway for 5 minutes.
STATEMENT OF WILLIAM J. DUNAWAY, CHIEF FINANCIAL OFFICER, INTL
FCStone, INC., KANSAS CITY, MO
Mr. Dunaway. Chairman Lucas, Ranking Member Peterson, and
other Committee Members, thank you for inviting me to testify.
I serve as the CFO of both FCStone, LLC, a registered FCM, and
INTL Handling, a registered swap dealer. INTL was one of the
first to register as a swap dealer under Dodd-Frank, and we
were the first non-bank to register. My oral testimony will
summarize my written statement submitted to the Committee,
which goes into these complex topics in greater detail.
Dating back to 1924, INTL FCStone is now a global firm that
services more than 20,000 mostly midsize commercial customers
who are producers and end-users of virtually every major traded
commodity. The largest market we serve is agriculture. Our
customers handle about 20 percent of the grain production in
Texas, 40 percent in Kansas, and 50 percent of the grain
production in both Iowa and Oklahoma. INTL FCStone supports the
Dodd-Frank Act; however, there are rules implementing the Act
that may prohibit end-users from using our products to hedge
their risk.
Other proposals, if unchanged, could push independent firms
like INTL FCStone out of the market, leaving thousands of
smaller end-users with nowhere to turn for hedging. In our
conversations with the CFTC staff about the capital and margin
rules, we have learned that our non-bank swap dealer may be
required to hold regulatory capital up to hundreds of times
more than that of a bank-affiliated swap dealer for the same
portfolio of positions. Other non-bank commodity swap dealers
will be in the same disadvantaged position.
There are two reasons for this discrepancy. First, under
the new rules, bank-affiliated swap dealers can use internal
models to calculate the risk associated with customer
positions. Non-banks cannot. Internal models allow for more
sophisticated netting of commodity positions to determine
market risk capital charges. The CFTC's approach will permit
only limited netting for non-bank dealers, forcing non-banks to
hold capital against economically offsetting commodity swap
positions. This means higher capital requirements overall and
relative to those of bank-affiliated swap dealers using
internal models.
In addition, the CFTC's approach relies on Basel II, which
treats commodity derivatives more harshly than any other type
of derivative when calculating risk. As a result, the same
derivatives portfolio that would require a bank-affiliated swap
dealer to hold $10 million in regulatory capital would require
us to set aside $1 billion in capital. This is entirely
unsustainable, and will cause non-bank swap dealers to exit the
business. The direct result will be higher costs for end-users,
and then for consumers.
Increasing concentration in the industry until only the big
banks are left will leave the smaller end-user with no place to
go. It is not too late to fix this. The Commodity Exchange Act
requires regulators to maintain comparable minimum capital
requirements for all swap dealers. We believe the CFTC should
revise its proposed capital rules to ensure that the
requirements applicable to non-banks and bank-affiliated swap
dealers are comparable by altering the non-bank rules to allow
for full netting of offsetting commodity swap positions, allow
match positions offering offsetting, or permit all swap dealers
to use internal models. If the CFTC fails to make these
changes, we request this Committee codify one or more of these
alternatives as part of the CEA reauthorization.
Turning to our FCM, the CFTC has proposed rules requiring
that FCMs residual interest exceed margin deficiencies at all
times, and to reduce the margin call collection period to 1
day. These rules will have a substantial negative impact on
some customers' ability to hedge their commercial risks, and
will severely challenge small and midsize FCMs continued
operation. The CFTC should study these issues and conduct a
cost-benefit analysis before proceeding.
It is simply not feasible for an FCM to determine whether
margin deficiencies are present at all times throughout a day;
therefore, FCMs will have to hold margin that assumes the
failure of all customers every day. Such a worst case scenario
is unheard of and is not applied to any other financial
entities. Under the new rule, FCMs will require customers to
put up more money at all times, possibly doubling margins and
likely resulting in customers being required to prefund their
margin.
In addition, we feel the Commission's proposal mandating
what amounts to a 1 day margin call collection period for FCM
customers as opposed to the current 3 business days is not
realistic. Our customers include a large number of farmers and
ranchers who meet margin calls by using checks. They may be
required to double or triple their margin payments to be able
to meet the 1 day payment requirement. Many of our customers
also finance their margin calls, requiring more time to arrange
wire transfers. Foreign customers have different time zones
that make the 1 day deadline impossible. We strongly believe
that 2 day deadline is more reasonable and equitable for our
customer base.
Finally, as a result of the external business conduct rules
now in effect, many of our customers have abandoned OTC
derivatives, even though OTC is the most effective hedging
tool, because the paperwork requirements are simply too
burdensome. Others have asked us to refrain from providing a
mid-market mark, because they can either derive this
information themselves or prefer immediate execution at market
price and cannot even afford seconds delay in their execution.
The proposed rule on capital margin allows customers to opt in
or opt out of certain protections, including the segregation
requirement, and we ask that this same option be extended to
some of the business conduct rule disclosures.
INTL FCStone also has some concerns about the
extraterritorial application of Title VII of Dodd-Frank, the
definition of eligible contract participant as it pertains to
farmers, and the issue of the futurization of swaps, and I
address each of these in my written comments. INTL FCStone is
not interested in dismantling Dodd-Frank; in fact, most of the
concerns I have outlined here are about the implementation of
the rules, not the Act itself. We are simply trying to ensure
the final rules function as intended and commercial end-users
in the firms like INTL FCStone who serve them do not face
greater regulatory burdens than those in the market who
speculate or create systemic risk.
Thank you for inviting me to testify today, and I look
forward to any questions that you may have.
[The prepared statement of Mr. Dunaway follows:]
Prepared Statement of William J. Dunaway, Chief Financial Officer, INTL
FCStone, Inc., Kansas City, MO
Chairman Lucas, Ranking Member Peterson, and other Members of the
Committee, thank you for inviting me to testify at this important
hearing. I am the Chief Financial Officer (``CFO'') of INTL FCStone
Inc., a position I have held since the merger of International Assets
Holding Corporation and FCStone Group, Inc. in September 2009. In
addition, I am the CFO of both, FCStone, LLC, a registered Futures
Commission Merchant (``FCM''), and INTL Hanley, LLC, a registered Swap
Dealer. Prior to the merger, I was the CFO of FCStone Group, Inc. I
began my career more than 19 years ago as a staff accountant with Saul
Stone and Company LLC, and since that time, I have served in various
capacities, all of which included regulatory accounting and financial
reporting, including CFO of Saul Stone and Company LLC, Executive Vice
President and Treasurer with responsibility over the regulatory
accounting of FCStone, LLC, the successor FCM to Saul Stone and Company
LLC.
INTL FCStone Inc. and its affiliates (collectively, ``We'', ``INTL
FCStone'' or the ``Company''), a publicly held, NASDAQ listed company,
dates back to 1924 when a door-to-door egg wholesaler formed Saul Stone
and Company, which went on to become one of the first clearing members
of the Chicago Mercantile Exchange. In June of 2000, Saul Stone was
acquired by Farmers Commodities Corporation, which at the time was a
cooperative, owned by approximately 550 member cooperatives, and was
renamed FCStone LLC. Through organic growth, acquisitions and the 2009
merger between International Asset Holding Corp. and FCStone Group, we
have become a global financial services organization with customers in
more than 100 countries serviced through a network of 33 offices around
the world.
INTL FCStone offers our customers a comprehensive array of products
and services, including our proprietary Integrated Risk Management
Program, as well as exchange and OTC execution and clearing services,
designed to limit risk, reduce costs, and enhance margins and bottom-
line results for our customers. We also offer our customers physical
trading in select soft commodities including agricultural oils, animal
fats and feed ingredients, as well as precious metals. In addition, we
provide global payment services in over 130 foreign currencies as well
as clearing and execution services in foreign exchange, unlisted
American Depository Receipts and foreign common shares, while also
providing asset management and investment banking advisory services.
Today, INTL FCStone services more than 20,000 mostly mid-sized
commercial customers, including producers, processors and end-users of
virtually every major traded commodity whose margins are sensitive to
commodity price movements. Although we have become a global company,
our largest customer base is serviced from offices in the agricultural
heartland, such as West Des Moines, Iowa, Omaha, Nebraska, Minneapolis,
Minnesota and Kansas City, Missouri. We are successful because we are a
customer-centric organization, focused on acquiring and building long-
term relationships with our customers by providing consistent, quality
execution and value-added financial solutions. The primary markets we
serve include: commercial grains; soft commodities (coffee, sugar,
cocoa); food service and dairy (including feed-yards); energy; base and
precious metals; renewable fuels; cotton and textiles; forest products
and foreign exchange. Our offices are located near the customers we
serve and our customers are the constituents of the Members of this
Committee--the farmers, feed yards, grain elevator operators, renewable
fuel facilities, energy producers, refiners and wholesalers as well as
transporters, who are in involved in the production, processing,
transportation and utilization of the commodities that are the backbone
of our economy. As an example, we believe our customers handle more
than 40% of domestic corn, soybean and wheat production, including 20%
of the grain production in Texas, 40% of grain production in Kansas,
and 50% of grain production in Iowa and Oklahoma.
We offer our clients sophisticated financial products, but are not
a Wall Street firm. Our mid-sized Futures Commission Merchant
(``FCM''), FCStone LLC, according to recent industry publications, is
the 20th largest FCM based upon customer segregated assets on deposit.
However, it is the third largest independent FCM not affiliated with a
banking institution or physical commodity business. As the Committee
may know, our wholly owned subsidiary INTL Hanley LLC was one of the
first to register as a Swap Dealer under the Dodd-Frank regulations. At
that time, we were the only organization not affiliated with a bank to
register.
Support for Dodd-Frank
INTL FCStone supports the goals of the Dodd-Frank Act and we are
deeply committed to safe, efficient OTC derivatives markets that
support the health and growth of the real economy. We likewise support
the G20's efforts to reduce systemic risk by focusing on improving
counterparty credit risk management and transparency in the OTC
derivatives markets. Much of the Dodd-Frank Act works toward those
goals, and we support those provisions that do so.
However, it is our view that some of the regulations that were
drafted to carry out the objectives of Dodd-Frank undermine or do not
support the goal of systemic risk reduction. Other changes do not
appear mandated by the Act, nor called for by policy concerns. Instead,
these regulations seek to impose changes to the market's structure
without posing any quantifiable benefit. In addition, they embed an
uneven and uncompetitive operating environment for firms doing business
in the U.S. compared to our competitors abroad.
We believe these changes will adversely affect the markets'
functioning, impose unnecessary costs on us and our customers, and will
limit our customers' ability to manage their risks.
Capital and Margin Requirements--Swap Dealer Issues
Ensuring that swap-dealers have an adequate capital base and that
customer collateral arrangements do not add to systemic risk are
positive and commendable objectives under Dodd-Frank. However, the
capital and margin requirements, as proposed,\1\ would significantly
disadvantage Swap Dealers that, like INTL FCStone, are not affiliated
with a bank, in favor of the bank-affiliated Swap Dealers--the very
entities that contributed to the financial crisis.
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\1\ Sections 731 and 764 of the Dodd-Frank Act require regulators
to adopt rules setting capital and margin requirements for uncleared
swaps for swap entities (Swap Dealers and major swap participants) and
security-based swap entities (security-based Swap Dealers and major
security-based swap participants). The ``Prudential Regulators''--the
Federal Reserve, Federal Deposit Insurance Corporation, Office of the
Comptroller of the Currency, Farm Credit Administration and Federal
Housing Finance Authority--are required jointly to adopt these rules
for the banks and related swap entities and security-based swap
entities (Bank Holding Company-affiliated or ``Bank Swap Entities'')
under their jurisdiction, and the Commodity Futures Trading Commission
(``CFTC'') and the Security and Exchange Commission (``SEC'') are
required to adopt these rules for other swap entities and security-
based swap entities, respectively.
---------------------------------------------------------------------------
Before I explain this issue in detail, I want to stress to the
Committee that the competitive advantage given to the bank-affiliated
Swap Dealers under the proposed rules is not modest. In fact, the
opposite is true. Our conversations with CFTC staff about the
anticipated operation of the rule suggests that our Swap Dealer, INTL
Hanley, will be required to hold regulatory capital potentially
hundreds of times more than that required for a bank-affiliated Swap
Dealer for the same portfolio of positions. Part of this stems from the
fact that bank-affiliated Swap Dealers can use internal models to
calculate the risk associated with customer positions, while non-banks
cannot.\2\ The use of internal models is an important tool because
these models generally provide for more sophisticated netting of
commodity positions to determine applicable market risk capital
charges. As a result of limited netting under the CFTC's ``standardized
approach,'' a non-bank Swap Dealer will have to hold market risk
capital against economically offsetting commodity swap positions,
resulting in a higher capital requirement \3\ overall, and relative to
the capital requirement for a bank-affiliated Swap Dealer using an
internal model.\4\ This increased capital requirement would have the
perverse effect of actually incentivizing a non-bank affiliated Swap
Dealer to not fully offset the risk of an customer OTC transaction and
thus incurring potentially unlimited market risk.
---------------------------------------------------------------------------
\2\ The ``standardized approach'' for calculating the market risk
component of regulatory capital for Commodity Swap Dealers is based
largely on the ``Standardized Measurement Method'' in the Market Risk
Amendment. Conceptually, the Standardized Measurement Method applies a
market risk charge to an entity's net position in a financial
instrument. In the Proposed Capital Rule, offsetting of equity
positions is allowed for positions ``in exactly the same instrument,''
and for single-name credit positions offsetting is allowed for
``identical'' positions. Similarly, market risk calculations that apply
to non-commodity asset classes under the Standardized Measurement
Method (i.e., interest rate, equity, and foreign exchange) permit
offsetting of ``matched'' positions. In contrast, the CFTC's
``standardized approach,'' as described in discussions with CFTC Staff,
does not provide comparable guidelines for identifying the extent to
which commodity positions are offsetting.
\3\ Dealers should depend primarily on spreads between transactions
for earnings, not on directional price change speculation. This is an
underlying intent of many provisions of Dodd-Frank (e.g., the Volcker
Rule). In the ordinary course of their operations, Swap Dealers relying
on spreads are incentivized to run flat books, which in turn reduces
risk in the market. Based upon our conversations with staff, we
understand that the CFTC does not intend to allow Swap Dealers to
recognize commodity position offsets as to maturity and delivery
location. If this is true, it seems counterproductive from a capital
and a risk standpoint. A capital rule that adequately risk-adjusts
offsetting positions would properly incentivize Swap Dealers to run
flatter portfolios (thereby decreasing systemic risk) because the Swap
Dealer would be able to lower its capital requirement by entering into
offsetting positions.
\4\ We consider it significant that the SEC's proposed rules on
capital, margin and collateral segregation for non-bank Security-Based
Swap Dealers and non-bank Major Security-Based Swap Participants permit
the use internal value-at-risk models. So the CFTC really is the
outlier with its capital and margin rules.
---------------------------------------------------------------------------
Another factor of major concern under the ``standardized
approach,'' which is based on European banking standards (i.e., Basel
II) , is that commodity derivatives like the ones we offer our
agricultural client base are treated more harshly than any other
derivatives asset class in terms of calculating risk. Taken in
conjunction, the same derivatives portfolio that would require a bank-
affiliated Swap Dealer to hold $10 Million in regulatory capital using
standard internal models would require us to set aside up to $1 Billion
in capital in a worst case scenario. Regulatory capital requirements of
this magnitude are wholly unsustainable for a company our size and
economically unfeasible for a company of any size. The calculations
supporting these estimates are attached to this testimony as Addendum
A. INTL FCStone submitted these same calculations to the CFTC with our
comment letter on this issue.
As I mentioned, INTL FCStone was the first non-bank to register as
a Swap Dealer. As other non-banks register, particularly those in the
agricultural and energy space, additional market participants will be
caught in this position and either squeezed out of the market, or at
least seriously disadvantaged relative to the bank-affiliated dealers.
Obviously, this regulatory capital disparity is not a small hurdle
for the already disadvantaged independent dealers to overcome. If left
unchanged, these capital rules will eventually cause non-bank Swap
Dealers to exit the business. The direct result will be higher costs
for end-users, and then for consumers. Increasing concentration in the
industry until only the big banks are left will leave many customers
with no place to go. Serving farmers, ranchers and grain elevators has
not been a focus or a profitable business model for the large dealers.
Even larger customers who might be able to access to OTC hedging
tools through bank-affiliated dealers will still face higher costs as
the big bank dealers will be able to take advantage of decreased market
competition. A larger percentage of customers carried through a handful
of large, bank affiliated Swap Dealers will increase systemic risk.
The Members of this Committee, obviously, do not see eye-to-eye on
every issue. But one thing I think that every Member of this Committee
would agree on is that Dodd-Frank was not intended to preclude small
commodity producers from hedging, to increase swap concentration at the
banks, or to create greater potential for systemic risk. But with the
capital and margin rules as proposed, that is the result that will
follow.
We believe that this problem can be easily corrected. The Commodity
Exchange Act requires the CFTC, the prudential regulators, and the SEC
to establish and maintain ``comparable'' minimum capital requirements
for all Swap Dealers. However, the proposed Capital Rules clearly are
not ``comparable.'' Pursuant to its mandate under the CEA, we believe
that the CFTC should revise its proposed capital rules to ensure that
the capital and margin requirements applicable to non-bank Swap Dealers
are comparable to those applicable to bank-affiliated Swap Dealers.
This can be accomplished by altering the rules to permit the following:
Full Netting--Revising the ``standardized approach'' in the
CFTC's proposed capital rules to make clear that it allows full
netting of offsetting commodity swap positions, which will
create a capital requirements framework that is more similar to
the prudential regulators;
Matched Position Offsetting--Alternatively, the CFTC could
allow position offsetting for ``matched positions,'' either on
a per commodity/per expiry basis, or by using a ``maturity
ladder'' approach to netting, as described in the Basel
Committee's Amendment to the Capital Accord to Incorporate
Market Risks (the ``Market Risk Amendment''), in order to
facilitate the netting of commodity swap positions; or
Internal Models--The CFTC could permit all Swap Dealers,
including Commodity Swap Dealers, to request approval of, and
rely upon, internal models to measure market risk. To the
extent that the CFTC currently lacks the resources to review
and approve such internal models, it should permit Swap Dealers
to certify to the CFTC or the NFA that their models produce
reasonable measures of risk, subject to verification by the
CFTC when its resources enable it to do so.
Flat Book Incentives--Default risk is reduced when an entity
maintains a relatively flat book. The CFTC should incentivize
dealers to reduce default risk by decreasing capital
requirements for operating a flat book. This incentive can be
achieved by revising the Capital Rules to recognize netting for
economically offsetting commodity swap positions (whether
through the maturity ladder approach, or otherwise). Under the
current proposal, dealers get no credit, from a capital
perspective, for running a flat book and in fact are penalized.
If the CFTC fails to make these changes, INTL FCStone requests that
this Committee consider codifying one or more of these alternatives as
part of the CEA reauthorization.
Capital and Margin Requirements for FCMs--Residual Interest/Customer
Funds
As I mentioned before, I have spent virtually my entire career
working with issues relating to regulatory accounting, FCM capital, and
customer segregated assets. In November of 2012, the CFTC proposed new
comprehensive regulations relating to residual interest and the
handling of customer funds by FCMs. These proposed changes were part of
the CFTC's efforts to address customer protection issues that arose
during the recent MF Global and Peregrine Financial Group bankruptcies.
Customer confidence in the safety of segregated funds and FCM stability
are crucial to the continued success of our markets. INTL FCStone
supports efforts to enhance customer confidence through appropriate
regulation, and fully agree that additional regulation can provide
meaningful additional protections and assurances to market
participants.
However, certain aspects of the CFTC's proposed rules--
specifically, the requirement that FCM's residual interest in futures
customer funds exceeds the sum of all of its customers margin
deficiencies at all times, and the proposal to require FCMs take a
capital charge for margin deficiencies that are outstanding for 1 day
or more--will dramatically alter the way that FCMs and their customers
have done business for decades These proposals will also have a
substantial negative impact on most customers' ability to hedge their
commercial risks, and will severely challenge small and mid-sized FCMs'
ability to continue to operate.
Residual Interest
The Commission has proposed to add a new Rule 1.20(i)(4), and to
amend Rule 1.22(a), to require that ``an FCM must be in compliance with
its segregation obligations at all times and . . . [i]t is not
sufficient for an FCM to be in compliance at the end of a business day,
but to fail to meet its segregation obligations on an intra-day
basis.'' This proposal represents a massive shift in the current
policy, which allows FCMs to ``net'' excess funds of other customers
against the margin deficits of others.
There is also a practical dimension to note. Because it is not
feasible for FCMs to determine whether residual interest exceeds the
sum of all margin deficiencies at all times throughout a day, the new
interpretation suggests that FCMs should model for the failure of ALL
customers, EVERY day. Such a worst-case scenario is unheard of, and is
not applied to any other financial entities. Basel III does not require
banks to hold a dollar for dollar reserve in anticipation of loan
losses of ALL customers. CFTC regulations do not require clearinghouses
to hold dollar for dollar reserves in anticipation of ALL clearing
members failing.
In the end, this new interpretation will result in FCMs requiring
customers to put up more money at all times, likely resulting in
customers being asked to pre-fund their margin. In addition to
requiring customer pre-funding, some have suggested that this rule will
likely require an FCM to double a customers' overall margin
requirements: in essence requiring customers to fund their potential
margin deficiencies. As such, the customer would be required to keep
margin funds far in excess of exchange minimum margin requirements. Our
mid-sized commercial customers rely upon their lending institutions,
such as CoBank, a member of the Farm Credit System, to fund their
commercial activities including their hedging activities. A potentially
doubling of their funding needs to support their hedging activities
would significantly impact the profitability of such customers.
In addition to the negative customer impact, the rule will also put
significant financial pressure on FCMs. If the sum of an FCM's customer
margin deficits is greater than the residual interest an FCM typically
maintains in their customer accounts, then the FCM would have to
increase the amount of residual interest it maintains in customer
segregated accounts. On ``limit up'' or ``limit down'' days in the
agricultural exchange traded markets, our firm may be required to
deposit up to $400 million to satisfy exchange demands for margin. In
order to ensure that our residual interest would be in excess of the
sum of all of our customers margin deficiencies in such a situation, we
would need to require our customer pre-fund their potential margin
deficiencies or in effect require us to pre-fund their potential margin
requirements by maintaining our capital in customer segregated
accounts. Requiring massive additional injections of our own capital to
support the new residual interest requirements will, at some point,
become unsustainable for us and others, again leading to the real and
substantial risk of increased concentration in an already shrinking
market.
One-Day Margin Call
The Commission has also proposed to amend Rule 1.17(c)(5)(viii) to
require an FCM to take a capital charge with respect to any margin call
that is outstanding more than 1 business day. The rule currently allows
an FCM 3 business days to collect margin before taking take a capital
charge. INTL FCStone opposes this proposal because it is impractical
and will result in substantial negative consequences for agricultural
customers and for the FCMs that serve them.
INTL FCStone understands the CFTC's objective in proposing to
shorten the time in which an FCM must take a capital charge for
accounts that are undermargined. Clearly, margin collection is a
critical component of an FCM's risk management program. But it is not
realistic to expect that all margin calls can or will be met in one
day. There are several reasons for this.
First of all, INTL FCStone's customers include a large number of
farmers and ranchers, many of whom meet margin calls by using checks
because of the expense and impracticality of wire transfers in their
circumstances. Check-paying customers are likely to have to double or
triple their margin payments in order to make sure that they can meet
the 1 day requirement. This would be very costly for many farmers and
ranchers.
Second, many of our customers finance their margin calls, which can
require additional time to arrange for delivery of margin call funds
due to routine banking procedures. Finally, foreign customers often
have considerable difficulty meeting margin calls in 1 business day due
to time zone differences and varying bank holidays. In some countries
customers face regulatory restrictions or formalized processes in
connection with any transfers of funds out of their country. This can
often impact such customers' ability to meet margin calls in one day
and, in some cases, make it legally impossible.
Combined Impact
These proposals, taken together, will result in very substantial
costs for FCMs and their customers. For many small and medium-sized
FCMs, the costs of obtaining the required additional capital to cover
increased margins--either in the form of general credit or permanent
capital--could be insurmountable. In order to lower some of these costs
or meet these requirements, FCMs would have to require customers to
prefund some or all of their potential margin obligations, increasing
costs to the end-users and ultimately may have the unintended
consequence of giving smaller commercial customers no alternative to
hedge their commodity price risk.
The increased financial requirements for FCMs will negatively
impact the ability of non-bank FCMs to compete effectively, leading to
a greater concentration of customers at the remaining FCMs and
potentially increasing systemic risk. At the same time, neither of
these proposals brings greater transparency to protect customer funds,
which is what brought down MF Global and Peregrine.
Before making these significant changes, the CFTC should conduct a
more thorough study and then conduct a cost-benefit analysis of the
affects the proposals would have on FCMs, their customers and the
markets. Should the CFTC proceed in a rulemaking that that will shorten
the time period in which an FCM must take a capital charge for under-
margined accounts, we strongly believe that a 2 day deadline is more
reasonable and equitable. Increasing the time to meet a margin call by
an extra day takes into account the challenges and cost considerations
facing many key market participants, such as the agricultural clients
that make up a significant portion of INTL FCStone's customer base.
From our experience, making the margin call deadline 2 business days
would take care of about 90% of the situations where the customer faces
a delay in meeting a margin call.
Customer Issues
External Business Conduct Requirements
I would like to briefly touch on another set of rules that are
having a negative impact on customers of INTL Hanley, our registered
swap dealer: namely, the External Business Conduct Rules that went into
effect on May 1st of this year. As this Committee is well aware, these
Rules generally attempt to enhance protections for counterparties of
Swap Dealers and major swap participants through due diligence,
disclosure, fair dealing and anti-fraud requirements. These External
Business Conduct Rules require the Swap Dealer to deliver pre-trade,
product risk disclosures and a ``mid-market mark'' for the transaction.
Substantial information gathering about our customers is also required
to satisfy new ``know your customer'' and suitability requirements. As
a result, all of our customers have been required to complete extensive
new account forms, and amend their swap documentation so that we, in
turn, can comply with these new rules.
Although these requirements may seem innocuous and un-burdensome to
the regulators, a substantial number of our customers have abandoned
OTC derivatives altogether because the paperwork requirements are
simply too burdensome. Others have asked us to refrain from providing a
mid-market mark because they can either derive this information
themselves, or prefer immediate execution at the market price and
cannot afford even seconds delay in execution.
The proposed rules on capital and margin allow customers to opt-in
or opt-out of certain protections, including, most significantly, the
requirement that collateral be segregated. More than anything else,
segregation of customer funds and prompt transfer of those funds to
customers in the event of a bankruptcy is a core protection embedded in
the Commodity Exchange Act. Because there is an existing regulatory
recognition that customers can make informed choices about whether to
opt-in or opt-out of certain protections, we believe that giving
customers the right to opt-out of certain Business Conduct Rule
disclosures--such as receiving a mid-market mark--would be highly
beneficial.
Eligible Contract Participant Rules
Even prior to Dodd-Frank, CFTC rules limited participation in the
OTC markets to transactions between ``Eligible Contract Participants''
(``ECPs''), i.e., entities with $10 million in total assets or with a
net worth of at least $1 million, who are engaged in hedging qualify as
ECPs. However, Dodd-Frank amended the standard for individuals to
qualify as ECPs by replacing the ``total assets'' test with an
``amounts invested on a discretionary basis test.'' The term ``amounts
invested on a discretionary basis'' is not defined in the Dodd-Frank
Act, and it is unclear from the legislative history what Congress
intended by this amendment. At this point, it is not clear whether a
farmer's ownership interests in legal entities that hold farm and
related assets (which may include the farmer's residence) would
constitute ``amounts invested on a discretionary basis'' under the new
ECP definition for individuals.
INTL FCStone would urge the CFTC and the SEC to use their broad
rulemaking authority to provide guidance on the meaning of the phrase
``amounts invested on a discretionary basis,'' and we request that such
guidance interpret the phrase broadly to permit individuals with
significant farming operations to be deemed ECPs and, therefore,
permitted to use OTC swaps.
Absent such regulatory guidance, we request that this Committee
include a definition of the phrase ``amounts invested on a
discretionary basis'' in the CEA reauthorization bill, and that such
definition be broad enough to capture individuals with significant
farming operations.
Extraterritorial Application of Dodd Frank
Another issue of concern to most market participants is the
international reach of Title VII of the Dodd-Frank Act. As everyone
here knows, the CFTC has issued proposed rules that would essentially
grant the broadest possible extraterritorial reach to U.S. swaps
regulations. According to the CFTC's proposed rules and interpretive
guidance, any swap between a U.S. person and a non-U.S. person will
generally be subjected to U.S. swap regulation. This presents obvious
conflicts with foreign regulations. For example, a cross-border swap
cannot be cleared in both a U.S.-registered clearinghouse and
separately in a different clearinghouse registered in the European
Union.
Although its latest guidance is a move in the right direction,
throughout the regulatory process, the CFTC has consistently insisted
on a broad interpretation of the definition of a ``U.S. person'' and of
the activities that would be deemed to have ``a direct and significant
connection with activities in, or effect on, commerce of the United
States.'' The result is a complex and confusing regulatory scheme that
threatens to expose U.S. Swap Dealers and FCMs to considerable
regulatory risk and would effectively extend the CFTC's reach into any
jurisdiction around the world.
This issue is of great concern to INTL FCStone because our largest
geographic area of growth for our OTC swaps is Brazil. Brazil is a
fast-growing, but still developing market that desperately needs good
hedging tools. INTL FCStone can provide these hedging tools and we can
bring the business from Brazil and other countries into the U.S., so
long as the Dodd-Frank rules do not put us at a disadvantage. But, if
local agriculture producers in Brazil have to comply with Dodd-Frank
requirements if they hedge with us and do not have any comparable
requirements or burdens if they hedge with a non-U.S. firm, they will
go with the non-U.S. firm and we will lose the business.
Other U.S. market participants share our general views on the
cross-border topic, but INTL FCStone wants the Committee to be aware
that the cross-border issue is not one that is only of concern to the
Wall Street firms and the other large players.
The Securities and Exchange Commission's (``SEC'') recent proposal
is a significant improvement over the CFTC's, especially with respect
to the broad view taken by the SEC on the issue of substituted
compliance. By basing its determination of equivalency on outcomes,
rather than requiring a rule-by-rule comparison of the regulations, as
stipulated by the CFTC, the SEC is, I hope, moving us toward a workable
solution where non-U.S. rules that attempt to address the same issues
and get to the same end point should be deemed comparable.
Bottom line--subjecting swaps transactions to multiple, and
potentially conflicting rules and requirements is simply unworkable. It
is imperative that the U.S. regulators work together to promulgate one
set of clear, simple and workable cross-border rules before firms are
expected to comply. In addition, U.S. firms need enough lead time to
digest and comprehend the rules so that we can plan for the scope of
Dodd-Frank's impact on our global businesses.
``Futurization of Swaps''
I want to briefly address an issue that has been called the
``Futurization of Swaps'' because I understand that at least one House
Subcommittee has held a hearing on this issue and the CFTC held a staff
roundtable to discuss it, so I know it is a matter that at least some
in Washington are reviewing. Of course, the ``Futurization of Swaps''
refers to the post-Dodd-Frank Act evolution of end-users bypassing
swaps transactions in favor of futures.
We have been told by a number of our customers that they have
determined that they will no longer use ``vanilla'' or ``look-alike''
OTC instruments, and instead will rely exclusively on exchange traded
futures. It is important to note, however, that this decision has not
been the result of a considered decision about which instrument serves
as the most cost-effective risk management tool, but instead, is wholly
the result of the regulatory burdens associated with swaps as opposed
to futures.
For instance, we have a number of customers who have told us that
the extensive new reporting and record-keeping requirements for swaps
(both cleared and un-cleared) are the factor that has lead them to exit
the OTC markets, although that was never the intent of Congress in
enacting Dodd-Frank. Although exchange-traded futures are often an
appropriate and suitable risk management tool, there are other
instances where futures may not be as beneficial from the customer's
perspective
In our experience, for farmers and others in the agriculture space,
vanilla OTC in fact may be the most cost-effective and practical
hedging vehicle available to them based on the ability to offer
customized credit arrangements, or because there is greater liquidity
in OTC markets. But, due to concerns over the burdens associated with
record-keeping requirements and the likelihood of increased costs of
using swaps, some of our customers have taken a short-sighted view and
have fled the OTC markets for futures. Others have decided not to hedge
at all. This trend runs counter to the intention of Dodd-Frank to allow
end-users a continued ability to access the OTC markets.
Conclusion
INTL FCStone is not interested in dismantling Dodd-Frank. In fact,
most of the concerns expressed in this testimony are about the
implementation of rules, not the Dodd-Frank Act itself. We are simply
trying to ensure that the final rules function as intended and that the
commercial end-users, and the firms like INTL FCStone, who serve them
do not face the same regulatory burden as those in the markets who
speculate and create systemic risk.
Firms like INTL FCStone and our customers did not contribute to the
financial crisis and we support common-sense reforms that strengthen
and bring more transparency to these markets, but we are now being
asked to bear additional regulatory burdens that actually put us at a
competitive disadvantage to the very firms that caused the financial
crisis. This is unfair and, quite frankly, is not good policy. But, we
will continue to work with the regulators throughout this process to
ensure that firms like INTL FCStone will be here well into the
foreseeable future to help our customers manage their risk. And we will
continue to advocate for our customers in seeking regulations that are
drafted in such a way that they continue to allow even the smallest
end-users to have access to hedge against market risk.
These are challenging times for our industry, not only due to the
regulatory changes described above, but also due to fundamental shifts
in the business model that underlies the futures industry. With
depressed futures volumes, historically low interest rates, and
extremely competitive pricing, FCMs are under tremendous strain
financially. Many of us are concerned that the business is reaching a
point where it cannot absorb additional costs without a substantial
shift in the model--whether that is considerable consolidation among
FCMs or some firms leaving the business altogether. This type of risk
concentration in a few firms is not, in my opinion, what was intended
by Dodd-Frank, and it will make the clearing system--and our broader
economy--more vulnerable to catastrophic losses. So as our regulators
consider the pending rules and this body continues to execute its
oversight mandate, I urge you to consider both the immediate and the
long-term consequences that these rules bring for the small and mid-
sized commodity producers, processors and end-users that are so
important to a strong U.S. economy.
Thank you for inviting me to testify today. INTL FCStone greatly
appreciates the ongoing work and support that the Committee has
provided during some very trying times for our nation, and I look
forward to answering any questions that you may have.
Addendum A: Capital Cost of Alternative Approaches To Netting of
Commodity Swap Positions
The necessity of the revisions to the Proposed Capital Rule
recommended by INTL FCStone is evident when an analysis of the various
capital requirement approaches is conducted based on a hypothetical
portfolio. Below we apply the ``standardized approach'' to a
hypothetical commodity swap portfolio held by a swap dealer. This
analysis illustrates how the Proposed Capital Rule's failure expressly
to permit the netting of commodity positions results in significantly
higher capital costs for Commodity Swap Dealers as compared to all
other swap dealers.
As demonstrated above, the commodity position market risk charges
under the ``standardized approach'' are not ``comparable'' to the rules
of the banking regulators. This lack of comparability is inconsistent
with the CFTC's statutory mandate under Section 731 of the Dodd-Frank
Act. In addition, the Proposed Capital Rule's disregard for netting of
commodity swap positions under the ``standardized approach'' is
inconsistent with the fundamental goal of a capital regime, which is to
incentivize prudent risk management by a swap dealer. Keeping all other
factors equal, maintaining a flatter portfolio should yield lower risk
capital charges.
The table below compares the impact of these alternative approaches
to netting of commodity positions under existing approaches to market
risk, including (i) gross calculation with absolutely no offsets, (ii)
the standardized measurement method with offsetting of the exact same
commodity, month, strike, and put/call, (iii) the standardized
measurement method with offsetting in the same expiry, (iv) the
maturity ladder approach with offsetting in the same expiry, and (v)
the internal models based approach.
For purposes of illustrating the impact of these alternative
approaches, we have set a hypothetical baseline of $20 Million (the
minimum capital requirement) as the standardized approach with
offsetting by commodity and expiry. The percentages in the illustration
below are representative of the actual percentage differences seen in
our portfolio in applying the different calculation methods. However,
as noted, the dollar amounts are for illustration purposes only.
The only variable changed between Rows 1-3 is the offsetting used
with the calculation of the 3% supplemental charge. Row 4 uses
paragraphs 7 through 11 of the Market Risk Amendment of which
paragraphs 8 through 10 prescribe application of the Maturity Ladder
Approach. Row 5 represents an internal models approach using Historical
Value at Risk with a 99% confidence interval, 3 year look-back and a 10
day time horizon.
------------------------------------------------------------------------
Percent as
compared to the
Row Market Risk Capital Total Market Risk Row 3
Calculation Approach Capital Charge ``Standardized
Approach''
------------------------------------------------------------------------
1 ``Standardized $536,688,787.53 2,683%
Approach'' (Gross
Calculation with
absolutely no
offsets)
2 ``Standardized $112,939,994.78 565%
Approach''
(offsetting exact
same (commodity,
month, strike, put/
call))
3 ``Standardized $20,000,000.00 100%
Approach''
(offsetting within
same commodity and
expiry)
4 Total for Maturity $17,738,970.37 89%
Ladder Approach with
offsetting in same
expiry
5 Internal Models-Based $3,863,209.48 19%
Approach (HVaR, 99%
CI, 3 year Lookback,
10 day time horizon)
------------------------------------------------------------------------
As depicted in the table above, the differences between the capital
costs associated with the various approaches are astronomical and,
unless the Proposed Capital Rule is clarified/revised, the effects on
the competitive balance between Commodity Swap Dealers and all other
swap dealers would be substantial. While the Internal-Based Models
Approach best corresponds an entity's capital charge to its market
risk, in the event that an internal model is not appropriate for a
given entity, interpreting or modifying the standardized approach under
the Proposed Capital Rule to permit netting by commodity and expiry or,
alternatively, through application of the Maturity Ladder approach, is
a much better alternative and will allow the market to maintain some
semblance of competitive balance.
Additionally, the table depicts the sizeable differences between
approaches permitting different types of offsets. The approaches using
offsets that more accurately gauge an entity's market risk result in
capital charges that are more reasonable and are closer to the capital
charges that result from using a models-based approach. See Appendix A
for an illustration of the differences in the calculations used above.
Appendix A
The purpose of this Appendix is to provide a detailed illustration
of the netting of offsetting exposures described in the comment letter.
For the sole purpose of this illustration, we have put together the
below hypothetical portfolio which contains both OTC and centrally-
cleared corn swaps, swaptions, futures and futures options. This is not
the same portfolio used for the calculations noted in the comment
letter, but rather a much smaller and single commodity portfolio.
For simplicity, this illustration only covers the market risk
charges applicable to 15% directional risk on the net position and the
3% of ``gross'' to cover forward gap, interest rate and basis risk. The
Maturity Ladder Approach (iv) and Internal Models (VaR) (v) are
excluded from this illustration. The initial offsetting allowed under
the Maturity Ladder Approach is the same as reflected in (iii) below
although the resulting charges would be slightly less due to lower
charges (1.5%) for offsetting exposures within a broader ``Time Band''.
Corn
------------------------------------------------------------------------
Position OTC Delta
------------------------------------------------------------------------
A Long 50 December 2013 swaps 250,000
B Long 100 December 2013 5.50 (164,379)
puts
C Long 250 December 2013 6.50 518,800
calls
------------------------------------------------------------------------
Position Central Clearing Counterparty Delta
------------------------------------------------------------------------
D Short 150 December 2013 futures (750,000)
E Short 100 December 2013 5.50 (164,384)
puts
F Short 25 March 2013 6.91 puts 59,762
G Short 25 March 2013 6.91 calls (65,199)
H Short 25 July 2013 6.92 puts 57,717
I Short 25 July 2013 6.92 calls (65,199)
------------------------------------------------------------------------
Definitions of fields used in the below illustrations:
Underlying Group--the underlying commodity upon which the position
is based.
Positions Included--the positions from the above portfolio that are
included in each line. This really helps to illustrate how the netting
described is working.
Contract Month--the delivery month of the underlying on which the
position is based.
Option Type--Call, Put or, in the case of swaps and futures, N/A
for the position shown.
Strike--The strike price for the position shown.
Delta--the underlying equivalent size of the position expressed
here, not as futures equivalents, but notional quantity (i.e., Notional
Delta). In this illustration using corn, the delta is expressed in
bushels. To derive the futures contract equivalent size, simply divide
the number shown by 5000.
Spot Price--in this case, the spot price of corn used in the
calculations as prescribed by the proposed rules.
Delta Notional--derived by multiplying Delta * Spot Price. This is
the notional value of the based upon the delta as prescribed to do in
the Amendment to the Capital Accord to incorporate market risks page 31
under Delta-plus method.
15% Net Charge--this calculation only applies to the net remaining
position and is the capital charge for directional risk. It is derived
by multiplying to total net Delta Notional by 15%.
3% Gross Charge--this value is derived by multiplying the absolute
value of Delta Notional by 3% per line item. This is the only charge
which will vary between the examples below and is dependent upon what
is allowed to offset/net.
(i) Standardized Approach with no offsetting--Same methodology used in Row 1 of the comment letter.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Positions Spot 15% Net
Underlying Group included Contract Month (MMM-YY) Option Type Strike Delta Price Delta Notional Charge 3% Gross Charge
--------------------------------------------------------------------------------------------------------------------------------------------------------
Corn
A Dec-13 N/A 0 250,000.00 5.9975 $1,499,375.00 $44,831.35
C Dec-13 Call 6.5 518,800.17 5.9975 $3,111,504.00 $93,345.12
B Dec-13 Put 5.5 ^164,379.00 5.9975 $(985,863.08) $29,575.89
D Dec-13 N/A 0 ^750,000.00 5.9975 $(4,498,125.00) $134,943.75
E Dec-13 Put 5.5 164,383.79 5.9975 $985,891.79 $29,576.75
F Mar-13 Put 6.91 59,761.61 5.9975 $358,420.27 $10,752.61
G Mar-13 Call 6.91 ^65,198.86 5.9975 $(391,030.18) $11,730.91
I Jul-13 Call 6.92 ^67,119.50 5.9975 $(402,549.20) $12,076.48
H Jul-13 Put 6.92 57,716.57 5.9975 $346,155.12 $10,384.65
------------------------------------------------------------------------------------------
Corn Total Net Total 3,131.62 5.9975 $18,781.89 $2,817.28 $377,217.50
--------------------------------------------------------------------------------------------------------------------------------------------------------
(ii) Standardized Approach offsetting exact same Commodity, Month, Strike, Put/Call--Same methodology used in Row 2 of the comment letter.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Positions Spot 15% Net
Underlying Group included Contract Month (MMM-YY) Option Type Strike Delta Price Delta Notional Charge 3% Gross Charge
--------------------------------------------------------------------------------------------------------------------------------------------------------
Corn
F Mar-13 Put 6.91 59,761.61 5.9975 $358,420.27 $10,752.61
G Call 6.91 ^65,198.86 5.9975 $(391,030.18) $11,730.91
H Jul-13 Put 6.92 57,716.57 5.9975 $346,155.12 $10,384.65
I Call 6.92 ^67,119.50 5.9975 $(402,549.20) $12,076.48
A, D Dec-13 N/A 0 ^500,833.15 5.9975 $(3,003,746.82) $90,112.40
B Put 5.5 4.79 5.9975 $28.71 $0.86
C Call 6.5 518,800.17 5.9975 $3,111,504.00 $93,345.12
------------------------------------------------------------------------------------------
Corn Total Net Total 3,131.62 5.9975 $18,781.89 $2,817.28 $228,403.03
--------------------------------------------------------------------------------------------------------------------------------------------------------
(iii) Standardized Approach offsetting within same commodity and expiry--Same methodology used in Row 3 of the comment letter
--------------------------------------------------------------------------------------------------------------------------------------------------------
Positions Spot 15% Net
Underlying Group included Contract Month (MMM-YY) Option Type Strike Delta Price Delta Notional Charge 3% Gross Charge
--------------------------------------------------------------------------------------------------------------------------------------------------------
Corn
F, G Mar-13 ^5,437.25 5.9975 $(32,609.91) $978.30
H, I Jul-13 ^9,402.93 5.9975 $(56,394.09) $1,691.82
A, B, C, D, E Dec-13 17,971.80 5.9975 $107,785.89 $3,233.58
------------------------------------------------------------------------------------------
Corn Total Net Total 3,131.62 5.9975 $18,781.89 $2,817.28 $5,903.70
--------------------------------------------------------------------------------------------------------------------------------------------------------
Mr. Conaway. I thank the witnesses, and recognize Mr.
Neugebauer, for 5 minutes.
Mr. Neugebauer. Thank you, Mr. Chairman.
Mr. Duffy, you mentioned that industry had taken a lot of
steps to make sure that customers' segregated funds were
protected, and could you kind of just elaborate on how you
think we are today versus where we were, say, 2 years ago prior
to MF Global and----
Mr. Duffy. Sure, I would be happy to. Mr. Roth elaborated
on a couple of the new methodologies that we are deploying to
shore up the system, but where we are at is whether we are
asking the CEO or the CFO to sign off on the movement of
certain segregated funds, a couple of things that Mr. Roth
highlighted, but what is still missing and what is missing in a
lot of things in legislation is teeth in anything. I am a
proponent of regulation to an extent. I am a proponent of
regulation that makes sense on a global basis. What I think we
are also missing is the deterrent for people not to go down the
paths that someone did like at MF Global. I think that we have
shored up the system. People have said to me is there a crisis
of confidence in your market participants? I spoke at the
Kansas Grain and Feed Association. There wasn't a crisis of
confidence in the market, there was a crisis of confidence in
what was the lack of not being done to a certain individual
that went in and used their money for their own purposes.
This is where the problems lie, sir. I think that the old
saying is ``Don't throw the baby out with the bath water.'' We
have good systems in place in our industry. We have added three
or four more to shore that up. What we need to do is put teeth
into these things and make people make certain they don't go
down this path.
Mr. Neugebauer. Just to kind of move forward on that, in
one of the proposals that is out there is an insurance program,
and I was thinking this morning--and also looking at your
testimony, and you mentioned that you were opposed to the user
fees that the--or the fee that the President proposed in his
budget. Do you worry that if you put these user fees on and you
implement an insurance program, that you drive the
transactional cost up for some of the end-users? And we have
already seen a decline in activity. Are we driving some
additional people out of the markets?
Mr. Duffy. I think there is no question that is true. I am
not a proponent of insurance. I supported the study to Mr.
Roth's comments. I think it is the right thing to do. We should
never make a knee-jerk reaction when it comes to something like
this, so the study was a good idea. The problem is it should be
voluntary, not mandatory. I think if people want to have their
costs go up, which they will--you have to realize, sir, we put
$100 million fund in place at CME. I couldn't get it insured. I
had to self-insure that fund because the cost of the insurance
would be a lot more than it is worth, so can you imagine trying
to insure $158 billions of customer segregated funds, what that
would do to the consumer or to the risk offsets that people are
trying to do at FCStone or places? They wouldn't be able to
afford it. So I don't think Congress should mandate it. I think
we have good rules in place, and I don't think insurance is a
bad idea, but it is up for the individual if they want to
acquire it to acquire it, and Congress should not mandatorily
put it in place.
Mr. Neugebauer. Thank you.
Mr. Sprecher, I understand that the EU could, as early as
June, make a determination whether or not the U.S. regulatory
standards are equivalent to theirs. Should that determination
be not equivalent, what would be the ramifications on EU
clients doing business regularly in the U.S. markets, and vice
versa?
Mr. Sprecher. Thank you for the question. The concern that
I have is that if the EU were to make such a determination, and
you rightfully pointed out that they may do that as soon as
June, they would deny access for European customers to U.S.
markets. As a market operator and sitting next to another great
market operator, we enjoy sitting in the United States and
having the world come to us. We enjoy having the world's
agricultural markets in the United States. My company has a
contract called World Sugar, which is largely produced outside
the U.S. and largely consumed outside the U.S., but yet trades
in U.S. markets. I think if we start denying access or if other
countries decide to deny access of global market participants
to the U.S., it will have broad repercussions on keeping these
markets here and regulated in the U.S.
Mr. Neugebauer. Well, the--issue is extremely important to
our--isn't it?
Mr. Sprecher. Absolutely important to our market and our
domestic market participants. We know--and the United States
has benefitted from the globalization of commodities. We are at
the center of that, and it would be sad to see the world get
balkanized as the result of the lack of regulatory
harmonization.
Mr. Neugebauer. Thank you, Mr. Chairman. I yield back.
Mr. Conaway. Thank you, Mr. Neugebauer.
The Ranking Member for 5 minutes.
Mr. Peterson. Thank you, Mr. Chairman.
Mr. Dunaway, I was reading your testimony here, and I guess
I need more clarification or information here about this issue
with the capital margin requirements. I don't understand what
is going on here, why it is the businesses under the bank, the
capital margin requirements are less than they are if they are
not, and that is one issue. And then is this why people are
pushing this swap push-out bill, because the more they can get
under the bank, the less capital they have to come up with? Is
that--I have been kind of mystified why there has been all this
push for this swap push-out bill.
Mr. Dunaway. Well, I can certainly address the first part
of your question. I am not quite as familiar with the second
half, but with regards to the regulatory capital requirement
for a non-bank swap dealer, it really comes down to the fact
that the banks already have internal models that have been
approved by the regulators and the CFTC is willing to rely on--
--
Mr. Peterson. What regulator?
Mr. Dunaway. Either the SEC or the Prudential Regulators
have approved their models.
Mr. Peterson. And so the CFTC has gone along with that?
Mr. Dunaway. They have accepted the internal models that
those banks, but however----
Mr. Peterson. But they are trying to put a different model
on people that are outside?
Mr. Dunaway. They are not accepting--at this point, they
are not approving any other internal model, so they are taking
a standardized----
Mr. Peterson. So you don't know what they are doing, or
what?
Mr. Dunaway. I do know what they are doing, and it is laid
out in our comment letter that we made to the CFTC. They are
taking a page out of the Basel II regulations and creating a
standardized approach, but the real downfall of that is it
takes a complete gross position for non-bank affiliates. We are
taking a market risk, even if we have economically offsetting
positions.
Mr. Peterson. So you have had discussions, obviously, with
the CFTC staff, I guess?
Mr. Dunaway. Yes, we have.
Mr. Peterson. What is their explanation for this? I mean,
it doesn't seem to make any sense. Why are they doing this?
Mr. Dunaway. We have--the beginning of January, we
submitted our comment letter, which I believe has been provided
to the Committee, with the calculations, and we followed that
up with discussions with both CFTC staff and some of the
Commissioners. I don't have a good answer as to why they are
doing it. I know that we have not received any direct feedback
addressing our concerns, other than that they understand the
concern, but we haven't seen any tangible evidence of rule
changes being proposed.
Mr. Peterson. Okay. But they have not actually finalized
this, and so if nothing changes, you are going to have to put
up significantly more capital than the banks.
Mr. Dunaway. If the rules are incorporated, yes, as they
are currently stated.
Mr. Peterson. I guess the way this was proposed, 90 percent
of the swaps that are out there are going to be allowed to
remain under the banks, and about ten percent would have been
pushed out into a separate entity, the reason being that the
banks have government money, taxpayer money behind them and
these swaps that we are pushing out have nothing to do with the
banking activity. They are different. So there is a bill to
allow 99 percent of the swaps to be pushed out, so there will
be hardly anything left in the bank. I was trying to figure out
why they were doing this. Well maybe it is because of this,
that they are going to have to--if they don't allow it under
the banks, they are going to have to put up significantly more
capital in this new entity that they create to hold those ten
percent swaps that are pushed out. But you haven't run into
that or nobody----
Mr. Dunaway. I am not familiar if they push it out, if they
can still use the internal model or not, but I would assume
that they would still have the benefit of utilizing the
internal model, otherwise I am not sure. You can see the
dramatic effect it has on our capital requirements. Even the
large banks, I don't think that they could economically handle
or----
Mr. Peterson. I mean, that would be even more questionable
that they would allow--if they did have to set up the separate
entities and ten percent of the swaps were pushed out, if they
allowed the banks to use that other definition and not you,
that would be even worse.
Mr. Dunaway. I would agree.
Mr. Peterson. You know, it doesn't make any sense. So I
guess my staff would like to follow up with you and also with
the Commission and try to figure out what is going on here.
Mr. Dunaway. Certainly. I would appreciate that. Thank you.
Mr. Peterson. It doesn't seem to make any sense to me.
I yield back.
Mr. Conaway. The gentleman yields back.
I recognize myself for 5 minutes.
The Committee last Congress, and this Congress, have passed
a cost-benefit bill that would basically encapsulate what the
President asked all agencies to do with respect to determining
what the costs are of a particular proposed rule. We have been
particularly disappointed in the way the CFTC has done that.
Can you give us some real world examples, anybody on the panel,
of where the CFTC did do a cost-benefit analysis and either got
it right or got it wrong with respect to the implementation
that you are now going through? So Mr. Sprecher, Mr. Duffy, any
of you can give us some examples of where that is--either lined
up with what the CFTC said, or is out of line?
Mr. Sprecher. Well, the most obvious example that affects
both the CME Group and ICE has been the position limit rules
which came out and ultimately are the subject of court matter
over this very issue. Our customers every day want certainty
about position limits. People are--as you well know, our mutual
constituents want certainty so that they can make informed
decisions, going forward, as part of reinvigorating the economy
is making forward decisions, and unfortunately, this whole
position limit area is tied up in courts over this very issue,
and we are in the unfortunate position of not being able to
help our customers with any kind of guidance on how they might
want to hedge their future risks.
Mr. Conaway. So Mr. Duffy?
Mr. Duffy. Yes, if I could add, I was going to mention
position limits but I am glad Jeff did, because we are both
affected by it. But one of the things--I will try to give you
the other side of the equation of what I think they got right,
and that is on the margin issue as it relates to futures versus
swaps, 1 day versus 5 days. They have historical backgrounds
and data to show that futures should be margin 1 day. They also
have historical data to show that swaps have been margin 5
days, hence Mr. Sprecher's clearinghouse in London at ICE Trust
for credit default swaps. So to say that a swap is identical to
a future is just flat wrong, and it should not be margin in the
same respect because there are certain participants who can
participate in the default. There are certain ones who can't.
There are 12\1/2\ to 20 million contracts a day traded in the
regulated futures market where people can participate in
default. There are 2,000 transactions a day in the over-the-
counter swaps market where a handful of participants can
participate. I think that is where they got it right, if you
want to look at where they got it right.
Mr. Conaway. Okay. Mr. O'Connor, can you give us your
thoughts on the importance of harmonization with respect to the
SEC and the CFTC, as well as the world regulatory scheme?
Mr. O'Connor. Yes. I think a useful example might be the
impact of the CFTC's reach outside of the U.S. jurisdiction, so
the CFTC is fairly unique in that it requires swaps dealers to
register and there is a reluctance on the part of overseas
banks to register with the CFTC, and in fact, on the part of
their own regulators as well to have that happen. So what has
happened is that many, many international banks have now
stopped trading with U.S. banks in the swap markets, since to
do so would trigger a requirement for them to register with the
CFTC, and there might be some perceived actual burden
associated with such registration.
So what that means is that liquidity has been harmed in
that U.S. banks can no longer access liquidity provided by the
overseas banks and vice versa, and the overseas banks, in
addition to not trading with U.S. banks, are not trading with
their U.S. clients either, so U.S. corporations and investment
firms that used to trade with offshore banks now have seen that
liquidity dry up as well, so that is an example.
Mr. Conaway. Is there a way to quantify that in terms of--I
understand the overall concepts, but is there a way to quantify
the lack of liquidity or the increase in costs as a result of
lack of liquidity that we can point to specifically with hard
data?
Mr. O'Connor. Not one that springs to mind immediately, but
certainly we can try to do some work and get that to you.
Mr. Conaway. All right. Mr. Roth, you mentioned the study
that some of you are conducting. What is the timing for when
that is supposed to be done? I think Mr. Lukken said this
summer, but is that what your expectations are?
Mr. Roth. Yes, I am always more optimistic. We are in the
process of--the consultant has all the data that he needs. He
needs to provide that data to the insurance companies and then
get responses back from insurance companies to his requests for
estimates for cost. So it is going to be a little bit out of
his control. It is going to depend on how long those insurance
companies take to get back to him, but we were hoping within
the next 6 weeks we would have a response.
Mr. Conaway. All right, thank you. I will yield back.
Mr. Scott for 5 minutes.
Mr. David Scott of Georgia. Thank you, Mr. Chairman. It is
good to have all of you here and Mr. Sprecher, good to have you
here up from Atlanta, Georgia.
Mr. Sprecher, let me start with you. You have been working
with the CFTC and the SEC for quite some time on what we call
portfolio margining regime for credit default swaps. Can you
give us a brief update on the progress of that?
Mr. Sprecher. Sure. Thank you for the question.
First, let me say that I think it is the nature of my
testimony and hearings like this in general to point out
failings of the agencies because we want to correct them, but
we very much appreciate that both SEC and CFTC have been given
a tall mandate to implement Dodd-Frank in a short period of
time. And one of the areas that is a tall mandate is how to
cooperate on this so-called portfolio margining. The CFTC
largely has its work done and we thank them for that. We have
now turned to the SEC and are trying to work through their
process. They obviously have a different priority set,
different time table on the things they are working on on Dodd-
Frank, so we have tried to raise the priority level of this
issue with them. We have also asked many of you to help us
raise that priority issue.
There is a critical deadline coming up in June 10 where
more of our mutual constituents are going to be required to do
clearing, and we are advocating very hard and strongly with the
SEC that they finish their work in this area by June 10, or if
they cannot finish their work, at least provide some kind of
interim relief that would not make it expensive for end-users
to start clearing, which they are going to be required to do by
law. I have some hope from our recent conversations, including
in the past 24 hours, that the SEC understands that deadline
and is making efforts to try to make sure that our mutual
constituents will see some relief.
Mr. David Scott of Georgia. That June deadline is very
important for that as well for the joint rulemaking, which is
what I would like to talk to you for a minute now. You are
somewhat caught in the middle of that between the CFTC and the
SEC. Can you tell us, is that harmonization possible? Where
could you pinpoint the problem as to why we can't get the SEC
and the CFTC to harmonize? That is critical, and like you said,
June is just a few days away when Europe will be making their
decisions.
Mr. Sprecher. Yes. Both agencies come from two different
perspectives. One, an agency that is very used to overseeing
farmers and ranchers and commodity traders, and another that is
overseeing individual shareholders and securities investors.
They have had different regimes, as many of you know, and a lot
of history with their regimes and they both bring their own
biases and backgrounds to the discussion on how to harmonize.
Frankly, they are trying to find the best of both worlds.
Securities law and just the size and breadth of the SEC is
large and complicated, and so it was not surprising to us to
see the CFTC be able to get its work done quickly. But the SEC
is a very complicated process that is embedded in past history.
I am hopeful that they understand the issue. A lot of end-users
and our mutual constituents have been in to inform them how
important getting this right is, and I do think that that has
had an impact on them to raise the priority on this issue.
Mr. David Scott of Georgia. In your estimation, do you
think it is possible that they can come together and coordinate
and harmonize?
Mr. Sprecher. I think it is a minimum they will provide
some interim ability is my hope. I think the process of
harmonizing is going to take significantly more time, however.
Mr. David Scott of Georgia. And I want to ask you one more
quick question.
You mentioned the importance, in your estimation, of what
you referred to as bona fide hedging.
Mr. Sprecher. Yes.
Mr. David Scott of Georgia. And how that would hurt
commercial end-users. Could you tell us how that would be the
case?
Mr. Sprecher. Sure. You know, in custom and practice over
the last many years, we have had at the Exchange many bona fide
hedgers. These are farmers, ranchers, industrial companies that
are looking to specifically hedge risk. The definition--some of
the definitions that have been proposed are very, very specific
on how one would consider a hedge and go way beyond the history
of how we have been looking at this in the past. For example,
my father-in-law, who is a farmer, is right now planting his
corn. He is going to hedge his corn risk in some way on CME
markets. He has no idea exactly how much corn he is going to
end up with at the end of the year. His hedge will not be a
perfect hedge. It will, by nature, be an imperfect hedge. He
has to make a guesstimate as to how many sunshine days they are
going to have, how his crop might do, how the yields will be
this year. If we hold him to a standard where he has to be
specific up front, it is almost an impossibility and if you go
to very complex industrial companies that are hedging foreign
exchange risks because they are global, they are hedging
interest rate risk because they borrow, they are hedging
commodity risk because of the inputs, they don't have perfect
information and they often buy more contracts than they need or
less contracts than they need and we understand that at the
exchange level. We work with these people day in and day out.
We challenge them on what they do and we think that process
historically has worked very well.
Mr. David Scott of Georgia. Thank you, Mr. Sprecher.
Mr. Sprecher. Thank you.
Mr. Conaway. Mr. Scott for 5 minutes.
Mr. Austin Scott of Georgia. Thank you, Mr. Chairman, and
the gentleman Mr. Neugebauer asked most of my questions about
the European Union, which is what I wanted to concentrate on,
and the potential for two different sets of rules.
One of my primary concerns with what I see coming out is
the effect on liquidity, whether it is an increased transaction
cost, which means you have fewer transactions, or one set of
rules for the U.S. and one set of rules for the European Union.
If the European Union is going to give us an answer in June,
which is 1 month from now, what do you expect to happen between
now and the end of June from U.S. regulatory agencies, and what
do you anticipate the liquidity challenges, not only for the
U.S. but for the world, would be if we end up with the EU
saying we will not accept the rules from the U.S.?
Mr. Sprecher. Thank you for the question, Congressman
Scott.
We hope that, given the short time that you indicate, the
CFTC engages on this on a meaningful level, and if it cannot
work with the EU in such a short period of time, that the two
of them agree to come up with a different deadline.
I think all of us in the room have seen our end-users have
to make last minute decisions or seek last minute relief, and
it is agonizing and it is imperfect. For my own company, we are
having to make decisions do we break apart the liquidity and
contracts and launch U.S. versions and separate European
versions, because the two regulatory regimes may not come
together. We can't do that overnight. We would have to give a
lot of conversation with the global market participants on why
we would be looking at splitting markets and how it is going to
impact them, and if that is what regulators are asking us to
do, we ourselves need a lot of time. So the deadlines are
frightening in their immediacy, and we really hope that the
CFTC will engage at a very meaningful level with Europe. The
relationship between the U.S. and Europe is one that you would
hope that we would be able to come to much commonality.
Mr. Duffy. If I could add a little bit. We are obviously
concerned about the overreaching potential of what the U.S.
Government and what is going to be retaliated back on U.S.
participants in foreign markets. You know, one of the examples
is right now Europe is proposing a 2 day margin for their
products and then there is--so people are saying well what does
that mean? If we don't accept that here in the U.S., will they
start to put different restrictions on U.S. participants in
foreign markets? Well, what they fail to recognize is in the
United States, we do interday margin, so we do margin on a real
time basis every--we don't do it once a day. We do it twice a
day, sometimes three times a day because we do mark to market
every 12 hours, and more if needed. They don't do that in
Europe. What they do is they only do it on a basis of what
market conditions predict. So they are trying to get
commonality across the platforms, and this is one of the
reasons how they are going to bring it out. Well we already
have an answer for that. We do it and we do it even more than
you do it today.
The other issue on the tax, which is something you raised
which is a concern of mine. First of all, Great Britain, to
their credit, have already said they will not accept a Tobin
Tax on users fees as the rest of the European Union is
proposing it. What they also failed to admit is they are going
to have another vote after the elections in November and codify
that at the end of the year. So we will see how that vote goes
first. So the worst thing this Congress could do is react on a
knee-jerk reaction to compare what Europe is going to do prior
to us and then us doing it first. So that is a big concern we
have in our industry.
Mr. Austin Scott of Georgia. I don't believe it will be the
Congress that has a knee-jerk reaction. It might be an agency
or an Administration.
Just real quick--I am almost out of time. What percentage
of the global markets trade through our U.S. entities?
Mr. Sprecher. Well, my company, which as you know is based
in Atlanta, Georgia, has more than 50 percent of our revenues
come from entities outside the United States.
Mr. Austin Scott of Georgia. I think that, again, gets back
to one of our primary concerns in that we want those foreign
businesses doing business in the United States. It is good for
the United States and it is good for our economy.
With that, Mr. Chairman, I am down to about 20 seconds
here. I yield the remainder of my time to you.
Mr. Conaway. The gentleman yields back. Thank you very
much.
Mr. Costa for 5 minutes.
Mr. Costa. Thank you very much, Mr. Chairman.
Mr. O'Connor, your testimony was somewhat critical on
business conduct standards in Dodd-Frank, which were designed
to provide customer protection in the swap market. Do you
believe that we should have some sort of customer protection,
or should we go back to pre-2008?
Mr. O'Connor. I absolutely believe there should be customer
protection. I think the main point that I was attempting to
make was that the approach has been ultra prescriptive rather
than principle-based, and that has led to an enormous challenge
from an implementation perspective.
Mr. Costa. I think you also have to remember, we were
reacting to a crisis. We had a meltdown. I mean, some argue
that, economists, we were this close to a worldwide depression.
Your testimony also bemoans the possibility of multiple
swap data repositories, and we had a lot of debate, as you
know, on Dodd-Frank. The Committee heard similar complaints
from other organizations like yours and private companies that
sought a government mandate to a single swap data repository,
always for the benefit of, one would argue, the regulators.
This Committee rejected that approach in letting the market
decide whether or not a single or multiple repositories would
be best. Well the single repository is such a great idea and
multiple repositories are so bad, why are you seemingly afraid
of letting the market come to the conclusion by itself?
Mr. O'Connor. My point--and I am almost wearing a regulator
hat here, is that the idea behind the data repositories is to
provide one database where regulators can go to look at
behavior in the market and all transactions from all market
participants, and I think that, as I said in my written
testimony, that would give regulators an unprecedented tool in
global markets, and no other market anywhere in the world has
there been the chance to create something that would give
regulators tools to see what every counterparty was doing in
every market. And as a single model, if that is split up into
ten repositories, then that is an opportunity lost is the point
I am trying to make.
Mr. Costa. All right, before my time expires, Mr. Duffy and
Mr. Sprecher, in your testimony--or in the testimony, Mr.
O'Connor expressed worries about fragmentation of derivatives
trade reporting. Each of your companies, I am told, has your
own swap data repository, and the CFTC has been sued by another
swap data repository for approving rules governing each of your
SDRs. Do you agree with Mr. O'Connor's view that
fragmentation--on the fragmentation of swap reporting?
Mr. Duffy. I will say this, that if the swap is being
cleared at Mr. Sprecher's clearinghouse or mine, the cost to
the participants are a lot less. If you have--and second of
all, the regulator already gets a copy of each and every swap,
so he doesn't have to worry about going to one place. He gets a
copy of the swap transaction from the SDRs.
Second, the costs associated with duplication of having a
swap cleared at IntercontinentalExchange or at CME Group and
then sent to one central swap depository is going to cost the
participants multiples of that. So we are already doing that.
Mr. Costa. Mr. Sprecher, quickly before my time expires.
Mr. Sprecher. Yes, and in fact, CME Group and ICE every day
arrange for Large Trader Reports to go to the CFTC to show the
entire positions in our clearinghouse, and so this is really
just an augmentation of what exists today.
Mr. Costa. Let me ask you my final question here. You have
all kind of expressed your concerns about what is going on here
with the implementation of the regulatory scheme of Dodd-Frank.
I don't know that I have really clearly heard you say what
concerns you about what the Europeans are doing right now
because I have some interaction with my colleagues there and
what are your concerns about what is going on there?
Mr. Lukken. Just quickly, one of the issues that we are
dealing with that has been resolved in the United States is how
swaps are segregated here in the United States using the LSOC
methodology. In Europe, that is exponentially more complex,
given that Europeans through a mirror have to give a choice of
both omnibus segregation for swaps and individually segregated
accounts for swaps. That is being interpreted by several
jurisdictions within Europe differently, so companies that we
represent have to come in and build multiple systems in order
to account for each of those different interpretations. We are
working with ESMA in Paris to help to consolidate that, to make
it one comprehensive guidance on how that is going to be built
for the Europeans, and that is just beginning. We are about a
year behind where we are with Dodd-Frank in Europe, but we are
starting to focus our attention----
Mr. Costa. How would you describe the--well----
Mr. Conaway. Nice try, Mr. Costa. The gentleman's time has
expired.
Mr. Costa. Thank you, Mr. Chairman.
Mr. Conaway. Mr. Fincher for 5 minutes.
Mr. Fincher. Thank you, Mr. Chairman, and I thank the panel
for being here today.
Listening to the comments from you all and then some of my
colleagues on the--here today, just thinking about who is going
to regulate the regulators, who is going to oversee the
overseers. You know, how big can it get? How out of control can
it get? I was listening to the Ranking Member, my friend who is
very knowledgeable about these issues, and him being reluctant
from Mr. Dunaway's testimony about how cloudy a lot of these
rules still are.
I guess my point--and Mr. Duffy, I am going to let you
comment on this--we are going to be placed at a terrible
disadvantage. We are seventh generation farmers. I come from a
family farm background. We farm about 12,000 acres of corn and
cotton, soybeans, and wheat. I know firsthand, from having to
deal with Cargill Bungees selling your product and then them
having to go in the market and take a position on that market
that I may deliver in September, December, March, June,
whatever the month may be. When you start really pressing down
on them with more regulations, more margin requirements, then
they come back to me and say Mr. Fincher, we need more capital.
We need a higher risk protection, and my bottom line starts to
decrease. Mr. Scott and I have a credit valuation adjustment
bill that is a study, and my fear is we are going to open the
door to the European institutions on having the advantage over
us because just the credit valuation is a prime example. They
are delaying or not going to enforce it and we are.
Mr. Duffy, would you comment on some of that?
Mr. Duffy. I would be happy to try to comment on that. I
think you are absolutely right. I think that especially when
you look at London, London is truly a one-trick financial
institution. That is what it does. It is going to do everything
in its power to capture financial services business, and if
anybody thinks that excludes agricultural derivative trading or
anything else of that nature, they are sadly mistaken. They
already trade those products throughout Europe today. I said
this before and I will say it again. If we become an importer
of those types of goods and services in this country it will be
a shame, because what will happen when you become an importer
of those products, you become an importer of that price and you
will be determining what they do.
Mr. Sprecher gave a great example about World Sugar. It
trades here in the United States. We set it, we don't even use
it. That is a huge advantage that we have and we should never
want to give that up, sir. I think that our financial markets,
as long as they have the proper oversight, should be free to
operate in the global capacity that we do, and that is
critically important for you as a farmer, or a banker, or any
other--mortgage or reinsurer.
Mr. Fincher. We are so fortunate. I mean, money loves a
safe place and capital, it loves a safe place. And thinking
about MF Global, Mr. Corzine, and the things that happened
there and farmers and ranchers losing money all across the
country, I have a news flash for everybody. I don't care how
many laws you pass in Congress, bad actors are still going to
go bad things, and you are going to tighten down the market to
the point that no one can do business and we have no room for
opportunity, and we are going to lose the market share. I feel
that is what is going to happen from my small perspective.
One last question. I have a minute left. Explain why moving
to a 1 day margin is so unreasonable for many customers, Mr.
Duffy.
Mr. Duffy. Moving to a 1 day margin? You know, again,
margin at the CME Group is based on the evaluation of the risk
of the portfolio, so we really don't measure it. Our risk
department is taught not to measure it in days, it is taught to
measure in risk. What is the cost of the position, and that is
the way we do things to protect the system. Fortunately, the
government has come up with a system that either 1 day, 2 days,
5 days or 10 days on how they decide the collection for the
regulatory floor. I think that is important, because whether
you are a farmer, rancher, or a reinsurer, capital is tight but
yet you still need to risk your portfolio. I don't care that
insurance rates are next to zero. What happens if they go to
five percent overnight and you don't have your portfolio risk
and you are stuck with a bunch of mortgages at zero? You are
going to have a real big problem. So people have to make sure
they have the ability to do risk management, and at the same
time, they can't tie all their capital up in margin, which is
completely unnecessary to the system.
Mr. Fincher. Absolutely. Well my time is almost up. I
appreciate the comments. Thank you. I yield back.
Mr. Conaway. The gentleman yields back.
Mr. Davis for 5 minutes.
Mr. Davis. First of all, thank you, Mr. Chairman, and thank
you to each and every one of you. I apologize, I had to leave
and I am coming back, so if there is anything redundant, please
forgive us.
I would like to ask you kind of an open-ended question,
starting with Mr. Duffy. Is there anything that--any questions
that you haven't had asked yet that you think are very
imperative that this Committee needs to understand so that we
can move forward in ensuring that this regulatory environment
does not stop what you guys are doing on a regular basis?
Mr. Duffy. I don't know if there has been not a question
asked, Mr. Davis, but what is important for this Committee that
oversees the regulator is to make sure that they are enacting
what was in the spirit of the Dodd-Frank law, and not to come
up with some interpretations that had nothing to do with the
law that puts us at what Mr. Fincher said is a complete
competitive disadvantage, because that is exactly the path we
are going to go down if we continue to have the law interpreted
by the regulator that was not voted on by the Congress.
Mr. Davis. Thank you, Mr. Duffy. I appreciate your comments
and I could not agree more. Is there anybody else on the panel
that would like to address this issue?
Mr. Lukken. I would just mention--and we would like to
leave this thought for the Committee is the amount of work that
has gone on since MF Global and since Peregrine to try to
restore customer confidence. Many of these panelists have
talked about this today, all of the different changes that have
gone on, whether it is the automatic verification system that
Mr. Roth has talked about where we are getting daily
confirmations directly with the bank to verify that the money
is there that the FCMs are holding, that is huge. That is
unprecedented, and these guys are way ahead of the curve with
other industries in this area. Whether it is all the changes,
the Corzine rule that the CME and the NFA have adopted where if
a firm is going to move customer money, anything above 25
percent, that they have to get the CFO or the CEO to sign off
on that, I mean, that is accountability, the controls that have
been put into place. So I just wanted to make sure this
Committee understand the enormous amount of work that the self-
regulatory organizations and the industry and the CFTC and the
rulemaking it is currently contemplating are doing to restore
customer confidence, and we just want to make sure that the
Committee understands that fully.
Mr. Davis. Thank you, sir.
Mr. Roth. Congressman, if I could--I am sorry. Just one
comment I would make as far as an issue that we haven't talked
about. Our goal is obviously to prevent FCM insolvencies. When
they do happen, at some point we need to look at the experience
with MF Global and with Peregrine and identify changes
regarding the bankruptcy proceedings to make sure that
customers receive the priority that Congress intended. I know
that is a very complicated question. We have ongoing
discussions with basically everybody here at the table, trying
to make sure we come up with a solution to those issues. I
think we have to look at the bankruptcy proceedings themselves.
There may be a way to do this without--by just amending the
Commodity Exchange Act. We need to explore that. I think
bankruptcy issues, at some point we have to get our arms around
that a little bit better.
Mr. Davis. Thank you, Mr. Roth.
Mr. O'Connor?
Mr. O'Connor. Thank you. I wanted to sort of drill into a
little bit on the international aspect here. I think that is
one thing that has been consistent in all of the testimonies,
and the point I would like to make is while the CFTC has a tool
through the no action letter to make changes and--relief, and
ISDA knows this, because we submitted 17 no action letters
which were almost entirely granted, and by the way, we
appreciate the work of the CFTC staff in granting that, but it
does tax resources both at the regulator and the industry to
have to go through that motion. The point, though, is that the
Europeans don't have such a mechanism and they have a very,
very rigid process for--to get to regulation that to change is
like turning around an oil tanker. So, people shouldn't
underestimate the seriousness of potential conflict that might
be out there.
Mr. Davis. Thank you, Mr. O'Connor. Anybody else? Mr.
Dunaway?
Mr. Dunaway. Sure, I will just add one thing real quick.
One thing I want to make sure the Committee understands is just
the sheer burden that is being placed on smaller OTC
participants, the smaller farmers, small commercial entities
that are really being pushed out of the OTC markets. You know,
we are fully supportive of clearing of swaps on the very
clearinghouses, but the sheer burden of the paperwork and the
disclosures and the hoops that we are making the smaller
participant jump through really ends up pushing them to
products that don't fully hedge their risks. They are going to
exchange rate of product which we are fully happy to offer
them, but it won't particularly hedge their individual
commodities. There is an extreme burden that is pushing a lot
of the smaller farmers, a lot of the smaller commercial
companies to really hedge themselves ineffectively or not at
all.
Mr. Davis. Thank you, Mr. Dunaway, and thank you all very
much for your time today, and your insight. I yield back.
Mr. Conaway. The gentleman yields back.
Mr. LaMalfa for 5 minutes.
Mr. LaMalfa. Thank you, Mr. Chairman. I apologize. I had to
step out of the room for a few minutes here. Some of our
western folks are with us today. Did we get a chance to talk a
little bit about the no action letters in any of our questions
from the Committee here? I had one directed for Mr. Duffy here,
if we--if that hasn't been covered. I don't want to be
redundant here.
The point about numerous no action letters being issued at
last moments for market participants in having to comply with
the new regulation, many of them having been done just since
last summer on the ones that we know about that are public.
Would you be able to elaborate a little bit on how these last
minute no action letters are being a barrier or very harmful to
what you are trying to do as you make business decisions as
well as in the marketplace?
Mr. Duffy. The best thing I could say to that, Congressman,
is being around the markets for 33 years like I have, the worst
thing you could ever have--there is enough uncertainty that you
have in your everyday business, but when you have uncertainty
in the way the rules are, how you are supposed to comply, you
absolutely have no chance to do your risk management business.
And when we are going to the final hour of the deadline without
the rules being understood or disseminated properly and then a
no action letter comes out at the 11th hour, these are harmful
for risk management, for farmers, for bankers, for reinsurers
as I have said earlier, across the board no matter what it
applies to. So these no action letters, which have been
numerous, are actually coming out at the 11th hour, as I said,
and it is the worst thing that could happen is uncertainty,
because uncertainty will chase people away from the marketplace
and it will do what your colleague said. They will go to other
markets in different jurisdictions that don't present this type
of uncertainty. This is critically important. So whatever the
rules are, I am a big believer--when I saw Sarbanes-Oxley and a
lot of people said they couldn't comply with 404, well now they
are complying with 404, but you have to give people time to
understand the rules and to comply with them. You cannot issue
a no action letter at the 11th hour.
Mr. LaMalfa. How do you think that this is a justified way
of doing business, and why do you think this is this way and it
continues to be that pattern?
Mr. Duffy. If I ran the CME Group like that, we wouldn't be
in business.
Mr. LaMalfa. Thank you very much. Yes, that is the thing.
Anybody in business has to make a commitment one way or the
other with their time, their resources, making long-term
commitments. You have to have predictability. You have to know
ahead of time what the ground rules are going to be on
taxation, anything else, otherwise you are on an incomplete
playing field that there is no way to know if the bottom line
is going to be met with the rules that are coming at you at the
last minute.
So I thank the entire panel for your testimony here today,
and hopefully we can make better policy out of this through
this Committee. So thank you so much.
I yield back, Mr. Chairman.
Mr. Conaway. The gentleman yields back.
Mr. Gibbs for 5 minutes.
Mr. Gibbs. Thank you, Mr. Chairman. I just wanted to
mention on the no action letters it is kind of what the EPA
does with guidance letters.
First of all, I want to thank you all for being here. I am
going to kind of pick off Mr. Fincher a little bit, because I
am a farmer/producer too, and I am really concerned. Sitting
here listening to your testimony, there is kind of a common
theme with all these new regulations and more regulatory
enhancement, concern about liquidity in the market, confidence
in the market for price discovery, and if people don't have
confidence, we lose liquidity and we lose price discovery and
we lose a risk management tool for our farmers out there, and
that is my top concern.
So going on that a little bit, it seems to me that we look
to MF Global and some other things that--moving forward on
segregation of funds, keeping that separate in your daily
reporting, that is an area that I believe it looks like to me
that CFTC should really be focused on to make sure that there
is a firewall there and there is accountability. Some of these
other things, the transaction tax and increased margin that
would put a lot of producers out of the market, am I correct in
my hypothesis, I guess, on this? You are all shaking your
heads, so I guess I am.
Mr. Duffy. Good comment, sir. I think you are absolutely
spot on. You have basically touched on everything that you are
talking about. Confidence is of extreme importance, whether you
are referring to MF Global or anything else. If the
participants don't have confidence in the system or the
marketplace, they won't participate, so at the CME Group, we
spend over $40 million a year--and I don't think there is
anybody else in our industry that can even match that number--
on just regulatory issues to show that we have compliance. I
just spent the last 14 to 16 months on the road in the middle
of the country talking to farmers and ranchers and others about
the confidence in the marketplace, the tools that we put into
place. I think that is one of the things that they want to see.
So we are actually showing them what we are doing.
Mr. Gibbs. Just, Mr. Duffy, to go on with that, since we
have had the crisis of MF Global and others, what are you
seeing with customer funds coming back, participation in the
market----
Mr. Duffy. Yes, we are up a couple percent year over year,
and our overall volume, our agricultural products are actually
doing quite well, so I am seeing the farmer come back and
hedging in their products again. And again, as I said earlier,
I don't believe it was a crisis in the CME Group or anything
else. I think it was a crisis in the system how it failed them
and allowed somebody to touch their customer segregated
property, which they did not believe could ever possibly
happen. So, now that we have hopefully shored that up a little
bit, the participants are back in the marketplace, sir.
Mr. Gibbs. That is good. Do you want to add Mr. Roth?
Mr. Roth. Congressman, I just wanted to add that since we
have implemented this system for the daily confirmation of seg
balances, it officially became active February 15. I should
also mention that all of the data that we receive is always
available to the CFTC as well, so that we can have a third set
of eyes looking at that. We always make all of our data,
regulatory data immediately available to the CFTC, and so they
can see the same stuff that we see and I think it is a huge
improvement from where we were just a year ago.
Mr. Gibbs. Just to follow up, another question about the
Bankruptcy Code. You know, the first in line if there is a
bankruptcy, we see funds that people from the segregated firms
fail, segregated accounts. Specifically can you provide any
insight how that Code should be amended to make sure that our
producers are protected?
Mr. Roth. Yes, I can just mention an issue that the CFTC
has always defined customer property under the bankruptcy
rules--under its bankruptcy rules, it has defined customer
property and in the event of a shortfall in seg funds, customer
property has always been defined to include all of the assets
of the FCM until the customers have been made whole. That is a
great definition. That is exactly the way it should be. It is
the way it has been for a long time. There was in a proceeding
maybe 10 years ago a district court opinion which was
ultimately rendered moot because the matter was settled, but
that court decision rendered--created some doubt as to the
validity of the CFTC's definition, and that is a doubt I don't
think we should have to live with. I think that cloud should be
removed and we should figure out a way to make very clear----
Mr. Gibbs. I am just about out of time. Just a quick
question. MF Global, our producers out there and getting
reimbursed, what is the status, Mr. Duffy?
Mr. Duffy. I will be happy to take shot. Right now, the
best estimates are that 4D, which are U.S. clients trading on
U.S. markets, have roughly 99 on the dollar back, and then
there is another, what are called 30.7, which are U.S. clients
trading on foreign markets, which have around 97 on the dollar
back, so we are seeing most of the property returned to the
participants that it was taken from. Now obviously there are
shortfalls on the broker/dealer side, but again, in our world,
because of some of the steps that we were able to take, along
with our colleagues down the line here, we were able to get the
money back.
Mr. Gibbs. Thank you very much. Thank you, Mr. Chairman.
Mr. Conaway. The gentleman's time has expired.
Gentlemen, I appreciate each of you coming today and
helping us with your perspectives on how well the CFTC is doing
and not doing, both the good and the bad. We have several
hearings yet to be held with the Subcommittee, and we will look
forward to additional comments.
I ask unanimous consent to enter into the record letters
from the Institute of International Bankers, from SIFMA, and
the American Bankers Association on this issue.
[The information referred to is located on p. 59.]
Mr. Conaway. Again, thank you, gentlemen, for your time
this morning, and we are adjourned.
[Whereupon, at 11:49 a.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Letters by Hon. K. Michael Conaway, a Representative in
Congress from Texas
May 21, 2013
Hon. Frank D. Lucas,
Chairman,
House Committee on Agriculture,
Washington, D.C.;
Hon. Collin C. Peterson,
Ranking Minority Member,
House Committee on Agriculture,
Washington, D.C.
Dear Chairman Lucas and Ranking Member Peterson:
In connection with the Agriculture Committee's hearing on ``The
Future of the CFTC: Market Perspectives'' and given the role of the
CFTC with respect to swaps regulation under Title VII of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (DFA), the Institute of
International Bankers (IIB) would like restate our support for a number
of important issues. We recognize and applaud the Committee's efforts
to address these issues in legislation approved by the Committee
earlier in the year, and in the previous Congress.
The IIB represents internationally headquartered financial
institutions from over 35 countries around the world, and its members
are extensively involved in activities regulated by the CFTC, including
in particular swaps activities that are subject to the requirements of
Title VII. Indeed, IIB members constitute approximately \1/2\ of the
firms that are currently registered as swap dealers under Title VII.
As the Committee initiates its CFTC reauthorization process, we
believe whether through standalone legislation or as part of
reauthorization, that it is important that the Committee provide: (i)
certainty with respect to the application of the requirements of Title
VII to cross-border swaps activities, including the effective and
efficient coordination and harmonization of U.S. rules with those of
other countries; and (ii) national treatment for the U.S. operations of
foreign banks vis-a-vis U.S.-headquartered banks in connection with
their swaps activities in the United States.
Cross-Border Swaps Activities--Certainty in the Coordination of U.S.
and International Rules
(1) A substantial majority of swaps transactions are effected
between counterparties in different countries. Ensuring proper
alignment of U.S. rules with those of other countries therefore
is crucial to maintaining the vitality of the U.S. swaps
market.
Substituted compliance is an important component of harmonizing
U.S. swaps rules with the rules of other jurisdictions.
Reflecting the strong U.S. commitment to the principles agreed
to by the G20 leaders in 2009, DFA Sec. 752 directs the CFTC to
consult and coordinate with its regulatory counterparts outside
the United States in order to promote effective and consistent
global regulation of swaps. The cross-border dimensions of
swaps regulation are also addressed in DFA Sec. 722(d), which
establishes a general prohibition against the application of
Title VII's requirements to swaps activities outside the United
States, except with respect to activities that have a ``direct
and significant connection with activities in, or effect on,
commerce of the United States'' or as may be necessary to avoid
evasion of Title VII.
Unfortunately, efforts to this point to achieve an appropriate
cross-border harmonization of Title VII's requirements with
those of other countries have born little fruit. As a result,
there remains considerable uncertainty regarding the cross-
border application of Title VII's requirements, which in turn
has given rise to significant concerns regarding the prospect
of fragmenting and disrupting the international swaps market.
Mutual recognition of each other's rules through substituted
compliance is an important means to accommodate the rules of
different countries in a manner that fosters coordination and
avoids unnecessary duplication or conflict. Consistent with
international comity principles, permitting a financial
institution to comply with equivalent rules of another
jurisdiction in connection with its cross-border swaps
activities best achieves the purposes underlying DFA Sections
752 and 722(d).
At this stage of Title VII's implementation, there exists a very
real potential for conflict between U.S. rules and those of
other countries. Absent a satisfactory resolution of these
conflicts, many global swap dealers will face the untenable
position of violating one country's rules or laws in order to
comply with another's. We appreciate the Committee's efforts on
this issue in approving H.R. 1256, the Swap Jurisdiction
Certainty Act. We believe it is essential to make it explicitly
clear that reliance on broadly equivalent rules of other
countries is an integral part of the cross-border swaps
regulatory regime intended under Title VII.
Ensuring National Treatment
(2) DFA Sec. 716, also known as the ``swap push-out rule'',
contains an acknowledged oversight that results in unequal
treatment for uninsured U.S. branches and agencies of foreign
banks compared to that of U.S. banks. Sec. 716 sets forth a
general prohibition against ``Federal assistance'' (including
access to the discount window) for swap entities, but includes
certain grandfather and transitional provisions that permit the
phased-in implementation of the prohibition with respect to
insured depository institutions as well as safe harbor
provisions that allow insured depository institutions to
continue to engage in swap activities related to their bona
fide hedging and traditional bank activities. The uninsured
branches and agencies of foreign banks are not afforded the
benefit of these provisions. Senators Dodd and Lincoln
recognized that this exclusion was unintentional and
acknowledged that there was a need ``to ensure that uninsured
U.S. branches and agencies of foreign banks are treated the
same as insured depository institution.'' \1\
---------------------------------------------------------------------------
\1\ 156 Cong. Rec. S5903-S5904 (daily ed. July 15, 2010) (colloquy
between Senator Dodd, Chairman of the Senate Banking Committee, and
Senator Lincoln, Chairman of the Senate Agriculture Committee and
sponsor of Sec. 716).
Uninsured U.S. branches and agencies are licensed by a Federal or
state banking authority and subject to the same type of safety
and soundness examination and oversight as U.S. banks. Based on
the policy of national treatment, uninsured branches and
agencies are afforded equivalent treatment to U.S. banks,
including access to the Federal Reserve's discount window.
Access to the discount window is an important tool for
maintaining a sound and orderly financial system, and the
branches and agencies of U.S. banks are provided access to
similar facilities in other countries.
Based on the disparate treatment to which they are subject under
Sec. 716, the uninsured U.S. branches and agencies of foreign
banks are facing the prospect of having to ``push-out'' all
their existing swap positions and ongoing swap activities to a
registered swap affiliate by the July 16, 2013 effective date--
an impossible compliance task and one that places these
uninsured branches and agencies at a substantial competitive
disadvantage vis-a-vis insured depository institutions that
benefit from the grandfather, transitional and safe harbor
provisions. The resulting disparity is wholly at odds with the
longstanding U.S. policy of national treatment; the legislation
approved by the Committee H.R. 992 would address this
unintended oversight.
(3) The definition of a ``Swap Dealer'' under Sec. 1(a)(49) of the
CEA (as modified by the DFA) provides an exclusion for insured
depository institutions, specifying that in ``no event shall an
insured depository institution be considered to be a swap
dealer to the extent it offers to enter into a swap with a
customer in connection with originating a loan with that
customer.'' Similar to the unintended omission of uninsured
U.S. branches and agencies of foreign banks in DFA Sec. 716,
this exclusion is provided only for insured depository
institutions and results in unequal treatment for those
uninsured branches and agencies that generally enter into swaps
transactions only in connection with their lending
activities.\2\
---------------------------------------------------------------------------
\2\ For those insured depository institutions that generally enter
into swaps transactions with customers only in connection with their
lending activities, the exclusion ensures that such ordinary course
banking activities will not result in their having to register as a
swap dealer. At the same time, swap transactions conducted by an
insured depository institution outside the context of its ordinary
banking activities may result in it having to register as a swap
dealer.
This exclusion permits small U.S. banks the ability to enter into
interest rate swaps in connection with their lending activities
without having to register as swap dealers, thereby providing
them a competitive advantage over the similarly-situated
uninsured U.S. branches and agencies of foreign banks, which
are denied this parity of treatment. In the last Congress, the
Committee approved legislation that addressed this issue. We
would urge the Committee to address this important national
---------------------------------------------------------------------------
treatment issue as part of the CFTC reauthorization process.
We thank you for your attention to and efforts on these important
issues, and are happy to provide additional information at your
request.
Sincerely,
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Sarah A. Miller,
Chief Executive Officer,
Institute of International Bankers.
______
May 14, 2013
Ananda Radhakrishnan,
Director of Division of Clearing and Risk,
Commodity Futures Trading Commission,
Washington, D.C.
Re: Request for Relief with respect to Rule 39.13(g)(2)(ii)
Dear Mr. Radhakrishnan:
The Asset Management Group (the ``AMG'') \1\ of the Securities
Industry and Financial Markets Association (``SIFMA'') is writing to
request that the Commodities Futures Trading Commission (the
``Commission'') take prompt action to provide relief from the terms of
Rule 39.13(g)(2)(ii). In particular, we are writing to support the
requests made on behalf of Bloomberg L.P. (``Bloomberg'') in a letter
dated March 11, 2013, and a Motion for Stay dated April 24, 2013, for
relief from the 5 day minimum liquidation time required for the
calculation of initial margin requirements for swaps (other than swaps
on agricultural commodities, energy commodities and metals) cleared on
derivatives clearing organizations (``DCOs''). We understand that,
notwithstanding the related legal actions recently filed on behalf of
Bloomberg in District Court for the District of Columbia, such requests
remain pending with the Commission.
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\1\ The AMG's members represent U.S. asset management firms whose
combined assets under management exceed $20 trillion. The clients of
AMG member firms include, among others, registered investment
companies, endowments, state and local government pension funds,
private sector Employee Retirement Income Security Act of 1974 pension
funds and private funds such as hedge funds and private equity funds.
In their role as asset managers, AMG member firms, on behalf of their
clients, engage in transactions that will be classified as ``security-
based swaps'' and ``swaps'' under Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (the ``Dodd-Frank Act'').
---------------------------------------------------------------------------
We are aware of the extensive attention given to this issue by the
Commission and its staff, including the Commission's consideration of
comments received on the rule as initially proposed and your
solicitation of public input through the Public Roundtable on
Futurization of Swaps (the ``Roundtable'') held on January 31, 2013. We
take this opportunity to offer the perspective of our buy-side member
firms and to highlight several important market developments.
Background
Rule 39.13(g) provides that DCOs shall employ models that will
generate margin requirements adequate to cover the DCOs' potential
future exposure to a clearing customer's position based on price
movements between the last collection of variation margin and the time
within which the DCO estimates that it would be able to liquidate a
defaulting clearing member's positions. Under the final rule the models
must assume, unless an exception is granted, that it will take at least
1 day to liquidate futures and options (``Futures'') and agricultural
commodity, energy commodity and metal swaps (``Commodity Swaps'') and
that it will take at least 5 days to liquidate all other cleared swaps
(``Non-commodity Swaps''). In the preamble to the final rule, the
Commission explained that these ``bright-line'' minimum liquidation
times would provide certainty to the market, ensure that margin
requirements would be established for the ``thousands of swaps that are
going to be cleared'' and prevent a potential ``race to the bottom'' by
competing DCOs.
AMG believes that the minimum liquidation time of 5 days for Non-
commodity Swaps (a) is arbitrary and overly conservative, (b) is based
on a fundamentally flawed assumption as to a difference in liquidity
between futures and swaps, (c) creates an artificial economic incentive
for market participants to use futures rather than swaps and (d) is
contrary to Congress's goal of promoting trading of swaps on swap
execution facilities (``SEFs''). We strongly believe that the minimum
liquidation time for Noncommodity Swaps should be the same as for
Futures and Commodity Swaps--i.e., 1 day--with DCOs using their
reasonable and prudent judgment to set higher liquidation times for
particular types or classes of transactions where warranted by their
specific liquidity characteristics as evidenced by quantitative
analyses derived from sources such as swap data repository data.
The 5 Day Minimum Liquidation Time for Non-Commodity Swaps Is Arbitrary
and Overly Conservative
Nowhere in the adopting release for the final or proposed rules
does the Commission explain why the minimum liquidation time for Non-
commodity Swaps should be five times that for Commodity Swaps and
Futures. Initial margin set by a DCO for a particular transaction is
intended to cover the potential future exposure of the DCO during the
maximum period between the last collection of variation margin and the
time within which the DCO estimates that it would be able to liquidate
a defaulting clearing member's position(s) in such transaction. Thus,
the appropriate liquidation time for a particular transaction will be
affected by a number of factors, including: the trading volume, open
interest, and predictable relationships with highly liquid products of
such transaction. In adopting a one-size-fits-all 5 day liquidation
time for Non-commodity Swaps, the Commission relied on a flawed
assumption, which we discuss below, that Non-commodity Swaps
categorically take five times longer than Futures and Commodity Swaps
to liquidate. This belief is not supported and fails to adequately take
into account the wider range of options available for closing out swap
transactions as compared to Futures.
Moreover, a 5 day liquidation time for Non-commodity Swaps is
overly conservative. The Commission does not provide any data or
analysis of the liquidity in the interest rate, credit default, foreign
exchange or equity index swap markets to support the 5 day liquidation
time for Non-commodity Swaps.
The Commission's Assumption About the Difference in Liquidity Between
Futures and Commodity Swaps, on the One Hand, and Non-Commodity
Swaps, on the Other Hand, Is Fundamentally Flawed
The Commission's assumption that Non-commodity Swaps are
categorically five times less liquid than Futures and Commodity Swaps
is fundamentally flawed. Many swap contracts have become highly
standardized and fungible; conversely, new swap futures offerings have
customized terms. This convergence makes prior distinctions between
futures and swaps no longer relevant.\2\
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\2\ In its Final Rule defining ``swap'' and ``security-based
swap,'' the Commission described a comment received from the CME that
the CFTC should ``clarify that nothing in the release was intended to
limit a DCM's ability to list for trading a futures contract regardless
of whether it could be viewed as a swap if traded over-the-counter or
on a SEF, since futures and swaps are indistinguishable in material
economic effects.'' The Commission declined to provide the requested
clarification noting that prior distinctions between swaps and futures
(such as the presence or absence of clearing) may no longer be
relevant, and as result it is difficult to distinguish between the two
instruments on a blanket basis. Further Definition of ``Swap,''
``Security-Based Swap,'' and ``Security-based Swap Agreement''; Mixed
Swaps; Security-Based Swap Agreement record-keeping, 77 Fed. Reg.
48208, 48303 (Aug. 13, 2012).
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Standardization of over-the-counter swap terms has been underway
for some time and is currently accelerating in response to the new
regulatory developments under the Dodd-Frank Act such as the
implementation of mandated central clearing and exchange trading. For
example, the standardization of auction settlement and contract terms
of credit default swaps began in 2009 under ISDA's ``big bang''
protocol. More recently, interest rate swaps (``IRS'') are becoming
standardized as well. AMG, working in collaboration with ISDA, has
introduced Market Agreed Coupon Contracts (``MAC Contracts'') which are
IRS contracts with pre-defined, market-agreed terms, including start
and end dates and fixed coupon rates.\3\ Similarly, trueEX LLC
(``trueEX''), a Designated Contract Market (``DCM'') launched in 2012,
plans to list for trading on its electronic trading platform U.S.
dollar denominated Standard Coupon & Standard Maturity Interest Rate
Swap contracts (``SCSM Contracts'') with standardized coupons,
maturities, roll dates and other terms. In both cases, these
standardized specifications are intended to create fungible, liquid
contracts regardless of the date acquired and are highly similar to
swap futures contracts offered on futures exchanges.
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\3\ See SIFMA website: http://www.sifma.org/services/standard-
forms-and-documentation/swaps/.
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Despite having highly similar, or in some case indistinguishable,
trading and liquidity characteristics, the arbitrarily longer
liquidation time mandated for Non-commodity Swaps by Rule
39.13(g)(2)(ii) puts them at a significant competitive disadvantage and
creates an artificial economic incentive for market participants to use
futures rather than swaps, which could result in unintended and
unjustifiable regulatory arbitrage. For example, in December 2012, Eris
Exchange launched ``Eris Standards,'' swap futures contracts with
quarterly effective dates, pre-determined fixed rates, and cash
settlement upon maturity, but as described in a press release, these
swap futures contracts ``are expected to offer margin savings of 40-80%
compared to cleared OTC interest rate swaps.'' \4\ In contrast, without
relief from the Commission, the MAC Contracts--which also have
quarterly effective dates, predetermined fixed rates and more flexible
means of settlement, including cash unwind--would be required to use a
5 day liquidation time under Rule 39.13(g)(2)(ii).
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\4\ Eris Exchange to Launch New, Margin-Efficient Interest Rate
Swap Futures (Press Release, Dec. 5, 2012) avail at http://
www.prnewswire.com/news-releases/eris-exchange-to-launch-new-margin-
efficientinterest-rate-swap-futures-182180261.html.
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AMG believes that these deliverable swap futures contracts and MAC
swap contracts are similar instruments and would require substantially
similar time periods to liquidate in the case of a customer default.
Accordingly, we strongly believe that the minimum margin requirements
for these instruments should be the same. Also, we do not believe there
is any basis whatsoever to increase the margin requirements or minimum
liquidation times for Futures. As expressed in our prior comment
letters, we also continue to believe that the Commission should not
require minimum liquidation times that exceed 1 day for cleared swaps,
whether Commodity Swaps or Non-commodity Swaps.\5\
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\5\ See SIFMA AMG Letter to the Commission on Risk Management
Requirements for Derivatives Clearing Organizations (Jun. 3, 2011),
available at http://sifma.org/workarea/downloadasset.aspx?id=25861
(``In the context of cleared transactions, we believe that a 1 day
liquidation period for swaps executed on either a DCM or SEF and a 2
day liquidation period for all other swaps is sufficient for this
purpose . . .'').
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Rule 39.13(g)(2)(ii) Is Contrary to Congress's Goal of Promoting
Trading of Swaps on SEFs
By creating incentives favoring futures trading over swap trading,
Regulation 39.13(g)(2)(ii) runs counter to Congress's explicit goals
``to promote the trading of swaps on swap execution facilities and to
promote pre-trade price transparency in the swaps market.'' \6\ A
nearly identical concern led the Commission to abandon its originally
proposed bright-line distinction between 1 day and 5 day minimum
liquidation times for swaps executed on DCMs and SEFs, respectively. In
the preamble to the final rule, the Commission noted that ``requiring
different minimum liquidation times for cleared swaps that are executed
on a DCM and similar cleared swaps that are executed on a SEF could
have negative consequences.'' \7\ The Commission acknowledged the
comments of multiple parties that this distinction, among other things,
would put SEFs at a competitive disadvantage to DCMs, potentially
create detrimental arbitrage between standardized swaps traded on a SEF
and contracts with the same terms and conditions traded on a DCM and
undermine the goal of the Dodd-Frank Act to promote trading of swaps on
SEFs.\8\ In response to such comments, the Commission determined not to
mandate different minimum liquidation times for cleared swaps based on
whether they are executed on a DCM or a SEF.\9\ We believe that the
same logic should be applied such that minimum liquidation times for
cleared swaps executed on a DCM or a SEF should be no higher than that
for exchange-traded futures.
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\6\ Commodity Exchange Act 5h(a)(1)(e).
\7\ Derivatives Clearing Organization General Provisions and Core
Principles, 76 Fed. Reg. 69334, 69367 (Nov. 8, 2011).
\8\ Id. at 69366.
\9\ Id. (``The Commission is persuaded by the views expressed by
numerous commenters that requiring different minimum liquidation times
for cleared swaps that are executed on a DCM and equivalent cleared
swaps that are executed on a SEF could have negative consequences.'')
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By arbitrarily setting the liquidation time for Non-commodity Swaps
at 5 days, as compared to 1 day for Futures, Rule 39.13(g)(2)(ii)
increases the margin required for Noncommodity Swaps relative to
Futures and creates an artificial economic incentive for market
participants to favor Futures, even though the trading and liquidity
characteristics of the two instruments may be the same. Surely, it
could not have been Congress' intent in adopting Title VII of the Dodd-
Frank Act for the Commission to create a market structure that would
move liquidity away from swaps and into Futures.\10\ However, Rule
39.13(g)(2)(ii) puts SEFs at a competitive disadvantage to DCMs, and
creates a detrimental arbitrage between Non-commodity Swaps and futures
contracts with the same terms and conditions. It is critical to our
members' interests as swap market participants that SEFs be robust and
vibrant trading platforms and not disadvantaged by external costs that
arise solely due to regulatory status. However, if the minimum
liquidation times established by the Commission under Rule
39.13(g)(2)(ii) remain unchanged, the Congressional goal of promoting
trading of swaps on SEFS will be undermined.
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\10\ Indeed, post-implementation of rules adopted by the Commission
under the Dodd-Frank Act, the cleared swaps markets may provide more
protections to participants than the Futures market, For example, the
Commission's collateral segregation model for cleared swaps (complete
legal segregation), once implemented, will be more protective than the
model for Futures, as the MF Global and Peregrine collapses have shown.
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Relief Requested
Accordingly, we encourage the Commission to provide relief in the
form of a stay of Rule 39.13(g)(2)(ii) that would immediately adjust
the minimum liquidation time for all cleared Non-commodity Swaps,
whether executed on a SEF or DCM, to a 1 day liquidation time,
conditioned on the obligation of the relevant DCO to use its reasonable
and prudent judgment to set higher liquidation times for particular
types or classes of transactions where warranted by their specific
liquidity characteristics, as evidenced by quantitative analysis
derived from sources such as swap data repository data. We respectfully
request that the Commission act expeditiously to do so, in view of the
importance of relief before the June 10, 2013 mandatory clearing date
for category 2 participants, as Bloomberg has explained in its Motion
for Stay. Relief before June 10 is necessary to give market
participants more certainty and provide a greater incentive for
participants to clear their Non-commodity Swap trades.
Based on the foregoing, we respectfully request that the Commission
grant the relief described in this letter. We appreciate the
Commission's consideration of this request, and stand ready to provide
any additional information or assistance that the Commission might find
useful. Should you have any questions, please do not hesitate to call
Tim Cameron at [Redacted] or Matt Nevins at [Redacted].
Sincerely,
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Timothy W. Cameron, Esq.,
Managing Director, Asset Management Group,
Securities Industry and Financial Markets Association;
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Matthew J. Nevins, Esq.,
Managing Director and Associate General Counsel, Asset Management
Group,
Securities Industry and Financial Markets Association.
CC:
Hon. Gary Gensler, Chairman, Commodity Futures Trading Commission;
Hon. Jill E. Sommers, Commissioner, Commodity Futures Trading
Commission;
Hon. Bart Chilton, Commissioner, Commodity Futures Trading Commission;
Hon. Scott O'Malia, Commissioner, Commodity Futures Trading Commission;
Hon. Mark Wetjen, Commissioner, Commodity Futures Trading Commission.
Certification Pursuant to CFTC Regulation 140.99(c)(3)
As required by CFTC Regulation 140.99(c)(3), we hereby (i) certify
that the material facts set forth in the attached letter dated May 14,
2013 are true and complete to the best of our knowledge; and (ii)
undertake to advise the CFTC, prior to the issuance of a response
thereto, if any material representation contained therein ceases to be
true and complete.
Sincerely,
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Timothy W. Cameron, Esq.,
Managing Director, Asset Management Group,
Securities Industry and Financial Markets Association;
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Matthew J. Nevins, Esq.,
Managing Director and Associate General Counsel, Asset Management
Group,
Securities Industry and Financial Markets Association.
______
May 21, 2013
Hon. Frank D. Lucas, Hon. Collin C. Peterson,
Chairman, Ranking Minority Member,
House Committee on Agriculture, House Committee on Agriculture,
Washington, D.C.; Washington, D.C.
Dear Chairman Lucas and Ranking Member Peterson:
The American Bankers Association (ABA) appreciates the opportunity
to participate in the comprehensive review of the Commodity Exchange
Act (CEA) and Commodity Futures Trading Commission (CFTC) regulatory
oversight. As noted in your request, this reauthorization comes at a
challenging time. Not only has the CFTC remained responsible for
oversight of the futures markets, but also it has proposed and
finalized dozens of rules to implement the new regulatory framework
required by the Dodd-Frank Act.
ABA encourages the Committee to address the following issues
related to the new swaps regulations during the reauthorization:
implementation transition, cross-border jurisdiction, eligible contract
participant (ECP) definition, and risk-based measurement for the
clearing exemption.
Implementation Transition
New swaps regulations must be implemented carefully so that they do
not unnecessarily interfere with bank or bank customer risk management.
The vast majority of banks use swaps to hedge or mitigate risk from
their ordinary business activities, including lending. Hedging and
mitigating risk are not only good business practices generally, but are
important tools that banks use to comply with regulatory requirements
to prudently manage risks associated with their assets and liabilities.
Some banks also give customers the option of using swaps to hedge
and mitigate their loan risk from changes in interest rate or currency
exchange rates. Farmers and energy companies may want to hedge against
price changes in commodities. Swaps can be used for all of these
purposes.
If banks cannot afford to continue using swaps to hedge risk
because the regulations are too burdensome or are not implemented in a
way that ensures a smooth transition, it will affect their ability to
provide long-term, fixed rate financing. Customers may find long-term
business planning difficult and may hesitate to borrow if they are only
able to get short-term loans or loans with variable interest rates.
They may also defer other business plans if they do not have a cost-
effective way to hedge and mitigate their foreign currency, commodity
price, or other risks.
The new regulatory framework for the swaps markets is not yet
complete. Banks, bank customers, and other market participants need
clarity as the new regulations are implemented. ABA believes that clear
rules and interpretive guidance as well as appropriate no-action relief
will ensure a smooth transition for swaps markets.
Cross-Border Jurisdiction
Banks operating globally also need clarity about the jurisdictional
scope of the U.S. regulatory requirements. Although Title VII of the
Dodd-Frank Act includes provisions that generally limit its
extraterritorial reach, the language does not clearly delineate a
standard for determining which cross-border activities should be
subject to U.S. jurisdiction. Nor does it address the competitive
imbalances that might arise if swaps regulations apply differently to
banks depending on the country where they are headquartered.
The CFTC has issued proposed guidance and an exemptive order to
address the applicability of Title VII regulations to cross-border
swaps transactions. The Securities and Exchange Commission (SEC) has
indicated that it will issue a proposed rule addressing security-based
swaps transactions. In the meantime, banks operating globally are
uncertain about which U.S. regulatory requirements may or may not apply
to some of their derivatives activities and whether the jurisdictional
scope may differ depending on whether the bank is headquartered in the
United States or in another country.
ABA supports the goal of promoting consistency between the cross-
border application of all Title VII rules. Market participants that
engage in swaps and security-based swaps need clarity and would benefit
from consistency between CFTC and SEC rules.
Eligible Contract Participant Definition
ABA has previously asked the CFTC for rulemaking, interpretive
guidance, or exemptive relief on the eligible contract participant
(ECP) definition. The ECP definition is a key component of the new
regulatory framework for the swaps markets, since it will be illegal to
enter over-the-counter (OTC) swaps with non-ECPs. Many swaps will still
be OTC transactions because they are exempt from clearing or they are
customized to meet individual customer needs, so banks and their
customers need clarity about which individuals or entities will be
ECPs.
Following ABA's request, the CFTC staff subsequently issued helpful
interpretations and no-action relief on some issues related to the ECP
definition. However the no-action relief only addressed interest rate
swaps. Furthermore, the Commission has not yet taken formal action and
the no-action relief will expire no later than June 30, 2013.
Absent formal Commission action, banks and their customers will be
left wondering whether they will be able to engage in certain swaps
transactions or, if they do, whether the swaps will be subject to
rescission or possibly a private right of action once the no-action
relief expires. The uncertainty is already having an impact on loan
negotiations. Since it takes months to negotiate and close a loan, many
of the loans currently being negotiated will not close until after the
staff no-action relief expires. As a result, loan officers remain
uncertain whether many of their customers will be able to use swaps to
hedge commercial risk. This affects the customers' ability to repay the
loan and the banks' ability to lend to those customers.
ABA believes that it is important that the CFTC act expeditiously
to provide clarity and legal certainty to ensure the transition to the
new regulatory regime does not unduly disrupt the lending markets.
Absent clarity, banks will be unnecessarily discouraged from offering
swaps to customers if it is unclear whether those customers will
qualify as ECPs. The result will be decreased lending--especially to
individual entrepreneurs and small and mid-size businesses--at a time
when our country needs access to credit to ensure sustained economic
recovery.
Risk-Based Measurement for Clearing Exemption
Many banks use swaps to hedge or mitigate risk the same way that
other commercial end-users do, but they were not automatically exempted
from the swaps clearing requirements even though other end-users were.
This is incongruous considering that banks are already subject to
comprehensive regulatory oversight.
Banks are required to have internal risk management practices and
are subject to regular supervision by bank regulators. They are also
subject to legal lending limits that cap the exposure that a bank may
have to any individual or entity. As a result of the Dodd-Frank Act,
legal lending limits will now explicitly include swap transactions in
the measurement of credit exposure to another person.
The CFTC was required to consider an exemption from swaps clearing
requirements for certain banks that use swaps to hedge or mitigate
risk. Even though the CFTC's exemptive authority was not limited to
institutions of a certain asset size, the Commission adopted a final
rule exempting banks with total assets of $10 billion or less from the
clearing requirements.
ABA asserts that a risk-based measurement for the end-user clearing
exemption for banks would be more appropriate. For example, even banks
with $30 billion or less in assets account for only 0.09 percent of the
notional value of the bank swaps market as of December 2012. Rather
than a $10 billion asset threshold or any other arbitrary asset
threshold, a more appropriate measurement for the exemption might be in
proportion with size of swaps portfolio and risk to the market. Swaps
activity of this magnitude simply does not pose any significant risk to
the safety and soundness of swap entities or to U.S. financial
stability.
Conclusion
Thank you for your consideration of these issues that the ABA
believes are essential to successfully functioning swaps markets.
Please feel free to contact Edwin Elfmann at [Redacted] or Diana
Preston at [Redacted] if you have any questions or need additional
information.
Sincerely,
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
James C. Ballentine,
Executive Vice President, Congressional Relations & Political Affairs,
American Bankers Association.