On 26 April 2018, Chairman J. Christopher Giancarlo of the US Commodity Futures Trading Commission (the CFTC), with CFTC Chief Economist Bruce Tuckman, published a white paper entitled "Swaps Regulation Version 2.0: An Assessment of the Current Implementation of Reform and Proposals for Next Steps" (the White Paper)1. Drawing from academic research, market activity and CFTC experience, the White Paper assesses the successes and deficiencies of the CFTC’s implementation of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in five areas: central counterparty clearing; trade reporting; trade execution; swap dealer capital; and the end-user exception. The version referenced in the title of the White Paper is purposely included to underscore the CFTC’s responsibility to continuously pursue improvements and upgrades to the CFTC’s first round of swaps reform. The authors intend the White Paper to contribute to the process of swaps reform to produce a regulatory framework consistent with congressional intent, and that balances market durability and systemic risk mitigation with liquidity and economic growth. The White Paper offers high-level recommendations, not detailed modifications to specific CFTC regulations and refrains from giving specific timetables for implementation.2
A summary of the White Paper's assessments and recommendations for each of the five areas is presented below:
Swaps Clearing and Central Counterparties
The White Paper states that the clearing mandate has had the most far-reaching and consequential effects and has successfully moved large quantities of over-the-counter derivatives to central clearing counterparties (CCPs). While acknowledging the successes, particularly with respect to daily risk management and recovery planning, the authors identify three main remaining challenges: CCP risk mitigation; CCP recovery; and CCP resolution.
CCP Risk and Risk Mitigants
The key challenge for CCPs is to mitigate risk and remain safe and sound under extreme but plausible scenarios. The White Paper considers the following issues related to CCP risk mitigation:
Liquidity of Prefunded Resources. The CFTC requires that CCPs hold margin in safe and liquid assets, restricting both the securities that members post as margin and the CCP’s investments of cash posted as margin. Nevertheless, CCPs are exposed to the risk of a depository or repo counterparty’s failure. As a consequence of such a failure, a CCP may be unable to convert investments to cash as contractually stipulated. The White Paper stresses the importance of preserving the liquidity of prefunded resources by diversifying exposures to depositories and repo counterparties and monitoring liquidity risk of securities holdings. The White Paper also argues that the measure by which CCPs that are designated as systemically important are allowed to deposit money directly with the Federal Reserve may have the unintended consequence of further concentrating the CCP field, or raising barriers to entry for smaller CCPs.
Correlated Defaults and Network Effects. The White Paper recommends using new methodologies to study and analyze correlated defaults and network effects. Suggested approaches include looking at correlations across positions at various financial institutions, or studying networks of relationships that may spread defaults across the system.
Liquidation of Defaulted Swaps Positions. The White Paper notes the difficulty of quantifying liquidation costs and suggests applying more scrutiny to the margin charge collected by CCPs for protection against liquidation costs. Before accepting new, less liquid products for clearing, the liquidation cost of these products and the ability of CCPs to guarantee this cost should be considered.
Design of the Waterfall. The White Paper notes that while current regulations dictate the total quantity of prefunded resources (margin, default fund contributions and skin-in-the-game), they do not dictate the respective portions of such resources from members (in the form of default contributions) and CCPs (in the form of skin-in-the-game). The White Paper asks that consideration be given to how the incentive structure should be adjusted so that CCP incentives are aligned with the optimal level of risk tolerance.
In preparation for adverse scenarios where CCPs cannot cover all their losses, large and important CCPs must have reliable recovery plans in place to maintain viability without government assistance. One presented approach is combining gains-based haircuts (GBH) with partial "tear-ups." GBH reduce variation margin payments due to clearing members and customers pro rata until the payables no longer exceed resources available, ensuring that a CCP does not owe more in variation margin than it can pay. However, GBH do not ensure that a CCP has enough funds to replace defaulted positions. Tear-ups are a strategy to restore a matched book by tearing up a selection of offsetting, non-defaulted positions according to an ex ante formula when the CCP does not have enough resources to replace defaulted positions. However, the GBH/tear-up strategy is not perfect and the authors note remaining issues, such as improving the transparency and predictability of the recovery plans and reducing the uncertainty of knowing who will (or will not) honor levied assessments. The White Paper also warns against regulators being exceedingly prescriptive about the workings of the recovery plans.
In the event that recovery plans prove inadequate, Title II of Dodd-Frank provides for the resolution of a CCP where government authorities intervene and make resources from the orderly liquidation fund available to ensure continuity of clearing services. According to the White Paper, the CFTC is working closely with the Federal Deposit Insurance Corporation to coordinate the planning and execution of a CCP resolution and to provide the market with more transparency in the process.
Swaps Reporting Rules
Since the publication of the CFTC’s swap data reporting requirements in 2012, the CFTC, reporting counterparties and Swap Data Repositories (SDRs) have collaborated to improve swap data collection and integrity. However, still, the reporting structure is incomplete and does not provide regulators with a complete and accurate picture of counterparty credit risk. Sufficient technical specifications on the information to be reported have been missing since the initial implementation of the reporting regulations. Standardized data standards, schema and templates would make the reported information more consistent and, hence, usable. The CFTC has prepared an outline for changing reporting regulations (including Parts 43, 45 and 49) in its 2017 Roadmap to Achieve High Quality Swaps Data (the Roadmap).3 The White Paper recommends the following as next steps in the Roadmap process in order to improve the quality, accuracy and completeness of data available to the CFTC and the public:
Validation of Data Accuracy and Completeness. The White Paper recommends that both SDRs and swap counterparties be required to verify the swap data that has been reported to the SDR, as they do with portfolio reconciliation. SDRs could regularly provide swap data reports to the relevant reporting counterparties, and the reporting counterparties would respond to the SDR with a confirmation or correction.
Validation of Incoming Data. The White Paper suggests requiring SDRs to validate swap data upon receipt, similar to what the European Securities and Markets Authority (ESMA) already has in place. In this connection, reporting entities would need to correct and resubmit data that fails validation in a timely manner.
Changes to Part 45 Regulatory Reporting. The White Paper believes fewer, yet better defined and standardized, data fields would improve both the quality of swaps reporting and regulators' ability to utilize swaps data. The authors specifically suggest considering giving more time to market participants to submit fewer, more defined data fields, adjusting the reporting requirement to a T+1 timeframe that matches overseas regulatory counterparts, and implementing swaps reporting data standards that CPMI-IOSCO published.
Real-Time Public Reporting. A pilot program to study the effects of varying cap sizes, block sizes and time delays potentially across different Swap Execution Facilities (SEFs), asset classes and/or specific products is suggested.
Distributed Ledger Technology (DLT). The authors see great promise in the use of DLT for trade reporting. DLT contributes to increasing the speed and quality of reporting, permitting more timely oversight of the swaps markets, all at a lower cost and with less or no intervention from humans or intermediaries. The White Paper calls for the CFTC to cultivate "regulator nodes" on distributed ledgers and have a long-term plan to take advantage of DLT and other new technologies, while ensuring standardization, interoperability and security. The White Paper proposes that the CFTC ensure that its regulations are technologically neutral by not prescribing how principles or parameters must be met.
Swaps Execution Rules
Consistent with the observations Giancarlo made in his 2015 White Paper,4 the authors express criticism about the way in which the CFTC promulgated the Dodd-Frank trade execution requirement. Dodd-Frank requires that swaps subject to the clearing requirement be executed on an SEF or designated contract market (DCM) unless no SEF or DCM makes the swap available to trade. While Dodd-Frank does not require that SEFs use any particular method of trading or execution, the CFTC implemented the mandate by prescribing specific execution methods. The authors argue that the current CFTC rules are a flawed and ad hoc implementation of congressional intent, and that the better approach would be to focus on shepherding the professional conduct of swaps execution through licensure, testing and adoption of codes of conduct. The White Paper details numerous studies that link the current regulations to fragmenting the market, stunting swaps trading and price discovery on SEFs, reducing liquidity and hindering technological innovation.
The White Paper recommends:
Eliminating prescriptive execution methods. Despite Congress's directive that SEFs operate by "any means of interstate commerce," CFTC regulations currently specify that swaps subject to the trade execution requirement be executed on an SEF either through an order book or a request-for-quote system involving three unaffiliated participants (RFQ-to-3). CFTC regulations also require that an SEF offer an order book for all swaps it lists. The authors believe these rules impose significant costs to SEFs and market participants and burden the markets from organically innovating and becoming more efficient. The White Paper urges the CFTC to move away from the prescriptive order book and RFQ-to-3 requirements and permit flexible methods of execution.
Eliminating the Made Available to Trade (MAT) process. Under current CFTC regulations, the process of determining which swap is "made available to trade" is initiated by SEFs and DCMs, which submit a determination that a swap is MAT to the CFTC. The CFTC may then deny or approve such MAT determination. The White Paper recommends aligning the MAT determination process with the clearing determination so that all swaps subject to the clearing mandate are MAT. This would promote swaps trading on SEFs and accomplish increased market transparency by expanding the range of products, increasing liquidity and encouraging price discovery on SEFs.
Swap Dealer Capital
As around half of the 100 swap dealers registered with the CFTC are banks, and another 30 percent are subsidiaries of bank holding companies, the bank capital regime is extremely relevant to the swaps market. The White Paper discusses how some components of the bank capital regime overestimate the risk of swaps. In particular, the standardized models required by regulators fail to recognize that the notional amount is not representative of credit risk and does not account for posted margin or offsetting swap positions. The authors see many benefits to using internal models developed by the banks instead, as they are customized for the business of that firm and better able to capture the relevant risks. The authors recommend that regulators improve their capabilities to approve and monitor internal models used by firms. They note that refining standardized models is also an option, but that would by necessity create further complications.
Recognizing the cost of clearing and uncleared margin requirements, Dodd-Frank made certain accommodations for end-users. The White Paper considers further improvements that can be made to reduce the burden for end-users that are unlikely to be sources of systemic risk. The White Paper distinguishes commercial end-users, small banks and financial institutions with simple business models and balance sheets as unlikely sources of systemic risk, different from financial institutions with complex businesses. The authors make the following recommendations:
Codifying the existing clearing no-action relief for small banks. The CFTC currently has in place no-action relief from clearing requirements available to bank holding companies and savings and loan holding companies holding consolidated assets of no more than US$10 billion. The White Paper recommends the CFTC codify this relief and consider additional, incremental rule changes to reduce the burden for such small banks.
Reconsidering the definition of "financial entity." The White Paper asks the CFTC to consider narrowing the definition of "financial entity" to bring clarity and relief to a variety of end-users, such as treasury affiliates, certain special purpose vehicles and energy firms.
Reworking the determination and application of "material swaps exposure" (MSE) threshold. Financial end-users that are below the MSE threshold are excepted from initial margin requirements. The authors urge regulators to set the MSE threshold using better metrics than the notional amount (which inappropriately adds offsetting long and short positions together). The authors offer Entity-Netted Notionals (ENNs), which nets longs and shorts within pairs of legal counterparties, product classes and currencies, as an alternative that better captures actual risk. The White Paper also recommends a relative, rather than absolute, MSE threshold, based on the ratio of ENNs to assets, and that the MSE threshold except end-users from variation margin requirements.
Reworking uncleared initial margin calculations. The authors argue that the current uncleared margin rule is overly prescriptive and produces a bias in favor of cleared products. The White Paper references Chairman Giancarlo’s previous statements about the 2016 final rule on margin requirements for uncleared swaps, in which he asserted that there is nothing in Dodd-Frank directing regulators to set punitive margin levels on uncleared products to drive end-users to cleared products, and that such punitive margin levels may have the unintended consequence of driving market participants to inadequately hedge exposure. The authors point to the ten-day margin period of risk (MPOR) requirement for uncleared products compared to the five-day MPOR for clearinghouses as a prime example of a standard favoring cleared swaps. The standard, they argue, is an overstatement of the risk of uncleared swaps and a broad and imprecise model for a wide variety of uncleared swaps. The White Paper recommends a non-prescriptive regulatory standard, which covers a 99 percentile adverse event, and then permits market participants to elect customized models that are approved by regulators or simple and conservative models offered by the regulators.