In a speech published but not delivered, J. Christopher Giancarlo, one of the new commissioners of the Commodity Futures Trading Commission, roundly criticized the CFTC’s swaps trading regime. He claimed that the Commission’s swaps trading rules are flawed, contrary to plain language in the Dodd-Frank Wall Street Reform and Consumer Protection Act, and causing non-US persons to avoid engaging in swaps transactions with US counterparties.

Mr. Giancarlo had prepared his speech for delivery before the SEFCON V conference sponsored last week in New York City by the Wholesale Markets Brokers’ Association, Americas. However, he was precluded from delivering his speech under a 2009 White House ethics order because of his prior association with the WMBAA. Mr. Giancarlo said he was not able to obtain a waiver to give his presentation.

Although Mr. Giancarlo reaffirmed his commitment to central counterparty clearing of swaps and the reporting of trades to centralized data repositories, he lamented the CFTC’s trading rules, which he termed “mismatched to global swaps markets.” According to Mr. Giancarlo,

I believe the CFTC’s swaps regime is fundamentally mismatched to the natural commercial workings of the swaps markets. It is ill-suited to its stated goals of market stability, enhanced transparency and regulatory supervision. It is a square peg being forced into a round hole. The misalignment of the regulatory framework with the underlying market characteristics results from a CFTC implementation process that was misconceived from the start. This misalignment with the true nature of global swaps trading causes the CFTC’s regulatory structure to dampen market activity and repel global capital rather than welcome and reward it.

In a nutshell, Mr. Giancarlo observed that while Dodd-Frank requires most cleared swaps to be executed on designated contract markets or swap execution facilities, it permitted SEFs to organize flexible methods for execution using “any means of interstate commerce.” This flexibility was additionally encouraged, said Mr. Giancarlo, when Congress, in enacting Dodd-Frank, “articulated goals, not requirements for this SEF framework to maintain its flexibility.”

The CFTC corrupted Congress’ objective, claimed Mr. Giancarlo, when it limited methods of execution on a SEF to an order book or an order book and a request for quote system with a minimum of three participants. The CFTC also misread Congressional intent (and the plain language of the statute) when it distinguished between required and permitted transactions, said that block trades must be executed “off-SEF,” as opposed to “on-SEF,” and tried to require the execution of swaps subject to mandatory trading on a DCM or SEF subject to an order book or RFQ system even when such swaps were part of so-called "package transactions" involving multiple product legs.

As a result of the CFTC’s flawed approach, concluded Mr. Giancarlo, there have been many unintended results, including fragmented market liquidity:

The CFTC’s flawed SEF framework is causing a range of unintended adverse consequences. For one, it is ensuring that big platforms get bigger and small platforms get squeezed out because of the sharply increased legal and compliance costs of registering and operating a SEF. The CFTC’s restrictive approach to methods of execution is thwarting technological innovation that promises to better serve market participants. It is causing non-US persons to stop using the services of US-based support personnel and thereby harming American financial service jobs. …It is also harming relations between the CFTC and foreign regulators. Most seriously, the CFTC’s swaps trading framework is the cause of abrupt fragmentation of global swaps markets between US persons and non-US persons. This has led to smaller, disconnected liquidity pools and less efficient and more volatile pricing and shallower liquidity, posing a significant risk of failure in times of economic stress or crisis.

Mr. Giancarlo indicated that he intends further to expand his analysis of the CFTC’s trading rules and propose an alternative approach in a separate white paper to be published at a later date.

My View: Hopefully Mr. Giancarlo’s well-reasoned thoughts on possible flaws in the CFTC’s approach to swaps trading will prompt critical reflection of whether there might be a better way. The CFTC’s recent flurry of no-action letters amending previously adopted rules adopted in a hurry after the passage of Dodd-Frank evidence a sensible determination that some well-meaning rules are impractical, if not impossible, to implement without material unintended consequences. Perhaps it’s time to institutionalize this tinkering process to consider where wholesale rule changes may be warranted. There are many examples, as Mr. Giancarlo points out, involving swaps trading.