On April 26, 2018, J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission (“CFTC” or “Commission”) and Bruce Tuckman, the CFTC’s Chief Economist, issued a white paper outlining changes to swaps regulation that the Chairman intends to pursue during his remaining term in office.[1] The white paper expressly states that it represents the personal views of the authors only and does not reflect the views of the Commission and, while it sets out recommendations for rule changes, it does not propose any rules for notice and comment.

The paper drew criticism from one of the CFTC Commissioners, Rostin Behnam, who noted that “adding another white paper just pushes back the timeline for getting to actual deliverables [e.g., proposed rules] . . . and takes a lot of staff time when budgets are tight.”[2] Commissioner Behnam’s concerns over timelines for “actual deliverables” seem especially appropriate given the Chairman’s recent statement that he would not seek reappointment when his term ends in April 2019, and his stated reluctance to move ahead on certain rulemakings without all five CFTC Commissioners in place (only three of five Commissioners are now seated). Nonetheless, because the Chairman sets the agenda for the Commission and directs the staff, the white paper carries weight inasmuch as it reflects his priorities for the remaining months of his term.

The white paper provides an overview of the regulatory topics that the Chairman may ask the Commission to consider as part of his “Reg Reform 2.0” initiative, likening the changes to a software upgrade. These topics fall into five areas:

  • Swaps Central Counterparties;
  • Swaps Reporting Rules;
  • Swaps Execution Rules;
  • Swap Dealer Capital; and
  • End User Exemption from Uncleared Swaps Margin Requirements.

The paper contains both specific ideas that may be embodied in proposed rules, such as the swap execution facility rules that recently were announced would be forthcoming as soon as this July,[3] and more general assessments of the CFTC’s implementation of Dodd-Frank swaps reform where the authors identify further work or analysis that may need to be done without specific recommendations for action. It is the second white paper authored by Chairman Giancarlo since he joined the CFTC, the first having been issued when he was a Commissioner in 2015.

Below is a discussion of the five topic areas.

Swaps Central Counterparties

The white paper notes that the CFTC’s swaps clearing mandate was highly successful, but asserts that its success has significantly increased the volume of swap transactions cleared through central counterparties (“CCPs”) and has led to a number of challenges that require further consideration. These include:

  • ensuring the safety and soundness of CCPs,
  • providing that CCPs have transparent and credible recovery plans to maintain their viability without government assistance, and
  • putting in place government resolution plans should these recovery processes fail and authorities deem it necessary to intervene.

Specifically, the white paper recommends further analysis be undertaken to ensure the safety and soundness of CCPs in extreme but plausible conditions, including to ensure the liquidity of funded resources, to understand correlated defaults and network effects, and to properly account for liquidation of defaulted swaps positions and the cost of replacement. With regard to recovery plans—plans which describe how a CCP, in extreme adverse scenarios, would comprehensively allocate losses, restore its matched book and replenish its financial resources—the white paper recommends that such plans should be as transparent and predictable as possible in order to allow clearing members and customers to manage and control their own risks. Regulators should insist on credible plans but remain cautious about imposing prescriptive requirements about the workings of such plans. With respect to government resolution of CCPs, the white paper expresses the view that there is still much to be done collaboratively by the Federal Deposit Insurance Corporation (“FDIC”) and the CFTC, with the ball “very much in the courts” of the two agencies.

Swaps Reporting Rules

The white paper notes that despite the work that has gone into establishing swap data repositories and supplying them with swaps data, a decade after the financial crisis swap data repositories (“SDRs”) still cannot provide regulators with a complete and accurate picture of counterparty credit risk in global swaps markets. The authors find this particularly disappointing given that gaining visibility into counterparty credit risk borne by major financial institutions was the most pressing need to emerge from the 2008 financial crisis. Nonetheless, the white paper mentions that substantial progress has been made in the United States and abroad in standardizing data nomenclature, reporting elements and reporting protocols, citing efforts already underway through the CFTC’s 2017 Roadmap to Achieve High Quality Swaps Data (“Roadmap”) initiative.[4]

As part of the Roadmap process, the white paper suggests that the reporting rules could be enhanced by more clearly requiring both SDRs and reporting counterparties to perform verification of swaps data, similar to a portfolio reconciliation exercise. They could also be improved by requiring SDRs to validate data as it arrives, similar to data validation required by the European Securities and Markets Authority (“ESMA”). Currently, according to the authors, SDRs sometimes validate a subset of data that is reported to them, but they are inconsistent and do not always aid in making accurate and complete data available. An additional enhancement suggested by the authors is to amend the reporting rules to allow market participants additional time to submit fewer swaps messages per transaction, each containing a more defined list of data fields that describe the swap. They also suggest considering an adjustment to the timing of the regulatory reporting requirement to a T+1 timeframe that would harmonize CFTC reporting requirements with overseas counterparts such as ESMA. The authors further recommend that consideration be given to a pilot program to study the effects of varying cap sizes, block sizes and time delays potentially across different swap execution facilities, asset classes and/or specific products. For the future, the white paper recommends examining opportunities to utilize emerging digital technologies, such as cloud computing, automated “big data” analysis and distributed ledger technology to make trade data reporting more accurate, reliable and automated.

Swaps Execution Rules

In an argument that will be familiar to those who remember the previous white paper that Chairman Giancarlo released in 2015, the new white paper argues that the CFTC’s swaps execution rules, which limit execution methods for certain swaps, are overly prescriptive and contrary to Congressional intent. Under current CFTC rules, transactions that are required to be executed on swap execution facilities (each, a “SEF”), known as “required transactions,” must be executed by means of either an order book or a system in which a request for quote is sent to three or more unaffiliated recipients. The authors note that this is contrary to the express language of Dodd-Frank, which states that swaps may be executed by “any means of interstate commerce.”

The white paper considers that the CFTC rules limiting execution methods on SEFs have fostered market fragmentation, hindered technological innovation, increased market liquidity risks and incentivized price discovery to occur off-SEF. The authors note the considerable extent to which the market has in fact fragmented into numerous segments since the time when the CFTC’s SEF rules were introduced. They conclude that SEFs should be permitted to offer flexible means of execution.

The authors argue, in addition, for the elimination of the current rules by which SEFs determine that a swap is “available to trade” (such rules, the “MAT Rules”) and thus subject to required SEF execution. They would favor, instead, a rule under which all swaps that are subject to required clearing would be subject to execution on a SEF unless the relevant swap were not listed for trading. The authors understand the current MAT Rules (which require a swap to be liquid before it is deemed available to trade) to be a result of the CFTC’s restrictions on execution methods. They argue that eliminating prescriptive execution requirements would permit market participants to use an execution method appropriate for their particular swap without regard to liquidity concerns.

Swap Dealer Capital

The white paper takes the view that bank capital rules are generally biased against swaps. It states that some components of the bank capital regime rely inappropriately on notional amounts to measure risk, some fail to recognize to the extent appropriate offsetting swap positions with the same counterparty, and some do not sufficiently take into account the risk mitigation associated with margin.

More specifically, the authors argue that the widely-used Current Exposure Method (“CEM”) for calculating risk mistakenly permits margin to offset only the current value of a swap and not potential future exposure. In addition, they state, the CEM dramatically overstates potential future exposure when some positions are long and some are short, even while incorporating offsets that are inadequate or arbitrary.

The white paper suggests that the best way forward would be not to modify regulatory risk models but instead to place greater reliance on banks’ internal risk models. While a firm’s internal model is likely to be well suited to the firm’s business, and sufficiently complex to reflect relevant risks, the authors state, standardized models tend to be biased against swaps, treating them harshly relative to their risk. The authors suggest that regulators should improve their ability to approve and monitor firms’ use of internal models.

End User Exception

In the CFTC’s current regulatory regime, a financial end user is not required to post initial margin if that financial end user does not have material swaps exposure (“MSE”), which is defined by reference to the aggregate notional amount of the party’s swaps. However, no similar threshold applies with respect to the required clearing of swaps or the posting of variation margin.

The white paper suggests that both mandatory clearing and variation margin requirements should be made subject to a threshold similar to the MSE threshold. In other words, the authors suggest, even financial entities or financial end users, if they engage in a relatively low volume of swaps activity, should not be subject to required clearing or to variation margin requirements. Such changes, the authors argue, would better position clearing and margin requirements to apply to parties that could constitute sources of systemic risk.

That is not to say, however, that the white paper favors the use of MSE in its current form as it now applies with respect to initial margin. Rather, the authors state that the CFTC’s current notional amount-based definition of MSE should be reworked to measure in units more meaningful than notional amounts.

The white paper also argues against what it sees as overly prescriptive margin requirements, including the CFTC’s “remarkably coarse” assumed 10-day closeout period to calculate initial margin for uncleared swaps. The authors state, in addition, that the CFTC should codify existing no-action relief provided to small banks with respect to clearing requirements.