J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission, issued a white paper calling for the CFTC to expand the ways swaps should be traded on swap execution facilities consistent with congressional intent and to mandate that all swaps that must be cleared must also be traded on a SEF.

In a wide-ranging report entitled “Swaps Regulation Version 2.0,” Mr. Giancarlo also called for further study to (1) ensure the safety and soundness of clearinghouses and how the CFTC and Federal Deposit Insurance Corporation might better coordinate the resolution of a collapsed systemically important clearinghouse; (2) improve real-time reporting of swaps trades by calibrating requirements to the nature of the relevant products, entities, markets and asset classes; (3) enhance regulators’ capability to approve and monitor internal models for capital computations that more effectively measure the risk of swaps positions by considering the benefits of offsetting positions as well as the risk mitigation of posted margin; and (4) potentially exempt smaller financial end users from obligations to clear swaps and post margin on uncleared swaps.

In his white paper, Mr. Giancarlo stated that the CFTC did not follow Congressional instruction when implementing swaps trading rules as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Rather than permitting SEFs to operate by “any means of interstate commerce” as Congress instructed, the CFTC limited transactions required to be executed on a SEF to two means – an order book or a request for quote from three-persons. According to Mr. Giancarlo, the CFTC’s SEF trading rules have caused a “sharp fragmentation of global trading liquidity into numerous disjointed market segments.”

Mr. Giancarlo indicated that, consistent with expanding the ways swaps should be executed on SEFs, the CFTC should make the mandatory SEF execution requirement – the so-called “MAT determination” (made available to trade) for a swap coterminous with a determination that the swap must be centrally cleared. According to Mr. Giancarlo, this would bring “‘daylight to the marketplace’ subjecting a much broader range of swaps products to SEF recordkeeping and regulatory supervision and oversight.”

Mr. Giancarlo also suggested that, in the future, swaps reporting might be enhanced through application of distributed ledger technology, and that the CFTC should explore this possibility with other regulators.

Although Mr. Giancarlo provided no timetable to implement his recommendations, he indicated, “[w]e will move forward in regular order and in good order – we will get this done.”

In 2015, before he was nominated as CFTC chairman, Mr. Giancarlo issued another white paper that also severely criticized the Commission’s swaps trading rules and proposed an alternative framework that he claimed more accurately reflected congressional intent. (Click here for background in the article “CFTC Commissioner Laments Flawed US Swaps Trading Model” in the February 1, 2015 edition of Bridging the Week.)

Swaps Regulation Version 2.0 was co-written by Bruce Tuckman, the CFTC’s chief economist.

My View: Mr. Giancarlo’s latest overview of US swaps regulation provides a thoughtful reflection on central clearing, trade reporting, trade execution, swap dealer capital and the end user exception. As before, in most areas, he and his co-author get it totally right. However, I still think Mr. Giancarlo’s path for arriving at his conclusions still overly depends on the nature of swaps being swaps, as opposed to the characteristics of the swaps themselves. To me this is an incorrect starting point, although it is appropriate given the constraints of current law.

As I wrote in 2015, “[i]t is not that all swaps behave one way and all futures another that they should be regulated differently—it is because some swaps are much less liquid than many futures. However, many delivery months of futures are equally illiquid as are many strike prices of options. 

Regulators, particularly in the United States—because of artificial divisions created by law—, have gotten it wrong when they base regulation on the name of the product they are overseeing rather than on its characteristics. It is simply not relevant whether a financial product is called a futures contract, a security or a swap. What is relevant is solely (1) whether a financial product is sold for future settlement (where payment now represents a partial down payment to ensure performance later), (2) how distant in the future is the settlement scheduled, and (3) if a financial product that is sold is settled today, can the product be purchased on leverage and, if yes, for how much and what are the conditions? Moreover, at any time, how liquid is the financial product today and over time? 

Viewing the characteristics of products rather than their names would permit regulators to develop more appropriate trading and business conduct rules. It certainly would avoid scenarios where cleared swaps can be transformed over a weekend to cleared futures, options can be regulated both as securities and futures, and highly correlated but differently named financial products can have different regulatory and tax treatments.”