On April 26, Commodity Futures Trading Commission (“CFTC”) Chairman Christopher Giancarlo and the agency’s Chief Economist Bruce Tuckman released a new white paper entitled Swaps Regulation Version 2.0: An Assessment of the Current Implementation of Reform and Proposals for Next Steps (the “White Paper” or “Swaps Regulation Version 2.0”). The White Paper does not set out a specific short-term agenda for the CFTC, as the Chairman has done in recent speeches. Rather, it presents a thoughtful assessment of real-world experience—including a review of available economic literature—during the four years of CFTC regulation of the swaps market pursuant to the Dodd-Frank Act.
The White Paper is premised on the view that the swaps regulatory regime that has developed in the wake of the financial crisis must do a better job of balancing systemic risk mitigation with healthy trading liquidity. Guided by that view, “Swaps Regulation Version 2.0” takes a broad perspective on where we are, how we got here, what is working, and what improvements are needed in five key areas of swap regulation: central counterparties, reporting, trade execution, swap dealer capital, and derivatives end-users.
Central Counterparties After noting the success of the Dodd-Frank Act’s clearing mandate in increasing the volume of swaps cleared through central counterparties (“CCPs”), the White Paper discusses the challenges surrounding CCPs, given their enhanced role in the global financial system as a result of that success. These challenges include assuring the safety and soundness of these newly enlarged CCPs, improving the transparency and predictability of CCP recovery plans in case they get into trouble, and the development of resolution plans by the CFTC and FDIC in the event that CCP recovery plans prove inadequate.
Reporting The White Paper touts the progress made to date in standardizing data nomenclature and reporting elements and protocols. It also identifies work remaining to be done in areas such as data verification and validation, so regulators can properly assess and quantify the counterparty credit risk of large banks and swap dealers. It then provides an intriguing glimpse into the future, where distributed-ledger technology, if appropriately developed, has the potential to make trade data reporting more accurate and reliable—at lower cost.
Trade Execution Here, the White Paper returns to a theme that Chairman Giancarlo has addressed before: his view that the CFTC’s flawed implementation of the Dodd-Frank Act trade execution mandate, by artificially limiting the available methods of execution on swap execution facilities (“SEFs”), has resulted in fragmented global trading liquidity and poor price discovery. The White Paper argues that the CFTC should permit flexible methods of trade execution on SEFs, while also raising the standards of conduct for professionals involved in SEF trading and expanding the universe of swaps subject to mandatory trading.
Swap Dealer Capital On a granular level, the White Paper urges the correction of problems it sees in current swap capital requirements: inappropriate reliance on notional amount to measure risk, insufficiently recognizing offsetting swap positions between pairs of counterparties, and insufficiently recognizing the risk-mitigation role of posted margin. At a higher level, though, it also urges regulators to rely more heavily on the internal risk models used by banks and their swap dealer affiliates.
Derivatives End-Users The White Paper implicitly concludes that the primary concerns of commercial end-users to the CFTC’s implementation of the Dodd-Frank Act have been satisfactorily addressed, as it focuses instead on financial end-users such as pension funds and insurance companies. It asserts that smaller financial end-users should be exempt from clearing and margin requirements based on a material swaps-exposure threshold, and that uncleared margin rules should be less prescriptive than currently written.
The White Paper candidly acknowledges the difficulties that will confront efforts to act upon some of its proposals—for example, the approaches of other regulators (both domestic and international) on issues that require regulatory harmonization. Yet, it must be remembered that our existing securities and futures regulatory frameworks did not arise overnight. “Swaps Regulation Version 2.0” provides a valuable “long view” to help focus the development of the swaps regulatory landscape in the years ahead.