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Under Pressure: Risk, Compliance and the New Wave of Regulations

By Shagun Bali, TABB Group
Originally published on TABB Forum

Intensifying regulatory demands are forcing financial institutions to streamline application portfolios, standardize and normalize data more effectively, and ensure the rapid integration and sharing of data across systems. But many banks simply do not have the systems or control of data they need to make complex analytics an integral part of workflow.

The institutional capital markets are dealing with the aftermath of one of the most aggressive periods of regulatory intervention since the Great Depression. Not only have new governance, risk and compliance (GRC) rules forced institutions to manage more data than ever, they are forcing many of these institutions to do so in increasingly shorter timeframes. 

Across the board, regulators want more and more information from financial institutions and, consequently, institutions and banks are mandated to store, manage, analyze, and produce (whenever required) data needed to address regulatory challenges/requirements and mitigate risk. And the pressure to get it right is dramatically increasing, as fines are becoming increasingly harsh.

Anyone who doesn’t believe these new rules are changing the way that banks think about their businesses need only look at the front page of virtually any major newspaper’s financial section. Just this past week, 10 banks were fined for commodities trading practices, and one global bank announced it is returning $100 billion in customers’ deposits because new capital rules make just holding this money problematic.

In response to many of the challenges, senior industry members gathered this past week for a Cognizant-sponsored roundtable discussion on GRC, hosted by TABB Group CEO Larry Tabb. Reflecting the urgency of the industry response, it was a full house, with 20 very senior industry professionals eager to share ideas and discuss the impact and complexity of new GRC rules, including macro-prudential rules such as Basel III, Volcker, EMIR and MiFID2, as well as traditional regulatory initiatives such as the Consolidate Audit Trail (CAT) and the FINRA proposed Comprehensive Automated Risk Data System, or CARDS.

GRC regulations have made it imperative for all functions and businesses within financial institutions to share information more readily and rapidly in order to meet regulatory requirements and support and improve investment decision-making as a whole. For the effective aggregation of data, institutions need to streamline their application portfolios, standardize and normalize data more effectively, and ensure the rapid integration and sharing of data across systems. However, the consensus among attendees was that many banks simply do not have the systems or control of data they need to make complex analytics an integral part of workflow or enable information to be passed back and forth within different functions.

Rather, most institutions have monolithic legacy and proprietary IT systems that operate as silos and impede the 360-degree view needed to gather and aggregate enterprise information. Aggregating data from various businesses and functions in a central repository or data warehouse is almost impossible in today’s world, as the typical financial institution can have as many as 1,100 data elements from more than 60 different systems and data formats ranging from one-year-old standards to 30-year-old standards.

In addition, institutions have to place a great deal of emphasis on the quality of data that is required to drive new reporting and risk analytics, as problematic outcomes could causes banks to have problematic stress-test results. And the importance of getting this right can’t be downplayed, as getting it wrong means very harsh scrutiny from management, regulators and investors.

On the other hand, new regulations are pushing banks to streamline internal operations and upgrade systems. As banks evolve their compliance strategies to collaborate across business units, they wish to move toward simplified workflows and automated solutions that are flexible enough to keep pace with changing regulatory demands and integrated to maintain a comprehensive view of the business. With the right investments, banks will be in better shape to achieve not only compliance but also higher standards of efficiency and risk management in the future. And that makes regulation an opportunity as well as a challenge, roundtable participants agreed.

Rome wasn’t built in a day; nor will all the IT problems of financial firms be solved overnight. Yes, financial institutions are struggling with the implementation of these new regulations; however, TABB Group advises institutions to reach out and seek help and advice from the vendors – they understand the IT challenges and can offer expert advice going forward. Today, institutions are very averse to working with vendors on their GRC deployments; we suggest this needs to change.

The bottom line is that more than ever, institutions need sophisticated systems and tools to assess and manage data of all classes, from the start of every trade or order, and to incorporate analytics and regulatory constraints into all their workflows. Those that make the real-time analysis and exchange of data part of their everyday workflow across the front, middle and back office functions will be primed for both compliance and profitable growth.

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SDRs: The SEC Weighs in on Swaps Reporting – Part 2

By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum

All of the world’s swap regulators recognize that reporting is a mess. And while the SEC’s final rule on Swap Data Repositories does not mandate SDRs monitor reporting data quality, there are signs that such monitoring may be in the offing. But don’t bet on the SEC getting the rules right.

In my last article, I reviewed the SEC’s final and proposed rules on transaction reporting by market participants (“Missed Opportunity: The SEC Finally Weighs in on Swaps Reporting – Part 1”). In this article I will look at the final rule on SDRs, and make some observations on the effectiveness of current and future reporting regimes.The SEC’s final SDR rule is entitled “Security-Based Swap Data Repository Registration, Duties, and Core Principles” and runs some 468 pages. Don’t worry – you don’t have to read them all; just go to page 424 to find the beginning of the rule text. The bulk of the rule is in §232.13, which itself is divided into 12 subsections:

  • 240.13n-1 Registration of security-based swap data repository.

  • 240.13n-2 Withdrawal from registration; revocation and cancellation.

  • 240.13n-3 Registration of successor to registered security-based swap data repository.

  • 240.13n-4 Duties and core principles of security-based swap data repository.

  • 240.13n-5 Data collection and maintenance.

  • 240.13n-6 Automated systems.

  • 240.13n-7 Recordkeeping of security-based swap data repository.

  • 240.13n-8 Reports to be provided to the Commission.

  • 240.13n-9 Privacy requirements of security-based swap data repository.

  • 240.13n-10 Disclosure requirements of security-based swap data repository.

  • 240.13n-11 Chief compliance officer of security-based swap data repository; compliance reports and financial reports.

  • 240.13n-12 Exemption from requirements governing security-based swap data repositories for certain non-U.S. persons.

The Boring Stuff

As we can see from the list above, the first three sections of the rule pertain to registration as an SDR, or, as the SEC abbreviates it, SBSDR (except that the regulator very seldom abbreviates  it). Given that SDRs have been functioning in the US for more than a year, it would be astonishing if the SEC had significantly different registration requirements from the CFTC’s, and it doesn’t. So 13n-1 through 13n-3, 13n-6 through 13n-8, and 13n-11 are pretty much as expected.

Items of Interest

In light of the recognized problems with reporting accuracy, the following wording in 13n-4 bears examination:

(b) Duties. To be registered, and maintain registration, as a security-based swap data repository, a security-based swap data repository shall:

(7) At such time and in such manner as may be directed by the Commission, establish automated systems for monitoring, screening, and analyzing security-based swap data;

13n-5 has similar wording:

(i) Every security-based swap data repository shall establish, maintain, and enforce written policies and procedures reasonably designed for the reporting of complete and accurate transaction data to the security-based swap data repository and shall accept all transaction data that is reported in accordance with such policies and procedures.

So far, none of the regulators have mandated any responsibility on the part of the SDRs to monitor data quality, nor have they laid out any guidelines for doing so. However, there are signs that such monitoring may be in the offing, and this language lays that responsibility squarely on the SBSDR. How extensive the monitoring might be, how the regulators would verify that it was being done, and what the penalties would be for failing in this function aren’t covered here. And, since 13n-4 is the only place in the rule text where the term “monitoring” is used, it isn’t covered anywhere else in the rule or, as it turns out, in the preamble.

The Current State of Affairs

In January 2014, the CFTC issued a proposed rule called “Review of Swap Data Recordkeeping and Reporting Requirements.” The comment period ended May 27, 2014. I haven’t been able to find any comment letters on this proposal on the CFTC’s website, nor any final rule on this subject.

So how accurate is swaps reporting today? I took a look at a snapshot of the most liquid swaps category, rates, from the DTCC SDR site and posted it below. The questionable items are in red.

tabbf 2 25 resized 600

Just to help us read the table, the first item is a new, uncleared ZAR three-month forward rate agreement beginning 5/18 and ending 8/18. The notional amount appears to be ZAR 1,000,000,000, and the rate is 6.12%. With that as background, let’s look at some of the anomalies.

Item 4 is a new two-year USD basis swap beginning 9/21/2016. A basis swap is normally between two different floating rates, but the underlying assets in this transaction appear to be the same (USD-LIBOR-BBA). I’m not sure what a basis swap between the same rates would be, unless it is between two different term rates, like 1-year and 5-year. However, if that’s true, the report doesn’t tell us, so we are in the dark as to what this trade really is.

Item 7 is a new 8-year Euro-denominated fixed-fixed above the block threshold (that’s what the plus at the end of the notional means), which appears to have gone unreported for two weeks. There is a delay in reporting block trades, but it isn’t two weeks. One of the monitoring functions the regulators might implement would be any trade where the difference between the execution and reporting timestamps is greater than the rule allows.

Item 13 is a new 12-year Euro-denominated fixed-floating swap that appears to be above the block threshold of €110,000,000. What is interesting here is that the 12-year Euro rate at the time was about 0.4%, not 0.824%. If there is no other parameter on this trade, it looks to be significantly off the market, unless there was a large credit risk component.

Item 15 is … what, exactly? It’s a new trade in some exotic that went unreported for 5 days, with no price given, apparently. Since the notional looks like 5,000,000,000 Chilean pesos, or about US$8,000,000, perhaps we don’t need to worry too much about what it really is; but exotics of this size denominated in dollars should cause us to ask just what kind of swap was done, and how much risk it entails.

Summing Up

All of the world’s swap regulators recognize that reporting is a mess. For example, here’s an excerpt from ESMA’s annual report:

In order to improve the data quality from different perspectives, ESMA put in place a plan which includes 1) measures to be implemented by the TRs and 2) measures to be  implemented by the reporting entities. The first ones were/will be adopted and monitored by ESMA. The second ones are under the responsibility of NCAs. This plan was complemented by regulatory actions related to the on-going provision of guidance on reporting, as well as the elaboration of a proposal for the update of the technical standards on reporting, leveraging on the lessons learnt so far by ESMA and the NCAs.” (emphasis added)

However, it is hard to find any mention of such a plan in ESMA’s 2015 work programme.

We might have expected that the SEC, the latest to the swaps reporting party, would have taken pains to get it right and perhaps lead the way to a better world. Since some of its rulemaking is still in the proposal stage, we might still see the regulator get it right. But I wouldn’t bet on it.

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Missed Opportunity: The SEC Finally Weighs in on Swaps Reporting – Part 1

By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum

Global regulators have missed a golden opportunity to shed light on the opaque swaps market. The SEC, seeking to rectify this, recently issued two final swaps reporting rules and one proposed rule. But the final requirements remain muddy.

The all-important swaps reporting requirement has been badly mishandled by regulators worldwide, missing a golden opportunity to shed some light on this otherwise opaque market. In the US, one of the nagging problems has been that the SEC hadn’t put out its reporting rules, so there was no required reporting on one of the riskiest areas of the market – single-name CDSs.

Recently, though, the SEC took a major step in rectifying this, by issuing some proposed and final rules. So how well did they do? Let’s take a look.

First Things First

Actually, the SEC issued three rules – two final and one proposed – which means that we will have to patch them together to get as complete a picture as we can. The final reporting rule is: Regulation SBSR-Reporting and Dissemination of Security-Based Swap Information. There is also a proposed rule with an identical name, indicating that it will be combined with the final reporting rule at some point. I will cover both of them in this article. I will cover the SDR rule, Security-Based Swap Data Repository Registration, Duties, and Core Principles, in a later article.

Including their preambles, these three rules comprise more than 1,350 double-spaced pages. My practice has always been to go right to the rule text, since that is what everyone will be bound by, and then read any sections of the preambles that provide necessary clarifications. The rules themselves comprise 92 pages, a significantly more manageable reading assignment. I’ll cover only the unexpected or potentially troublesome aspects, but people should read all 92 pages.

In the SEC rulebook, the reporting rules are §§242.900-242.909. Specifically:

  • 242.900 Definitions

  • 242.901 Reporting obligations.

  • 242.902 Public dissemination of transaction reports.

  • 242.903 Coded information.

  • 242.904 Operating hours of registered security-based swap data repositories.

  • 242.905 Correction of errors in security-based swap information.

  • 242.906 Other duties of participants.

  • 242.907 Policies and procedures of registered security-based swap data repositories.

  • 242.908 Cross-border matters.

  • 242.909 Registration of security-based swap data repository as a securities information processor.


There are a few oddities among the definitions, each perhaps a warning about other oddities later on. One is:

“Trader ID means the [Unique Identification Code] UIC assigned to a natural person who executes one or more security-based swaps on behalf of a direct counterparty.”

So that seems to be leading to a requirement to identify the person who executed the trade. Unless, of course, the trade was executed by a computer. Do we use HAL’s UIC then?

There is also this:

Trading desk ID means the UIC assigned to the trading desk of a participant,” and, “Trading desk means, with respect to a counterparty, the smallest discrete unit of organization of the participant that purchases or sells security-based swaps for the account of the participant or an affiliate thereof.”

So will we be identifying both the desk and the trader who did every trade? That’s not required anywhere else, and certainly looks like overkill.

Who Reports?

Under the reporting obligations, we find another oddity:

(a) Assigning reporting duties. A security-based swap, including a security-based swap that results from the allocation, termination, novation, or assignment of another security-based swap, shall be reported as follows:

(1) [Reserved].

It looks like we are missing an important section. Sure enough, we find it in the proposed rule:

(1) Platform-executed security-based swaps that will be submitted to clearing. If a security-based swap is executed on a platform and will be submitted to clearing, the platform on which the transaction was executed shall report to a registered security-based swap data repository the information required.(emphasis added)

And one more item in the proposed rule:

(i) Clearing transactions. For a clearing transaction, the reporting side is the registered clearing agency.

I think that means that the SEF reports the original trade, and the DCO immediately reports the cleared trade.

What about life cycle events for cleared swaps? Here, the final rule says:

(i) Generally. A life cycle event, and any adjustment due to a life cycle event, that results in a change to information previously reported … shall be reported by the reporting side, except that the reporting side shall not report whether or not a security-based swap has been accepted for clearing.

(ii) [Reserved]

Back to the proposed rule:

(ii) Acceptance for clearing. A registered clearing agency shall report whether or not it has accepted a security-based swap for clearing.

So if the reporting side of the original trade is the SEF, and the DCO reports that it accepted the trade for clearing, does the DCO report the life cycle events of cleared swaps? That should be the case, but the rules are a bit confusing about that.

What Transactions Must Be Reported?

This is obviously a crucial question, and the final rule says:

(1) A security-based swap shall be subject to regulatory reporting and public dissemination if:

(i) There is a direct or indirect counterparty that is a U.S. person on either or both sides of the transaction; or

(ii) The security-based swap is accepted for clearing by a clearing agency having its principal place of business in the United States. (emphasis added)

And an indirect counterparty is defined as:

Indirect counterparty means a guarantor of a direct counterparty’s performance of any obligation under a security-based swap such that the direct counterparty on the other side can exercise rights of recourse against the indirect counterparty in connection with the security-based swap; for these purposes a direct counterparty has rights of recourse against a guarantor on the other side if the direct counterparty has a conditional or unconditional legally enforceable right, in whole or in part, to receive payments from, or otherwise collect from, the guarantor in connection with the security-based swap.

So a swap done between, for example, an EU dealer and a guaranteed EU subsidiary of a US corporation is reportable in the US, as well as by both parties in Europe. How fun! And who reports in the US? Back to §242.901.

In addition, the final rule requires reporting of all swaps in existence on the rule’s effective date (called backloading) and, although there is a phase-in for the rule as a whole, there doesn’t appear to be a phase-in period for backloading.

What Data Must Be Reported?

Here, in addition to the usual transaction material, the final rule requires:

(2) As applicable, the branch ID, broker ID, execution agent ID, trader ID, and trading desk ID of the direct counterparty on the reporting side;

Since only one side is reporting under the SEC rule, in dealer-to-dealer trades this appears to mean that the reporting dealer must supply all of this information, but not the non-reporting dealer. What that accomplishes, I’m not sure.

There’s one other data requirement in this section:

(5) To the extent not provided pursuant to paragraph (c) or other provisions of this paragraph (d), any additional data elements included in the agreement between the counterparties that are necessary for a person to determine the market value of the transaction;

Thus it appears that the reporting party must determine what data is necessary for an outside entity to price the transaction, and include that if it’s not already delineated.

Public Availability

This section requires immediate public availability of the usual information (i.e., no identification of the parties) with this exception:

(3) Any information regarding a security-based swap reported pursuant to § 242.901(i);

And 242.901(i), in the proposed rule, says:

(i) Clearing transactions. For a clearing transaction, the reporting side is the registered clearing agency that is a counterparty to the transaction.

Does this mean that cleared trades are reported but aren’t publicly available? If so, what is the logic for that? If not, what does it mean? Beats me.

Other Factors

There is a significant section in the final rule called § 240.901A, covering reports the Commission is expecting from the staff “regarding the establishment of block thresholds and reporting delays.” The Commission will use these reports to determine “(i) … what constitutes a large notional security-based swap transaction (block trade) for particular markets and contracts; and (ii) the appropriate time delay for reporting large notional security-based swap transactions (block trades) to the public.” One of the considerations the rule highlights is “potential relationships between observed reporting delays and the incidence and cost of hedging large trades in the security-based swap market, and whether these relationships differ for interdealer trades and dealer to customer trades.” So block sizes and block reporting delays haven’t been decided yet.

Finally, the final rule defers the compliance dates to the proposed rule, and although the rule itself doesn’t say, the preamble lists two phases:

Compliance Date 1 – Proposed Compliance Date 1 relates to the regulatory reporting of newly executed security-based swaps as well pre-enactment and transitional security-based swaps. On the date six months after the first registered SDR that accepts reports of security-based swaps in a particular asset class commences operations as a registered SDR, persons with a duty to report security-basedswaps under Regulation SBSR would be required to report all newly executed security-based swaps…Registered SDRs would not be required to publicly disseminate any transaction reports until Compliance Date 2.

Compliance Date 2 – Within nine months after the first registered SDR … commences operations … (i.e., three months after Compliance Date 1), each registered SDR in that asset class …would be required to comply with Rules 902 (regarding public dissemination), 904(d) (requiring dissemination of transaction reports held in queue during normal or special closing hours), and 905 (with respect to public dissemination of corrected transaction reports) for all security-based swaps in that asset class—except for “covered cross-border transactions.

So six months from sometime for reporting, and nine months for public disclosure.

Summing Up

Given the long delay between the CFTC’s reporting rules and these, we might expect that there would have been considerable communication between the agencies, and there might have been. It does appear that the CFTC is totally re-examining its reporting rules, and that might be a good thing. Meanwhile, as firms get ready to report SEC-regulated swaps, the situation still looks pretty muddy. It might get better, but I’m not very optimistic about that. 


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The Benefits of Portfolio Cross-Margining of Swaps and Futures

By Amir Khwaja, Clarus Financial Technology
Originally published on TABB Forum

Clarus analysis shows that it is clearly worth moving Futures positions that serve to reduce the risk of Swap positions from SPAN margined accounts to Portfolio margined accounts.

We often get asked about Cross-Margining of Swaps and Futures, as well as SPAN margin for Futures. In this article I will introduce the benefits of cross-margining, using a few simple examples and the CME Clearing model. As this is my first article on this topic, I will endeavor to keep it as simple as possible and in future blogs will plan to go into more detail.

First Example: IRS and ED

Let’s create two portfolio accounts: First. an account containing a single 5Y Swap Receiving Fixed on $100m.For a CME Client account, this has an Initial Margin requirement of $2.3 million (as shown below):


Second, an account with EuroDollar Futures short 2000 June 2015 contracts.

Running SPAN margin on this second portfolio shows that the IM is $700,000:

Margined independently, these two accounts have an IM requirement of $2.3 million plus $0.7million, which is $3 million.Now what if we were to move all the ED futures into the Swaps account?

Which shows that:

  • The IM is now $1.975 million
  • A reduction of $305,000, or 13% of the swap margin
  • Or a 34% reduction in total IM (from $3m to $1.975m)

We know this is because the Futures position serves to reduce the risk of the Swap trade. So in this case the client would be better off moving the Futures position from the SPAN margined account to the Portfolio margined IRS account.

Note: Interestingly, from above we see that the “WhatIf” column shows $810,870 as the margin of the Futures position, which can be compared to the $700,000 of SPAN margin for the same Futures position.

Second Example: IRS and Bond Future

Let’s now keep the same IRS portfolio account but introduce a different second account, this time one with 5Y Treasury Note short 1000 March 2015 contracts.

Running SPAN margin on this second portfolio shows that the IM is $800,000:


Margined independently, these two accounts have an IM requirement of $2.3 million plus $0.8 million, which is $3.1 million. However, if we now move all Treasury Futures into the Swaps account, we get the following:

Showing that:

  • The IM is now $646,000
  • A reduction of $1,634,000, or 72% of the swap margin
  • Or a 79% reduction in total IM (from $3.1m to $0.646m)

As before, we know this is because the Futures position serves to reduce the risk of the Swap trade. In this case much more than for the first example, and so the client would be better off moving the Futures position from the SPAN margined account to the Portfolio margined IRS account.

Note: Interestingly, from the above we see that the “WhatIf “column shows $1.846 million as the margin of the Futures position, which can be compared to the $800,000 of SPAN margin for the same Futures position.

Third Example: IRS and ED Futures Strip

Let’s now keep the same IRS portfolio account but introduce a different second account, this time one with a strip of ED Futures, from 1 to 20 (so out to Dec. 2019), with a short 100 contract in each contract deliverable month.

Running SPAN margin on this second portfolio shows that the IM is $1,033,000:


Margined independently, these two accounts have an IM requirement of $2.28 million plus $1.03 million, which is $3.31 million. However, if we now move all ED Futures into the Swaps account, we get the following:

Showing that:

  • The IM is now $454,920
  • A reduction of $1,850,000, or 80% of the swap margin
  • Or an 86% reduction in total IM (from $3.31m to $0.45m)

Again, the client would be better off moving the Futures position from the SPAN margined account to the Portfolio margined IRS account.

With each successive example we have decreased the margin more as a consequence of better hedging the risk of the Swap position.

We could continue further, but I will leave it there for today.

It is clearly worth moving Futures positions that serve to reduce the risk of Swap positions from the SPAN margined account to the Portfolio Margined one.


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CCPs: Risky Is as Risky Does – In Europe

By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum

On one hand, the European Commission is concerned that variation margin requirement for European pension funds in the event of an upward move in rates is so large that the repo market couldn’t handle it. On the other hand, it’s comfortable that the risk could be handled in the bilateral market. What’s the real risk?

Recently I wrote about the debate in the US over risk management programs at CCPs, and how “skin in the game” was not a very comforting approach (CCPs: Risky Is as Risky Does). A recent report by the European Commission on the use of CCPs by pension funds brings another aspect of this to light.

First, the report points out that:

Under EMIR, OTC derivatives that are standardised (i.e., that have met predefined eligibility criteria), including a high level of liquidity, will be subject to a mandatory central clearing obligation and must be cleared through central counterparties (CCPs).

Then it says:

Pension Scheme Arrangements (PSAs) in many Member States are active participants in the OTC derivatives markets. However, PSAs generally minimise their cash positions, instead holding higher yielding investments such as securities in order to ensure strong returns for their beneficiaries – retirees. The inability of CCPs to accept non-cash assets as collateral to meet [variation margin] VM calls means PSAs would need to generate cash on a short term basis either by borrowing cash or selling other assets in order to meet the CCP margin calls.

After observing that PSAs can post non-cash margin in the bilateral world, the report notes that a transition period was, “explicitly provided for under EMIR in order to provide further time for CCPs to develop technical solutions for the transfer of non-cash collateral to meet VM calls.” The solution envisioned was for PSAs to repo securities owned free and clear to generate the cash needed for VM.

On its face, this would be a workable solution, since there is an active market for repos in Europe, with several clearinghouses, such as LCH RepoClear, providing those services. If the derivatives were cleared at LCH, for example, it doesn’t seem to be too much of a stretch to imagine a linkage between RepoClear and SwapClear, where VM requirements would trigger a repo of securities held at LCH, and excess VM would trigger an unwind and return of the securities. Sounds like a good business model to me.

 However, the report points out an immediate concern:

The baseline study indicates that the aggregate VM call for a 100 basis point move would be €204–255 billion for EU PSAs. Of this, €98–123 billion (£82–103 billion) would relate to UK PSAs, and predominantly be linked to sterling assets, and €106–130 billion would relate to euro (and perhaps other currency) assets. Even if PSAs were the only active participants in these markets, the total VM requirement for such a move would exceed the apparent daily capacity of the UK gilt repo markets and would likely exceed the relevant parts of the EU Government bond repo market — i.e., primarily that in German Government bonds (bunds).

In other words, as I pointed out last July, the swaps markets are so large that a 100 bp move in short rates would create an enormous VM requirement. Given that risk, the report says:

The Commission therefore intends to propose an extension of the three-year period referred to in Article 89(1) of EMIR by two years through means of a Delegated Act. The Commission shall continue to monitor the situation with regards to technical solutions for PSAs to post non-cash assets to meet CCP VM calls in order to assess whether this period should be extended by a further one year.”

So, on the one hand, the VM requirement for European pension funds in the event of an upward move in rates is so large that the repo market couldn’t handle it. On the other hand, we’re all comfortable that the risk could be handled in the bilateral market. Really? Well, if all the PSAs are doing with swaps is hedging the risk of owning fixed rate debt, then we would expect them to be paying fixed and earning floating. Then, if rates rise, they will be receiving VM, not posting it. If, on the other hand, they own floating debt, why would they be hedging against a rate rise?

As it turns out, the management of this risk, as with all investment risks, doesn’t depend on whether the positions are carried in a CCP or not. It depends on whether the swaps positions are hedges and, if so, what risk they are hedging. If the PSAs are using swaps as a hedge, then the VM requirements would not be insurmountable, since the size of the positions would be commensurate with the size of the bond holdings. Thus the repo problem would solve itself. If they are not hedges, however, then someone should be asking what they are used for.

A good reporting system would help us assess this risk, but, as we all know, swaps reporting has been a disaster around the world. Thus we have very little chance of knowing how big the risk is, how well it has been managed, and when it will re-emerge. Instead, we’re focused on whether PSAs are required to clear their positions. Isn’t this another case of looking at second while the ball is going to first?


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The FTT – Finally a Reality

By Rebecca Healey, TABB Group
Originally published on TABB Forum

After years of wrangling, France and Austria appear to have broken the deadlock between the 11 ‘enhanced co-operation’ countries, and a compromise agreement has apparently been reached on a financial transaction tax. As of Jan. 1, 2016, all financial transactions, excluding primary market and bank loans, will be taxed if at least one of the parties is based in the EU. Is this finally it, or is it just more political posturing?

The agreement by France to tax all derivatives, rather than just credit default swaps (CDS), as well as shares and bonds was an important step in re-igniting the implementation of the financial transaction tax. But it now appears that the remaining stumbling block of the issuance versus residency principle has also been overcome. Finance Ministers from the 11 Member states met in Brussels earlier this week to sign an agreed text. The question is: What is the agreed text?

The FTT is to be implemented on all financial products except the primary market and bank loans. The proposed rate is reported to be 0.1% for shares and bonds and 0.01% for derivatives. It would appear that the Italian model based on the issuance principle has been dropped due to the significant legal challenges of imposing a tax on a state that does not wish to be part of the proposed tax regime.

The introduction of a specific minister, the Austrian Finance Minister Hans-Jörg Schelling, to push the FTT over the line to implementation is indicative of the political will to put the FTT into place; but still the question remains as to how this tax will be collected and enforced. Portugal will be leading on the technical implementation and France’s former economy minister, Pierre Moscovici, is in charge of the matter at the European Commission.

Currently, Italy and France collect the tax on a net basis at the end of day (EOD), meaning the very traders the tax was supposed to impact (intraday speculative traders) could get off scot-free, provided their EOD position is flat. With transaction information to be included in the standardized mandatory matching fields that CSDs now need to provide their NCAs under the new Central Securities Depositary Regulation, is this how the European Commission plans to track payment of the FTT?

The Outcome

Given that the tax is to be based on the widest possible base and lowest rate to take into account the impact on the real economy and the risk of relocation of the financial sector, perhaps the intention is to make the tax so onerously difficult to avoid that, given the minimal cost, it may be easier just to cough up.

However, as we have seen from recent stats produced by Credit Suisse, markets have a knack of delivering unintended consequences. In Italy, average trading volumes have declined by almost 12% since the introduction of the tax versus an overall 7% increase in European volumes. In France, volumes have been less impacted due to the high number of exemptions – to all participants it would seem except the retail investor.

As @RemcoLenterman posted this morning on Twitter:

You really could not make it up.

While the news out this morning is probably more political posturing, Europe is significantly closer to the implementation of the dreaded FTT. The question now will be whether this makes the possibility of a Brexit in May more likely?

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Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank – A White Paper by CFTC Commissioner Giancarlo

By J.C. Giancarlo, CFTC
Originally published on TABB Forum

In a new white paper, CFTC Commissioner J. Christopher Giancarlo analyzes flaws in the CFTC’s implementation of its swaps trading regulatory framework under Title VII of the Dodd-Frank Act and proposes a more effective alternative. He identifies the adverse consequences of the flawed swaps trading rules and proposes an alternative swaps trading framework that better aligns with swaps market dynamics and is more true to congressional intent.

The views expressed in this Executive Summary and White Paper reflect the views of Commissioner J. Christopher Giancarlo and do not necessarily reflect the views of the Commodity Futures Trading Commission (CFTC), other CFTC Commissioners or CFTC staff.

Read the full White Paper at the end of this executive summary.

Market participants are encouraged to submit their comments and feedback below.This White Paper is written by Commodity Futures Trading Commission (CFTC or Commission) Commissioner J. Christopher Giancarlo, a public supporter of the swaps market reforms passed by Congress in Title VII of the Dodd-Frank Act, namely clearing swaps through central counterparties, reporting swaps to trade repositories and executing swaps transactions on regulated trading platforms. The author supports the CFTC’s implementation of the first two reforms, but is critical of the CFTC’s implementation of the third, as explained in this White Paper.

This paper (a) analyzes flaws in the CFTC’s implementation of its swaps trading regulatory framework under Title VII of the Dodd-Frank Act and (b) proposes a more effective alternative.This paper begins with a broad overview of the complex structure of the global swaps market. It then reviews the clear legislative provisions of Title VII of the Dodd-Frank Act. Next, it reviews in detail the Commission’s flawed implementation of the Dodd-Frank Act’s swaps trading provisions. This paper asserts that there is a fundamental mismatch between the CFTC’s swaps trading regulatory framework and the distinct liquidity and trading dynamics of the global swaps market. It explains that the Commission’s framework is highly over-engineered, disproportionately modeled on the U.S. futures market and biased against both human discretion and technological innovation. As such, the CFTC’s framework does not accord with the letter or spirit of the Dodd-Frank Act.   This paper identifies the following adverse consequences of the flawed swaps trading rules:

  • Driving global market participants away from transacting with entities subject to CFTC swaps regulation. 
  • Fragmenting swaps trading into numerous artificial market segments.
  • Increasing market liquidity risk.
  • Making it highly expensive and burdensome to operate SEFs.
  • Hindering swaps market technological innovation. 
  • Opening the U.S. swaps market to algorithmic and high-frequency trading.
  • Wasting taxpayer money when the CFTC is seeking additional resources. 
  • Jeopardizing relations with foreign regulators.
  • Threatening U.S. job creation and human discretion in swaps execution.
  • Increasing market fragility and the systemic risk that the Dodd-Frank regulatory reform was predicating on reducing.

This White Paper proposes an alternative swaps trading framework that is pro-reform. It offers a comprehensive, cohesive and flexible alternative that better aligns with swaps market dynamics and is more true to congressional intent. The framework is built upon five clear tenets:

  • Comprehensiveness: Subject the broadest range of U.S. swaps trading activity to CFTC oversight.
  • Cohesiveness: Remove artificial segmentation of swaps trading and regulate all CFTC swaps trading in a holistic fashion.
  • Flexibility: Return to the Dodd-Frank Act’s express prescription for flexibility in swaps trading by permitting trade execution through “any means of interstate commerce,” allowing organic development of swaps products and market structure, accommodating beneficial swaps market practices and respecting the general nature of core principles.
  • Professionalism: Raise standards of professionalism in the swaps market by establishing requirements for product and market knowledge, professionalism and ethical behavior for swaps market personnel.
  • Transparency: Increase transparency through a balanced focus on promoting swaps trading and market liquidity as Congress intended.
This White Paper asserts that its pro-reform agenda would yield a broad range of benefits. It would:
  • Align with congressional intent to promote swaps trading under CFTC regulation.
  • Promote vibrant swaps markets by regulating swaps trading in a manner well matched to underlying market dynamics.
  • Reduce global and domestic fragmentation in the swaps market.
  • Foster market liquidity.
  • Reduce burdensome legal and compliance costs of registering and operating CFTC-registered SEFs.
  • Encourage technological innovation to better serve market participants and preserve jobs of U.S.-based support personnel.
  • Free up CFTC resources and save taxpayer money at a time of large federal budget deficits.
  • Provide another opportunity for the CFTC to coordinate with other jurisdictions that are implementing their own swaps trading rules.
  • Reverse the increasing fragility of the U.S. swaps market by allowing organic development and growth for greater U.S. economic health and prosperity.
Of Note:
  1. Commissioner Giancarlo asserts that the CFTC’s swaps trading rules do not accord with Title VII of the Dodd-Frank Act. He calls for greater adherence to the express language of Title VII in conformance with congressional intent.
  2. Commissioner Giancarlo contends that the CFTC’s swaps trading rules increase rather than decrease the systemic risk that the Dodd-Frank Act was premised on reducing.
  3. Commissioner Giancarlo contends that the CFTC’s restrictive and over-engineered swaps trading rules have failed to achieve their ostensible objective of meaningful pre-trade price transparency.
  4. Commissioner Giancarlo contends that the CFTC’s swaps trading rules add unprecedented regulatory complexity without meaningful benefit wasting taxpayer money at a time when the CFTC is seeking additional funding.
  5. Commissioner Giancarlo contends that the CFTC’s rules open the U.S. swaps market to algorithmic and high-frequency trading that is not otherwise present.
  6. Commissioner Giancarlo is the first CFTC Commissioner to call for and put forth a proposal to raise the standards of professional conduct for swaps market personnel.
  7. Commissioner Giancarlo proposes a comprehensive, cohesive and transparent swaps trading framework that is pro-reform and better aligns with swaps market dynamics and the express provisions of Title VII of the Dodd-Frank Act.

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CCPs: Risky Is as Risky Does

By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum

Has mandatory clearing for swaps concentrated risk in the CCPs and made them too big to fail? Two recent industry papers bring into sharper focus the debate that has been raging under the surface of the markets.

Recent white papers by the CME (Clearing – Balancing CCP and Member Contributions with Exposures) and ISDA (CCP Default Management, Recovery and Continuity: A Proposed Recovery Framework) bring into sharper focus a debate that has been raging under the surface of the markets: Has the introduction of mandatory clearing for swaps concentrated risk in the CCPs and made them too big to fail? As with any document published by a participant in a debate, we have to remember who wrote these, but they should help clarify this important topic.

The crux of the debate is about how much capital (in whatever form) is necessary to ensure the safety of the cleared swaps market, and who should put up the bulk of it. Since everyone is now aware of the extent to which increased capital requirements raise the costs of trading, everyone should expect all the market participants to argue that any additional capital should come from any other class but theirs. And that just about sums up this debate.

There are, of course, compelling arguments on both sides. For the CME’s part, after saying that “CCPs are fundamentally risk managers responsible for ensuring the overall safety and soundness of their markets,” it goes on to say, “Ensuring that market participants and clearing firms have the proper skin in the game is one of the most critical roles of a CCP.” This sets the stage for most of the CME’s argument: that recent financial failures were due to the perpetrators not having the same exposure as their customers or the government – i.e., not having skin in the game.

The CME argues that the waterfall approach, in which increasing losses tap into ever more general pools of money – from the customer’s IM to the clearing member’s IM, to the clearing member’s part of the default fund, to the default fund in general, to assessments on members – serves not only to spread the risk appropriately but also to discourage risky behavior. CME concludes that:

“The discussion of skin in the game should focus largely on the amount of skin in the game that each clearing member must contribute to the waterfall, including IM, concentration margin, default fund, and assessments. A clearing member’s skin in the game should scale with the exposures they bring to the CCP.”

ISDA says:

“Effective default management is predicated on the ability of a CCP to transfer the defaulted clearing member’s (CM’s) positions to solvent CMs in order to re-establish a matched book. The primary tool to re-establish a matched book is a voluntary portfolio auction, which is already built into the default management process (DMP) of many leading CCPs. In trying to achieve this objective, a CCP has loss-absorbing resources available that include the defunct CM’s pre-funded default resources (its initial margin (IM) and its contribution to the default fund (DF)), as well as mutualized resources. Such default resources are organized and consumed in the order of a pre-defined default waterfall (DW).”

One of its footnotes postulates that:

“Any calls to CMs should be pre-defined, limited, reasonable and quantifiable. Without certainty regarding exposures, clearing as a business becomes problematic because CMs would be deprived of the ability to quantify their risk exposures. Also, multiple assessment calls on non-defaulting CMs at a time of stress could become a significant source of pro-cyclicality with systemic consequences that could threaten the viability of remaining CMs.”

So ISDA is focused on the auction process for moving the customer positions from a defaulting CM to a solvent one, without much focus on default prevention. But, as they say, an ounce of prevention is worth a pound of cure.

So it is appropriate now to take a closer look at how swaps clearing actually works, and see if we can determine how risk is created and then managed. The first thing to understand is that in the omnibus model, the clearing member truly stands between the CCP and the customer that is actually creating the risk. Unless the CCP maintains separate accounts for each customer, it performs no KYC, does no credit checking, and assigns no limits to each customer. It knows which positions and margin are proprietary to the clearing member and which are customer positions, but nothing about which customer has which positions. In other words, the CCP is relying totally on the clearing member’s risk management. No wonder they want the members to have lots of skin in the game.

However, there are several other considerations, at least in the minds of market participants. One is that providing clearing services is very much a volume business, in the same way that custody or payment clearing is. Volume businesses always tend toward concentration, since higher volume leads to lower costs. But since clearing is also about risk, this phenomenon automatically tends toward risk concentration.

The second consideration is the typical pattern of financial disasters. The risk always starts out as manageable, and the forecast is rosy. Then a few things start to go wrong, and the victim makes a few “temporary” adjustments to rectify the situation. Then those start to go wrong, and even more questionable measures are taken. All the while, everyone in the know makes sure nobody else knows, because making it public will only make it worse. Then, under further deterioration, some blatantly illegal things are done, just before the wave breaks and everyone finds out how bad things are. Except that the public panic makes it significantly worse.

One implication of this scenario is that, as vigilant as a counterparty may be, it might not see the cracks in the façade until the edifice is already falling down. In the bilateral world, firms deal with this risk by limiting their exposure to any party to only what they would be comfortable losing. Obviously, customers can open accounts with multiple counterparties and thus build up gargantuan positions; but at least the risk is spread out, based on each firm’s risk appetite.

Clearing adds a few wrinkles to this scenario, but some aspects remain the same. Assuming the customer opens accounts at several clearing firms, and each of them independently does its own due diligence, the same opportunity for a market meltdown exists. And it is likely that the distant rumblings of trouble would be as muted as in the bilateral world, until it all comes out. So far, no difference.

The big question is: What happens when it does come out. Assuming that this one customer represents, say, 70% of the positions on the losing side, everyone would immediately ask, “Where were those positions cleared?” Now, instead of having them spread out among many firms, they all appear in one place, the CCP. And the resolution plans of many CCPs indicate that they could use the VM expected to be paid on the winning positions to cover the losses.

Knowing that, customers would rush to withdraw their segregated balances from the clearing members, and the members from the CCP, and we start to have lines around the block. It all looks worse, though, if the culprit is a clearing firm itself. In that case, one could be sure that it would have already accessed all of its IM, default contributions, and any other cash, and possibly its customers’ cash as well.

As grim as this scenario is, it has already happened on a minor scale. The point is that the swaps markets are huge. The fixed-float outstanding notional is still around $400 trillion, as far as I can tell, so a 100 bp move in short rates represents a full-fledged earthquake in terms of VM. Who actually holds all those positions? Nobody knows – not the regulators, not the CCPs, not the clearing firms, nobody.

So in the end, skin in the game may give some folks comfort, but not me. The only way to guard against the dreaded creeping, mushrooming default is transparency and good business practices on the part of the clearing firms. In some ways, the CCPs may simply be very interested bystanders, and then everyone’s skin is in the game. So risky probably is as risky does.

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ESMA's Draft Regulatory Technical Standards for Interest Rate Swaps Are Changing

In a recent letter, the European Commission outlined its intention to endorse ESMA’s draft regulatory technical standards (RTS), which set out which interest rate swaps will be subject to mandatory clearing under EMIR. However, before formally doing so, the European Commission has asked ESMA to make some amendments in specific areas. These include:

  • Postponing the calculation period for counterparties to determine whether they are in category 2 or 3  

  • Clarifying that the calculation for investment funds should be made at fund, rather than group, level

  • Delaying the start of the frontloading window to allow counterparties more time to prepare

Although there no proposed changes to the scope of instruments that will be subject to mandatory clearing, it is now anticipated that the final rules will apply (“enter into force” *) later than originally estimated impacting the clearing start date for each type of counterparty.

Assuming the RTS enter into force in early April 2015, the following timeline will apply:


* Note: The RTS will “enter into force” 20 days after they are published in the Official Journal


Category 2 or 3 determination

Counterparties whose aggregate month-end average notional amount of non-cleared derivatives in the three months following the publication of the RTS in the Official Journal is above 8bn EUR will be classified as Category 2. The calculation period excludes the month of publication. Counterparties who fall below this threshold will be in Category 3.

By way of example, if the final RTS are published in the Official Journal in March 2015, the three month-end calculations would now include April, May and June 2015 exposure.

Calculation threshold for investment funds

The letter clarified that the calculation for investment funds should be carried out for each single fund, rather than at group level, as long as, in the event of fund insolvency or bankruptcy, the funds are distinct legal entities.

Delay to the start of frontloading

Frontloading is the requirement to centrally clear certain derivatives contracts entered into before the clearing obligation for the counterparty takes effect. The start date of frontloading for interest rate swaps has been delayed to give counterparties more time to prepare for its implementation.

For Category 1 counterparties, the frontloading window will open two months after the RTS enter into force. For Category 2 counterparties, this will now be five months after the RTS apply.

It is the intention that Category 3 and 4 counterparties are not subject to the frontloading requirement.

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CFTC Is Kicking the Extra Point

By Sol Steinberg, OTC Partners
Originally published on TABB Forum

Recent rule changes by the CFTC indicate that the Commission has largely crossed the goal line with respect to OTC reform and is now in the process of ‘fine-tuning’ regulatory requirements in the US. Cross-border harmonization, however, remains a critical challenge.

With ESMA recently taking significant steps to catch up with the financial market reforms that have been implemented by U.S regulators, it’s a good time to stop and reflect on where we are, where we’ve been, and all that’s been accomplished since the financial crisis.

Here in the U.S., the last significant regulatory moves were the changes to the rules governing Residual Interest, Recordkeeping Requirements, and Forwards With Volumetric Optionality, which were proposed by the CFTC in November 2014. Given that this is Super Bowl week, I liken these moves — all of which were approved by the Commission — to setting up for the extra point after the game-winning scoring drive. The strategies of Bill Belichick and Pete Carroll have all come down to this, and now we’re just waiting for Gostowski or Hauschka to end the game.

The odds-makers say it’s going to be Hauschka; but for the purpose of this analogy it really doesn’t matter. The point is, the game is almost over. That latest round of proposed rules changes, which are detailed below, fall into the realm of “fine-tuning.” That’s how they were characterized by CFTC Chairman Timothy Massad, and he was right.

The Commission’s actions between 2010 and 2013 were highly effective and cannot be overstated. Four years ago, the $700 trillion OTC derivatives market was largely unregulated, but now most of the truly hard work is complete. Thanks to former Commissioners Gary Gensler, Bart Chilton, and Scott O’Malia (the longest-serving commissioner in CFTC history), we’ve crossed the goal-line of regulation.

However, the credit cannot go to the regulators alone. Industry figures such as Dan Maguire, Jeff Sprecher, and Sean Tully deserve great appreciation for their efforts in helping create a realistic regulatory framework to govern the massive and unwieldy OTC derivatives space.

Now that we’ve made it into the end-zone, so to speak, rules changes like those proposed in November are akin to kicking the extra point. The only difference is that we are likely to see several more extra points as we move forward and continue dealing at the edges of regulation.

That’s not to say these recent adjustments are insignificant. In fact, they are quite important.

New Rules Changes

Residual Interest Deadline

The first change affects Rule 1.22, which was created to help ensure that the funds deposited by customers with Futures Commission Merchants (FCMs) remain safe by prohibiting FCMs from using the funds of one customer for the benefit of another customer. Pursuant to the rule, FCMs are obliged to maintain their own capital when customers are required to post additional margin but have not yet done so. The FCM must now deposit those additional funds by close of business (6:00 pm Eastern Time) the next day following a trade.

The rule also stipulated that, on Dec. 31, 2018, the deadline would automatically move to start of business (9:00 am Eastern Time) the day after a trade if the Commission failed to take any action beforehand. That automatic termination of the phase-in compliance period has now been removed, and the Commission may only revise the Residual Interest Deadline through a separate rulemaking.

I strongly support this change. Moving the deadline to the start of business — thus requiring customers, mainly farmers, to pre-fund margin accounts — has the potential to create larger losses in the event of another failure along the lines of MF Global or Peregrine Financial.

This situation, however, illustrates how important it is to ensure that policy properly balances the Commission’s intentions. I speak specifically about the goal of strengthening FCM risk-management requirements while guaranteeing adequate accessibility to the derivatives marketplace and continued market liquidity. Under certain circumstances, these goals can be at odds with each other. Each one must, therefore, be approached with a conscious understanding of how it affects the other.

This rule change was unanimously approved by the four members of the Commission, each of whom commented to varying degrees:


“An earlier residual interest deadline better protects customers from one another, in line with the statute, but we want to make sure we move deliberately so that the model works best for customers in light of all of their interests, since the deadline will affect how much margin customers have to post and when.”


“This has the effect of increasing certainty to FCMs that any further change to the deadline would occur only following the robust procedures associated with a rulemaking, in addition to the already required study and roundtable, which is an outcome I support.

“The resulting certainty provided to the FCM community outweighs the potential value of incentivizing FCMs to improve their margin-collection practices to comply with a future, time-of–settlement deadline.”


“Without [this change], the so-called and, perhaps, misnamed ‘customer protection’ rule finalized in October 2013 would likely result in significant harm to the core constituents of this Commission: the American agriculture producers who use futures to manage the everyday risk associated with farming and ranching.

“As it stands, the rule will cause farmers and ranchers to prefund their futures margin accounts due to onerous requirements forcing FCMs to hold large amounts of cash in order to pay clearinghouses at the start of trading on the next business day. Without revision, the increased costs of pre-funding accounts will likely drive many small and medium-sized agricultural producers out of the marketplace. It would likely force a further reduction in the already strained FCM community that serves the agricultural community.”

Recordkeeping Requirements

The second rule change approved by the Commission clarifies the definition of how transaction records must be “identifiable.” Under the latest proposal, members of DCMs and SEFs that are not registered with the Commission do not have to keep text messages or store their other records in a manner that is identifiable and searchable by transaction. Additionally, CTAs do not have to record oral communications regarding their swap transactions.

This is another small but extremely important move by the Commission. I applaud the CFTC for recognizing that the costs of complying with certain aspects of the rule as it is currently written might exceed the potential benefits for certain market participants. The important thing to consider here is that the costs of maintaining those records would ultimately be passed along, via transaction fees, to those whom the rule seeks to protect: the customers.

However, the changes provide an incomplete sense of accomplishment. Yes, they achieve an important element of clarity; but they do not address concerns that the rule may be needlessly onerous and may hurt small FCMs, which are already burdened by low interest rates and increasing regulatory requirements. We see this painfully illustrated in the fact that there are currently about half as many FCMs serving our nation’s farmers as there were a few years ago.

The amendments to Regulation 1.35 were approved three to one, with Giancarlo opposed.


“The revisions to Rule 1.35 that the Commission is proposing today go a long way towards addressing the Rule’s difficulties. Unfortunately, they do not go far enough. The proposed Rule text raises unanswered questions. It continues to contain provisions that may be difficult or overly burdensome in practice for certain covered entities. In my opinion, many of the problems stem from imprecise construction and definition in the legal drafting.

“Without healthy FCMs serving their customers, the everyday costs of groceries and winter heating fuel will rise for American families… In implementing the Dodd Frank Act, I am conscious that the stated purpose, and indeed its official title purports to reform ‘Wall Street.’ Instead, we are harming ‘Main Street’ by forcing burdensome new compliance costs onto our country grain elevators, farmers, and small FCMs.

“Rather than facilitating the collection of useful records to use in investigations and enforcement actions, the underlying rule and the lack of sufficient relief provided in today’s proposal will instead result in senseless cost increases. Increased costs may even curtail the use of sound risk management tools needed to help farmers hedge the risks — and there are many — of growing the crops that feed and fuel our nation.”

Forwards With Embedded Optionality

The third and final rule change approved by the CFTC clarifies its interpretation of the seven-part test that is used to determine if an agreement, contract or transaction with embedded volumetric optionality would be considered a forward contract. The clarifications are designed to address concerns raised by utilities and other commercials as to whether these contracts should be treated as physical forwards or as swaps. This is a key distinction, as physical forwards are not subject to CFTC jurisdiction, while swaps are.

The clarifications spelled out in this rule change were essential. Over the past year, it appears that a number of participants have withdrawn from the market because of the ambiguities in the rule as it is currently written. This resulted in inferior execution for commercial firms and seems to have had a negative impact on electricity and gas consumers.

The proposed rule changes were approved unanimously by the four Commissioners:


“I appreciate that a number of market participants and end-users want clarity regarding which volumetric options qualify as forwards and, therefore, are excluded from our jurisdiction. I am sympathetic to these concerns and agree we should try to make our guidance on this point clearer.

“Yet, I worry that the current proposal as written goes too far and will cause too many options to be incorrectly regarded as forwards. I think the trade option exemption provides a much clearer and cleaner approach to address the issues raised regarding volumetric optionality. I hope the Commission can consider revising our trade option regulations soon.”


“The bottom line is that such uncertainty in the seven-part test increased transaction costs for commercial firms and limited their access to an effective risk-management tool.

“Today’s proposal should go a long way towards providing commercial firms adequate guidance.”


“Without [this change], the so-called and, perhaps, misnamed ‘customer protection’ rule finalized in October 2013 would likely result in significant harm to the core constituents of this Commission: the American agriculture producers who use futures to manage the everyday risk associated with farming and ranching.

“As it stands, the rule will cause farmers and ranchers to prefund their futures margin accounts due to onerous requirements forcing FCMs to hold large amounts of cash in order to pay clearinghouses at the start of trading on the next business day. Without revision, the increased costs of pre-funding accounts will likely drive many small and medium-sized agricultural producers out of the marketplace. It would likely force a further reduction in the already strained FCM community that serves the agricultural community.”

The Road Ahead

Now that most of the difficult regulatory work is finished (see Appendix A for a full list of CFTC rulemakings), the Commission will have a much simpler job in 2015. I don’t foresee any major changes in the near future; just more “fine-tuning” to keep everything running smoothly.

I see proof of this in the fact that only one of the Commissioners who had a hand in the major regulatory initiatives of 2010 through 2013 — J. Christopher Giancarlo — remains in place. All the other key figures have moved on.  

We can expect to see more amendments to rules that have automatic deadlines for implementation of higher standards, such as the Residual Interest Rule discussed above. In particular, I anticipate that the threshold for determining when a firm must register as a swap dealer, which will automatically drop from $8 billion to $3 billion in 2017, will be one of the areas that are fine-tuned in the coming months. We should also expect to see more amendments to the rules governing package transactions and position limits.

The biggest task I foresee for the CFTC over the next few years is to increase cooperation with other regulatory bodies around the world. Chairman Massad echoed this sentiment earlier this month when he said, “We have agreed to consider changes that would further harmonize our rules with European rules governing these clearinghouses. This would in turn facilitate their recognition of our U.S. clearinghouses.”

At the moment, the CFTC is continuing to consider how to apply its rules to swaps trades between non-U.S. entities that are arranged, negotiated, or executed in the U.S. While I’m glad to see the Commission taking steps toward global cooperation, I question whether we have the right people in place to accomplish this in the most efficient manner. None of the current Commissioners have substantial experience dealing with international regulatory agencies.

As a result, I would advise the Commission to rely on industry ambassadors, such as the ones acknowledge above, to help push the new global market initiative. With more and more new requirements going into effect, this will be the key regulatory issue in the months and years ahead, so its importance cannot be overstated.

We’re already seeing increased emphasis in this area, as exemplified by Federal Reserve Governor Jerome Powell’s recent call for more coordinated global regulation of derivatives clearinghouses. Specifically, Powell said, “We need transparent, actionable and effective plans for dealing with financial shocks that do not leave either an explicit or implicit role for the government.”

I fully agree. Over the past few years, central clearing of standardized derivatives has brought more transparency to the market. However, it has also increased the damage that could be caused by the failure of a large clearinghouse. In order to ensure that clearinghouses do not become the new “too-big-to-fail” entities, they must increase their liquidity, transparency and ability to withstand shocks without government bailouts.

Consequently, global regulators should consider establishing coordinated, standardized stress tests for clearers, and the results of those tests should be made public.

Appendix A

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