SPEECHES & TESTIMONY

Statement of Chairman J. Christopher Giancarlo Regarding Notice of Proposed Rulemaking on Swap Execution Facilities and Request for Comment on Post-Trade Name Give-Up

November 5, 2018

Washington, DC – I start by referencing an important White Paper written in 1970 by a young graduate student in economics at UC Berkeley.  That White Paper, entitled, “Preliminary Design for an Electronic Market,” written for the Pacific Commodity Exchange, was the world’s first written conceptualization of a fully electronic, for-profit futures exchange.

The White Paper was written by Dr. Richard Sandor.  That White Paper has now been republished in a new book by Dr. Sandor.[1] In it, he recounts how his idea lay mostly dormant through the 1970s to mid-1980s before being slowly developed, in fits and starts, first in Europe in the 1990s and then in the United States in the 2000s.  His book notes that electronic execution of futures products with continuous liquidity has become almost ubiquitous today, while other exchange traded asset classes with more episodic liquidity, like options and swaps, continue to trade by voice.

What I found fascinating in Dr. Sandor’s recounting of this five-decade long evolution from trading pits to electronic trading of futures was the absence of any grand plan behind the transformation.  Instead, it was a series of incremental commercial developments and technology innovations.  At all times, the impetus was the demands of market participants and the response of market operators to reduce trading costs and transaction friction.  At no time, did government step in and say, “Henceforth, all futures trading shall be on electronic exchanges.”  Instead, market evolution happened because a good idea was coupled with capable technology and mutual commercial interest with enough time to catch on and gain traction.

Before I joined the Commission, I spent a decade and a half at a leading operator of swaps marketplaces.  We launched many innovative electronic platforms still in use today.  Some of the platforms caught right on with our customers, others did not.  Yet, we designed all of them to increase efficiency and reduce trading friction.  It was just that sometimes our competitors designed better or cheaper ones or just simply got the timing right.

The point is that the design of trading platforms and the evolution of market structure is best done by platform operators, through trial and error, customer demand, commercial response and technological innovation.  Regulators will never be close enough to the heartbeat of the markets, the spark of technology or the cost of development to prescribe the optimal design of trading platforms or business methods.  Regulators can never know which trading methods will work best in the full range of market conditions, from low to extreme volatility.

Congress understood this.  That is why Title VII of Dodd-Frank permits Swap Execution Facilities (SEFs) to conduct their activities through “any means of interstate commerce,” not “such means that may be chosen by regulators.”

Once regulators step in and dictate who serves who with what type of service, we are picking winners and losers.  We are simply not authorized, nor are we competent, to act in this way.  If we do, the winners will invariably be those with the most persuasive voices and best lobbyists.

Congress knew that swaps are not traded by retail participants, but for sophisticated, institutional traders.  Wall Street banks, hedge funds, prop shops and large energy companies have the wherewithal to demand the transaction services they need without regulators holding their hands.  And the platform operators are not public utilities, but seasoned competitors.  If there is money to be made, trading efficiencies to be achieved, customers to be served or costs to be saved, they will find them.  If there is a better mousetrap to be built, they will build it.

Unfortunately, the CFTC did not listen to Congress.  Contrary to provisions of Dodd-Frank that permit SEFs to operate by “any means of interstate commerce,” the current SEF rules constrain swaps trading to two methods of execution – request-for-quote or order book. While swaps not subject to the trade execution mandate can utilize other methods, SEFs must nevertheless provide an order book for such permitted transactions.  All other “required” transactions have to be executed exclusively on one of those two options.  Further, the rules incorporate a number of practices from futures markets that are antithetical to swaps trading, such as the 15 second “cross” and execution of block trades off platform.  Additionally, the SEF core principles are interpreted in ways that are not conducive to environments in which swaps liquidity is formed and price discovery is conducted.

One effect of this approach has been to incentivize the shift of swaps price discovery and liquidity formation away from SEFs to introducing brokers (or “IBs”).  SEFs have turned into booking engines for trades formulated elsewhere, often on IBs.  Yet, IBs are not appropriate vehicles to formulate swaps transactions.  The intended purpose of IBs in the CFTC’s regulatory framework is to solicit orders for futures transactions, not swaps.  Moving swaps price discovery and liquidity formation away from SEFs to IBs is not what Congress intended in Dodd-Frank.  The goal was to have the entire process of swaps liquidity formation, price discovery and trade execution take place on licensed SEF platforms.  IBs are not subject to conduct and compliance requirements appropriate for swaps trading.  Their employees are not required to pass exams for proficiency in serving institutional market participants in over-the-counter swaps markets but they are for retail customers who are prohibited from trading swaps.

Another effect of the current approach is the paucity of platform innovation and new platform operators competing for market share.  The stagnation has allowed a few incumbents to consolidate and dominate market share.  According to one large swaps trader, “the biggest disappointment of SEFs is that nothing has really changed.  I’m still trading the same way today as I was 10 years ago.”[2]  And, yet, the current rules were supposed to have caused as much as a hundred firms to register as SEFs.[3]

I have written a few white papers of my own. I have called for revising our current restrictions on SEF activity and allowing flexible methods of execution for swaps transactions using any means of interstate commerce, exactly as Congress intended.[4] 

Today’s proposal does just that.  It will allow SEFs to innovate to meet customer demand and operate trading environments that are more salutatory to the more episodic nature of swaps liquidity.  At the same time, it will make the “made available for trading” determination synonymous with the clearing determination to include all swaps subject to the clearing requirement and listed by a SEF or DCM.  This is meant to bring the full range of liquidity formation, price discovery and trade execution on SEFs for a broader range of swaps products.

The promotion of swaps trading on SEFs brings “daylight to the marketplace” by subjecting a much broader range of swaps products to SEF record keeping, regulatory supervision and oversight, just as Congress intended.

It is said that if CFTC mandates for minimum trading functionality go away, so will the current degree of electronic execution in the market.  Sorry, but that is a naïve concern.  Those electronic SEF platforms that are successful provide too much competitive advantage and cost efficiency and sunk costs to be shut down simply because they are no longer subject to a regulatory mandate. No firm is going to give up electronic trading market share and profitability and increase trading friction because regulation suddenly becomes less prescriptive.

A word about “impartial access,” Dodd-Frank requires SEFs to have rules to provide market participants with “impartial access” to the market and permits SEFs to establish rules regarding any limitation on access.

“Impartial access” means just that, “impartial”.  It does not mean that SEFs must serve every type of market participant in an all-to-all environment.  If it did, then Congress would not have allowed SEFs to establish rules for limitation of access.

The new proposal would establish what is meant by “impartial access”.  The proposal will generally define “impartial” as transparent, fair and non-discriminatory as applied to all similarly situated market participants in a fair and non-discriminatory manner based on objective, pre-established requirements.

Today’s proposal would also enhance the professionalism of SEF personnel who exercise discretion by adopting proficiency requirements and conduct standards suitable for swaps.  Furthermore, the proposal adopts rule changes in a number of places where staff has previously issued guidance or no-action relief from the current rules, thereby increasing regulatory clarity and certainty.

We have approached today's proposal with the principle that the CFTC engage its international counterparts with respect and due consideration.   The staff of the CFTC and I have made every effort to ensure that non-U.S. authorities had the opportunity to review and discuss the 2015 SEF White Paper that set out the concepts underlying today’s proposal.  Based on that outreach, I see no reason why today’s proposal would be viewed as inconsistent with the regulatory systems of other G20 jurisdictions.  We certainly welcome further dialogue with them. In fact, today’s proposal is entirely consistent with, and anticipated by, recent discussions with foreign authorities about the CFTC's SEF regime, including the equivalence agreement for swaps trading platforms with the European Commission that EC Vice President Dombrovskis and I announced one year ago here in this room.  That agreement, which focused on an outcomes-based approach toward EU equivalence and CFTC exemptions, was made by both parties with full knowledge and understanding of the changes advocated in the 2015 SEF White Paper and presented to us today.

Let me briefly address today’s request for comment on the practice of name give up in swaps markets. There are a range of perspectives on this market practice.  I have an open mind as to the advisability of restrictions on the practice and what form a rule would take, if at all.  I look forward to comments and hearing more about the current impact of this practice in the marketplace.

One final point: today’s proposal will invariably be slammed by opponents of change as a “rollback” of Dodd-Frank.  Any such characterization would be disingenuous.

Those who examine my record know that I have been a consistent supporter of the swaps reforms embodied in Title VII of the Dodd-Frank Act.  In fact, of the current five Commissioners, I may have been the first to publicly state my support for Title VII.[5]  And, I have not waivered since.  Congress got Title VII right.  There, I said it again.

My support for the Title VII reforms – swaps clearing, swap dealer registration and requirements, trade reporting and regulated swaps execution - is not based on academic theory or political ideology.  It is based on fifteen years of commercial experience.  Done right, the reforms are good for American markets.

So is today’s proposal.  It is not a rollback, but a policy improvement, a step forward, to enhance swaps market health and vitality that is true to Congressional intent and purpose. I trust that market participants and interested parties will fairly consider it with the good faith with which it is presented. I look forward to a broad and active discussion.

In closing, I compliment the DMO staff for putting together a balanced rule proposal and request for comment.  I would like to commend them for their many hours of hard work, the quality of the written proposal and their thoughtfulness and engagement throughout. 

You know, it is satisfying to see how an old White Paper, with ample time and reflection, can become a formal proposal, an arrow hitting its mark. 

I look forward to the public’s comments, healthy discussion, and a final rule in 2019.

 


[1] Sandor, Richard L., “Electronic Trading & Blockchain: Yesterday, Today and Tomorrow,” 2018, World Scientific Publishing Co. Pte. Ltd.

[2] Robert Mackenzie Smith, “SEF reforms could distort new, sounder benchmark rates,” Risk.net, 19 Oct. 2016, at: https://www.risk.net/derivatives/6049931/sef-reforms-could-distort-new-sounder-benchmark-rates.

[3] Christopher Doering & Roberta Rampton, “US May See 100 New Swaps Execution Entities: Broker,” Reuters, Oct. 12, 2010, at: https://www.reuters.com/article/us-financial-regulation-sefs/u-s-may-see-100-new-swap-execution-entities-broker-idUSTRE69B69020101012.

[4] Commissioner J. Christopher Giancarlo, Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank, Jan. 29, 2015, http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/sefwhitepaper012915.pdf; (“2015 SEF White Paper”); and Swaps Regulation Version 2.0: An Assessment of the Current Implementation of Reform and Proposals for Next Steps, April 26, 2018.

[5] Wholesale Markets Brokers’ Association, Americas, Commends Historic US Financial legislation, Jul. 21 2010, available at: http://www.lexissecuritiesmosaic.com/gateway/CFTC/Speech/01_WMBAA-Dodd-Frank-Law-press-release-final123.pdf