Statement of Chairman Heath P. Tarbert in Support of Final Swap Dealer Capital Rule
July 22, 2020
Today marks 10 years and a day since the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) was signed into law. Much has changed during the past decade—our derivatives markets today are faster, increasingly digital, and more deeply connected to the global economy than they were in 2010. Yet amidst these changes, there has been at least one constant: the absence of capital requirements for swap dealers and major swap participants for which the CFTC is responsible. As a response to the credit crisis of 2008, Section 731 of the Dodd-Frank Act amended the Commodity Exchange Act (“CEA”), providing that the CFTC “shall adopt” capital and financial reporting requirements for these entities. It is high time to fulfill this mandate and close the book on our Dodd-Frank Act responsibilities. After all, “late” is always better than “too late.”
There is another compelling reason to finalize a capital rule that is more than a decade in the making: certainty. One of our strategic goals as an agency is to enhance the regulatory experience for market participants at home and abroad. Certainty is the bedrock of this goal. Our swap dealers cannot effectively plan for compliance without clarity from us about what their capital obligations will look like. Today we lift this cloud of uncertainty by finalizing a capital rule that carefully accounts for the differences among our swap dealers.
The final capital rule is designed to enhance customer protection and reduce systemic risk in the financial system. Capital requirements are the ultimate backstop, ensuring that customers are protected and the financial system remains sound in the event that all other measures fail. While our uncleared margin rules have effectively absorbed the shocks of recent pandemic-driven volatility, a capital regime will provide further assurances that our markets and their participants can weather new storms.
The final capital rule requires swap dealers and major swap participants to maintain a level of minimum capital based on one of three basic approaches. Each approach incorporates minimum amounts of capital based on various criteria, including a $20 million floor, a level of capital required by the National Futures Association, and the amount of margin on uncleared swap transactions. The three basic approaches will be the focus of my remarks because they are effectively tailored to the distinctive type of swap dealer involved.
Our derivatives markets are vibrant in large part because of the diversity of swap dealers and other market participants. Of the 108 provisionally registered swap dealers, 56 will be subject to the capital requirements. Of those, four are futures commission merchants that are dually registered with the SEC as broker-dealers and 12 are non-bank subsidiaries of bank holding companies. Others are non-banks that deal in financial swaps involving interest rates, foreign currency, credit, and the like; still more are primarily engaged in agricultural and energy businesses; and several are subject to the laws and regulations of other countries.
The final capital rule applies to entities with a variety of business structures, asset profiles, and risk levels. For example, a swap dealer primarily involved in the energy business is fundamentally different from a large bank involved in financial swaps. A “one-size-fits-all” approach would be incompatible with the rich gradations in our derivatives markets. As a result, the final capital requirements offer regulatory flexibility by accounting for key differences among covered entities. This flexible approach is designed to enhance the regulatory experience for our market participants while safeguarding the markets, as more fully discussed below.
1. Capital Requirements for FCM Swap Dealers
The CFTC has longstanding capital requirements for Futures Commission Merchants (“FCMs”) to ensure customer funds are protected in the event of an FCM failure. The final rule preserves existing FCM capital rules for swap dealers that are also registered as FCMs, but makes a few key adjustments to better address risk and customer protection associated with dealing in swaps.
The final rule requires FCM swap dealers to maintain minimum capital equal to or greater than the sum of: (i) the current FCM risk margin amount of 8% of customer and noncustomer cleared futures, cleared foreign futures, and cleared swaps positions; and (ii) 2% of the total margin amount associated with uncleared swaps. Security-based swaps are excluded from both margin amounts. In addition, the final rule increases the $1 million minimum capital “floor” for FCMs to $20 million for FCM swap dealers.
These changes reflect sound policy. In particular, excluding security-based swaps comports with the CFTC’s longstanding respect for the SEC’s jurisdiction over those products. Moreover, excluding cleared swaps from the 2% risk margin amount brings our capital requirements in line with the lower credit risk posed by cleared products. This approach is also consistent with the CFTC’s net capital requirement for Registered Foreign Exchange Dealers, as well as the SEC’s capital rules for broker dealers.
2. Capital Requirements for non-FCM Swap Dealers
Well-crafted rules must account for the differences among our market participants. For swap dealers that are not FCMs, the final rule provides three methods of determining minimum capital that respond to their different business models, risk profiles, and capital structures.
a. The Net Liquid Assets Approach
Some swap dealers have responsibility for customer funds, such as those that are dually registered with the SEC as broker dealers. For these swap dealers, capital requirements can advance customer protection where all else has failed, by providing a “cushion” for orderly liquidation. An effective cushion requires liquidity, which can be analogized to the readily available cash in one’s wallet. Consistent with this analogy, swap dealers may select the Net Liquid Assets approach in the final rule—requiring them to maintain 2% of the margin amount associated with uncleared swaps—which we believe is sufficient to protect customer funds in the event of a liquidation.
The Net Liquid Assets approach is not only about customer protection: it also facilitates sensible harmonization with SEC capital requirements for dual registrants. In doing so, the Net Liquid Assets approach supports the CFTC’s strategic goal of improving the regulatory experience for market participants.
b. The Bank-Based Approach
Banks are the backbone of our financial system, and are subject to a specific statutory regime managed by the Federal Reserve Board and other federal banking regulators. Banks—and by extension their non-bank swap dealer subsidiaries—naturally raise greater systemic risk concerns than other types of swap dealers.
While the cash in one’s wallet is the appropriate analogy when thinking about capital as a measure of customer protection, the central role banks play in our financial system requires us to consider a much bigger picture. For banks, capital must facilitate safety and soundness, ensuring that they act prudently. The personal finance analogy for assessing bank capital, therefore, is not just cash-in-wallet, but also savings accounts, checking accounts, retirement funds, and other assets.
This broad view of bank capital as a window into solvency is designed to reduce overall risk in the financial system, advancing a strategic goal of the CFTC. As stated in the agency’s 2020-2024 Strategic Plan, “[t]aking steps to avoid systemic risk will not only protect market participants, but increase confidence in the soundness of U.S. derivatives markets.” Our bank-based capital approach is designed to meet this goal.
Accordingly, swap dealers selecting the Bank-Based Approach may satisfy their capital requirements by retaining (i) 8% of risk-weighted assets (“RWA”), composed of at least 6.5% of tier 1 common equity (“CET1”), and (ii) 8% of their uncleared swap margin amount. Requiring at least 6.5% of a swap dealer’s RWA to be composed of CET1—the highest-quality regulatory capital—addresses potential systemic risk by ensuring that available capital can immediately stem losses, avoiding financial contagion. Second, the requirement that swap dealers electing the Bank-Based Approach must retain 8% of margin for uncleared swaps reflects the uniquely critical role they play in the financial system.
c. The Tangible Net Worth Approach
Finally, some swap dealers are not financial entities, but rather commercial businesses engaged in the agriculture and energy sectors. These swap dealers help American families put food on the table and gas in the car. Unlike financial entities, their balance sheets often contain significant physical assets, such as oil refineries, grain warehouses, and even railroad rolling stock. Net worth—inclusive of physical assets—is the appropriate measure to assess minimum capital for these commercial entities. In extending our analogy, capital for these swap dealers must be inclusive not just of cash or retirement account holdings, but one’s house and car—the assets that could be pledged as collateral in borrowing.
The final capital rule recognizes that commercial entities are fundamentally different from other swap dealers. This is reflected in the Tangible Net Worth (“TNW”) approach, which sets minimum capital at 8% of the margin amount for uncleared swaps. Eligibility for the TNW approach is determined at the consolidated parent level, which allows a financial subsidiary of a commercial entity that is registered as a swap dealer to elect the approach.
3. Market and Credit Risk Models
In addition to capital requirements, today’s final rule makes important adjustments to the requirements that swap dealers must satisfy to rely on internal market and credit risk models rather than the standardized models provided in Regulation 1.17. Like minimum capital requirements, market and credit risk models will be most effective when they reflect a swap dealer’s unique business and risk profile. In addition, internal models specific to a swap dealer’s portfolio can provide a more nuanced view of risk than standardized models.
That said, the final rule provides a certification process for swap dealers relying on internal market and credit risk models, ensuring flexibility while retaining oversight through the National Futures Association. Permitting swap dealers to rely on bespoke models that best account for their particular situations is good governance and enhances the regulatory experience. At the same time, by subjecting those models to objective validation by the National Futures Association (and potentially other domestic and foreign regulators), there is a check on that flexibility. Further, this approach makes the CFTC’s model approval process more closely aligned with the SEC and federal banking regulators.
Allowing swap dealers to rely on internal risk models is also an appropriate instance of principles-based regulation, as prescriptive requirements that do not account for differences among firms simply cannot measure risk as accurately as internal models that account for key differences among swap dealers.
4. Financial Reporting
Today’s final rule also adopts financial reporting, recordkeeping, and notification requirements for swap dealers and major swap participants. These requirements include the obligation to provide financial statements and reports to the CFTC and the National Futures Association. Most importantly, covered entities must alert us when there is undercapitalization, a books and records problem, and/or a specified triggering event, such as the failure to post required margin. The rule also includes public reporting requirements for those swap dealers not subject to the jurisdiction of a banking regulator.
These reporting requirements should serve as early warning systems for systemic risk, allowing the CFTC to react quickly to emerging threats to financial stability. At the same time, the reporting requirements are designed to harmonize, as appropriate, with existing financial reporting requirements for FCMs, bank swap dealers, and SEC-registered entities. The final rule also eliminates weekly position reporting, which does not materially advance our ability to monitor systemic risk. In short, balance is the touchstone of the financial reporting rules, allowing us to achieve greater insight into potential systemic risk without placing undue burdens on market participants.
5. Substituted Compliance
Last, our final rule today accounts for non-U.S. domiciled swap dealers by allowing them to petition the CFTC for substituted compliance in satisfaction of their capital and financial reporting requirements. These swap dealers may seek a comparability determination based on the capital and financial reporting rules of their home jurisdictions, provided certain conditions are met. In providing this option, the final rule supports international comity while enhancing the regulatory experience for market participants abroad.
Today we mark a decade and a day following the enactment of the Dodd-Frank Act by completing the CFTC’s required rulemakings under Section 731. The final capital rule is flexible and tailored, to accommodate the wide array of swap dealers that touch every corner of our markets. The final rule is also long on customer protection and systemic risk mitigation, advancing the CFTC’s mission of promoting the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation. After 10 years of hard work by CFTC staff, I am pleased to support the final rule and the long-awaited certainty it brings to our markets. Given the current economic crisis the world faces in light of the continuing COVID-19 pandemic, we are fortunate to have a final rule that has come late, but not too late.
 The CFTC does not have jurisdiction to establish capital requirements for swap dealers subject to the jurisdiction of a federal banking regulator as identified in Section 1a(39) of the CEA, 7 U.S.C. §1(a)(39) (2018).
 See Section 4s(e) and 4s(f)(2) of the CEA, 7 U.S.C. § 6s(e), 6s(f)(2) (2018).
 Section 731 of the Dodd-Frank Act also required the CFTC to establish initial and variation margin requirements for uncleared swaps, which are being implemented on a phased schedule that currently extends to all but the smallest swap market participants. See Statement of Chairman Heath P. Tarbert in Support of Extending the Phase 5 Initial Margin Compliance Deadline (May 28, 2020), https://www.cftc.gov/PressRoom/SpeechesTestimony/tarbertstatement052820c.
 The capital rule was first proposed in 2011 and re-proposed in 2016. See Capital Requirements of Swap Dealers and Major Swap Participants, 76 FR 27802 (May 12, 2011); see also Capital Requirements of Swap Dealers and Major Swap Participants, 81 FR 91252 (Dec. 16, 2016). The comment period was re-opened in December 2019, allowing the Commission to glean additional insights from market participants prior to presenting today’s final rule. See Capital Requirements of Swap Dealers and Major Swap Participants, 84 FR 69664 (Dec. 16, 2019).
 See CFTC Strategic Plan 2020-2024, at 4 (discussing Strategic Goal 3), https://www.cftc.gov/media/3871/CFTC2020_2024StrategicPlan/download.
 Heath Tarbert, Volatility Ain’t What it Used to Be, Wall Street Journal (Mar. 23, 2020), https://www.wsj.com/articles/volatility-aint-what-it-used-to-be-11585004897.
 See CFTC Strategic Plan, supra note 5, at 4.
 See Regulation 1.17, 17 C.F.R. § 1.17 (2019).
 See Section 2(c)(2)(C) of the CEA, 7 U.S.C. § 2(c)(2)(C) (2018), and Regulation 5.7(a), 17 C.F.R. 5.7(a) (2019).
 See SEC Rule 240.15c3-1, 17 C.F.R. § 240.15C3-1 (2019).
 See Regulation 23.101.
 Former SEC Commissioner Dan Gallagher, “The Philosophies of Capital Requirements” (speech in Washington, D.C., Jan. 15, 2014) at 1, https://www.sec.gov/news/speech/2014-spch011514dmg.
 See CFTC Strategic Plan, supra note 5 at 4 (discussing Strategic Goal 3).
 See Gallagher, supra note 12, at 1.
 See CFTC Strategic Plan, supra note 5, at 5 (discussing Strategic Goal 1, which is to strengthen the resilience and integrity of our derivatives markets while fostering their vibrancy).
 See CFTC Strategic Plan, supra note 5, at 7.
 The market and credit risk model approval process in the final rule is similar to the requirements established by the Federal Reserve Board for bank holding companies, as well as the SEC’s requirements for security-based swap dealers.
 For a discussion of the circumstances in which to apply principles vs. rules, see Heath P. Tarbert, Rules for Principles and Principles for Rules: Tools for Crafting Sound Financial Regulation, 10 Harvard Business Law Review (2020).
 See CFTC Strategic Plan, supra note 5, at 4 (discussing Strategic Goal 3).