Dissenting Statement of Commissioner Rostin Behnam on the Exemption from Derivatives Clearing Organization Registration; Notice of Supplemental Proposal

July 11, 2019

Introduction

I respectfully dissent from the Commodity Futures Trading Commission’s (the “Commission” or “CFTC”) supplemental notice of proposed rulemaking addressing the granting of exemptions from registration as a derivatives clearing organization (“DCO”) to non-U.S. clearing organizations and further permitting such “exempt DCOs” to clear swaps for U.S. customers through intermediaries that would be wholly outside the Commission’s direct regulation and oversight (the “Supplemental Proposal”).  While I supported the Commission’s 2018 proposal to codify its current policies and procedures for granting exemptions from DCO registration[1] as a positive step towards increased cross-border cooperation and deference to our foreign regulatory counterparts, I cannot support it in its “supplemental” form.  The Supplemental Proposal is not the product of internal consensus and its brief history and questionable timeline signal a lack of appropriate scrutiny and evaluation of the potential consequences of taking these first steps towards diverging from the customer protection model provided by the Commodity Exchange Act (“CEA” or “the Act”) and U.S. Bankruptcy Code.[2]

I support the Commission’s endeavor to explore ways to adapt and—if appropriate—seek to alter the current intermediary structure established under the CEA and Commission regulations to better accommodate both U.S. customer demand for increased access to clearing in foreign jurisdictions and evolving global swaps market structures.  However, I cannot support the Commission’s proposed use of its limited public interest exemptive authority to create a regulatory easement as a short cut to legal certainty in furtherance of such efforts and to the detriment of U.S. customers, market participants, and the financial system.

If the Commission believes it is appropriate at this time to provide U.S. customers with greater access to non-U.S. swap markets, then we can and should engage in a more careful analysis of options, assessment of alternatives, and evaluation of consequences.  Policy decisions made in haste amid ongoing uncertainty undermine the regulatory process and our accountability.  As I have said before, when evaluating our regulatory landscape and making critical determinations as to which parts to revisit, which to complete, and how we can guide legislation and develop regulations to address market evolution and developments—regardless of the underlying impetus, we must hold one another accountable, adhere to appropriate process, be wary of false progress, and engage in genuine dialog.[3]  Today’s Supplemental Proposal in its timing, in its limitations, and in its uncertainty, is at best, false progress and, at worst, the false promise of benefits that will never be realized.

The substantial revisions to the Supplemental Proposal throughout these last several weeks with their various additions and carefully crafted excerpts do little to bolster the justifications and rationales put forth in advocacy of the proposed change in policy and attendant exemptive relief that would permit U.S. customer positions to be cleared at an exempt DCO through a foreign intermediary that is not registered as a futures commission merchant (“FCM”).  Nowhere is this clearer than in the Request for Comments.[4]

The Supplemental Proposal utilizes its Request for Comments primarily to explore why this proposal represents the regulatory route that will cause the least amount of harm by soliciting the public for their best arguments as to the operation of the U.S. Bankruptcy Code (and relevant laws), and to solicit feedback on eligibility elements and several conditions of the exemption for DCOs.  However, it also introduces and requests comment on alternatives to the Commission’s longstanding policy (consistent with longstanding interpretation of the CEA) of allowing U.S. customers’ swap positions to be cleared only through registered FCMs at registered DCOs.  While this is an entirely appropriate issue to raise in the context of a proposed rulemaking (or other formal request for public comment such as an advance notice of proposed rulemaking, request for input, or concept release), the effectiveness of any comments received will be largely lost in this “supplement” since the line of questioning fails to accentuate—or itself propose—a rule from which any final Commission action could be taken as a logical outgrowth.[5]  A line of questioning that seeks to introduce potentially new policy considerations for future consideration by a Commission in the midst of changing leadership is ill-fated, detracts commenters from the critical issues at hand, and undermines the integrity of the 2018 Proposal and the Supplemental Proposal.[6]

When You are Boxed in by Uncertainty

Though I have many concerns with the Supplemental Proposal, I am most concerned with the Commission’s contorted plan to permit DCOs that it would exempt from registration to clear swaps for U.S. customers through unregistered foreign intermediaries.  This juggernaut of a proposal gained momentum from the ongoing uncertainty regarding the extent to which U.S. customers’ funds would be protected under the U.S. Bankruptcy Code when clearing swaps at an unregistered DCO.  While the Commission’s decision to put a premium on legal certainty is laudable, it is not clear to me that the Commission ought to do so if it undermines key components of the CEA’s customer protection regime aimed at protecting both U.S. customers and the stability of our markets and misaligns the Commission’s already questionable use of its public interest exemptive authority with the purposes of the Act.[7]  It appears that in attempting to deliver on the concept of permitting exempt DCOs to clear swaps for FCM customers—introduced just months ago by the Commission as a single question in the 2018 Proposal[8]—the Commission found itself boxed in by uncertainty.  The only way out would be to remove any and all doubt that a U.S. customer who seeks to clear swaps on an exempt DCO will have to do so through a foreign intermediary not subject to CFTC regulation or oversight and outside the protections of the U.S Bankruptcy Code.[9]

Ongoing uncertainty

The Supplemental Proposal would permit U.S. customers to clear at an exempt DCO only through a foreign intermediary and not through an FCM due to uncertainty regarding the protection of U.S. customer funds in the event of an insolvency of the FCM.  The Commission is continuing to consider and evaluate this issue, consider alternative approaches, and identify possible risks to customers that may result from that uncertainty.  While this approach was selected as a means to provide the greatest clarity with regard to the Commission’s current understanding of the U.S. Bankruptcy Code, given that it necessitates the Commission’s exercise of exemptive authority to permit foreign intermediaries to accept U.S. customer funds to clear swaps without having to register as FCMs (or having to comply with Commission rules and regulations applicable solely to registered FCMs), it would seem, on its face, to be inconsistent with the customer protection regime established under the CEA and Commission regulations.[10]  This should give the Commission ample reason to pause its consideration of moving forward on the Supplemental Proposal at this time.  Inexplicably, it does not.  And instead, the Commission is soliciting comments from the public on a number of issues involving the interpretation and applicability of the U.S. Bankruptcy Code (or other relevant laws) and the clearing of swaps customer funds deposited at an exempt DCO by an FCM directly or through a foreign member of the exempt DCO.[11]

Misuse and Abuse of Authority

In order to permit foreign intermediaries to clear swaps for U.S. persons, and to ensure that only foreign intermediaries that are not FCMs will clear U.S. customer positions on exempt DCOs, the Commission is proposing to exercise its authority under section 4(c) of the CEA to exempt foreign intermediaries from the prohibition in section 4d(f) of the CEA against accepting customer funds to clear swaps at a registered or exempting DCO without registering as FCMs.  Even assuming that the Commission’s exemptive authority extends to the non-U.S. clearing organizations and intermediaries that are the subject of the Supplemental Proposal,[12] the Commission’s proposed justifications for the use of such authority do not align with the very purpose of the authority to promote innovation and competition without sacrificing key components of the Commission’s regulatory and oversight structure.

Section 4(c) of the CEA, commonly referred to as the public interest exemption, authorizes the Commission, in order to promote responsible innovation and fair competition, by rule, regulation, or order, to exempt, among other things, any person or class of persons offering, entering into, rendering advice, or rendering other services with respect to transactions from any of the provisions of the CEA other than certain enumerated provisions.[13]  When enacting section 4(c), Congress noted that the purpose of the provision is “to give the Commission a means of providing certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner….with due regard for the continued viability of the marketplace and considerations related to systemic risk in financial markets.”^[14]  Indeed, in exercising its exemptive authority under section 4(c) of the CEA, the Commission has long understood that it was Congress’s intention and expectation that “the Commission will assess the impact of a proposed exemption on the maintenance of the integrity and soundness of markets and market participants.”[15]  As well, Congress, in requiring the Commission to consider any material adverse effect on regulatory or self-regulatory responsibilities, indicated that the Commission is to consider such regulatory concerns as “market surveillance, financial integrity of participants, protection of customers, and trade practice enforcement.”[16]

The Commission’s section 4(c) proposal, which would be codified in § 3.10(c)(7) of the Commission regulations, purports to be consistent with the exempt DCO framework being proposed in that it is based on deference to the regulation and supervision of foreign intermediary’s home country regulator.  To qualify for the exemption, the foreign intermediary: (1) must accept funds from a U.S. person to margin, guarantee, or secure swap transactions that are cleared by an exempt DCO; (2) may not engage in other activities requiring registration as an FCM or voluntarily register as an FCM; and (3) must be a clearing member of an exempt DCO and must directly clear the swap transactions of the U.S. person at an exempt DCO.  A foreign intermediary that is exempt from registering as an FCM pursuant to the foregoing requirements is not required to comply with those provisions of the Act and of the rules, regulations, or orders thereunder applicable solely to any registered FCM and may provide commodity trading advice to U.S. persons without registering as a commodity trading advisor (“CTA”), provided that the advice is provided solely with respect to swaps that are cleared by an exempt DCO.[17]

The Commission believes the proposed exemption for foreign intermediaries promotes responsible financial innovation and fair competition, and is consistent with the public interest and purposes of the CEA.  In support of these beliefs, the Commission focuses on: (1) the provision allowing U.S. persons additional options for trading and clearing swap transactions and the concomitant expansion of available intermediaries, which has the potential to reduce the current concentration of U.S. customer funds in a small number of FCMs and (2) increased access for U.S. persons to swaps that are cleared in foreign jurisdictions, which may provide for greater hedging opportunities and increased liquidity in more standardized, cleared contracts.[18]  However, these rationales ignore that this approach removes U.S. customers from the protections of the U.S. Bankruptcy Code and puts both FCMs and registered DCOs at a competitive disadvantage and with respect to clearing in non-U.S. swaps markets.  While the Commission puts forth mitigating factors in response to the loss of U.S. Bankruptcy Code protections, as discussed below, its solution can only be said to promote “responsible” innovation if we assume that individual U.S. Customers need nothing more than notice of their lack of protections to engage responsibly in foreign financial markets to prevent harm to themselves and to the larger financial system.  It is my belief that history has not demonstrated that this is the case.  Regarding the competitive disadvantage to FCMs and registered DCOs, the Commission admits that this is a cost of its proposal, [19] but makes no arguments regarding fairness beyond briefly discussing the economics of being regulated as a clearing organization in any jurisdiction.

The Commission also concludes that the proposed exemption will be limited to appropriate persons, “as only U.S. persons that are eligible contract participants (“ECPs”) would be permitted to maintain accounts with a foreign intermediary for swaps cleared at an exempt DCO” and cites CEA section 2(e) which makes it unlawful for any person, other than an ECP, to enter into a swap unless the swap is entered on or subject to the rules of a designated contract market.[20]  Of note, the Commission makes no reference to whether or how the foreign intermediary will comply with this limitation and the proposed conditions of exemption for DCOs do not require the DCO to have rules that would limit a foreign intermediary’s ability to solicit and accept U.S. customers that are not ECPs.  Similarly, it is unclear as to whether the Exempt DCO or the foreign intermediary’s home regulator will ensure that the foreign intermediary does not solicit or provide trading advice to U.S. customers warranting CTA registration beyond the trading advice permitted by the exemption. It is difficult to even evaluate whether the Commission considered the adverse effect on its regulatory responsibilities, in terms of market surveillance, financial integrity of participants, protection of customers, and trade practice enforcement.

The Commission acknowledges that (1) some foreign regulatory regimes may prove to be less effective than the United States and (2) that foreign intermediaries clearing for customers at an exempt DCO may not be subject to the same level of effective supervision as an FCM. [21]  However, it does not elaborate on the obvious concerns that ought to be raised by these assertions.  Rather, the Commission maintains that any risks to U.S. customers from clearing swaps traded on exempt DCOs through foreign intermediaries that are not registered as FCMs would be mitigated under the Supplemental Proposal’s requirements for exempt DCOs in two key ways.[22]  First, the exempt DCOs must be in good regulatory standing in their home country jurisdictions, and subject to comparable, comprehensive supervision and regulation that includes a regulatory structure consistent with the PFMIs.  Second, an exempt DCO must require a foreign intermediary to provide written notice to, and obtain acknowledgement from, a U.S. person in advance of engaging in any clearing on their behalf that: (1) the clearing member is not a registered FCM; (2) that the exempt DCO is not registered with the CFTC; and (3) that the protections of the U.S. Bankruptcy Code do not apply to the U.S. person’s funds.  The notice must also explicitly compare the protections available to the U.S. person under U.S. law and the laws of the exempt DCO’s home country regulatory regime.

There is much to be said for the views of the Commission in this regard, but in the interest of brevity, this approach favors what amounts to wholesale deregulation in the interest of deference absent any analysis of the potential individual customer and systemic consequences.  Congress did not intend for the Commission to use its section 4(c) exemptive authority to engage in “wide scale deregulation of markets falling within the ambit of the Act,”[23] so it seems even more egregious that it would attempt to reach beyond the Act to empower U.S. customers to act outside of the Commission’s jurisdiction as conduits of risk.  Indeed, given the Commission’s own struggles with the application of the U.S. Bankruptcy Code, I am especially curious to hear from U.S customers seeking to hedge risk or access non-U.S. swaps markets as to whether the Commission’s proposed “caveat emptor” notice model would satisfy the rigors of internal risk management.

Conclusion

In issuing this dissent, I have only touched upon the many issues of concern raised by the Supplemental Proposal.  With each reading, I find myself questioning how the 2018 Proposal morphed from a “Project Kiss” initiative[24] to codify the policies and procedures currently followed by the Commission with respect to granting exemptions from DCO registration—which we have historically used sparingly—into a quest to capture a concept of how U.S. swaps customers may fare outside the protections offered through operation of the U.S Bankruptcy Code and protections offered by the CEA and Commission regulations.  I believe that the Commission has acted in haste, without due consideration of the risks to individuals and the financial system, and outside its authority.  I remain hopeful that the public comment period will provide ample time and opportunity for thoughtful consideration and response to the critical questions posed directly and issues raised by the Supplemental Proposal.

Despite today’s dissent, and as I have said many times before,[25] I look forward to working with my colleagues on cross-border policies that will meet our core responsibilities of promoting safe, transparent and fair markets, while supporting global market access through responsible rule-makings that further harmonize our rules with international partners.