Today, for the first time, the Commission adopts capital requirements for non-bank swap dealers (“Final Rule”).  This is the last major swap dealer regulation required under the Dodd-Frank Act.  The Dodd-Frank Act specified that the swap dealer capital requirement “shall—(i) help ensure the safety and soundness of the swap dealer or major swap participant; and (ii) be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.”[1]

Unfortunately, there is no rational basis to conclude that the minimum capital requirements in the Final Rule meet those standards and serve their intended purpose.  The Final Rule is not based on quantitative analysis of data or the appropriate level of capital for the risks presented by a swap dealer.  Rather, it appears to be designed with the objective of ensuring that most dealers will not need to raise more capital.  In its consideration of costs and benefits, the Commission concludes that, depending on the type of swap dealer, “the likelihood of . . . needing to raise additional capital due to this rule might be low,” “may not be significant,” or “that their tangible net worth greatly exceeds the Commission’s requirement.”[2]  For this reason, I dissent.

No Rational Basis to Conclude that Minimum Capital Levels are Appropriate

The Final Rule permits swap dealers, depending on their characteristics, to select one of three different approaches to calculate their minimum capital requirements.  The approaches are identified as the: (1) “Net Liquid Assets Capital Approach,” (2) “Bank-Based Capital Approach,” and (3) “Tangible Net Worth Capital Approach.”  The first two approaches are based on existing CFTC, Securities and Exchange Commission (“SEC”), and Federal Reserve capital requirements for futures commission merchants (“FCMs”), securities broker-dealers (“BDs”), and banks.  The third approach is designed to accommodate commercial swap dealers whose capital is normally in the form of physical assets. 

These methods are based on existing holistic, all-enterprise capital approaches that take into account a broad spectrum of risks.  They are not necessarily suited to the swap dealers subject to the CFTC capital requirements, which are mostly stand-alone legal entities for swap dealing.  Accordingly, it is not clear that these methodologies will generate capital requirements that are “appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.”[3]  However, using those precedents has some advantages in that it allows the different types of swap dealers to manage capital using known structures.  While these historical approaches were not specifically designed to be able to meet the statutory standard, it may be possible to achieve the intended outcome using these structures if the specific methods, limits, and other factors had been developed based on the swap dealer specific standard.  Unfortunately, this did not happen.

In December 2016, the Commission issued a re-proposal of the previously proposed capital regulations (“2016 Re-Proposal”)[4] that contained minimum capital requirements in each approach that were largely based on existing levels for FCM capital requirements.  The 2016 Re-Proposal included cleared and uncleared swaps and uncleared security-based swaps in the calculation of the minimum requirements.     

Commenters objected that the 2016 Re-Proposal was too costly and burdensome.  At the end of last year the Commission, by a 3-2 vote, issued a second re-proposal (“2019 Second Re-Proposal”) consisting  of over 140 mostly open-ended questions designed to invite comments supporting reduced minimum capital requirements or otherwise lower the costs for swap dealers to comply.[5]

Not surprisingly, the Final Rule adopts numerous provisions that are weaker than the 2016 Re-Proposal.  The preamble to the Final Rule identifies “lower capital charges,” “harmonization,” and consistency with “historical” precedent as rationales for these provisions. 

While the Commission makes conclusory statements that the rule helps “ensure the safety and soundness” of the swap dealers, there is little or no analysis supporting these assertions.  Similarly, there is no analysis as to how or why these capital levels are “appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.”

The capital requirements for dually-registered FCM/BDs that are also swap dealers illustrate how this approach leads to arbitrary results from a risk-based perspective.  Under the 2016 Re-Proposal, in addition to capital required to be held for non-swap activity, the FCM/BD swap dealer would be required to hold capital equal to a minimum of 8% of initial margin for uncleared swaps, security-based swaps, and certain futures positions of the swap dealer.  As explained in the 2016 Re-Proposal, the 8% multiplier level is drawn from the Commission’s experience with its risk-based capital requirements for FCMs.[6] 

Based on comments received on the prior proposals, and on the desire to “harmonize” with the SEC, the Final Rule lowers the capital add-on multiplier level to 2%, and only applies the multiplier to uncleared swaps initial margin.[7]  Security-based swaps are not included in the calculation based on the rationale that only swaps are within the CFTC’s jurisdiction.  If the entity is also registered with the SEC and the SEC’s capital requirements are greater than the CFTC’s, then the entity can use the SEC’s requirement with no add-on for uncleared swaps.  The Commission makes these changes not based on any analysis of the risk to the registrant, but because this approach “maintains a consistency with the long-standing historical approach that the Commission and SEC have followed with respect to dually-registered FCM/BDs.”[8]

The following example shows how this approach can result in an arbitrary outcome from a risk perspective.  Under the Final Rule, if the amount of uncleared swap margin for an FCM that is not a BD is $1 billion, multiplying that amount by 2% yields a minimum capital add-on of $20 million.  Similarly, under the SEC’s capital rule, for a securities-based swap dealer that is not an FCM with $1 billion of required margin for uncleared security-based swaps, a 2% add-on would be $20 million.[9]  Now, let’s consider the add-on for a dually-registered FCM/BD.  Each of the CFTC and SEC capital rules individually require that the minimum capital requirements include capital based on either the uncleared swap positions or the uncleared security-based swap positions, respectively, but not the aggregate of both types of positions.  A dually-registered firm with the same aggregate risk margin amount of $1 billion, but split half to swaps and half to security-based swaps, would be required to reserve $10 million ($500 million * 2%).   Thus, the dually-registered firm with a total initial margin requirement of $1 billion held for a portfolio split evenly between swaps and security-based swaps would be required to reserve only half the capital required for the same amount of initial margin held for a portfolio that was either all swaps or all security-based swaps.  For such dually-registered firms, the amount of capital required to be held may ultimately be based on irrelevant and arbitrary considerations of “historical precedent” and agency jurisdiction rather than swap risk-based calculations.

Financial Data and Monitoring Capital Sufficiency

The capital requirements for swap dealers are one of the most complex and highly technical areas in our regulations.  The swap dealers subject to the CFTC capital requirements vary significantly and include (i) very large FCMs and/or BDs registered with the CFTC and the SEC; (ii) U.S. and foreign affiliates of banking organizations; (iii) large commercial enterprises and affiliates thereof; and (iv) other financial companies that are not affiliated with banks.  Each grouping has unique capital structures.  Furthermore, there was little available quantitative financial accounting data for the swap activities of these entities to calibrate the appropriate levels of capital.  Given this complex and technical backdrop, the Final Rule notes in several places that the Commission will gather and analyze the new financial reporting data now required under the rule and may reassess components of the rule to determine whether it needs to be amended to be better fit for purpose.  I strongly support that effort and will follow this monitoring and analysis closely.

Substituted Compliance for Capital Requirements

Under the Final Rule, swap dealers organized and domiciled outside of the United States, including many subsidiaries of U.S. firms, can satisfy the capital requirements by complying with the capital requirements of the country of their domicile if the Commission grants substituted compliance.  The methods and standards for such a determination are similar to those to be established in the final cross-border swap regulations scheduled for consideration by the Commission tomorrow.  Unfortunately, those methods and standards are substantively weaker than the standards currently used by the Commission and may result in outsourcing swap dealer capital oversight to other jurisdictions where not appropriate.

Conclusion

Notwithstanding my dissent, I want to once again acknowledge the complexity and highly technical nature of the capital requirements.  Given these difficulties, I would like to recognize the hard-working staff of the CFTC for their efforts in fashioning the Final Rule.  Some of you spent many a late night addressing comments and questions and revising the rule release.  While I cannot support the outcome, I nonetheless appreciate and thank you for the dedication you bring to your work here at the CFTC.

Unfortunately, the rule the Commission will be adopting today is simply an affirmation of the status quo.  This is not what Congress intended when it directed the CFTC to adopt capital requirements “appropriate for the risk” presented by uncleared swap activities of swap dealers.  For this reason, I dissent.