CFTC Commissioner O'Malia Discusses Global Efforts to Develop Rules for Trading Derivatives
Raphael Rosenblatt | Bloomberg Law
Commissioner Scott D. O’Malia of the U.S. Commodity Futures Trading Commission (CFTC) delivered the keynote address at the 7th Annual FIA Asia Derivatives Conference. Noting that three years have passed since the financial crisis began, O’Malia discussed the “challenge to develop rules and regulations—in a coordinated manner—that will benefit the global, highly-interconnected, and ultra high-speed markets.”
The Pittsburgh Communiqué
O’Malia described the Pittsburgh Communiqué, which was issued by the G-20 in response to the global financial crisis, and set forth four tenets for reforming over-the-counter (OTC) derivatives: (1) all standardized OTC contracts should be traded on exchanges; (2) such contracts should be cleared through central counterparties (CCPs); (3) such contracts should be reported to trade repositories; and (4) OTC contracts that are not cleared by a CCP should be subject to higher capital requirements. For its part, the United States passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in order to implement the Pittsburgh Communiqué. In the wake of Dodd-Frank, the CFTC has voted on 60 proposed rules and 18 final and interim rules.
O’Malia noted that while additional rulemaking is in the offing under Dodd-Frank, he has recommended that the CFTC publish a rule implementation schedule which would help accelerate market compliance with new rules and regulations and give regulatory counterparts in Europe and Asia a more definitive sense of the CFTC’s anticipated timeframe for implementing the Pittsburgh Communiqué.
O’Malia then focused on three specific challenges facing the CFTC and international coordination efforts. First, there must be coordination among jurisdictions about the “contours of their regulatory reach.” One issue that must be resolved is the global reach of Dodd-Frank, which currently is being addressed in a proposed rule interpreting Section 722(d) of Dodd-Frank, and which states that regulations “will not apply to activities outside of the United States unless those activities have a direct and significant connection or effect on commerce in the United States.”
The second challenge is having jurisdictions around the world agree on principles and standards for OTC derivatives reform. This, if achieved, O’Malia noted, would be central to “facilitating global regulatory convergence.” Lastly, jurisdictions should consult in order to institute mutual recognition for the rules and regulations which will, in turn, prevent duplicative or contradictory obligations for participants in the OTC derivatives market.
Dodd-Frank “made clearing the foundation of systemic risk management in the swaps market.” The two main factors of concern for the CFTC, O’Malia continued, are the “who”—who can become a CCP member—and the “what”—what should be cleared and what factors are relevant to such a determination.
— The “Who”
As part of Dodd-Frank, the CFTC implemented a provision on “open access,” which permitted any entity meeting objective and risk-based membership standards to become a clearing member. Despite the increased access, O’Malia noted that the CFTC “failed to clarify exactly how a CCP could legitimately balance risk management with open access.” O’Malia expressed concern about limiting a CCP’s assets to less than $50 million, and expressed hope that the CFTC would permit a CCP to have “more flexibility to adjust its membership requirements to reflect risk management.” A better approach, O’Malia explained, would be to adopt the recommendation of the International Organization of Securities Commissions (IOSCO), which advocated a more principles-based regulatory approach. For a more in-depth discussion of the IOSCO recommendations, see Bloomberg Law Reports®—Derivatives Law, New International Principles for Financial Market Infrastructures (Apr. 12, 2011). O’Malia advocated a regime that does not make clearing needlessly expensive.
— The “What”
Five factors—liquidity, pricing, systemic risk mitigation, competitive effects, and whether proper legal and operational frameworks exist—should be considered in determining whether an OTC derivatives contract is sufficiently standardized so as to qualify for mandatory clearing under Dodd-Frank. Although the CFTC has not clarified how it will weigh the five factors, O’Malia has “urged the [CFTC] to hold a public roundtable on the five factors, and on the interconnection between mandatory clearing and mandatory trading.”
Mandatory Reporting and Margin Requirements
O’Malia discussed the new swap data reporting requirements under Dodd-Frank. Intended to improve transparency, the requirements will require aggregation of data in a meaningful way. As a result, O’Malia noted the necessity of establishing an issuer of global legal entity identifiers as soon as possible. With regard to margin requirements, “international agreement on margining for non-cleared OTC derivatives contracts is nascent.” Thus, the CFTC has an opportunity to contribute to regulatory certainty by offering clearer definitions of its capital and margin requirements, and closely synchronizing its implementation schedule with that of international regulators.
Citing the MF Global insolvency, O’Malia urged the CFTC to take action to restore public confidence in the regime of segregated customer funds by (1) instituting random spot checks for segregation, and (2) providing additional transparency to customers regarding the risk profiles of intermediaries. In connection with high frequency trading (HFT), O’Malia advocated a specific definition of what activity constitutes HFT, and he has promulgated seven factors to consider as the “building blocks of an HFT definition.” Because high frequency trades are executed virtually instantaneously, human observation is impossible, so an automated surveillance program should be implemented.
O’Malia concluded by noting that although reforms are required, “we must not rush through rulemaking without conducting a careful and thorough discussion of our proposals.” Additionally, global regulation must be undertaken on a consistent basis.
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