“That it was all very complicated1,” writes Michael Lewis in his 2010 book The Big Short: Inside the Doomsday Machine. He was writing about how customers were sold publicly-traded credit default swaps (CDOs) by Wall Street firms and were kept in the dark about the nature and value of these investments. It was complicated because who would want to believe that customers were being duped into paying to essentially take out the trash generated by the housing bubble’s magnificent burst? Fortunately, today’s rulemaking slate seeks to require dealers to be more accountable to their customers and offer improved protection of segregated funds held by futures commission merchants.
I would like to thank the four teams responsible for today’s three final rules and one proposed rule. Combined, these documents total over 1,000 pages -- a massive amount of work for the Commodity Futures Trading Commission (“Commission” or “CFTC”) to review and provide comment. I commend the staff for their patience and willingness to help inform the Commission under very short timetables.
External Business Conduct Standards for Swap Dealers and Major Swap Participants
As was made clear from the Big Short, many customers were not provided a full picture of the risks of various products, including specifically mortgage-backed securities, let alone the inherent conflicts-of-interest when dealers took a position opposite their customers. Today’s final rules relating to external business conduct standards represent an informed integration of the statutory language, congressional intent, existing statutory, regulatory, and self-regulatory requirements for market professionals, securities law, and industry best practices. The final rules do not preserve unworkable proposals such as the proposed best execution standards and prohibition against trading and front running, which were not supported by comments. As well, there are multiple modifications to the proposed rule text to, where possible and appropriate, avoid creating trading delays or barriers through the chilling of communications between swap dealers (“SDs”) and major swap participants (“MSPs”) and their counterparties. One significant manner in which this is accomplished is by allowing, in many instances, demonstration of and compliance with the rules on a relationship basis through disclosures and counterparty representations in counterparty relationship documentation.
The rules also provide safe harbors for SDs from acting as an advisor to a Special Entity and for SDs and MSPs to meet the requirement that they have a reasonable basis to believe that a Special Entity’s representative meets the statutorily-specified qualifications to be a counterparty. The final rule also confirms directly through a statement from the Department of Labor, which will be included in the Federal Register as an appendix to these rules, that compliance with the Commission’s external business conduct rules will not cause a swap dealer or major swap participant to become an ERISA (or Employee Retirement Income Security Act) fiduciary under existing law, and that any subsequent changes to such ERISA fiduciary regulations will be harmonized with the business conduct standards adopted by both the Commission and the Securities and Exchange Commission (“SEC”).
With these many modifications, the external business conduct standards are, by nature, multifaceted and therefore somewhat vulnerable to misinterpretation. However, the Commission has endeavored to be responsive to such concerns through the provision of guidance in Appendix A to the subpart. As well, staff has assured me that market participants may always seek additional guidance from Commission staff if the rules are unclear or onerous. Based on the foregoing, I am supporting this rule today.
Protection for Cleared Swaps Customer Contracts and the Volcker Rule
I support the final rulemaking on the protection of cleared swaps customer contracts and collateral. However, this rulemaking does not address – much less solve – MF Global. This rulemaking, properly understood, is simply a first step in the Commission’s re-consideration of its customer segregation regime – for both futures customers (who are bearing the brunt of MF Global) and cleared swaps customers. I have drafted a separate statement on this final rulemaking – and its limitations – in an effort to inform the public and to prevent inaccurate perceptions of the protections that the Commission is affording today.
I do not support the Commission’s version of the Volcker Rule. It is an unworkable solution that is entirely too complex and provides the Commission with little-to-no means to enforce – and to deter violations of – the Rule. The Volcker Rule sets in motion what Sheila Bair, the former Chairman of the Federal Deposit Insurance Corporation and a former Acting Chairman and Commissioner of the CFTC, aptly described as an “[u]nder…300-page Rube Goldberg contraption of a regulation….proposed by federal agencies”.2
As many commenters – including foreign banks and end-users – allege the rule may have unpredictable consequences for swaps liquidity. I have drafted a separate statement on Volcker as well.
Registration of SDs and MSPs
The Commission is finalizing a final rule that requires SDs and MSPs to become and remain members of a registered futures association (“RFA”).3 To implement this registration regime, the Commission has delegated to NFA its authority to perform the full range of registration functions and requires NFA to monitor compliance of applicants and persons registered as an SD or MSP. This is consistent with the current regulatory practice for futures and wisely builds upon the existing registration expertise of the NFA. This delegation will avoid the costly investment of taxpayer dollars to recreate NFA’s registration system at the Commission and will allow those resources to be better employed on the Commission’s other oversight responsibilities.
The final rule is an improvement over the proposal and revised in two significant ways to address the concerns of commenters. First, the final rule has been revised to make clear that provisional registration will be granted upon filing of one’s application and not upon NFA’s review and approval of the application documentation. This will allow market participants to continue to conduct business while NFA reviews their applications. Getting the timing and compliance periods for SDs and MSPs correct is very important because I believe that the dealer definitions are too broad and exemptions too narrow and so will capture many unsuspecting smaller firms. These firm will be forced to expend considerable resources complying with the registration rules and must be given adequate time to do so.
Second, the rule allows for a phased implementation of business conduct rules, and I ultimately hope for all Commodity Exchange Act (“CEA”) 4s rules (“4s Rules”). 4 Specifically, dealers will have 180 days after the effective date of that regulation or the date on which SDs or MSPs are required to apply for registration pursuant to Regulation 3.10.5 The final rule requires a potential SD or MSP registrant to demonstrate compliance with any applicable 4s Rules in effect at the time of its registration in order to be eligible for registration. The final rule recognizes that the timing of the adoption and compliance for many of the 4s Rules will be done on a rolling basis and so phasing is appropriate. Though this solution allows market participants more time to demonstrate compliance, it will still require market participants to track multiple rules to determine which 4s requirements they do or do not need to demonstrate compliance with in order to qualify for NFA registration. Only the government could think it wise to pass over a simple and clear-cut bright line rule and instead adopt a cumbersome and complex set of timing rules. This piecemeal approach makes it even more important that the Commission issue a schedule outlining the order of rules to be considered and an implementation timeline for all of the rules. More transparency into scheduling and implementation will accelerate compliance and ensure those who must be registered under this rule know the deadlines.
In an apparent oversight, the rule fails to address the issue of the treatment of individuals who conduct swaps-related activity on behalf of more than one SD or MSP or who are registered as an associated person (“AP”) of more than one firm. For futures, this situation is currently covered by Regulation 3.12(f) which addresses dual and/or multiple associations of a person registered as an AP of two or more Commission registrants by making each sponsor jointly and severally liable for the conduct of this AP in specified circumstances. Yet, today’s final rule fails to address this situation for swaps, and so deprives swaps participants of important customer protection and anti-fraud safeguards found in the futures world. Though the rule’s preamble indicates that this oversight will be remedied in a subsequent rulemaking, I hope that the Commission will cure this situation quickly to protect market participants.
Protection for Cleared Swaps Customer Contracts and Collateral and Volcker Rule statements are available at: http://www.cftc.gov/About/Commissioners/ScottDOMalia/index.htm.
1 Michael Lewis, The Big Short: Inside the Doomsday Machine 162 (W.W. Norton & Company 2010).
2 Sheila Bair, What We Need is a Volcker Rule That’s Simple and Makes Sense, FORTUNE, Dec. 26, 2011, at 48.
3 Currently the National Futures Association (“NFA”) is the only RFA.
4 The 4s regulations include, among others: capital and margin, reporting and recordkeeping, daily trading records, business conduct standards, documentation standards, duties, designation of chief compliance officer, and segregation.
5 See Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg, [___] ([__________]) (note 40 of the preamble).