Tuesday, April 19, 2011

A Report of the CFTC Inspector General Finds Perilous Cost-Benefit Analysis of Dodd-Frank Derivatives Rulemaking

A report of the CFTC Inspector General requested by House Agriculture Committee Chair Frank Lucas (R-OK) found that the CFTC used a perilous cost-benefit methodology for the adoption of regulations implementing the derivatives provisions of Dodd-Frank. The study found that the CFTC General Counsel played a dominant role in the cost-benefit analysis to the derogation of the CFTC Chief Economist, which has been a perilous path for other federal rulemakings. The study recommended an enhanced role in cost benefit analysis for the Chief Economist. The Inspector General examined four separate rulemakings as part of the study: confirmation requirements for swap dealers, core principles for designated contract markets, duties of swap dealers, and a jointly proposed rule with the SEC defining a number of terms under Dodd-Frank Title VII.

Although the development of a uniform methodology appeared to be an equal effort
between the Office of General Counsel and the Office of Chief Economist, noted the study, in practice the cost benefit analyses involved less input from the Chief Economist, with the General Counsel taking a dominant role. For the four rules that were reviewed, the cost-benefit analyses were drafted by CFTC staff in divisions other than the Chief Economist. While staff from the Office of Chief Economist did review the drafts, their edits were not always accepted.

For example, staff in the Office of General Counsel created the first draft of the cost-benefit analysis for the proposed rules defining swap dealer and major swap participant. While the Chief Economist favored addressing the operational and compliance costs that would flow from coverage under the definitions, the General Counsel determined only to address the costs and benefits associated with undergoing an examination or other process to determine whether one fell under the definitions.

While offering no opinion on the cost-benefit analyses for the specific four rules that were part of the study, the CFTC IG noted that similar economic analyses in the context of federal rulemaking have proved perilous for financial market regulators. For this proposition, the IG cited two federal appeals court opinions finding SEC rulemaking deficient. In American Equity Investment Life Ins. Co. v. S.E.C., 613 F.3d 166 (D.C. Cir.2010), the court vacated Rule 151A, which was adopted to ensure that purchasers of fixed income annuities would be entitled to the full protection of the federal securities laws, on the ground that the SEC failed to properly consider the effect of the rule upon efficiency, competition, and capital formation. In Chamber of Commerce. v. S.E.C., 412 F.3d 133 (D.C. Cir.2005), the appeals panel found that, while the SEC is authorized to condition the ability of mutual funds to engage in exemptive transactions under the Investment Company Act on having a board composed of at least 75% independent directors and headed by an independent chair, the Commission failed to adequately consider the costs imposed on funds by the two conditions.

In the letter requesting the study, Chairman Lucas said the CFTC does not appear to be conducting adequate cost-benefit analysis of the derivatives rulemaking. The CFTC has taken a vague and minimalist approach to cost-benefit analysis that is directly contrary to a recent Executive Order of the President and fails to achieve the objectives of Section 15(a) of the Commodity Exchange Act. Chairman Lucas said that the CFTC must approach the cost-benefit aspect of rulemaking thoroughly and responsibly to understand the costs and thus the economic impact that any proposed regulation will have on regulated entities and more widely the financial markets.

At the very least, said the Chairman, CFTC staff should conduct a detailed analysis in an effort to quantify the impact of a regulation using an objective, data-driven approach. Such an approach is absent in subjective and unqualified assessments, such as ``could impose significant compliance costs.’’ Without a detailed and diligent approach to cost-benefit analysis, noted the Ag Chair, the CFTC appears to be failing to comply with both the Executive Order, which admittedly does not bind it, and the spirit or principles of that Order.