Wednesday, October 28, 2015

Commissioner Giancarlo Warns Overregulation May Dry Up Liquidity, Increase Volatility

By Lene Powell, J.D.

A combination of rules in the U.S. and abroad are, when taken together, depriving financial markets of critical liquidity in times of market stress, warned CFTC Commissioner J. Christopher Giancarlo in recent remarks. According to the commissioner, many financial market regulators and important market participants are worried about a significant contraction of liquidity as well as volatility spikes in many markets, due in part to the combined effect of post-crisis regulatory policies imposed by U.S. and overseas prudential banking regulators.

“Experienced market veterans have openly voiced concerns that the unmeasured wave of regulatory constriction of bank capital will be the cause of a future market crisis,” said Giancarlo. “The question must be asked whether the regulatorily driven retreat of major banking institutions from active trading in financial markets is the disease of which it purports to be the cure.”

Giancarlo also briefly discussed the subjects of margin for uncleared swaps, automated trading, and cybersecurity.

Liquidity and volatility. Giancarlo pointed to serious concerns about liquidity in a variety of markets, including U.S. Treasury securities, to German Bonds, corporate bonds, equities, U.S. and euro interest rate swaps, single name credit default swaps (CDS), cross-currency swaps, repos and energy swaps and futures. Regarding volatility, CFTC Chairman Timothy Massad recently announced new research showing that “flash” volatility spikes have become increasingly common, with 35 spike events so far this year in core futures products including corn, gold, WTI crude oil, E-Mini S&P and Euro FX. In the past, large global money center banks have acted as shock absorbers for volatility by buying and selling reserves of securities or other financial instruments, Giancarlo said. Lately, however, banks appear to have been unable to step in aggressively to provide additional trading liquidity, and have also withdrawn from certain market services due to cost pressures.

Overall, the role of banks as intermediaries and risk takers has shrunk, said Giancarlo. In part this reflects the cumulative impact of rulesets like the Basel III capital requirements and leverage ratios, the Volcker rule’s ban on proprietary trading, CFTC derivatives trading rules, low de minimis levels for swap dealer registration, restrictive position limits proposals, and “unending” edicts from global shadow regulators like the Financial Stability Board that prioritize capital reserves over investment and balance sheet surplus over market making. Some also believe that automated trading may be playing a part in the increase in volatility, though it may also be contributing liquidity. The resulting reduction in trading liquidity and sharper volatility will have enormous implications for 21st century markets, and regulators need to honestly question the role of contemporary bank regulation, said Giancarlo.

Margin on uncleared swaps. Giancarlo is also concerned that the CFTC’s proposed rules requiring the posting of margin for cleared swaps are inconsistent with the European and IOSCO approach of exempting swaps transactions between certain affiliates from initial margin requirements. As a result, the cost of initial margin in inter-affiliate transactions will inevitably be passed on to U.S. derivative end-users, which will discourage end-users from entering into swaps transactions with international swaps dealers that, in turn, look to offset the hedge in markets outside the U.S. This will subject U.S. end-users to higher costs and wider bid/offer price spreads, and will ring-fence financial risk in the U.S. by increasing the costs of risk hedging in broader global markets. Thus, the rules will encapsulate risk in the U.S. marketplace, increasing rather than decreasing systemic hazard in American financial markets, the commissioner said.

Automated trading. According to Giancarlo, automated trading now constitutes approximately 70 percent of regulated futures markets, and it is important to have safeguards, but not in a way that will stifle innovation. The CFTC is working on proposed rules to regulate automated trading, and Giancarlo supports a principles-based approach. Specific risk controls like pre-trade risk controls, limits on self-trading and order cancellation mechanisms or “kill switches" are already supported by many automated trading firms.

Regarding the role of the CFTC, Giancarlo said that self-regulatory organizations may be better situated than the CFTC to surveil, oversee and report to the CFTC the operation and performance of automated trading systems in the futures marketplace. Giancarlo stated that he would not support any proposal for the CFTC to pre-test algorithms or pre-approve automated trading strategies, nor any framework that is not technologically neutral or that stifles beneficial market innovation. Also, any proposal to inspect algorithms must be carefully considered due to cybersecurity risks involved in giving the government access to trading firms’ source codes, he said.

Cybersecurity. A bottom-up approach is needed for cybersecurity, with lots of carrots and few sticks, said Giancarlo. The rapidly growing cyber risk insurance market is driving innovations in private sector defense and preparedness, and firms are increasingly retaining C-Suite level dedicated network security officers. To help registrants navigate the maze of Federal agencies and ensure they have access to the most up-to-date cybersecurity information available, Giancarlo proposes that the CFTC designate a qualified cybersecurity information coordinator.