By Lene Powell, J.D.
The CFTC Inspector General (OIG) concluded that the CFTC did not analyze possible costs and benefits in enough detail in considering a 2015 rule establishing margin requirements for uncleared swaps. Among other deficiencies, OIG found that the CFTC did not sufficiently address the possibility that the rule might undermine risk-hedging by market participants or exacerbate systemic risk in times of market stress. OIG recommended that the CFTC take specific steps in considering costs and benefits of proposed rules, improve its data infrastructure, and encourage long-term academic research to increase understanding of CFTC-regulated markets.
Swap margin rule. The Dodd-Frank Act bifurcated the U.S. swaps market into cleared and uncleared swaps transactions. Among other provisions, Dodd-Frank added Section 4s to the Commodity Exchange Act, requiring the CFTC to establish margin requirements for uncleared swaps. In December 2015, the CFTC finalized a rule requiring covered swaps entities (swap dealers and major swap participants for which there is no prudential regulator) to post and collect initial and variation margin for uncleared swaps.
Cost-benefit analysis. Under Section 15(a) of the Commodity Exchange Act, the CFTC must evaluate costs and benefits of a proposed action in light of specified factors including the protection of market participants and the public. The CFTC has written guidance interpreting the cost-benefit requirement.
OIG found that the CFTC’s published consideration of the uncleared swaps margin rule failed to provide sufficient economic analysis. The discussion did not effectively explain the nature of the market failure addressed by the rule, other than by referring to the financial crisis and the undefined catch-all term “systemic risk.” Discussion of costs was mostly restricted to immediate practical concerns like the cost of funding margin collateral. Unintended consequences were mentioned cursorily, if at all. OIG said that staff working on the rule were hampered by significant data limitations and a lack of institutional commitment to the identification and quantification of costs and benefits.
OIG recommended that the CFTC analyze costs and benefits more systematically: establish a baseline, specify the market failure, and consider whether the failure stemmed from existing regulation. The analysis should apply assumptions symmetrically and consistently, quantify likely effects and possible unintended consequences, and state expectations regarding the response of market participants to the rule. All rules should be subjected to periodic retrospective analysis to gauge effects.
OIG also recommended that the CFTC focus on improving its entire data infrastructure. In addition, the CFTC should invest more in economic knowledge, shifting its personnel investment toward more economists and analysts in the business divisions, and establish the Office of the Chief Economist (OCE) as a source and repository of juried economic research fostering greater understanding of CFTC-regulated markets.
Management comments. CFTC Management believed that the margin rule demonstrated that the Commission is committed to engaging in a thorough consideration of the rule’s costs, benefits, and economic outcomes. Management observed that OIG had found that the Commission had discussed most of the nine economic areas identified as relevant, and that the Commission was hamstrung in part due to poor-quality, error-ridden data from regulated entities in the swaps markets. Management agreed that a strong data infrastructure will improve data quality for cost-benefit discussions, and said the CFTC has worked with market participants to improve data quality.
Regarding legal considerations, management noted that OIG’s suggestion that the Commission consider the costs and benefits of actions commanded by Congress is not a legal requirement under controlling case law, including the D.C. Circuit. Further, although the Commission agrees as a policy matter with the importance of quantitative analysis, this is not always possible and is not a direct requirement under the Commodity Exchange Act, as the D.C. Circuit has held.