Wednesday, June 20, 2018

Chairman Giancarlo and Chief Economist Tuckman outline “Swaps Reform 2.0” plans

By Lene Powell, J.D.

In a “CFTC Talks” podcast, Chairman J. Christopher Giancarlo and Chief Economist Bruce Tuckman discussed the agency’s plans for continued swaps reform, including in the areas of swaps clearing, reporting, execution, capital requirements, and end user exceptions.

The podcast was hosted by CFTC’s Chief of Market Intelligence Andy Busch and focused on a recent white paper co-authored by Giancarlo and Tuckman, "Swaps Regulation Version 2.0: An Assessment of the Current Implementation of Reform and Proposals for Next Steps."

Swaps clearing. Busch noted that swaps clearing was a major area of Dodd-Frank reform and that there has been a dramatic increase in the percentage of centrally cleared swaps since implementation of CFTC rules. Tuckman said the CFTC is continuing and improving vigilance in this area in three ways:
  1. Making sure that central counterparties (CCPs) have the right amount of pre-funded resources, and that resources are held with adequate liquidity; 
  2. Making sure that CCP recovery plans are as transparent, predictable, and comprehensive as possible; and 
  3. Continuing to work on resolution plans. 
Swaps reporting. Busch observed that in working on a trading desk in a bank during the 2008 financial crisis, it was challenging to figure out what other banks had on their balance sheets and what risk they were taking in trading with them, and that data reporting was designed to help with that problem. Giancarlo agreed that there had previously been an inability to fully quantify credit exposure, which turned the crisis into a panic. Although swaps reporting was perhaps the most important area of reform, it is not yet fully in place. The CFTC has not given market participants enough detail about how swaps data should be reported, and reform has also been hampered by insufficient cross-border coordination. Reg Reform 2.0 addresses this. Currently, big data technology can help with swaps reporting, but ultimately, technologies on the horizon like distributed ledger technology (DLT) provide a long-term way of achieving this objective, said Giancarlo.

Swaps execution. According to Giancarlo, one problem with Dodd-Frank reform in the area of swaps execution is that it follows the futures model, which fits in some ways but not others. In particular, the CFTC tried to dictate the business model of swaps execution, as opposed to focusing on market participant conduct. The recent white paper explains that adverse consequences have come about, including swaps moving off regulated platforms into introducing brokers, which were not designed for swaps trading. The CFTC intends to address this in further rulemaking in the months and years to come.

Swap dealer capital. Many calculations that go into capital requirements for swap dealers are particularly harsh relative to the amount of risk, said Tuckman. The calculations rely too much on notional amounts, they don’t give enough offsets between long and short positions, and there’s not enough relief for margin posted against counterparty risk. Planned refinements will make capital requirements more proportional to risk and will not penalize derivatives relative to other types of risk borne by financial institutions.

End user rules. Dodd-Frank exempts commercial end users from capital and margin requirements, based on the theory that these entities don’t pose systemic risk through their participation in the markets. Dodd-Frank is less clear about financial end users like pension funds and insurance companies, but gives the CFTC discretion in how to handle these entities. The paper calls for creating exemptions from capital and margin requirements for end users that are small and do not contribute to systemic risk. In addition, rules for uncleared swaps margin should be less prescriptive and ensure that they don’t favor cleared products versus uncleared products.

Giancarlo concluded that if the CFTC continues to adapt and improve its Dodd-Frank rules, the underlying reforms will be preserved and reach their goals.

“As someone who supported that original law, I feel it’s incumbent on me and the agency, in my role as leader, to make sure that we’re continuing and improving. We’re looking at the data, what’s working and what’s not working so well, and then to take the steps to continue to improve and achieve the original objectives,” said Giancarlo.