Bumpy ride ahead for US structure reforms

The direction of travel for market structure rules has finally been given greater clarity as the Commodity Futures Trading Commission, the US derivatives regulator, has outlined its thinking on Dodd-Frank’s market participant requirements and how prop trading restrictions would affect markets.

The direction of travel for market structure rules has finally been given greater clarity as the Commodity Futures Trading Commission (CFTC), the US derivatives regulator, has outlined its thinking on Dodd-Frank’s market participant requirements and how prop trading restrictions would affect markets.

The watchdog narrowly passed its version of the Volcker rule after a fierce debate in the watchdog’s first public meeting of the year. Rules for segregation of swap customer funds and business conduct also suffered objection but were passed in a two-to-three vote by its commissioners.

The fiercest criticism of the regulator’s rules came from Republican CFTC commissioners Scott O’Malia and Jill Sommers.

“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 or to deter violations of this rule,” said O’Malia.

Attacking the rule’s complexity, Sommers also questioned why the CFTC had taken three months to table essentially the same rules as the other US watchdogs.

“I can’t help but question the timing of this vote and why the commission did not join the other agencies in their proposal back in October,” said Sommers. “Unfortunately, we are proposing rules that are virtually identical to the other agencies’ proposed rules well after they have been widely criticised and after many have called for those agencies to start over, including Paul Volcker.”

The CFTC’s version of the Dodd-Frank Act’s rule against prop trading by deposit-taking institutions mirrors the joint rule proposed in October by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission. Each US authority must provide a version of the Volcker rule that will be enforced for those firms it regulates.

CFTC chairman Gary Gensler, a Democrat, admitted the delay was due to resource constraints at the agency and said the watchdog had extended the public consultation period to 60 days for the proposed rule to allow for its complexity. Late December, the deadline for public comment on the joint proposition was put back a month to 13 February after lawmakers pleaded for more time.

Sommers asked what the CFTC would do if the other agencies re-proposed their rules. “Will we be prepared to withdraw our proposal and join a re-proposed Volcker rule with the other agencies? It seems as if we have put ourselves on a separate track, which I fear will needlessly complicate an already convoluted and likely unworkable set of rules.”

Gensler indicated the CFTC was now hoping to “fall into step” with other agencies if they were to re-propose Volcker. Currently, Dodd-Frank has set a 21 July effective day for the Volcker rule. CFTC staff said while the date would unlikely be pushed back, the date of compliance could be extended.

Several commissioners, including O’Malia and Bart Chilton, a Democrat, questioned the CFTC’s authority to enforce their version of the Volcker rule on firms they regulate.

In response, CFTC staff explained the regulator could not fine violators but had the authority when there was a violation, to order the offending activity be terminated or divested. But these actions could only come after notice had been given and the potential violator had an opportunity to be heard, and could involve court proceedings. With some positions potentially lasting barely minutes, O’Malia felt such restrictions made the rule essentially toothless.

Concerns were also raised over the extraterritoriality of the rule, which could apply to instruments and firms outside the US if they had US connections, presently loosely defined. O’Malia said yesterday that the CFTC had received a letter from the Canadian government, which was concerned the CFTC’s Volcker rule’s specific mention of Canadian bonds could lead to a squeeze in liquidity in its markets. Japanese watchdog the Financial Services Agency has sent a similar letter to US regulators.

Tim Ryan, president and CEO of US sell-side trade body, the Securities Industry and Financial Markets Association (SIFMA), said as with the earlier proposal from the other US regulators, the CFTC’s Volcker rule proposal was complex and had the potential to have a major impact on liquidity in markets.

“It could inhibit the ability of financial institutions to effectively make markets which will, in turn, hurt capital formation,” said Ryan, referring to a study commissioned by SIFMA indicating as proposed, the Volcker rule could cost investors between US$90 and US$315 billion in one time costs in the corporate bond market alone.

Segregating customer funds 

The CFTC yesterday also passed final rules on segregation of customer funds for cleared swaps.

Futures commission merchants (FCMs) and derivatives clearing organisations (DCOs) must now hold customer collateral in a separate account from that belonging to the FCM or DCO. Gensler said the new rule prohibited clearing organisations from using the collateral of non-defaulting, “innocent” customers to protect themselves and their clearing members.

“For the first time, customer money must be protected individually all the way to the clearing house,” he said.

But Sommers said the rules provided swap customers with protections from fellow customer risks that do not apply to futures customers, creating inequity in the regulator’s dealings with regulated firms and customers.

“We focused almost exclusively on the need to alleviate the risks that swap customers pose to their fellow swap customers with the same swap clearing member (SCM). We did not focus on the risks customers face due to the actions of the SCM,” she said, calling for the CFTC to rethink its approach in light of the failure of futures broker MF Global.

Mark Wetjen, a Democrat sworn in as commissioner in October 2011, said one of the issues the CFTC needed to explore further was whether similar protections for customer collateral in the futures markets would be appropriate.

Tighter conduct standards 

In a four-to-one vote with Sommers dissenting, the CFTC’s business conduct regulation was approved for public comment. Under the new rules, swap dealers will have to tell their counterparties the mid-market mark of their outstanding bilateral swaps every day. According to Gensler, the rule would bring “transparency to the markets and help to level the playing field for market participants”.

The rules also prohibit other forms of activity and implement requirements for swap dealers and major swap participants to provide balanced communications and disclose material risks, conflicts of interest and material incentives before entering into a swap.

But Sommers countered that rather than provide additional protections, the new rules would harm participants by making it more difficult for them to enter into “arm’s length transactions” with swap dealers.

“If our rules prove unworkable or raise unacceptable legal risks, swap dealers and major swap participants may choose not to do business with some counterparties, especially special entities as defined by Dodd-Frank,” warned Wetjen, nevertheless voting in favour of the rule so that it could be reviewed by the public. “This could deprive swap market participants of the liquidity they need to manage the risks.”

“The CFTC’s finalised business conduct rules could have a significant impact on the ability of pension funds and other retirement savings vehicles, as well as states and municipalities, to effectively manage risk,” said Kenneth E. Bentsen, Jr, executive vice president, public policy and advocacy at SIFMA.

Gensler also said that he hoped to finalise the definitions for swap dealer and swap during the first quarter of 2012. Present definitions in the rule have come under fire as being too vague.