CFTC’s O’Malia: Sef rules could favour Europe

The CFTC has a lot on its plate, including Sef rules, dealing with the extraterritorial impact of its regulations, and working out how best to manage the huge amount of data coming its way

Back in January, it looked very much like long-awaited rules on swap execution facilities (Sefs) – new derivatives trading venues conceived by the Dodd-Frank Act – would be released imminently. Speaking at an industry event in New York, Commodity Futures Trading Commission (CFTC) commissioner Scott O’Malia told delegates a vote on the rules would take place within weeks. “That’s right in time for Valentine’s Day, and nothing says ‘Valentine, I care’ like a Sef final rule-making,” O’Malia said.

Five months on from that speech, the Sef rules have finally materialised and O'Malia says he has learned a lesson on how not to "throw out dates" but instead keep quiet about when he thinks rules will be finalised. Speaking to Custody Risk before the rules were released, he said: "I gave a speech in January, thinking we would have a mid-February rule completed," adding that negotiations had "absolutely cratered", with request for quotes and block trade thresholds the main sticking points.

In the final Sef core principles, the proposal that requests for a quote would need to be sent to a minimum of five market-makers - potentially making it more difficult for these firms to manage their risks, critics claimed - has been watered down. Quote requests can go to two participants, during a one-year transition period, and three thereafter.

According to the final rules, the CFTC may even up block trade rules for swaps and swap futures. As things stand, swaps are subject to CFTC-set block thresholds - which allow big trades to avoid real-time reporting requirements - but exchanges can set their own thresholds for futures contracts. Critics have argued this disparity hands the exchanges - formally known as designated contract markets (DCMs) - an unfair advantage in cases where they are trading products that are economically equivalent to over-the-counter swaps.

The block rules for swaps establish a 67% notional size threshold. Any trades above this point in a given product's range of notional sizes can be executed bilaterally, away from a Sef, and will be subject to a reporting delay of at least 30 minutes - meant to give liquidity providers time to hedge themselves before the market is notified of a large transaction. The CFTC has calculated that roughly 6% of swaps will qualify as blocks under the final standard but the threshold will be set at 50% for the first year of the new regime.

Under the final block rules, the threshold applies to all swaps, regardless of whether they are traded on a Sef or a DCM. Market participants could sidestep this rule, however, by electing to trade a swap futures contract that is economically equivalent to the swap, thereby becoming subject to the DCM's own block threshold rather than adhering to federal limits.

Looking into the futures

One of the major areas of controversy in recent months has been the emergence of swap futures contracts - products that mimic the economic characteristics of OTC swaps, but have lower margin requirements. Would-be Sefs have grown increasingly vocal about what they perceive as an unfair advantage handed to exchanges as a result of CFTC rules on the minimum liquidation periods for the calculation of initial margin - essentially, an assumption about how quickly a clearing house would be able to liquidate or sell a portfolio belonging to a defaulted member firm. The CFTC has stipulated a minimum one-day liquidation period for futures, options and commodity-based swaps, and a minimum five-day period for all other derivatives. Several exchanges have launched swap futures contracts as a result - Chicago-based Eris Exchange and CME Group among them - and OTC participants argue Sefs will be unable to compete on a level playing field.

In fact, Bloomberg has decided to take this argument to the courts, filing a lawsuit against the CFTC on April 17. "We did not come to the decision lightly," the firm said in a statement. "Bloomberg has worked along with market participants and our buy- and sell-side clients since October 2012 to alert the CFTC to the consequences of its ruling. As well, the CFTC has failed to respond to our formal request - made by legal counsel Eugene Scalia - to change and stay the implementation of this rule, leaving us with no other option."

Bloomberg isn't putting all its eggs in one basket, though. The firm has suggested it may launch a DCM if its attempts at forcing a change in the regulations prove unsuccessful. O'Malia suggests this may become a wider trend. "I've talked to a number of Sefs that, for a mere $250,000, can have their lawyers draft up a DCM application just in case they might want to become a DCM."

Nonetheless, now the framework for Sefs is finalised, there may be "something of a halt" to the futurisation of OTC swaps, O'Malia believes. Other problems could emerge, however - not least, differences in the trading rules between Europe and the US. "In the transaction space, the European proposal is far more flexible than what's being considered for our Sef platforms. Does that mean as a result dealers will migrate to providing liquidity in Europe because our Sefs are too inflexible?"

Differences in regulatory standards across borders have been a concern more broadly - as have attempts by US regulators to apply their rules on an extraterritorial basis. An original interpretative guidance on the cross-border application of Dodd-Frank was published last July, and was immediately criticised by market participants as inconsistent, complex and potentially overlapping with foreign rules. A key point of contention was the definition of ‘US person', which observers claimed would capture a large number of offshore entities already subject to overseas rules.

The CFTC released a no-action letter in October and final exemptive order in December, which essentially narrowed the scope of the US person definition to any person who is a resident of the US, or any entity that is organised or incorporated in the US, or has its principal place of business in the US. However, that exemptive order expires on July 12 - and market participants are worried a broader definition of US person will come into force at that time.

This is vital, because this definition essentially determines who or what will be subject to Dodd-Frank entity-level and transaction-level requirements. In addition, the July 2012 interpretative guidance introduced the concept of substituted compliance, which would allow non-US swap dealers and foreign branches of US swap dealers to comply with foreign rules in certain circumstances, so long as the CFTC thinks the rules are comparable with Dodd-Frank - and it requires banks to prove they are compliant on a rule-by-rule basis. This requirement will come into force at the end of the exemptive order, but the problem is that few countries outside the US have equivalent rules in place yet.

As a result, some participants think the only option is for the exemptive order to be rolled over - and O'Malia agrees that is an option. "We have not begun to address that yet. I have no idea how that's going to be worked out at this point. I believe we will need to provide relief and the debate will be about whether to continue to extend the relief as is - with maybe some changes to the US person definition - or to implement the entire cross-border guidance and then provide exemptive relief to certain elements of that," he says.

Outside of these big, headline-grabbing issues, the CFTC is grappling with a number of challenges, not least its ability to monitor and analyse the huge flood of data coming its way as a result of mandatory reporting. O'Malia claims there is little consistency in the data that is being reported, requiring a huge effort to get it into a form that is usable. The regulator has pulled together staff on an ad hoc basis to mine the data, but needs to employ a more systematic approach, O'Malia says, involving the formation of a new data unit alongside a review of CFTC policies and procedures.

Some of the challenges stem from the fact the swap data repositories and market participants have interpreted CFTC rules in different ways, O'Malia says. "People are not reporting consistently and that could be our rules or their interpretation of our rules."

Use of different data standards compounds the problem, he adds. "If we don't get the columns to line up and the vocabulary to line up, then we are going to have a hard time digesting it and the data will not be useful to us. Right now it is not useful to us. We can and will solve this, but it's going to take some time."

 

Scott O’Malia

In public policy most of his career, Scott O’Malia has spent 18 years on Capitol Hill and in the US Senate. O’Malia was confirmed by the Senate in 2009 as a commissioner of the Commodity Futures Trading Commission (CFTC), to serve a five-year term that expires in April 2015. He is the current chairman of the CFTC technology advisory committee.

The CFTC consists of five commissioners appointed by the president, with the advice and consent of the Senate, to serve staggered five-year terms. No more than three commissioners at any one time may be from the same political party. O’Malia’s previous nomination to the CFTC in 2008, by President George W Bush, was blocked by Democratic Senator Maria Cantwell  in protest that the agency had not reined in what she termed excessive speculation in oil markets.

O’Malia previously served as staff director to the Senate Appropriations Subcommittee on Energy and Water Development, and prior to that was senior policy adviser on oil, coal and gas issues to the Senate Energy and National Resources Committee. During his career, O’Malia also founded the Washington, DC office of Mirant Corporation, where he worked on rules and standards for corporate risk management and energy trading among wholesale power producers.