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From Securities Regulation Daily, May 1, 2019

Outgoing Chairman Giancarlo urges sticking to cross-border agreements: ‘A deal’s a deal’

By Lene Powell, J.D.

In his final update to the Commodity Exchanges, Energy, and Credit subcommittee of the House Agriculture Committee, Giancarlo said the E.U. should adhere to a 2016 agreement on cross-border regulatory deference.

In a House Agriculture subcommittee hearing, CFTC Chairman Giancarlo answered questions about the CFTC’s response to proposed E.U. regulation of U.S. entities, the impact of Brexit on derivatives markets, the CFTC’s approach to automated trading and cryptocurrencies, a reduction in the number of futures commission merchants (FCMs), and the transition from LIBOR to the SOFR interest rate benchmark.

Although Giancarlo’s term expired in April, he has stayed on as chairman while a nominee for his replacement is considered.

Cross-border issues. Top of mind for several subcommittee members were cross-border issues. Subcommittee Chairman David Scott (D-Ga) asked for a status update on a new E.U. law, "EMIR 2.2," which could potentially set up the E.U. as a primary regulator over U.S. clearinghouses. The law may require U.S. clearinghouses to fund the primary E.U. market regulator, European Securities Markets Authority (ESMA), through surcharges, "just for the privilege of their regulating us," said Scott.

Giancarlo explained that EMIR 2.2 has been passed by the European Parliament, and has now moved on to regulatory implementation, "Level 2", where technical details are worked out. He issued a joint statement on March 13 with Vice President of the European Commission (EC) Valdis Dombrovskis, which anticipates more cross-border deference between the CFTC and the EU supervisors than is currently the case. Giancarlo said he is willing to participate in the Level 2 discussions, but only on the basis of the 2016 agreement reached by his predecessor, former Chairman Tim Massad, which Giancarlo called a "notable accomplishment" which the CFTC expected to stand the test of time.

"Where I come from, a deal’s a deal, and you don’t get to renegotiate it 18 months later," Giancarlo told Rep. Mike Bost (R-Ill), who also asked about the E.U. law.

In particular, Giancarlo objects to primary oversight of U.S. clearinghouses by the E.U., saying "this will not happen." He said that Heath Tarbert, the pending nominee for CFTC Chairman, has said the same thing. In response to Chairman Scott’s question whether E.U. is attempting to wrest control of the clearing business from London, Giancarlo said yes, he believes so.

Another cross-border issue concerning some members was Brexit, which Chairman Scott said "we need to get our arms around." Scott observed that the U.K. Parliament has now voted down Prime Minister Theresa May’s negotiated withdrawal agreement three times, even though an un-negotiated withdrawal would mean "chaos." Noting that the E.U. gave the U.K. an additional six months to come up with a way to leave on negotiated terms, but that so far there is no deal, Scott asked if Brexit issues are bleeding into other derivatives markets issues.

Giancarlo said the CFTC does not take a view on Brexit politically, and the U.S. does not seek to dictate where market servicing resides. However, economically, the exit of the U.K. from the E.U. would have a major impact on the U.S. He said that the listed derivatives or futures markets are an important export business for the U.S. For the global OTC swaps markets, although U.S. banks make up perhaps two-thirds of liquidity, the market is based in London, which has a long history and expertise in this area. In response to a question from Rep. Dusty Johnson (R-SD), Giancarlo added that if London is substantially destabilized in the processing of derivatives, that outcome would work its way into the real economy, with an impact on interest rates and other effects. Giancarlo said the CFTC has taken a lead role at FSOC on this issue.

Automated trading. Many members asked about how the CFTC is approaching technological innovations including automated trading and cryptocurrencies, a topic that Giancarlo discussed at length in his prepared testimony.

Regarding automated trading, Rep. Rick Crawford (R-Ark) said he has heard fear from farmers about the rise of algorithmic trading. This has essentially blocked them from using the markets to hedge risk and gain price discovery, which in turn has led to greater market volatility. Giancarlo agreed, saying that the markets serve important purposes for producers. Digitization is a force much bigger than any of us, he said. The CFTC cannot stop it, but it needs to understand it, and where there is distortion or manipulation, to stop it.

In response to a question from Rep. Stacey Plaskett (D – VI), Giancarlo said that he did not support the Regulation Automated Trading proposal put out by former Chairman Massad. He did not agree with the registration requirement, because he does not believe the CFTC has the resources to supervise over 2,000 additional registrants, as some estimated the regulation would result in. In addition, he did not support the authority of the CFTC to obtain algorithmic source code from market participants without a subpoena. However, he does support having a greater understanding and view into automated trading, which is why the CFTC created its Market Intelligence Branch as part of the Division of Market Oversight. That office issued a report in March 2019, Impact of Automated Orders in Futures Markets, which found that automated trading had not contributed to market volatility.

Virtual currencies. In response to questions from Rep. Abigail Spanberger (D-Va) and Rep. Sean Patrick Maloney (D-NY), Giancarlo said the biggest gap in the CFTC’s oversight of virtual currencies is in the area of spot cryptocurrency. The CFTC does not regulate non-derivative trading platforms. On the derivatives side, like Bitcoin futures, the CFTC has it, and if it involves securities, then the SEC has it. But for spot markets, oversight is primarily provided by FinCEN and state regulators. Giancarlo said he believes the CFTC’s ad hoc working group with the SEC could be further developed with additional legal authority, funding, and resources.

Physically settled bitcoin futures also present some challenges for CFTC oversight, because it involves issues of where the bitcoins reside, and custody is usually handled through state-sponsored organizations including banks and trusts. However, Giancarlo is not sure that new legislation is needed in this area.

Giancarlo also observed that many believe that the introduction of bitcoin futures allowed the bitcoin bubble to deflate, stabilizing the market. "That’s an area of some satisfaction," he said.

Subcommittee Ranking Member Austin Scott (R-Ga) said he is working with Rep. Darren Soto (D-Fla) on legislation to improve the CFTC’s ability to work with new market technologies. Giancarlo replied that this is an important issue because while the CFTC must keep up with new technologies, as a number of foreign regulators do through "sandbox" experiments, the CFTC is restricted under the law from participating in new technologies with market participants because of restrictions around "gifts." An example of this is blockchain, which Giancarlo said could have "enormous" transformational potential for the CFTC, as a regulator, to be able to analyze market data in real time. But the CFTC’s general counsel has advised that to receive the technology from market participants would be a "gift" that the agency cannot accept.

"I believe that blockchain could be a quantum leap forward" for the CFTC to monitor the markets, said Giancarlo.

Asked by Maloney about any concerns about a race to the bottom on cryptocurrency regulation, Giancarlo said that yes, there is a risk that cryptocurrencies could move to areas of less regulation globally, allowing for abuses. But there is also the risk of a "race to the top," in which cryptocurrency capital moves offshore to jurisdictions where development is officially encouraged, such as France, with its recent "PACT Act," and Germany, which is also looking at this area. This could lead to U.S. markets missing out, said Giancarlo. He noted that a third of the world does not have a functioning currency for larger purchases, like cars, though they do have local currency for smaller purchases, like food. He could see how many places could see cryptocurrencies as a more stable asset than their own local currency.

Reduction in FCMs. Rep. Jim Baird (R-Ind) expressed concern that the number of futures commission merchants (FCMs) has declined, saying that nearly half have left the business in the last two decades. This means fewer are available to serve rural customers, he said.

Giancarlo agreed with the concern, saying that FCMs play a vital role in connecting end users to derivatives markets, and the impact of fewer FCMs is not being felt by the major players, but by farmers. FCMs are increasingly concentrated in big banks, which don’t have the skills, reach, or interest in serving small agriculture producers. Giancarlo said part of the reason for the decline is due to the low interest rate, because FCMs make money off interest. Some of it is due to fraud and manipulation, including FCMs that went bust like Refco, Peregrine, and MF Global. And part of it is due to consolidation and costs. Giancarlo said that Project KISS tries to make the CFTC’s rules less costly and burdensome so that smaller players can continue in the business.

Transition from LIBOR. In response to a question from Spanberger about the transition in interest rate benchmarks from the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR), Giancarlo first explained why it is necessary to move away from LIBOR. Decades ago, when LIBOR was launched, banks used to actually lend to one another overnight. Now, there are less than a dozen of these trades a day, with only several billion dollars a day in volume. Banks simply don’t finance through overnight lending anymore; they use repo markets and other longer-dated instruments.

And yet, said Giancarlo, we have trillions of dollars in loans based on this rate. He likened it to a house that has only one stone left as its foundation, and could collapse at any time. Therefore, regulators are looking to act in advance of a crisis. According to Giancarlo, SOFR is a much more stable rate, and is gaining wide acceptance. It has been tested, CME and ICE have launched futures based on it, and ISDA is working on protocols for its use.

CFTC diversity and funding. In his remarks, Chairman Scott stressed the importance of diversity at the CFTC, pointing to a recent letter from Commissioner Rostin Behnam to the CFTC’s Office of Minority and Women Inclusion (OMWI).

"[Behnam] lays out some troubling numbers and asks some pointed questions, and they are things that we’re going to look into on this subcommittee but let me say this: diversity is a strength," said Scott.

The subcommittee chairman also emphasized the need for robust CFTC funding. For FY 2019, CFTC is funded at $268 million, while for FY 2020, the Commission is requesting a total of $315.0 million.

The chairman noted that the total nominal value of the U.S. swaps is $282 trillion and U.S. futures $27 trillion. "That’s real money and it conveys real weight to what we do here," said Scott.

Passing of former Commissioner Chilton. Many members and Giancarlo expressed sadness at the recent death of former CFTC Commissioner Bart Chilton, who served from 2007-2014. A colorful character and unconventional regulator, Chilton had a strong background in agriculture before joining the CFTC.

"He was a strong advocate for transparency and common sense in regulation, and we will miss him very much," said Chairman Scott.

MainStory: TopStory Blockchain CommodityFutures CyberPrivacyFeed LegislativeRegulatoryActivity Derivatives ExchangesMarketRegulation FinancialIntermediaries InternationalNews Swaps

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