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From Securities Regulation Daily, July 17, 2013

Hearings begin on CFTC reauthorization in wake of SEC-CFTC Path Forward on derivatives regulation

By Jim Hamilton, J.D., LL.M.

The Senate Agriculture Committee hearing on the reauthorization of the CFTC revealed a consensus on the need for the consistent regulation of cross-border derivatives, both domestically with the SEC and the CFTC and globally. Senator Debbie Stabenow (D-Mich.), the chairman of the committee, said that the committee must examine lessons from past market failures as it reauthorizes the CFTC in order to avoid repeat crises like the 2008 near-collapse of global financial markets. This hearing, which was the first official hearing in the committee’s CFTC reauthorization effort, featured testimony from a range of witnesses including market participants, end users, and regulators. Chairman Stabenow cited the 2011 collapse of financial firm MF Global, and its loss of $1.2 billion in segregated customer funds, as a critical reminder of the importance of ensuring that the markets are transparent and functioning as intended.

Chairman Stabenow said that, in the coming weeks, the committee will announce additional hearings and hold a series of staff briefings to more closely examine the issues raised at the hearing today.

SIFMA. In his testimony, Kenneth Bentsen, Jr., SIFMA President, said that the overarching concern of the securities industry is that the new derivatives regulations under Title VII of the Dodd-Frank Act be implemented in a coordinated manner between the various regulators responsible for derivatives reform. This is critical to the successful implementation of Title VII and other similar regulatory frameworks, he noted, as firms are making dramatic changes to their business, operational, legal, and compliance systems in order to adapt to the new OTC derivatives regulatory regime. The implementation of these new rules is not as simple as flipping a switch, noted Mr. Bentsen; rather, they require significant and multiple systems builds, testing, training, and new documentation involving both dealers and customers.

Additionally, while encouraged by the joint actions of the CFTC and EU, SIFMA continues to emphasize the importance of consistency and coordination between international regulators in implementing OTC derivatives reform in furtherance of G20 commitments. SIFMA believes that the international nature of the swap markets makes such global coordination, in addition to domestic coordination, critical in order to achieve an appropriate level of oversight of swaps activities.

Path Forward. European Commissioner for the Internal Market Michel Barnier and CFTC Chairman Gary Gensler reached an agreement for a Path Forward regarding their joint understandings on a package of measures for how to approach cross-border derivatives regulation. As part of the agreement, the CFTC and the European Commission have pledged not to seek to apply their respective regulations unreasonably in the other jurisdiction but to rely on the application and enforcement of the rules by the other jurisdiction. A possible requirement for certain market participants or infrastructures to register with an authority is acceptable to ensure recourse in the event of a failure to provide satisfactory application or enforcement of rules.

The Path Forward agreement reached by the European Commission and the CFTC references the need for both the CFTC and the EU to take a series of actions to accomplish a coordinated regulatory approach, noted Mr. Bentsen; however, there are still details to be worked out on how the laudable goal of implementing coordinated and consistent regimes is to be reached.

Similarly, as the CFTC has now moved forward with its final guidance on cross-border derivatives regulation, much work remains to be done in aligning the CFTC’s positions with the rules of other jurisdictions and with the SEC’s rules for security-based swaps. As the rules of other regulators and other jurisdictions come into being, it will likely be necessary for market participants to seek further no-action relief and guidance from the CFTC to avoid inconsistencies and duplicative regulation. In addition, legislative action may facilitate better coordination.

CME Group, Inc.. In his testimony, Terrence Duffy, CME Group, Inc. (CME) President, welcomed the recent Path Forward agreement and is hopeful that this positive development will lead to U.S. and EU regulators achieving workable, mutual recognition of derivatives trading and clearing regulation. In this regard, the joint statement of the CFTC and the European Commission noted the difference in treatment between the EU and U.S. of initial margin coverage. While the minimum standards, such as initial margin, that apply to central counterparties in the U.S. and the EU may differ, noted Mr. Duffy, they are both narrowly tailored to the relevant marketplaces in those jurisdictions. Mr. Duffy suggested that, in order to achieve the same risk mitigation outcome, initial margin is just one of many risk mitigation techniques employed by central counterparties, with others being concentration charges and variation margin/mark to market.

Due to CME’s twice daily mark-to-market rules, CME’s minimum margin period of risk of one day effectively covers twice the potential exposure of a portfolio in a given day. This approach to initial margin levels has been validated repeatedly during periods of market stress, said the CME head, including during the liquidation of house and customer portfolios where necessary.

The European Securities and Markets Authority (ESMA) has imposed a two-day minimum initial margin coverage. CME believes that the application of a two-day minimum for the U.S. futures markets is both inappropriate based on market characteristics and unnecessarily costly to end users, including small agricultural producers who use the markets as a necessary hedge to their business risks.

National Futures Association. As Congress begins the CFTC reauthorization process, the primary concern of the National Futures Association (NFA) is customer protection, which NFA President and CEO Daniel Roth described as “the heart and soul of what we do at NFA.” For years, the futures industry had an impeccable reputation for safeguarding customer funds, he noted, but since Congress last considered CFTC reauthorization, that reputation has taken a serious hit. First at MF Global and then at PFG, customers suffered real harm from shortfalls in customer segregated funds—the kind of harm that all regulators seek to prevent.

In light of the failures of MF Global and PFG, there have been renewed calls for some form of customer account insurance. In this regard, Mr. Roth noted that customer account insurance can take many forms; there are alternatives to the SIPC government sponsored model. Private insurance solutions can take several forms in terms of who is covered and to what extent. In addition, public confidence in the markets is critical, said the NFA head, but it is a means to an end. The real goal is to ensure that futures markets are effective and efficient and a benefit to the economy. Markets must therefore be liquid, he said, and that requires public confidence.

However, in the NFA’s view, attempting to bolster public confidence through insurance programs that prove to be cost-prohibitive is self-defeating and would damage liquidity. This question is too important to be dismissed out of hand because various forms of insurance might be too expensive, Mr. Roth stated. There is a need to know what kind of insurance is being purchased and at what cost; only then can Congress make an informed decision. With this in mind, the NFA has joined with CME, FIA, and the Institute for Financial Markets to commission a detailed analysis of various alternative approaches to customer account insurance. Armed with detailed customer account information from small, medium, and large FCMs, the study, planned for a mid-September completion, will calculate the estimated costs of each of the alternatives studied.

Futures Industry Association. Former Acting CFTC Chair Walter Lukken pointed out that a salient fact since the last reauthorization of the CFTC is the passage of the Dodd-Frank Act and the CFTC’s mandated implementation of Title VII of that Act. In the Dodd-Frank Act, Congress determined to extend clearing beyond futures to swaps. As such, the role of the futures commission merchants (FCMs) has also expanded, noted Mr. Lukken, currently CEO of the Futures Industry Association, because FCMs play a critical role in achieving the newly established clearing regime for swaps.

It must not be overlooked that both derivatives clearing organizations and FCMs face tremendous structural changes under some of the new rules, he continued, despite the fact that neither of these regulated entities were a contributing factor in the financial crisis.

Mr. Lukken posited that Congress envisioned when it passed Dodd-Frank that futures markets would serve as the model for this new swaps marketplace engendered by Dodd-Frank and implementing regulations. Certainly, the regulatory policies and benefits that have historically existed for clearing futures can largely be applied to swaps, he added.

There will obviously be the occasional exception necessitated by the fact that swaps and futures have evolved in different environments, he acknowledged. However, there is no need to reinvent the already-proven system that is familiar and tested for futures, he reasoned, especially at this critical juncture when the newly required clearing mandate for swaps is beginning to take effect.

MainStory: TopStory CFTCNews ClearanceSettlement CommodityFutures Derivatives Swaps

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