The CFTC has earned a reputation as a tough regulator under the leadership of former Goldman Sachs executive Gary Gensler. The commission is responsible for implementing rules for one of the most critical targets of the Dodd Frank law - the over-the-counter swaps market. “The Wall Street reform bill will, for the first time, bring comprehensive regulation to the swaps marketplace,” Gensler has said. “Swap dealers will be subject to robust oversight. Standardized derivatives will be required to trade on open platforms and be submitted for clearing to central counterparties.”
While the OTC swaps industry has embraced the concept of clearing, it has resisted the CFTC’s likely approach to regulating execution of trades in the vast market. The CFTC appears ready to force OTC swaps to be executed electronically, doing away with much of the human intervention that exists in the market. That would reduce transactions costs from $50 billion a year to $35 billion a year, The New York Times said, citing the Swaps and Derivatives Markets Association. Many swaps buyers support the idea.
That position has sparked a powerful backlash from the industry, however. The opposition is gaining some traction in Congress, where Scott Garrett, a Republican of New Jersey, and Carolyn B. Maloney, a Democrat of New York, have introduced a bill that would prevent regulators from imposing an electronic trading mandate on the swaps business.
Institutional Investor contributing writer Steve Rosenbush discussed the outlook for over-the-counter swaps regulation with J. Christopher Giancarlo, executive vice president of GFI Group, a brokerage and trading company in New York. Giancarlo is a strong opponent of the electronic trading mandate. Here are edited highlights of their conversation.
1. The CFTC’s approach to over-the-counter swaps regulation has run into stiff resistance from the industry. Why is that the case?
Title VII of Dodd Frank set forth a number of key pillars of swaps regulation. Let’s start with the point of view of what it did and did not do. What it did do was determine that the over-the-counter swaps market would be cleared, and that there would be regulatory transparency for all swaps and intermediation--on either an exchange or a swap execution facility--for clearable swaps. What it did not do--and there was a lot of tough discussions over this issue at the time of legislation--was require a specific electronic method of execution for swaps. In fact, Dodd Frank says that swaps execution can operate through any means of interstate commerce. Another thing Dodd Frank did not do is require a futures exchange model of execution, with a single silo for clearing and execution on central limit order book as the model for the OTC market.
Our concern is that while the CFTC creates rules to implement the legislation, it also may be adopting in a number of cases a futures-like regulatory approach that is not warranted under Dodd Frank.
2. Electronic execution seems to work for the futures business. Why can’t it work for OTC swaps?
Equity or futures contracts trade in many thousands of units a day, and are highly suitable for electronic execution and clearing. But the bulk of CDS trade less than 10 times a day. Some trade only once a day. In that event, requiring electronic execution is not suitable. Less liquid instruments require a lot of human intermediation and negotiation. A market maker is not going to let competing market makers see its position on a screen in instruments with so few bids, so little liquidity. In that case, there will be no liquidity.
The worry is that there is a true lack of understanding of the OTC world by regulators who are familiar with the commodities world, where a few thousand equity or futures instruments are traded thousands of times a day in very small sizes. In the OTC swaps world, on the other hand, a few instruments are traded a very few times a day, but in very large sizes, and that market does not lend itself to such an electronic order book. Congress understood that.
But the CFTC’s knowledge base is centered on the highly commoditized futures market and the single-silo electronic model for execution and clearing.
3. How do you think this regulatory standoff is likely to be resolved?
There are a lot of smart people at the CFTC and I have faith that market experts such as ourselves can help the CFTC better understand the over the counter swaps market.
The rules are not yet final, so there is no timetable for implementation. A vote on rules is expected during the second quarter of 2012. There is certainly plenty of time to get this right.
4. Critics would say you are simply fighting to preserve high-paying jobs in the OTC swaps business. How do you respond?
The reason we need to get this right isn’t entirely to preserve American jobs in the swaps market.
The reason we need to get this right is because American companies need access to liquid swaps markets to hedge their balance sheet risk, so they can use capital efficiently, grow and expand their business, and create American jobs.
5. How do you envision the execution of OTC swaps in a post Dodd Frank market?
I would envision the execution of swaps taking place the way it does today, with a range of methods. You can have cleared transactions with a human element. There is no debate over whether swap transactions should be cleared. We are huge supporters of the cleared swaps market. Clearing has nothing to do with the method of execution. Clearing is a follow-on activity, once execution has occurred. It essentially introduces a third party between the buyer and the seller, which controls credit risk.
The US energy markets make use of human execution but are still cleared, and they work extremely well. European regulators are not going down this road and limiting the means of execution. Asian regulators are not going down this road. Congress did not mandate it. The CFTC is alone in this. And in this day and age, liquidity can move to a different jurisdiction with the click of a mouse.
