Introduction
I want to thank Ken Bentsen and Ira Hammerman for inviting me to SIFMA’s 46th annual Compliance and Legal Seminar. I did not know until recently that Ira’s father Steve Hammerman spoke at an FIA Law and Compliance Conference 20 plus years ago. Steve worked for Merrill Lynch for many years and was a champion for the value and the importance of having in-house lawyers who worked on compliance. I am told that he delivered a powerful message at our conference that day about the importance of the compliance function at all of our member organizations. I could not agree more with that sentiment, and it is an honor and a privilege to return the favor by speaking here today.
Our focus at FIA is on rules that relate to listed and cleared derivatives, and we spend a large portion of our time discussing the regulation of these products with the Commodity Futures Trading Commission.
I know many of you may not follow the day-to-day workings of the CFTC so let me give you the two minute executive summary. The CFTC has long regulated the futures markets, and for three years following the financial crisis, former CFTC Chairman Gary Gensler masterfully out-maneuvered many opponents to put into place a new regulatory structure for OTC derivatives—vastly expanding the CFTC’s area of focus. In this short period of time, the CFTC put in place mandatory clearing for swaps, a new swap execution facility infrastructure, a reporting regime for swaps, an expansive cross-border policy, position limit rules…twice, and a new swap dealer registration regime with internal conduct rules.
Shortly after Chairman Gensler left in January and Commissioner Bart Chilton resigned, the CFTC was left with two Commissioners—Acting Chairman Mark Wetjen and Commissioner Scott O’Malia—to finalize the implementation of these various rules. This is a predicament because the Sunshine laws prohibit two Commissioners from discussing policy matters because technically they make a quorum of the Commission that requires an open public meeting. This makes finding solutions difficult if policymakers can’t talk to each other.
Three individuals have been nominated to fill the open seats—Tim Massad as Chairman and Sharon Bowen and Chris Giancarlo as Commissioners. It looks like the Senate Agriculture Committee will move on these nominees in the coming weeks but it is uncertain how long it will take the full Senate to confirm these individuals. Confirmations tend to happen around breaks in the Senate Calendar—the next one being Easter recess followed by the Memorial Day recess.
My point being that there is a significant amount of work that still needs to be done with implementing the rules that are in place—both domestic and international—but the Commission remains less than full strength for the time being and has limited ability in the short term to deal with such matters.
I know that you all have been spending the last several days zeroing in on the specific compliance and legal issues that affect your companies. I’d like to step back from the details and offer a few thoughts on five trends I see affecting the financial services industry—both securities and listed derivatives—and how these trends might affect this audience.
1. The Era of Regulatory Cooperation
As I mentioned, the CFTC has been very active in developing the new regulatory framework for derivatives. Since the passage of Dodd-Frank, the CFTC has completed 68 final rulemakings, 8 exemptive orders, 172 no-action letters and 34 advisories. Add to this the number of entities that have registered with the CFTC – 98 swap dealers, 19 swap execution facilities, and 4 swap data repositories—and it is clear that the CFTC has been extremely busy. The SEC faces a similar hectic schedule this year in finalizing its Dodd-Frank rule-writing.
This tidal wave of regulatory change must be viewed in the context of static to tightening budgets for both agencies and the increasing globalization of the markets. One trend becomes clear: regulatory compliance is going to require a cooperative and pragmatic approach across domestic agencies, foreign regulatory authorities, SROs and private sector compliance departments.
No one agency can police the entirety of the global marketplace without relying on these other partners to help in this effort. And such reliance is going to require pragmatism and building a level of trust between these regulatory partners. As a former chair of an agency, I know very well that this is easier said than done.
In getting these rules written and in place in such a short time, some of these relationships between regulators—both domestic and international—have been bruised. It will require time to rebuild these relationships but it is strategically important for our industry and will require compromise and trust.
Let’s look at one cooperative opportunity for regulators to make progress: the concept of mutual recognition that has allowed global futures markets to develop over the last twenty years.
Mutual recognition or substituted compliance is the concept that one domestic agency with possible legal jurisdiction over a foreign entity or transaction is willing to defer to the foreign authority as long as the foreign rules are comprehensive and comparable.
Such a concept of international comity looks to outcomes rather than the means of achieving such outcomes.
Europe and the US are now facing a real test of this concept in whether the EU deems US clearinghouses equivalent for EMIR by June. Finding US CCPs nonequivalent would have far reaching impacts on the global marketplace, including limiting foreign access to US exchanges, clearinghouses and products and potentially raising costs significantly on end-users. There are certainly differences between how the EU and US regulates CCPs, including EU 2 day net margining versus the US 1 day gross margining as well as differing customer money segregation regimes. However, these differences are mechanisms for achieving an outcome and not the outcome itself. As far as I am concerned, each jurisdiction meets the global standards for CCPs—known as the PFMIs—and should be found equivalent.
I am hopeful that regulators will find value in such a principled compromise that allows global markets to exist while still protecting the marketplace. Again, we need all the partners we can get to make this new regulatory regime work and this agreement between the EU and US would be a great example on this front.
2. The Lines between Securities and Derivatives Markets Are Blurring
Fourteen years ago, a startup exchange operator bought his first power exchange for a dollar. Last year, that same individual finalized a deal to buy NYSE Euronext for $8 billion.
I am of course referring to Jeff Sprecher and his company ICE. Their purchase of NYSE Euronext exemplifies the technological advances that now enable the equities and derivatives market infrastructure to complement one another.
The world of securities and the world of futures are very different. We have different origins, different economic purposes, different legal frameworks, and different regulators in Washington. But despite these differences, we are being pulled together like never before by the changes in the regulatory environment and the forces of technology.
The market structure for our respective industries is also very different. Futures exchanges have typically been vertical models with each exchange owning its own clearinghouse. While this model consolidates liquidity in one location and encourages product innovation, its critics believe that a vertical model creates significant barriers to entry for competition.
The market structure for the securities industry traditionally has followed the horizontal model, which allows many exchanges to plug into one clearinghouse. Such a model has spurred competition over time, but critics raise concerns that it may foster market fragmentation and discourage product innovation.
A hybrid of these two worlds seems to have developed with the development of new clearing and trading services for swaps. One of the fundamental premises of Dodd-Frank is that derivatives clearing organizations engaged in clearing swaps must offer “open access” to trading venues. While not exactly a horizontal market, this approach is offering greater opportunity for market participants to choose where trades are executed and cleared.
In some respects, the structure looks more like the equities market than the futures market. Where this developing market may learn from the securities market structure is how to encourage choice and competition while limiting the complexity of trading on multiple execution and clearing venues. More technical guidance and standards for SEFs from the CFTC would be welcome as this market comes online in order to avoid the complexity problems that have arisen in the securities field.
3. Regulators Are Rightly Focused on CCP Risk and So Should You
One of the lessons from the financial crisis was that clearinghouses worked to mitigate risk. Volumes on futures exchange actually increased during the crisis to manage the displacements that were occurring and to discover prices that were opaque in the OTC marketplace.
This consensus view on clearinghouses led to the G20 commitment in Pittsburgh in 2009 and ultimately Dodd Frank, which codified the requirement to put the $600 trillion OTC marketplace into clearing. But with this increased utilization of CCPs, regulators and policy makers began to wonder, “Are we creating the next ‘Too Big to Fail”?
As a result, we have seen an increased focus by regulators on every aspect of the clearing process. These concerns range from when trades enter the clearing system to ensure that brokers have properly screened these trades for credit checks to once accepted for clearing how does a given CCP manage the risk of a possible default through margin, guaranty funds and other protections. Even the settlement cycle and liquidity risk of the clearinghouse are being examined to ensure that at the time of a default, the clearing system is protected.
The recent default of a clearing member at the Korean exchange KRX has highlighted the risks involved with clearinghouses globally. FIA is committed to helping bring additional transparency and consistency to clearinghouse rules and procedures around the globe. This will benefit both regulators and market participants alike to ensure that global CCPs meet the highest standards of risk management.
4. Regulatory Costs for Clearing Will Begin to Be Realized with Consequences
With higher capital charges coming in Basel III and increased costs of compliance for firms, we are likely to see further consolidation in our industry. The consolidation trend has already been occurring over the long term. Ten years ago there were 177 futures commission merchants or FCMs—those firms holding customer funds for trading futures—and now we have less than 100. Ten years ago the top 10 FCMs handled 69% of customer trades and now they handle 77% of customer trades. The top five firms now account for 52% of the customer business compared to 42% 10 years before. In contrast, total customer funds held by FCMs was $62 billion 10 years ago and now it is $142 billion, a 129% increase. Clearly, there is a concentration of the clearing business among fewer and fewer firms.
The story is the same for exchanges. While volume in the futures industry over ten years has increased 191% from 7.2 billion to 21.6 billion, there are fewer exchanges in which that volume flows. Ten years ago there were 18 registered futures exchanges in the U.S. and today there are only 8.
Higher capital in combination with clearing and regulatory costs will only drive further consolidation. It is ironic that the rules meant to mitigate risk in our markets may have the unintended impact of concentrating risk and discouraging new entrants. This trend is something that both the industry and regulators should continue to monitor.
5. Fixing the Trust Deficit Begins with Us
So I stand before you looking in the rearview mirror at the financial services industry over the last five years and what do we see: Bear Stearns, Lehman Brothers, Bernie Madoff, AIG, Fannie and Freddie, MF Global, Peregrine Financial, London Whale, LIBOR rigging, Occupy Wall Street and now Flash Boys?
As an industry, we face a real trust deficit with the public. As dedicated as this audience is to doing the right thing, we are fighting tremendous headwinds.
In my view, the rebuilding of trust starts with us. It is incumbent on trade associations like FIA and SIFMA to play a lead role in this effort—to be transparent in our mission and to promote high standards, including high ethical standards, in our industries. We need to restore public trust in our industry but it is going to take time.
That is where you come in. Compliance has to be treated as an essential function in every bank, every exchange and every broker. This requires clear and certain rules from the regulators but also a new commitment and culture from us to do the right thing. I am confident that this industry can take on this challenge and reverse this distrust through perseverance, hard work and a commitment to compliance.
Thanks again for inviting me to speak.
