Demystifying Dodd-Frank

A Regulator Calls On His Colleagues For More Transparency

Commissioner Scott O’Malia of the Commodity Futures Trading Commission (CFTC) is on a mission. He says the process of writing new over-the-counter derivative contract rules needs more transparency. Over the past year he has repeatedly called for more roundtables and public comment on how rules are written. Why is this important? Because these rules, among other things, will determine which OTC derivative contracts must go through a clearing process and which ones can continue to use the old bilateral, dealer-to-dealer model. 

Yet often O’Malia has been the odd man out at the five-person CFTC. He is warning that the process of translating the mammoth Dodd-Frank Act into hundreds, perhaps thousands, of new rules could take years, while the industry’s providers of these contracts are left wondering how they are to comply in the meantime. The commissioner recently participated in a Q&A with CQ&D.



CQ&D: Do the CFTC and Securities and Exchange Commission have an effective process to write the rules the industry is waiting for on OTC derivatives transactions?

Mr. O’Malia: You are leading with a question regarding procedure, which is separate from the issue of content. I’ve been vocal about my dissatisfaction with the overall rule-making process. My greatest concern has been, and continues to be, the lack of transparency in our rule-making and implementation schedules. Since the winter of 2010, I’ve repeatedly asked the commission to publish a full, soup-to-nuts schedule on when each of the proposed and final rules are going to be considered by the commission and in what order they will be implemented. I think that will give the market a much better framework in which to determine their legal obligations and to make critical business decisions-including investment of resources-regarding such obligations. The markets and market participants are looking for guidance. Failure to provide such guidance will not only generate market uncertainty, but it may prevent us from effectively enforcing our own regulations. 


CQ&D: This kind of rule implementation that you advocate is the norm?

Mr. O’Malia: I believe that regulators and market participants in this and other jurisdictions agree that rules of this magnitude require thoughtful planning. We need to build our new regulatory structure on a solid foundation. Just last November, Congress, in the commission’s annual appropriations bill, directed the commission to develop and publish for public comment a full schedule for implementation and sequencing of all rules and regulations promulgated pursuant to Title VII of the Dodd-Frank Act. We now have to answer to Congress as to whether we are going to adopt a full implementation schedule.


CQ&D: Are there other commissioners who share your concern for more transparency?

Mr. O’Malia: I suspect there are. But I certainly have been the most vocal.


CQ&D: So why aren’t they joining you?

Mr. O’Malia: I think that would be a great question for every other commissioner.


CQ&D: Should the rules process go faster or slower?

Mr. O’Malia: We’re complying with requirements under the Administrative Procedures Act (APA), and in some cases (during the summer), we offered longer public comment periods than are required by the APA. There is pressure to move things along. For example, the two executive orders from President Obama emphasized that we should provide a 60-day comment period on our rule-makings. We have not done so in every case. Also, our final rule-makings vary in the extent that they analyze and incorporate public comment. Finally, without complete rule-making and implementation schedules, it is extremely difficult to consider the interconnections between rule-makings. As I stated earlier, we need to build our regulatory structure on a solid foundation. I’m afraid we’re going to rush through a large number of rule-makings without a very thoughtful analysis of individual rules, much less understand the way that they interconnect. I’m afraid the market will be the worse off for it.


CQ&D: So regulators could be overwhelmed by a process that doesn’t allow sufficient review of rules that will govern OTC derivative contracts for years to come?

Mr. O’Malia: I think if we try to put through too many rules, we’ll be back in the position of members of Congress on the health-care reform bill. When key members were asked if they’d read the bill, which clocked in at just over 960 pages, they responded that they had not. That is simply not acceptable.


CQ&D: End users of these contracts, you said, must be ready to pay more. How do you set margin limits to ensure safety in the market, but also ensure that customized OTC derivative contracts are still widely available? You don’t want to inhibit the inventiveness of these products, right?

Mr. O’Malia: Or the usefulness of them. Frankly, people use customized contracts because they have corporate needs to fulfill. That’s what their hedging needs are.


CQ&D: So is there an answer?

Mr. O’Malia: The swaps market has evolved over the past decade to effectively serve commercial businesses, among others. Whether it is an end user or a swap dealer, I’ve never had someone come in and tell me they need to find a better way to execute their transactions or that they need to find a new way to meet their unique transactional needs. To the contrary, market participants-including commercial end users-generally want to continue relying on the models they have worked hard to create and that they use on a daily basis. I do think that it is possible and beneficial to encourage the execution of swaps on trading platforms.

However, to be clear, regardless of what the new trading and clearing structures ultimately look like, hedging commercial risk will become more expensive. Trading, clearing, compliance, reporting-each imposes costs. I continue to assert that we must be measured and flexible in our rule-making process to avoid creating costs without concomitant benefits.


CQ&D: Couldn’t costs, as a result of reform, become an issue that discourages the growth of the OTC derivative markets?

Mr. O’Malia: Yes, and one of the concerns I’ve raised in a number of speeches is that we could make it too costly to clear. We don’t want people to be forced out of hedging their commercial risk; however, clearing is a good thing. We just have to make sure we don’t put it out of reach of all commercial firms.


CQ&D: Was Dodd-Frank passed too quickly and drafted in a way that is leaving regulators guessing over what lawmakers meant? I’ve heard there are debates over basic terms such as what constitutes a swap execution facility.

Mr. O’Malia: Well, Dodd-Frank is what it is. And having the experience of working on the Hill for 16 years; it’s not uncommon that Congress captures a theme or a goal, enshrines it in a statute and then leaves it up to the regulators with the expertise to ask the tough questions; to do the studies and understand the ramifications of all these statutory provisions and develop rules in a manner that they, in their best estimation, consider rational and appropriate given the congressional mandate.


CQ&D: For instance, Dodd-Frank requires you to develop position limits on OTC derivative trades…

Mr. O’Malia: There are a lot of people who have strong opinions on the impact of having position limits on a market. And I think a lot of people are going to be upset when they learn that position limits will not control prices as many had hoped. The responsibility was given to the regulators to do their homework; make sure they used their knowledge and expertise to understand the ramifications of their recommendations and the intent of Congress; then put out a variety of recommendations for public comment based on the governing statute, while being cognizant of the objectives to be achieved in the market.


CQ&D: What should exchanges and brokerages that are involved in this business do in anticipation of rules that may take years to write?

Mr. O’Malia: Undoubtedly, exchanges and brokerages are experiencing regulatory uncertainty. A published implementation and sequencing schedule, I hope, will help that; people will understand where we are going regarding implementation. Nobody wants to run afoul of the rules. They want to be in compliance. And I think that those who won’t be in compliance will find themselves in that position because they didn’t have the time to align their resources and obligations to get in compliance. In many cases, I suspect that this will largely be a technology and reporting feature.


CQ&D: And that means?

Mr. O’Malia: People will have fewer issues complying with commission deadlines if they have adequate time to make appropriate investments, including in technology, and to hire needed staff. Without complete rule-making and implementation schedules, they do not have any guidance on when they need to make these crucial business decisions.


CQ&D: Sometimes reporting has been a problem?

Mr. O’Malia: The new large swaps trader reporting requirements became effective in September. However, it became clear that we had asked for a form and format of reporting that wasn’t consistent with what we had asked for prior to the final rule, and this was confusing to the market. Market participants sought our advice and assistance, and the commission responded with temporary and conditional relief from certain requirements, so that those who were making a good-faith effort to comply with the new rules would not be penalized. I am pleased that we provided relief in a timely manner, but I can’t help but wonder whether we could have avoided this entire situation, had we designed and followed an appropriate implementation and sequencing plan.


CQ&D: F.A. Hayek, a famous philosopher and economist who wrote “The Road to Serfdom,” consistently argued that the government must strictly obey the same laws it imposes on society. Is the government obeying the law in implementing Dodd-Frank?

Mr. O’Malia: We’re pushing the bounds.


CQ&D: Do you agree with legislation that would delay the implementation of Dodd-Frank by a year and a half?

Mr. O’Malia: Congress ought to evaluate the rules that we, along with other regulators, have put out thus far, and determine for itself whether a “time-out” is needed. Right now, we have Dodd-Frank. The commission needs to focus on implementing Dodd-Frank in an appropriate manner, taking into account congressional mandates, public comments and costs and benefits.


CQ&D: Clearing is often pointed to as the way to prevent a rehash of the OTC derivatives problems of three years ago. Will more clearing prevent a repeat of the market meltdown?

Mr. O’Malia: There are a lot of features of the ’08 disaster that would have not been prevented as a result of clearing. But I do believe that clearing will help with risk management, and with encouraging the standardization of swaps. However, as I said earlier, certain end users will always need a customized swap product to hedge their commercial risks. We need to be cognizant that clearing may not work for those products. In addition to clearing, two steps are important to risk management. First, electronic trading. We need to further explore the link between clearing and electronic trading. For example, one of the questions I have asked-and received no answer to-is: Can a product have enough liquidity to be subject to mandatory clearing but not trading? That is a question that Asian regulators definitely have in mind, as my recent trip to that region proved. I am hoping the commission addresses this question in an upcoming roundtable on “made available for trading.”


CQ&D: The other feature?

Mr. O’Malia: The other feature is data reporting-giving the commission and the market more data. With data reporting, the commission-and other regulators-will have a window into swaps exposure and where systemic risk lies. That, in and of itself, will be a big improvement on ’08.


CQ&D: How do regulators determine which contracts can continue to use the bilateral, dealer-to-dealer or dealer-to-end-user model, and which ones must use clearing? Is there a rule of thumb regulators can use?

Mr. O’Malia: That’s a great question. I have been frustrated in our rule-making, and this means doing our homework on two things: One is what is clearable? We have five statutory features to direct our analysis as to what is clearable. Trading liquidity is one of them. We didn’t tell the market how we plan on using these statutory features, how they will be weighted in our decisions, etc.


CQ&D: You’re also saying that clearing is a good idea, but it also has its limitations as it relates to swap execution facilities.

Mr. O’Malia: I am saying this: Certain swaps can be mandatorily cleared. Others cannot be mandatorily cleared. We have offered the market no guidance on how we are going to distinguish between the two groups. I am further saying: Certain cleared swaps can be “made available to trade,” and therefore be subject to mandatory trading on an electronic platform. Others cannot be “made available to trade,” because the level of liquidity is insufficient. We have punted on giving the market guidance on this issue. Instead, we have permitted the SEFs to determine which swaps have been “made available to trade.” Unfortunately, SEFs have a conflict of interest, because they have no disincentive to deem every swap “available to trade.”


CQ&D: The market wants clarity here?

Mr. O’Malia: These are complicated issues for which the market is asking for guidance. Last year, I repeatedly requested roundtables on these issues. The chairman agreed at the end of last year. That’s good. But are we going to hold off on requiring mandatory clearing and trading before the commission grapples with these issues? I have received no answer to that question.


CQ&D: You want more transparency on how the commission arrives at these features?

Mr. O’Malia: The commission was not in the position to have a specific plan for conducting our analysis, so I went out with a letter to the market and said, “Will you please tell us what is clearable and the proper weighting?” I received more than a dozen letters from all sorts of market participants. We should now weigh those comments, as a commission.


CQ&D: And you asked the commission for a roundtable on what OTC derivatives contracts are clearable?

Mr. O’Malia: The chairman has agreed to do that. And that roundtable should be coming early next year.


CQ&D: How many rules will come out this rule-making process?

Mr. O’Malia: Title VII of Dodd-Frank is our mandate. I think we have put out 60 proposed rules and have finalized about 20 as of yesterday (late December). I think there will be more rules as a result of MF Global, especially on the customer segregation front. And those may or may not specifically be directed to Dodd-Frank. We’re going to change the segregation regime for swaps. Should we or can we change it for futures? Also, what about the Bankruptcy Code? Certain market participants have argued that the code may not be providing adequate protection for individual customers. Only Congress can revisit that issue. Will we make recommendations to Congress?


CQ&D: So when will these rules be finished?

Mr. O’Malia: I can’t tell you when we’re going to be done. But one of the big features will be the clearing mandate. But based on what we have done so far, I predict that we will probably have clearing among swaps dealers by the third quarter.


CQ&D: Which will add up to?

Mr. O’Malia: When all the regulatory authorities are done, there will be hundreds of individual rules, I suspect.


CQ&D: What should be done to prevent a recurrence of the segregation problems of MF Global, where huge amounts of money can’t be found?

Mr. O’Malia: Well, first of all we have to find out what went wrong with MF Global. On some of these things, there are customer protection rules, but we didn’t have the best insight into Futures Clearing Merchants (FCM) operations. The public may have had no insight into FCM operations. We didn’t have timely review of financial movements within the FCM and should probably require stricter measures. We probably need better deterrents in terms of reconsidering penalties and spot checks. We also need to expose some of the FCM practices so customers have a better idea of who their FCM is and what activities they are involved in. I put out a paper on this at my Web site.


CQ&D: Commissioner O’Malia, than you for your time and courtesy.

Mr. O’Malia: You’re welcome. Happy to do it.


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