In a new white paper, the derivatives trade association FIA argues that although derivatives reforms under the Dodd-Frank Act have made derivatives markets safer in some ways, they have also brought unintended consequences and costs. In its "Roadmap to Smarter Regulation & Healthier Markets," FIA urges a number of regulatory changes to return markets to a pathway of health, competition and innovation, including amending requirements relating to leverage-based capital, position limits, reporting and recordkeeping. FIA also recommends scrapping proposed rules on automated trading and modifying CFTC authorities and procedures, including restoring exemptive authority restricted by Dodd-Frank.
Market stagnation. According to FIA, the use of exchange-traded derivatives expanded rapidly in the three decades leading up to the financial crisis, boosted by the advent of electronic trading and a regulatory environment that allowed cross-border trading to thrive. From 2002 to 2008, the amount of customer margin for commodity futures grew by an average of 22 percent per year. But margin levels have not returned to their pre-crisis peak, and the flow of customer funds into exchange-traded futures has been at a standstill for nearly a decade, said FIA.
Compounding the stagnation, firms that clear trades have become more concentrated, leading to reduced access and choice for end users. FIA noted that the number of futures commission merchants (FCMs) that clear futures has dropped nearly in half since 2002, falling from 106 to 54. Some major banks have also exited the swaps clearing business, frustrating the regulatory goal of getting more derivatives into clearing.
Recommendations for market reform. To simplify the derivatives regulatory framework and promote growth while still protecting market integrity, FIA recommends specific changes in several areas:
- Eliminate the leverage ratio’s punitive effect on clearing. According to FIA, a leverage ratio in Basel Committee bank capital requirements is undercutting regulators’ efforts to encourage derivatives clearing, and could even increase systemic risk by concentrating risk in a small number of clearing members. FIA recommends actions by the Financial Stability Oversight Council (FSOC) and U.S. prudential regulators, including amendments to create an offset for client margin received as part of a centrally cleared derivative transaction.
- Improve end user access to risk transfer markets. FIA recommends various changes to improve market access for end users, including: (1) Re-propose position limit rules to expand bona fide hedging exemptions, restore a risk management exemption for all market participants, remove the "economically appropriate" test, and abandon efforts to impose limits beyond the spot month; (2) Provide certainty about the de minimis threshold for swap dealer registration by confirming the threshold will remain at $8 billion; and (3) Review the swaps trading regulatory framework to ensure end users have choice in the execution of their swaps trades.
- Simplify reporting rules. To avoid regulatory duplication and overbreadth, the CFTC should holistically review its recordkeeping and reporting rules and work with the SEC and international regulators to harmonize reporting requirements. The CFTC should use special calls only for unique, time-limited circumstances, not as a substitute for regular, ongoing reporting.
- Avoid market fragmentation. To preserve cross-border flows of capital and avoid duplicative regulation, the CFTC should develop a recognition regime for non-U.S. derivatives clearing organizations (DCOs), and for swap execution facilities (SEFs) when trading swaps on non-U.S. platforms.
- Scrap proposed rules on automated trading. The FIA believes the CFTC should withdraw proposed Regulation Automated Trading (AT). Any rules deemed necessary should be principles-based, and algorithmic source code should only be available to the CFTC through the existing subpoena process. The CFTC should avoid duplicative regulation of automated trading by allowing SROs to function as "front-line regulators."
CFTC process changes. The FIA recommends a number of changes to make CFTC policies and processes more transparent, clear, and fair:
- Modernize the regulatory toolbox. Congress should give the CFTC greater exemptive authority by restoring Commodity Exchange Act Section 4(c) to its original authority prior to the Dodd-Frank Act, said FIA. The CFTC should issue public guidance on its use of economic analysis in the rulemaking process to clarify what factors it considers, and the Office of the Chief Economist should sign off on the cost-benefit analysis for any rule. The CFTC should revisit staff interpretations that have materially amended regulations in a way that is causing market confusion and compliance challenges.
- Avoid regulating by enforcement. FIA urged the CFTC to take steps to avoid creating rules and interpretations through selective enforcement, including: (1) Require notice to subjects of investigations that the Commission has decided not to proceed; (2) Grant the subjects of enforcement matters the right to appear before the Commissioners or their staff; (3) Create an Enforcement Ombudsman; (4) Publish the Enforcement Manual; and (5) Provide a party against whom an administrative action has been brought the right to remove the matter to Federal Court.
The FIA believes the above steps would make the regulatory framework smarter and simpler without jeopardizing the safety and stability of the derivatives markets. The FIA said it will continue to engage on these issues with the Administration, Congress and industry stakeholders.
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