Source: Hester Peirce and Benjamin Klutsey, eds., Reframing Financial Regulation: Enhancing Stability and Protecting Consumers. Arlington, VA: Mercatus Center at George Mason University, 2016. CHAPTER 7 Reconsidering the Dodd- Frank Swaps Trading Regulatory Framework HON. J. CHRISTOPHER GIANCARLO* Commissioner, US Commodity F utures Trading Commission Though t here were a number of f actors said to have contributed to the financial crisis of 2008,1 many contend that bilaterally executed over- the- counter (OTC) swaps amplified and spread the crisis.2 In response, the US Congress enacted the Dodd-F rank Wall Street Reform and Consumer Protection Act (Dodd-F rank),3 which imposed a new regulatory framework for the OTC swaps market. One of Dodd- Frank’s major reforms is a requirement that counterparties execute most clearing-m andate swaps on regulated trad- ing platforms— that is, swap execution facilities (SEFs)4 or designated con- tract markets (DCMs).5 In enacting this reform, Congress put forth a fairly simple and flexible swaps trading framework suited to the episodic nature of swaps liquidity. This chapter analyzes the flaws in the implementation by the US Commodity Futures Trading Commission (CFTC) of the swaps trading regulatory frame- *The views expressed in this chapter reflect the views of the author and do not necessarily reflect the views of the US Commodity Futures Trading Commission (CFTC), other CFTC commissioners, or CFTC staff. This chapter is drawn from the author’s White Paper, dated January 29, 2015, entitled: “Pro- Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-F rank.” 155 dodd- Frank sWaPs trading FraMeWork work u nder Title VII of Dodd-F rank and proposes a more effective alterna- tive.6 It asserts that there is a fundamental mismatch between the CFTC’s swaps trading regulatory framework and the distinct liquidity and trading dynamics of the global swaps market. It explains that the CFTC’s framework is highly overengineered, disproportionately modeled on the US futures market, and biased against both h uman discretion and technological innovation. As such, the CFTC’s framework does not accord with the letter or spirit of Title VII of Dodd- Frank. The CFTC’s flawed swaps trading rules are triggering numerous adverse consequences, foremost of which is driving global market participants away from transacting with entities subject to CFTC swaps regulation, resulting in fragmented global swaps markets. The rules have also carved swaps trading into numerous artificial market segments, fragmenting markets domestically. This fragmentation has exacerbated the already inherent challenge in swaps trading— adequate liquidity— and thus is increasing market fragility and the systemic risk that Dodd- Frank reforms were predicated on reducing. The alternative regulatory framework outlined in this chapter is pro- reform. It is comprehensive in scope and more flexible in application. This alternative focuses on raising standards of professional conduct for swaps market person- nel rather than dictating prescriptive and ill-s uited trading rules. It provides flexibility so that market participants can choose the manner of trade execu- tion best suited to their swaps trading and liquidity needs. It better aligns regulatory oversight with inherent swaps market dynamics. Crucially, the alternative framework fully aligns with Title VII of Dodd-F rank to promote swaps trading under CFTC regulation and attract, rather than repel, global capital to US trading markets. The alternative approach seeks to lessen the market fragility and fragmentation that have arisen as a consequence of the CFTC’s flawed swaps trading regime. THE DODD- FRANK SWAPS TRADING REGULATORY FRAMEWORK Title VII of Dodd- Frank requires execution of most clearing- mandate swaps on DCMs or SEFs via a straightforward trade execution requirement.7 Congress expressly permitted SEFs to offer vari ous flexible execution meth- ods for swaps transactions using “any means of interstate commerce.” The law defines a SEF as a “trading system or platform in which multiple participants 156 Hon. j. cHristoPHer giancarlo have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the fac ili ty or system, through any means of interstate commerce, including any trading fa cil i ty, that—(A) facilitates the execution of swaps between persons; and (B) is not a designated contract market.”8 Despite continuing assertions to the contrary from some observers, Congress did not require SEFs to provide electronic execution. Additionally, Congress articulated goals, not requirements, for this SEF framework in order to maintain its flexibility. Congress set two goals for SEFs in Title VII of Dodd- Frank: to promote (1) the trading of swaps on SEFs and (2) pre- trade price transparency in the swaps market.9 Congress did not prescribe that the global swaps market be carved into an isolated US domestic market and then further sliced and diced into smaller and smaller domestic markets for swaps trading.10 Congress mandated “impartial” access to swaps markets rather than “open” access. It did not require SEFs to merge dealer-t o- client and dealer-t o- dealer market segments.11 Indeed, in providing that a SEF must establish rules to provide market participants with impartial access to the market, Dodd-F rank requires a SEF to set out any limitation on this access.12 This requirement confirms that Dodd-F rank does not demand that all market participants receive access to every market. There is no mandate or impetus for an all- to- all swaps market structure in Dodd- Frank. Congress further laid out a core princi ples- based framework for SEFs and provided them with reasonable discretion to comply with these princi ples.13 In short, Congress left it up to individual SEFs, not regulators, to choose their own business model based on their customer needs. In crafting Title VII of Dodd-F rank, Congress got much of it right.14 Unfortunately, the CFTC’s implementation of the swaps trading rules widely misses the congressional mark. THE CFTC’S FLAWED SWAPS TRADING REGULATORY FRAMEWORK In response to po liti cal pressure to hurry the implementation of Dodd-F rank and likely influenced by the naïve view that centralized order- driven markets are the best way to execute all derivatives transactions, the CFTC acted expe- diently and modeled its swaps trading rules on the well- known and readily available regulatory template of the US futures market. Unfortunately, that 157 dodd- Frank sWaPs trading FraMeWork framework is mismatched to the natur al commercial workings of the global swaps market. It is a square peg being forced into a round hole. In adopting this framework, the CFTC failed to properly respond to congressional intent and Dodd- Frank’s express goal of promoting swaps trading on SEFs.15 Limits on Methods of Execution The SEF rules create two categories of swaps transactions, Required Transactions (i.e., any transaction involving a swap that is subject to the trade execution requirement)16 and Permitted Transactions (i.e., any transaction not involving a swap that is subject to the trade execution requirement),17 and prescribe execu- tion methods for each category.18 Required Transactions must be executed in an order book (Order Book)19 or a Request for Quote (RFQ) System in which a request for a quote is sent to three participants operating in conjunction with an Order Book (RFQ System).20 Any method of execution is allowed for Permitted Transactions,21 but SEFs must also offer an Order Book for such transactions.22 There is no firm statutory support for segmenting swaps into two catego- ries or for limiting one of t hose categories to two methods of execution. A footnote to the preamble of the final SEF rules justifies this segmentation by stating that Commodity Exchange Act (CEA) section 2(h)(8) “sets out spe- cific trading requirements for swaps that are subject to the trade execution mandate . . . [and] [t]o meet these statutory requirements, [the SEF rule] defines these swaps as Required Transactions and provides specific methods of execution for such swaps.”23 The only t hing that CEA section 2(h)(8) expressly requires, however, is that swaps subject to the trade execution require- ment must be executed on a SEF or DCM.24 The statute nowhere references the concept of Required Transactions with limited execution methods and Permitted Transactions via any method of execution. These artificial cat- egories unnecessarily complicate Congress’s s imple and flexible swaps trad- ing framework. Rather, Dodd- Frank’s SEF definition contemplates a platform where mul- tiple participants have the ability to execute swaps with multiple participants through any means of interstate commerce, including a trading fa cil i ty.25 Congress clearly drafted this broad and flexible definition to allow execu- tion methods beyond an Order Book or RFQ System for all swaps, not just some swaps. Dodd- Frank also permits SEFs to offer swaps trading “through 158 Hon. j. cHristoPHer giancarlo any means of interstate commerce.” The phrase “interstate commerce” has a rich constitutional history, which US federal courts have interpreted to cover almost an unlimited range of commercial and technological enterprise.26 The CFTC rule construct is not supported by the plain language of the statute and expresses a bias for two specific execution methods over all o thers: one drawn from the all-t o- all US futures markets and one that is generally one-t o- many, not multiple- to- multiple. The CFTC’s limited execution method approach also does not comport with the way swaps actually trade in global markets. Trillions of dollars of swaps trade globally each day through a variety of execution methods designed to better account for their episodic liquidity. A swap product’s par tic u lar liquidity characteristics determine the execution technology and methodol- ogy, which can change over time. This liquidity continuum necessitates flexible execution methods as rightly authorized by Dodd-F rank. CFTC swaps trading rules, however, thwart trade execution flexibility and limit needed human discretion.27 By requiring SEFs to offer Order Books for all swaps, even very illiquid or bespoke swaps,28 the rules embody the uninformed and parochial view that centralized order- driven markets, like those in the US futures markets, are the best way to execute transactions for swaps. That flawed view is not reflective of global swaps market reali ty. The unique nature of swaps trading liquidity should drive execution methods, not the other way around. Block Transactions: “Occurs Away” from SEF The CFTC block trade definition— specifically, the “occurs away” requirement— is another example of artificial segmentation like the contrived distinction between Required Transactions and Permitted Transactions. A “block trade” is generally a transaction between two institutional traders for a large amount of the same product. Most or ga nized trading markets delay public reporting of block trades so that the counterparties can complete the transaction and any associated hedging without the market moving against them. A block trade is defined by the CFTC as “a publicly reportable swap transaction that: (1) Involves a swap that is listed on a registered [SEF] or [DCM]; (2) ‘Occurs away’ from the registered [SEF’s] or [DCM’s] trading system or platform and is executed pursuant to the registered [SEF’s] or [DCM’s] rules and procedures; 159 dodd- Frank sWaPs trading FraMeWork (3) Has a notional or principal amount at or above the appropriate minimum block size applicable to such swap; and (4) Is reported subject to the rules. . . .”29 It is unclear what is being achieved by the CFTC in requiring block trades to be executed away from the SEF’s trading platform. The “occurs away” requirement creates an arbitrary and confusing segmentation between non- block trades “on- SEF” and block trades “off- SEF,” especially given that a SEF may offer any method of execution for Permitted Transactions. The off- SEF requirement also undermines the legislative goal of encouraging swaps trad- ing on SEFs. The block trade definition is a holdover from the f utures model.30 In futures markets, block trades occur away from the DCM’s trading fa cil i ty as an excep- tion to the centralized market requirement.31 In t oday’s global swaps market, however, there are no on- platform and off- platform execution distinctions for certain- sized swaps trades. OTC swaps generally trade in very large sizes. These swaps are not constrained to Central Limit Order Books (CLOBs), but trade through one of a variety of execution methods appropriate to the prod- uct’s trading liquidity. Congress recognized t hese differences by not imposing on SEFs an open and competitive centralized market requirement with corresponding excep- tions for certain noncompetitive trades as contained in DCM Core Princi- ple 9.32 Congress knew that counterparties executed swaps on flexible trading platforms in very large sizes. Rather, Congress expressly authorized delayed reporting for block transactions.33 Congress got it right. The CFTC got it wrong. Its swaps block trade definition is inappropriate and unwarranted. Unsupported “Made Available to Trade” Pro cess Congress included a trade execution requirement in CEA section 2(h)(8) that requires SEF34 execution for swaps subject to the clearing mandate.35 In a simple exception to this requirement, Congress stated that this trade execution requirement does not apply if no SEF “makes the swap available to trade.”36 Rather than follow Congress’s simple direction, the CFTC created an unnecessary regulatory mandate, referred to as the “made available to trade” (MAT) pro cess, in order to identify those swaps subject to SEF execution.37 Under this platform- controlled MAT pro cess, a SEF submits a MAT deter- mination for swaps products to the Commission pursuant to part 40 of the 160 Hon. j. cHristoPHer giancarlo CFTC’s regulations after considering, as appropriate, certain liquidity factors for such swaps.38 The CFTC reviews the SEF’s determination, but may only deny the submission if it is inconsistent with the CEA or CFTC regulations.39 Once made available to trade, these swaps are Required Transactions and counterparties must execute them on a SEF pursuant to the limited execution methods permitted by CFTC rules.40 A plain reading of the trade execution requirement demonstrates that Congress did not intend to create an entire regulatory mandate around the phrase “made available to trade.” Unlike the clearing mandate in CEA sec- tion 2(h)(1), Congress provided no pro cess in CEA section 2(h)(8) for deter- mining which swaps must be traded on- SEF.41 Congress could have instituted a regulatory mandate for the trade execution requirement as it did for the clearing mandate, but chose not to.42 Congressional draft ers of Title VII w ere aware that, unlike f utures, newly developed swaps products are initially traded bilaterally and only move to a platform once trading reaches a critical stage. The trade exe- cution requirement expresses this logic by requiring that a clearing-m andated swap must be executed on a SEF unless no SEF makes that swap available to trade (i.e., offers the swap for trading). Unfortunately, however, congressional intent was not followed and an entire regulatory mandate was created based on nothing more than the phrase “makes the swap available to trade.” Beyond Impartial Access Congress required SEFs to have rules to provide market participants with impartial access to the market and to establish rules regarding any limitation on access.43 The Commission, through the preamble to the final SEF rules, and staff appear to view t hese provisions as requiring SEFs to serve e very type of market participant in an all-t o-a ll market structure.44 Given Dodd-F rank’s ref- erence to limitations on access, however, efforts to require SEFs to serve e very type of market participant or to operate all- to- all marketplaces are unsup- ported by law. There is no mandate for an all- to- all swaps market structure in Dodd- Frank. Congress knew that there were dealer- to- customer and dealer- to- dealer swaps markets before Dodd- Frank, just as there are in many other mature finan- cial markets.45 This structure is driven by the unique liquidity characteristics of the under lying swaps products.46 This dynamic has not changed post–D odd- 161 dodd- Frank sWaPs trading FraMeWork Frank, and the law’s impartial access provisions do not require or support the alteration of the pres ent swaps market structure.47 Dodd-F rank does not prohibit SEFs from serving separate dealer- to- dealer and dealer-t o-c ustomer markets. Its impartial access requirement must not be confused with open access.48 Impartial access, as the Commission noted in the preamble to the final SEF rules, means “fair, unbiased, and unpreju- diced” access.49 This means that SEFs should apply this impor tant standard to their participants; it does not mean that SEFs are forced to serve every type of market participant in an all- to- all futures- style marketplace. Congress could have imposed this mandate, but it chose not to do so. Even the Commission acknowledged in the preamble to the final SEF rules that a SEF may oper- ate diff er ent markets and may establish diff er ent access criteria for each of its markets.50 This preamble language and the statutory language regarding “any limitation on access” are meaningless if CFTC staff act u nder the supposition that SEFs are required to operate business models with the capacity to serve every type of market participant. Unwarranted Void Ab Initio The staffs of the Division of Clearing and Risk and the Division of Market Oversight (the Divisions) issued guidance that states that “any [swap] trade that is executed on a SEF . . . and that is not accepted for clearing should be void ab initio” (i.e., invalid from the beginning).51 The guidance also states that this result is consistent with CEA section 22(a)(4)(B), which prohibits partici- pants in a swap from voiding a trade, but does not prohibit the Commission or a SEF from declaring a trade to be void.52 The statute does not support the Divisions’ justification for this policy. Although CEA section 22(a)(4)(B) does not prohibit the Commission or a SEF from voiding a trade, it does not require this outcome if a trade is rejected from clearing.53 This section also does not prevent a SEF from implementing rules that allow a participant to correct errors and resubmit a trade for clearing.54 The CFTC staff’s void ab initio policy creates a competitive disadvantage for the US swaps market relative to the US f utures market. Th ere are legiti- mate reasons, such as operational or clerical errors, that cause swaps trades to be rejected from clearing. In the f utures market, DCMs have implemented rules to address the situation where an executed futures transaction is rejected 162 Hon. j. cHristoPHer giancarlo from clearing.55 Furthermore, the void ab initio policy introduces additional risk into the system. For example, after a participant executes a swap, the par- ticipant enters into a series of other swaps to hedge its risk. If the first swap is declared void ab initio and there is no opportunity to resubmit the trade, then the participant will not be correctly hedged, which creates additional market and execution risk. Expansive Scope for Uncleared Swaps Confirmations Under CFTC rules, a SEF is required to provide “each counterparty to a trans- action . . . w ith a written reco rd of all of the terms of the transaction which shall legally supersede any previous agreement and serve as a confirmation of the transaction.”56 Additionally, responding to public comments about a SEF’s confirmation for uncleared swaps, footnote 195 to the preamble of the final SEF rules states, in part, that “[t]h ere is no reason why a SEF’s written confir- mation terms cannot incorporate by reference the privately negotiated terms of a freestanding master agreement . . . p rovided that the master agreement is submitted to the SEF ahead of execution . . .”57 The CFTC’s approach to SEF confirmations is taken from the f utures model. DCMs own their f utures contracts and control the products’ standardized terms. SEFs, however, do not own swaps products. The products’ terms are akin to an open-s ource design that sell-s ide dealers created with their buy-s ide customers. Additionally, swaps market participants have long relied on master agreements that govern the overall trading relationship between counterpar- ties. These master agreements set out the nontransaction- specific credit and operational terms that apply to all transactions entered into under them. As a result, SEFs do not know or have access to all of a swap’s terms and corre- sponding documentation. This paradigm has not changed post–D odd- Frank for uncleared swaps transactions. Importantly, a master agreement and a confirmation serve diff er ent purposes and should be thought of as diff er ent documents. The CFTC swap documenta- tion rules recognize the importance and distinct purposes of these documents.58 The rules define a master agreement as including “all terms governing the trading relationship between the [parties]”59 and a swap confirmation as docu- mentation that “memorializes the agreement of the counterparties to all of the terms of the swap transaction.”60 The two are as alike as apples and oranges. 163 dodd- Frank sWaPs trading FraMeWork The burden of requiring a SEF to confirm and report “all of the terms” of a trading relationship to which it is not a party is significant. Absent reconsideration, the SEF confirmation requirements will continue to be an obstacle for the trading of uncleared swaps on SEFs. Embargo Rule and Name Give- Up Under the embargo rule, a SEF may not disclose swap transaction and pric- ing data to its market participants until it transmits such data to a swap data repository (SDR) for public dissemination.61 To effect such SDR transmission, a SEF must first enrich and convert such transaction data as required by the SDR. Alternatively, the SEF may choose to use a third- party provider to trans- mit data to an SDR. Only then can the SEF disclose swap transaction data to market participants on its trading platform. The embargo rule causes delays in transaction and data disclosure that inhibit the long-e stablished “workup” pro cess, whereby counterparties buy or sell additional quantities of a swap immediately a fter its execution on the SEF at a price matching that of the original trade.62 The workup pro cess may increase wholesale trading liquidity in certain OTC swaps by as much as 50  percent.63 This rule has hindered US markets from continuing a well- established and crucial global trading mechanism. The effect of the embargo rule appears to prioritize public transparency—in a market that is closed to the general public64—at the expense of transparency for a ctual participants in the marketplace. It is difficult to justify this unbalanced restraint on swaps liquidity.65 Similarly, name give-up is a long- standing market practice in many swaps markets. With name give-up, the identities of the counterparties are disclosed to each other after they have been anonymously matched by a plat- form.66 The origins of the practice lie in w holesale markets for self- cleared swaps and other products. There, counterparties to large transactions use name give-up to confirm the creditworthiness of their counterparties. In markets with central counterparty (CCP) clearing of swaps, however, the rationale for name give-up is less clear cut. That is b ecause the CCP and not the trading counterparty bears the credit obligations. Counterparties to CCP- cleared swaps primarily need assurance of each other’s relation to the CCP and not the opposing counterparty’s individual credit standing. 164