Five Priorities for Dodd-Frank Swaps Reform

Clearing and Central Counterparties (CCPs)

The white paper calls swaps clearing “probably the most far-reaching and consequential of the swaps reforms under Dodd-Frank,” citing data that shows large increases in clearing volumes from 2010 to 2018. It identifies lingering issues in regard to protecting the viability of CCPs in three areas: 

• CCP Risk and Risk Mitigants. The white paper asserts that in order to protect CCPs against extreme scenarios, such as the risk of multiple clearing members defaulting simultaneously, there is a need to increase the liquidity of funded resources, understand correlated defaults and network effects and properly account for liquidation costs of defaulted positions.
• Recovery Plans. CFTC regulations require large and systematically important CCPs to have credible recovery plans to remain viable without resorting to government assistance. According to the white paper, although CCPs and regulators have made “substantial progress” in putting these plans in place, issues remain regarding their transparency and predictability and the role of unfunded resources (namely, assessments).
• Government Resolution. The white paper acknowledges that in the “very extreme scenario” that CCP recovery plans may prove inadequate, government resolution may be necessary. The white paper stresses that the Federal Deposit Insurance Corporation and the CFTC have much work to do to formulate government resolution plans that would guide any such government resolution. 

Swaps Reporting 

The white paper indicates that while Dodd-Frank swaps reporting requirements help regulators measure the counterparty credit risk of large financial institutions, the swaps data repositories (SDRs) are still unable to provide regulators with a complete and accurate picture of counterparty credit risk.

The white paper argues that this failure is due to faulty implementation and ineffective project management by regulators, including the CFTC. It asserts that in order to complete the process of data standardization and cross-border harmonization in swaps reporting, the CFTC must devote high-level resources to effective project management. It emphasizes that the CFTC is committed to global reform efforts in swaps data reporting and will continue the dialogue with industry participants that was started though the CFTC’s Roadmap to Achieve High Quality Swaps Data, released in July 2017.²

The white paper recommends:

• updating the requirements for SDRs and swaps counterparties to verify the accuracy and completeness of reported data
• adding requirements for SDRs to validate data as it arrives
• adopting significant changes to the SDR regulations to standardize and refine the list of required data elements
• tailoring real-time reporting requirements to the liquidity profiles of the associated swaps to increase price discovery and confidence without introducing trading risk

During the ISDA AGM discussion, the Chairman noted that the CFTC has set a path to resolve the key swap reporting issues by the end of 2019.

The white paper also discusses the use of distributed ledger technology (DLT) for trade reporting and its potential to allow the CFTC and other regulators to access swaps data directly and automatically from reporting counterparties when a swap is executed or updated on a particular blockchain. To fully realize the potential of DLT in trade reporting, the white paper asserts that the CFTC should work with other authorities to develop “regulator nodes” on distributed ledgers. 

Swaps Execution 

Not surprisingly, given Chairman Giancarlo’s past observations on this topic, the white paper is highly critical of the CFTC’s implementation of Dodd-Frank’s requirement that certain swaps be traded on regulated swaps execution facilities (SEFs). Noting that “Congress got it right, but the CFTC got it wrong” during the ISDA AMG discussion, the Chairman’s remarks were critical of the CFTC’s existing regulation of swap execution facilities. The white paper echoes this theme and argues that the CFTC’s swap trading rules “missed the mark set by Congress” and that “[t]he impact of this flawed implementation has been to fragment swaps trading into numerous artificial market segments, increase market liquidity risk, hinder swaps market technological innovation, and incentivize a significant amount of price discovery and liquidity formation to take place off-SEF rather than on-SEF.” In particular, the white paper criticizes two aspects of the CFTC’s rules: (1) implementation of prescriptive execution methods for swaps subject to the trade execution mandate, and (2) adoption of an overly narrow definition of what it means to be “made available to trade.” 

To better utilize the SEFs in line with Congress’ intent, the authors recommend the following courses of action:

• Less Prescriptive Methods of Execution. The white paper recommends a less-prescriptive approach to swaps execution rules by permitting flexible means of execution and abandoning the requirements for swaps subject to the trade execution mandate to be executed on either an order book or an “RFQ-to-3 System.” It also recommends abandoning the requirement that SEFs maintain order books for all swaps listed. The authors argue that these changes would free SEFs from allocating valuable resources currently mandated for developing and maintaining order books and would lead to the development of more efficient methods of execution. 
• Removing “Made Available to Trade” (MAT) Requirement. The white paper also proposes synchronizing the MAT requirement and the clearing requirement. The authors argue that expanding the category of swaps subject to the trade execution requirement to include all swaps that are subject to the CFTC’s clearing mandate will ultimately promote price discovery, liquidity formation and trading swaps on SEFs as well as market transparency.
• Higher Standards of Professional Conduct. The white paper recommends that focus should be placed on raising the standards of professional conduct of swaps execution through licensing, testing and the adoption and abidance of codes of professional conduct. The authors assert that trading should be encouraged to take place on licensed SEF environments requiring high professional standards.

The CFTC is expected to propose amendments to its SEF rules consistent with these recommendations within the next few months.

Swap Dealer Capital

The white paper contends that the current regulatory regime does not address risk-based capital requirements with sufficient precision. In particular, it argues that the standardized models currently in use include a number of risk biases against swaps by inappropriately relying on swap notional amount to measure risk, insufficiently recognizing the importance of netting swap positions between pairs of counterparties and inadequately acknowledging the essential role of posted margin in mitigating credit risk.³

To correct these problems, the white paper proposes two alternative solutions: (1) continue to refine (and thus complicate) the standardized prescriptive models, or (2) determine a way for regulators to rely more heavily on the internal risk models used by banks and their swap affiliates. Given the parenthetical attached to the first proposed solution, it is not surprising that the white paper indicates the second option is “most in spirit” with its recommendations. 

End User Exception

Under Dodd-Frank, various market participants are required to clear standardized swaps, and swap dealers are required to collect and post margin on uncleared swaps. Commercial end users are exempt from these requirements, as these market participants are not viewed as sources of systemic risk and clearing requirements have traditionally been viewed as being particularly costly for end users (i.e., the “end user exception”).

In its examination of the decisions made by the CFTC and other regulators, the white paper asserts that there are several improvements that can be made to the framework for the end user exception to better balance the costs of hedging and the objective of systemic risk mitigation. The white paper recommends:

• codifying existing no-action relief from clearing requirements that the CFTC provides to small bank holding companies and savings and loan holding companies and considering incremental regulatory changes to further reduce the burdens on this category of market participant
• amending the “material swaps exposure” threshold, below which entities are excepted from initial margin requirements, to be measured in more meaningful units than notional amounts to better determine those end users who are not sources of systemic risk
• applying the material swaps exposure threshold against both variation margin requirements and clearing requirements
• reconsidering how the CFTC interprets the definition of a “financial entity” in order to bring additional clarity and relief to a variety of end users, including treasury affiliates, certain types of special purpose vehicles and some energy firms
• reworking the rules governing initial margin calculations for uncleared swaps to make them less prescriptive and unbiased with respect to cleared and uncleared products

The white paper does not recommend a timetable for implementing reforms to the CFTC’s swaps regulatory rules. However, during the ISDA AGM discussion, the Chairman noted that he is committed to a “ready, aim, fire” approach to getting the updated swap rules implemented rather than the “ready, fire, aim” approach taken by his predecessors, which resulted in hundreds of no-action letters clarifying positions taken in regulations that didn’t reflect current markets or commercial realities. Given the focus on getting the swap rule revisions right the first time, and the Chairman’s articulated desire for a vibrant economic market that isn’t altered by unnecessary regulations, the actual implementation of the reforms may take a while. The actual timing may be influenced by the fact that the Chairman’s current term expires in April 2019, although he has indicated his intention to remain at the CFTC until his replacement is nominated and confirmed.

The white paper is available here. 

¹ Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 721- 774, 124 Stat. 1641, 1641-1807.

² The CFTC’s Roadmap to Achieve High Quality Swaps Data can be found here.

³ Certain of these issues were recently addressed in a paper co-authored by several CFTC economists entitled “Introducing ENNs: A Measure of the Size of Interest Rate Swaps Markets,” available here.