Monday, December 3, 2012

The Transparent Future of Swaps Markets

CFTC Chairman, Gary Gensler, says he believes that the days of the opaque swaps market are ending and a new era of transparency and commonsense rules of the road is on the horizon. Gensler's October 10, 2012 address before the George Washington University Center for Law, Economics and Finance Conference provides some insights into how Mr. Gensler and his agency are paving the way for this new era. For starters, regulation of the swaps markets is now catching up to the great financial market reforms of the 1930s, such as public reporting of transactions, central exchange trading, and regulation of dealers. According to Gensler, these new Dodd-Frank regulations are implementing the same kinds of protections that have worked for decades in the securities and futures markets, bringing transparency to and lowering the risk of the swaps market. Mr. Gensler believes applying these time-tested tenants of risk management to swaps markets, and shining a bright light on its activities and players, is the best way to protect investors.


Bright lights will begin to shine on the swaps market. Transparency lowers costs for investors, consumers and businesses. It increases liquidity, efficiency and competition. And it shifts some of the information advantage from Wall Street banks to businesses across the country that use these markets to lock in a price or rate and hedge a risk.

By the New Year, we will have achieved real-time public reporting and reporting to swap data repositories (SDRs) of interest rate and credit default swap (CDS) indices. Reporting for energy and other physical commodity swaps begins shortly thereafter.

Regulators and the public will have their first full window into the swaps marketplace.

Regulating Dealers
[S]wap dealers begin the process of registering and, for the first time, will come under comprehensive regulation to lower their risk to other market participants and the economy. Once registered, swap dealers will implement crucial back office standards that lower risk and increase efficiency. Swap dealers also will be required to implement sales practices that prohibit fraud, treat costumers fairly, and improve transparency.
The Commission has made significant progress on bringing swaps into central clearing, which will lower the risk of the highly interconnected financial system. For over a century, through good times and bad, central clearing in the futures market has lowered risk to the broader public. 
Dodd-Frank financial reform brings this effective model to the swaps market. Clearing is particularly critical given the current economic uncertainty in Europe and recent ratings downgrades of many of the world’s leading banks.
Based on completed rules, clearinghouses are adopting risk management reforms that will be implemented by November 8. 
Among these are customer protection enhancements that require clearinghouses to collect margin on a gross basis and the so-called “LSOC rule” (legal segregation with operational comingling) for swaps. This rule prevents clearing organizations from using the collateral attributable to cleared swaps customers who haven't defaulted to cover losses of defaulting customers.
Future Regulation

The CFTC is not yet finished reforming swaps market regulation, however.  Gensler says that further enhancements are already in the works.  

First, the initial set of clearing determinations may be finalized as early as next month. This would lead to required clearing by swap dealers and the largest hedge funds as early as February. Compliance would be phased in for other market participants through the summer of 2013. 
Second, the CFTC is looking to finalize later this fall a set of rules promoting further transparency for the swaps marketplace. This includes rules on minimum block sizes, as well as for trading platforms called swap execution facilities. 
And third, the CFTC is working on final guidance on the cross-border application of Dodd-Frank swaps market reform. This guidance is critical because swaps executed offshore by U.S. financial institutions can send risk straight back to our shores. This happened with the London and Cayman Islands affiliates of AIG, Lehman Brothers, Citigroup, Bear Stearns and Long-Term Capital Management. Earlier this year, it happened again when JPMorgan Chase executed swaps through its London branch.

The CFTC is sensitive to how the timing of implementation of these reforms can affect market participants, Gensler says.  The agency has phased in the effective and compliance dates of the various reforms, and listened closely to market participants about the best timing for new regulations.

The CFTC also has worked to appropriately phase in compliance. We reached out broadly on the topic of appropriate timing for various market participants to comply with reforms. We put out a concepts document guide for commenters, held a two-day public roundtable with the SEC, and proposed rules on implementation phasing. The Commission has included phased compliance schedules within many of our rules, including data, real-time reporting and the recent guidance on cross-border application of swaps market reform.