CFTC Commissioner Brian Quintenz expressed concern that post-crisis reforms were not appropriately tailored to address market-specific risks. As a result, he said, regulators are disincentivizing activity that is necessary for healthy, efficient markets.
In remarks at the Structured Finance Industry Group Vegas Conference, Mr. Quintenz called for regulators to make a better effort to tailor such rules to true market risks, arguing that "we now have a second chance to get these financial capital rules and economic incentives aligned." He addressed three areas of concern involving current and past reform efforts: (i) swap dealer capital requirements, (ii) the supplementary leverage ratio ("SLR"), and (iii) margin requirements for uncleared swaps. Given the CFTC's expertise in derivatives market regulation, the agency will need to act to educate other regulators and find solutions when regulations have an outsized negative impact on derivatives markets, he said.
Swap Dealer Capital
The Commissioner warned that it is "critically important" that the CFTC finalize a capital rule that is "appropriately calibrated to the true risks" of a swap-dealing business. He said that capital costs imposed by regulators upon swap dealers ("SDs") can act as barriers to entry or spur SDs to leave the market or scale back activity: "For some firms, capital costs may be the most determinative factor in their decision to remain, or become, swap dealers. If capital costs are too expensive, firms will leave the market or reduce their activity under the registration requirement. As a result, the swaps markets over time will become less liquid, more heavily concentrated, and less competitive."
Mr. Quintenz said that he generally supports the CFTC approach in its December 2016 proposal. He cited the proposal's deference to capital regimes of other domestic and foreign regulators as a positive, but cautioned that this approach can be rendered ineffective when other regulators employ outdated or improperly calibrated regimes. He called for the CFTC to act as a "thought leader" and develop a new, alternative methodology for calculating derivatives exposures that reflects actual risk.
Supplementary Leverage Ratio
Mr. Quintenz criticized the SLR, saying that the risk-neutral approach incentivizes banks to hold higher-risk assets at the expense of lower-risk assets with lower returns. He argued that the SLR acts as a detriment to clearing and custody services that are essential to futures and swaps markets. Further, he said that the SLR should not treat segregated customer margin as an exposure of a bank that is a clearing member, thus forcing the bank to hold capital against customer collateral that it is holding in case of a customer's default. Mr. Quintenz asserted that this methodology ignores the fact that segregated margin is always used to absorb client losses before a central counterparty expects a clearing member to absorb residual losses. He expressed hope that the CFTC will be able to work with other regulators to revise the SLR to stop disincentivizing clearing services and more accurately reflect margin's purpose.
Margin for Uncleared Swaps
Mr. Quintenz criticized the ten-day liquidation period that swap dealers must use in calculating initial margin requirements for uncleared swaps (see CFTC Rule 23.154(b)(2)), saying that "there does not appear to be any empirical evidence to justify the selection of a ten-day window." The current rules, he said, drive up the price of uncleared swaps and force companies to fulfill their hedging needs with products that are either too expensive or not appropriately aligned with their hedging needs. Mr. Quintenz encouraged the CFTC to evaluate actual data and revisit the ten-day liquidation period, and perhaps consider a tailored approach based on asset class or common product types.
Commentary / Nihal Patel
Mr. Quintenz's suggestions for changes are straightforward, but his tone is quietly radical. On each of these three topics, Mr. Quintenz is suggesting that the CFTC may need to take actions that are different from the approaches taken by other domestic and foreign regulators. Two of the three issues addressed by Mr. Quintenz (capital and margin) are areas where the CFTC and the banking regulators share jurisdiction, and the third is an issue fully in control of the banking regulators.
Mr. Quintenz did not advocate that the CFTC must go it alone, and he recognized that there are costs to unilateral regulatory changes. His comments are clearly intended to urge bank regulators to be open to changes where, in Mr. Quintenz's view, their actions are harming derivatives market participants.
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