Commodity Futures Trading Commission Chairman J. Christopher Giancarlo is trying to set the stage for what he describes as a “regulatory reform 2.0” agenda.

To that cause, he has released a new white paper, “Swaps Regulation Version 2.0: An Assessment of the Current Implementation of Reform and Proposals for Next Steps.” The paper, co-authored with CFTC Chief Economist Bruce Tuckman, was released at the International Swaps and Derivatives Association’s annual meeting on April 26.

In response to questions about the timeline of implementation of the ideas in the paper, Giancarlo said: “I’m committed to a process in rule writing which is ‘ready, aim, fire.’ I think sometimes, regulators can use the ‘ready, fire, aim’ approach. I’m committed to a deliberative process and getting back to regular order at the agency. We’re not in the wake of a crisis right now, [so] we need to take the time to get this right. We have an ambitious timetable, and we will get this done, but we will do this right.”

The paper utilizes a range of academic research, market activity, and the agency’s regulatory experience with implementing current swaps reform, to assess the CFTC’s implementation of swaps reform, determine its strengths and deficiencies, and recommend improvements to the current swaps market reform framework.

Giancarlo and Tuckman say that a goal is to optimize the CFTC’s implementation of the Dodd-Frank Act “to strike a balance between systemic safety and stability and market vibrancy and economic growth.”

In the paper, they explain that financial regulators have a duty to review past policy applications continuously to confirm they remain improved for the purposes intended. Reviews should anticipate changing market dynamics and the impact of technological innovation.

The white paper takes a comprehensive look at five key areas.

Swaps central counterparties (CCPs)

Swaps clearing is probably the most far-reaching and consequential of the swaps reforms adopted under Title VII of the Dodd-Frank Act.

The CFTC implementation of Dodd-Frank’s clearing mandate “has been highly successful, significantly increasing the volume of swaps cleared by CCPs,” the paper says. “CCPs and the CFTC have made substantial progress to ensure that CCPs are safe and sound under extreme but plausible scenarios and have credible recovery plans to remain viable without government assistance.”

The authors conclude, however, that continued vigilance and improvement are essential with respect to ensuring the liquidity of prefunded resources; understanding network effects; estimating the liquidation costs of defaulted positions; and enhancing the transparency and predictability of recovery plans.

The Federal Deposit Insurance Corporation and CFTC “have much to do in formulating resolution plans, which would guide government intervention in the most dire of eventualities,” the paper adds.

Swaps reporting rules

Swaps data reporting was “an important mandate to assist regulators in measuring the counterparty credit risk of swaps by large financial institutions,” Giancarlo and Tuckman wrote, adding that 10 years after the Financial Crisis, the reporting structure is still incomplete. The initial implementation was “flawed and ineffective, providing insufficient technical specificity.”

Since then, the CFTC has laid out a more detailed and clear path forward under its July 2017 “Roadmap to Achieve High Quality Swaps Data.”

“Real-time reporting requirements should be tailored to the liquidity profiles of the associated swaps products to yield value of transparency to market (price discovery, confidence) without introducing trading risk,” the paper says, adding that the CFTC should look to collaborate with other authorities to cultivate the development of “regulator nodes” on distributed ledgers.

Swaps execution rules

Congress enacted the G-20 swaps execution reforms by requiring that swaps transactions be traded on regulated platforms called swap execution facilities and executed by “any means of interstate commerce.”

The CFTC incorrectly implemented the execution mandate by arbitrarily confining swaps execution to two methodologies and adopting trading rules from highly liquid futures markets, the wrong model for swaps that trade in more episodically liquid markets, the authors conclude. The adverse consequences of restrictive execution methods included the global fragmentation of swaps markets and pushing swaps liquidity formation and price discovery away from the SEF platforms, contrary to Congressional intent.

The CFTC could encourage a greater amount of swaps trades to take place on regulated SEFs by making the “Made Available to Trade” requirement synonymous with the clearing requirement, the paper suggests. Instead of trying to determine SEFs’ swaps execution business model, the CFTC should focus on raising standards of conduct for swaps trading.

Swap dealer capital

Several components of today’s bank capital regime overestimate the risks of swaps, the paper says. Conceptual problems are relying on swap notional amount to measure risk; failing to sufficiently recognize offsetting swap positions; and failing to sufficiently acknowledge the risk mitigation of posted margin.

“These problems can be addressed by iterating, and likely complicating, prescriptive models,” the authors write. “Alternatively, regulators might focus on how to rely more heavily but confidently on the internal risk models used by banks and their swap affiliates.”

End-user exception

Dodd-Frank intended a robust end-user exception from clearing and margin requirements and did not intend margin rules to favor cleared products, the paper says. To reduce the burdens on end users that are not sources of systemic risk and, in some cases, to reduce their liquidity risk, material swaps’ exposure thresholds should be established, below which entities would be excepted from clearing and margin requirements.

“Rules governing uncleared initial margin should be reworked to be less prescriptive and to be unbiased with respect to cleared and uncleared products,” Giancarlo and Tuckman wrote.

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