The U.S. Commodity Futures Trading Commission has completed Dodd-Frank Act rules requiring swaps brokers to decide within minutes whether to clear a trade in an effort to reduce risk in the $708 trillion global swaps market.
The CFTC voted 4-1 today to adopt the regulation, which requires Wall Street banks or clearinghouses operating on their behalf to accept or reject trades for clearing as soon as technologically possible -- in “milliseconds or seconds, or at most, a few minutes,” according to a CFTC summary of the rule.
“This lowers risk to the markets by minimizing the time between submission and acceptance or rejection of trades for clearing,” Gary Gensler, CFTC chairman, said at the meeting in Washington.
Vanguard Group Inc., based in Valley Forge, Pennsylvania; Citadel LLC, the Chicago hedge fund founded by Ken Griffin; and DRW Holdings LLC, a Chicago-based proprietary trading firm, have urged the CFTC to require real-time decisions on clearing to prevent the risks of disruption and uncertainty in the swaps market.
“Latency raises the potential for market movement which could lead to unacceptable breakage risks for one or both of the parties to a trade,” Vanguard’s Gus Sauter, managing director and chief investment officer, and John Hollyer, principal and head of risk management, said in a Sept. 30 letter to the CFTC.
The CFTC and Securities and Exchange Commission are leading U.S. efforts to write new regulations for the swaps market after largely unregulated trades helped fuel the 2008 credit crisis. Dodd-Frank, the 2010 financial-regulation overhaul, is intended to reduce risk by having most swaps guaranteed by clearinghouses that stand between buyers and sellers.
The CFTC may require Wall Street banks and large funds to clear certain types of swaps as early as October, Gensler said. The agency may publish recommendations in April for which types of swaps will face the mandatory clearing requirement, which would then be open to a 90-day review process.
Once the CFTC determines that a particular type of swap must be cleared, the largest swap-dealers have 90 days before they must comply with the mandate, Gensler said. The first determinations could come as early as July, he said.
The final Dodd-Frank regulations adopted today, which will take effect Oct. 1, also prohibit dealers from drafting trade documents with buyers that restrict their relationships with other dealers. Under the regulation, a dealer can’t limit the number of counterparties with whom a customer may trade or restrict the size of the position a customer may have with any individual counterparty.
The rule will boost competition for clearing by limiting any broker “from restricting a customer or counterparty access to other market participants,” Gensler said at the meeting.
“It tilts a little to the buy side. Every mutual fund, every pension fund, every asset manager that we’ve talked to has liked this,” Gensler told reporters after the meeting. “It is sort of the small group of dealers and the International Swaps and Derivatives Association Inc. that raises concerns because they’re rational. They’re protecting their revenue potential.”
Wall Street banks are the largest swap dealers with JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Morgan Stanley and Goldman Sachs Group Inc. controlling 95 percent of cash and derivatives trading for U.S. bank holding companies as of Dec. 31, according to the Office of the Comptroller of the Currency.
The CFTC regulations also require members of clearinghouses to establish risk-based limits on accounts. The rule will require clearing members to monitor the limits during the trading day and overnight.
Clearinghouse members will also be required weekly to stress-test positions that present material risk to brokers. The brokers will be required to test in-house proprietary trades as well as client positions that could expose the firms to risks.
The clearing-member requirements call into question the CFTC’s system of using designated self-regulatory organizations to oversee risks in the system, Scott O’Malia, a Republican commissioner who opposed the rule, said at the meeting. The CFTC is taking the position that the self-regulatory system, “is not enough and that to some extent ‘direct’ regulation is necessary,” he said. “I disagree with this approach.”
The CFTC is considering changes to the self-regulatory process after MF Global Holdings Ltd. collapsed last year, prompting CFTC, SEC and Justice Department investigations into missing customer funds. The bankruptcy trustee overseeing the liquidation of the New York-based company’s brokerage has estimated a $1.6-billion gap between customer claims and assets currently available.