Both the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) were given monumental tasks by Congress in promulgating rules that will shape the Dodd-Frank Wall Street Reform and Consumer Protection Act, the largest overhaul of the financial markets since the Great Depression. Along with the list of rules to write (see "Financial reform from A to Z"), they were both given very tight timetables for actually completing the job. Some rules, such as those pertaining to retail forex, had deadlines as little as 90 days after the passage of the Act. Most have a one-year deadline from enactment.
While some of the recent rules are areas the CFTC already has been studying, Dodd-Frank gave the Commission direction to bring an entire class of previously unregulated products under their rule. "They have an enormous job. They have been asked to create a regulatory system for a whole series of market participants and regulatory categories that didn’t exist before," says Daniel Waldman, partner at Arnold & Porter LLP. "They have to figure out what to require to be cleared, what to be exchange-traded, what new forms of exchange trading really mean and how trades will actually be executed in this new market paradigm."
In addition to this task, both agencies have been working hard to increase transparency in the rulemaking process, just as Dodd-Frank aims to increase transparency in the marketplace. In addition to almost weekly meetings to release rule proposals, the CFTC and SEC also hosted a number of public roundtables to gather public insight into issues. Also, the CFTC has issued advance notices of rulemaking in which they have asked for industry comment on subjects such as disruptive trade practices and anti-manipulation rules.
Considering the task and timetable the regulators have been given, most in the industry are pleased with the progress so far. "I’ve been impressed with the amount of openness shown by both the CFTC and SEC. The fact that they have given some of these time and study makes me applaud them," says Dr. Sharon Brown-Hruska, economist at NERA Economic Consulting and former CFTC commissioner. "I would ask that they slow down a little bit so we have time to digest and comment on what they have put out so far."
Others have been more impressed with the regulators’ commitment to accomplishing the task given to them. "In terms of the timeline, the CFTC and SEC have been pretty impressive. The CFTC grabbed the bull by the horns at the get-go and came out with the list of areas for which it needed to make rules and it has been rolling out proposed rules," says Willa Bruckner, partner at Alston & Bird LLP.
Challenges
Even since clearing the final legislative hurdles on its way to becoming law, the Dodd-Frank Act has faced challenges and passed those onto the regulators who now must shoulder them, end-users who must wait patiently and a new Congress with many fresh members who oppose the Act.
Regulators are being asked to write rules for a major overhaul of the markets by three standards that normally do not all go together — good, fast and cheap. An old production management axiom says that in any endeavor, you can pick two of those qualifications, but never all three. Congress gave the regulators a task that requires all three qualifications to be met for success. As such, each is an individual challenge and doing the job while meeting all three is an even greater one.
By the nature of the rules being written, they have to be good. "Regulators have to provide a fairly robust justification for the decisions they make," Brown-Hruska says. "It behooves them to do a very well reasoned and careful analysis; otherwise they may be subject to challenge. We’ve seen this at the SEC and even have seen some of its rules thrown out by judges."
Couple stringent dealines with the need for comprehensive, detailed rules, and you have a daunting task. A prime element of this is definitions.
Being new regulations, definitions to incorporate the new swaps market had to be adjusted and whole new ones created. Just to get rules out for comment, the CFTC had to promulgate many of them without formal definitions in place. "In an ideal world, there would have been a better way, but it has an incredible task in a very short amount of time. Congress put this legislation in place, but I’m not sure Congress sat down and realized what an enormous task they were giving the CFTC," Bruckner says. "If the CFTC had sat down to hash out the definitions first before writing all the rules, it may never have met the deadlines imposed on it."
Finally, regulators are being asked to create new market structures and rules on the cheap. Besides the initial task of writing all the new rules, they also have to be able to monitor, regulate and enforce them once they actually are enacted.
The CFTC has been acting swiftly and Chairman Gary Gensler says he has appropriate resources to complete the rule writing but will need considerable additional funding to implement the rules once they are in place (see "Gensler: Correcting the record," September 2010).
"Resources are a big issue for the regulators. While they have hired some additional staff, it is a task that is much bigger than anything they have had to deal with in the past," Bruckner says. "Once the rules are in place, they then have to implement and enforce them, so the resource issue will continue to be a challenge for them unless they get a lot more funding from Congress in order to meet those resource needs."
Those additional funds are going to be a difficult sell. "We’re in a major crisis in terms of the federal deficit and we need to see cuts and fiscal responsibility in general, and that is going to affect the CFTC and SEC as well," Brown-Hruska says. "There’s probably going to be some cutback in resources. That just makes it more and more difficult for the CFTC to get its work done."
The cost dilemma is mostly outside the CFTC’s hands as a new Congress consisting of many who opposed Dodd-Frank prepares to take power (see "Major turnover"). "[Republicans] may not be able to reverse the legislation, but they will be looking at other ways of modifying or impacting the outcome of that legislation. Not providing additional funding may be one way of doing that," Bruckner says.
That could be as effective as overturning it. "If the House won’t approve an expanded budget for the CFTC and SEC, it is almost impossible for them to implement the provision. It is a very indirect way of influencing," says Gary DeWaal, general counsel at Newedge. "It would be inappropriate, though, because the CFTC is an independent government agency."
These are challenges Congress will be facing in the upcoming session and ones whose impact may not be evident for some time. One thing working in the regulators’ favor that multiple experts mentioned is that many of the new Congressional representatives have little or no political experience, which may dampen the effects they are able to have on the budget and thus reform.
Finally, end-users, dealers and traders all are anxiously awaiting the finish of rule writing to see the new costs and capital requirements that now will be required.
"The problem is going to be the cost. This is going to be an incredibly costly proposition for firms to implement," DeWaal says. "The proposals out there are all about increasing cost and decreasing revenues. The economics of this business are really going to be challenged. If at the end of the day you have great theoretical rules but no participants, then you have defeated the purpose."
Those added costs to market participants are shaping up to take a variety of forms, including increased compliance costs, additional technology requirements and connectivity requirements. Finally, there are added requirements for business conduct as well as back office standards.
However, many have argued that by opening OTC markets to a broader group of participants, end user costs could go down. While compliance costs will go up, much of the complaining is coming from dealer participants who will face greater competition and reduced margins.
Included in the legislation are a number of provisions that drastically will change the marketplaces, including areas such as swaps and position limits. New requirements for swaps trading and clearing probably have the most far-reaching potential.
"This area is among the more controversial. On the one hand, they want to be careful not to discourage the use of exchanges to transact business that is a bit more customized," Waldman says. "On the other, they want to make changes to market structure to encourage more pre- and post-trade transparency. It is a delicate balance they are trying to strike."
What the new swap execution facilities (SEFs) will even look like has drawn considerable attention. "The nature of an SEF is going to be very important. There is a lot of sentiment out there that it should be more than just an exchange," DeWaal says.
Not only is the structure of the SEFs in question, but exactly what must be openly traded and cleared has left dealers wondering. "They have to be very sensible about what is eligible for clearing. They have to realize a significant number of these swaps are customized and not eligible for clearing," Brown-Hruska says.
The Dodd-Frank Act is a sweeping and far-reaching overhaul of the financial markets that calls for many changes in the coming months and years. Yet, there are nearly as many opinions as there are experts as to the actual benefits that Dodd-Frank will bring to the markets.
"It will certainly be a great help to have a lot of the bilateral products traded through a clearinghouse and executed on an exchange. Transparency is a good thing," DeWaal says. "The CFTC and SEC have to keep in mind the requirement of open access. If at the end of the day, the only people engaged in swap clearing are the current dealers, then this will be a failure."
This is a major issue for non-bank FCMs who feel the initial structure for CME Group’s interest rate swap clearing solution favored the major investment banks that have dominated the space — and were major contributors to the financial crisis — for years.
Brown-Hruska is less optimistic on changes. "[Reform] will be detrimental to the quality of the derivatives market. I am a proponent of exchange trading and the SEF is a great idea. On balance, though, they overshot the mark and are doing too much in terms of trying to decrease systemic risk and raise transparency."
At this point, most rules have been proposed and are in their comment period. As such, experts and regulators are urging dealers and traders to share their views with the regulators through comment letters so that rules can be adjusted and made to better fit the markets.
Moving forward, answers and basic structures are beginning to take shape, but there are still a lot of questions and definitions that needs to be added to reform. Brown-Hruska remembers her time as a commissioner and recalls burning the midnight oil just to stay up on her own reading at the time, and says she does not envy the job the current commissioners have of creating rules to reshape an entire market.
Considering the speed at which new rules are being written, it is apparent the current commissioners are burning their share of oil. It also might help explain the climb in coffee prices.
