Featured Commentary - Regulatory Arbitrage - Chris Giancarlo, October 2011
Editor's Note: On October 12, 2011, Chris Giancarlo offered testimony before the House Committee on Agriculture on Legislative Proposals Amending Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Swap Execution Facility Clarification Act"). He summarized his testimony into the commentary below.
American Capital Markets Risk Being Driven Offshore - Again
|J. Christopher Giancarlo|
|Occupation||Executive Vice President, Corporate Development|
|Employer||GFI Group, Inc.|
The US over-the-counter swaps markets is on the cusp of seismic changes that could have unintended yet far reaching consequences if not enacted with prudence and common sense.
As part of the Dodd-Frank Act, all swaps will need to be centrally cleared just like stocks and futures, and executed through an exchange or the newly coined swap execution facility moniker, SEF. In the coming months, regulators will adopt critical SEF regulations. Getting those rules right will impact not just banks and investment managers, but thousands of American businesses that use swaps to hedge risk and better manage their capital for growth and reinvestment into the economy.
A SEF is not a new concept. Long before, during and after the financial crisis, wholesale brokerage firms accounted for over 90% of intermediated swaps traded around the globe. Wholesale brokers handle hundreds of thousands of OTC trades, averaging $5 trillion daily. In passing Dodd-Frank, Congress recognized that the swaps markets were widely served by such long standing intermediaries and their critical role within the new regulatory framework.
Through decades of practical experience in global financial markets, we are highly concerned that certain SEC and CFTC rule proposals are overly proscriptive, may harm US market liquidity, increase trading costs and drive trading offshore. Unlike stocks and futures, liquidity for swaps is fundamentally different. The Federal Reserve Bank of New York recently published an analysis of trading in credit default swaps. The study confirms that CDS trading is far less active than most assumed, and that the majority of single name CDS contracts trade less than once a day. This is also the case for many other swaps products, where market liquidity is variable and episodic. This couldn’t be more different than the hundreds of thousands of trades that occur daily in many exchange-traded instruments.
Because of the challenges of fostering liquidity in swaps, wholesale brokers use trading methodologies that are specifically customized to the characteristics of individual markets and clients. Congress encouraged such flexibility under Dodd Frank by permitting SEFs to execute swaps transactions using any means of interstate commerce. There is therefore much concern with the CFTC’s proposed SEF rules to restrict trading methods and institute a one-size-fits-all approach that limits market efficiency and customer choice. The CFTC is essentially saying that SEFs can use any means of interstate commerce, while restricting the solutions and range of options needed for cleared, non-block trades. This is analogous to Henry Ford famously telling Model T buyers that they could have any color they wanted as long as it was black.
It is argued that these limitations on execution are needed to further regulatory and market transparency. However, wholesale brokers already report trades in a timely fashion and provide post-trade transparency regardless of execution method and this proposal will constrain the very systems that are needed to foster liquidity.
Another obstacle is the CFTC’s proposed “15 second rule,” which requires SEFs to impose a 15 second timing delay between the entry of two matched orders. This rule will restrict the certainty of dealers’ ability to commit capital for customers, leading to increased transaction costs and, ironically, less transparency for US market participants. We question what substantive analysis has been done on its economic effects of these rule proposals, which may dry up US trading liquidity and run up transaction costs.
A failure to harmonize these and other rules between the SEC and CFTC will lead to regulatory arbitrage and saddle market participants with overlapping compliance requirements. Similarly, US regulations need to be harmonized with those of foreign rules so that liquidity does not flee from US markets to overseas markets offering greater trading flexibility.
This is not unprecedented. Regulators should recall the outcome of another set of US financial market regulations that were put in place several decades ago which led to economic growth outside the United States, something we can ill afford to happen again. The catalyst for the development of the Euro-dollar market was Regulation Q under the Glass-Steagall Act. Under Reg Q, the Federal Reserve fixed maximum interest rates that US member banks could pay on US Dollar deposits. Because of these ceilings, Dollar deposits in non-US banks, paying a higher interest rate, became more attractive than deposits in US banks. As a result, the overseas Euro-dollar market grew rapidly. That non-US marketplace stimulated all manner of economic development and job creation in London, and elsewhere in Europe.
It is necessary to bear in mind the unintended consequences of ill-fated financial regulation as we enter the late stages of proposed SEF rulemaking. Such regulations need to be carefully considered not only in their own right, but more so for their snowball effect that could impact US economic growth, competitiveness and, most critically, much needed job creation.
In raising our objections inherent in some of the proposals, regulators should be aware that the outcome is not only important to Americans, but to the Lord Mayors of London and Geneva, the exchange operators of Singapore and the financial industrialists of Hong Kong and Beijing who are waiting with open arms to capture more market share, trading volumes and skilled financial workers.