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CFTC in Flux

With political divides, claims of insufficient funding to fulfill its role, a potential shortage of senior staff
and a wide array of challenges facing its new chairman, is the CFTC in an even greater state of flux than
the markets it regulates? Galen Stops finds out.

As the financial services industry continues to
undergo dramatic structural changes following
an unprecedented series of regulatory changes,
it appears as though one of the key regulatory bodies in
the US, the Commodity Futures Trading Commission
(CFTC) is in a similar state of turmoil.

The chronic underfunding of the CFTC has been
highlighted numerous times by its staff since its
regulatory mandate was widened in 2008, but the level
of rhetoric has stepped up recently as senior
commissioners claim that it is now impairing their
ability to carry out their mandated functions.

However, a clear political divide has opened up in
recent years between those demanding more resources
for the CFTC and those who argue that it needs to use
its current ones more effectively.

An Undersized Agency is a “Threat”

In what has become his traditional close at the end of each public speech, CFTC chairman Gary Gensler likes to highlight the enormity of the Commission’s task in comparison
to the resources available to it.

“The CFTC is basically done with rule writing, the first
significant compliance dates have passed and the new
marketplace is here. We’ve brought the largest and most
significant enforcement cases in the Commission’s history.

“These successes, however, should not be confused with the
agency having sufficient people and technology to oversee
these markets.

“One of the greatest threats to well-functioning, open and
competitive swaps and futures markets is that the agency tasked
with overseeing them is not sized to the task at hand,” he said in
a recent address delivered at George Washington University.

The CFTC has historically regulated the $30 trillion futures
market, but since 2008 its mandate has been increased to include
the $400 trillion swaps market. While at the same time, with 670
staff, it has only 36 more people than 20 years ago. According to
Gensler, this year President Obama asked for a substantial rise for
the CFTC’s budget. They have been operating on $195m this
year, but the president would like to raise that figure to $315m.

“Worse yet, as a result of continued funding challenges,
sequestration, and a required minimum level Congress set for the
CFTC’s outside technology spending, the CFTC already has
shrunk 6%, and was forced to notify employees of an
administrative furlough for up to 14 days this fiscal year,” added
Gensler.

The CFTC has said that four staff decided to quit after the
government shutdown, including some senior staff members.

Cops on the Beat

Last month Democratic Commissioner Bart Chilton took to the
airwaves to also highlight this issue.

“Everybody in government always says that they want more
money, but this is about cops on the beat watching markets,
markets that impact consumers….We can put the rules in place,
but if people violate the law we may not be able to catch them.
And the people who would be responsible for that happening 
would be Capitol Hill, those in Congress,” he said.


When asked his opinion on whether President Obama’s request 
for increased budget will be granted, Chilton responded ‘No’.
According to various Commission members, the effects of 
this lack of funding are already evident in the CFTC’s inability
to pursue criminal charges against those suspected of breaking
the rules.

The same week that he stepped down as the CFTC’s
enforcement chief, David Meister went public stating that in
some cases, including that of two traders at JP Morgan suspected
of hiding multi-billion dollar losses, the CFTC simply did not
have the resources to put together a case and prosecute.

Chilton confirmed this, stating that the case of the JP Morgan
traders “is just the one that’s being talked about, but it’s
happening in other places”.

This news comes despite the fact that the CFTC has brought
more criminal charges forward and collected more in revenue
from fines than ever before. Already this year the Commission
has collected over $1.5bn in fines.

Re-evaluating the Goals

Curiously the CFTC is the only financial regulatory agency that
is not at least partially self-funded, with the entirety of these fines
instead going directly to the US Treasury. This means that the
Commission is at the mercy of US politics because Congress
decides its budget and can therefore use this as a political tool.
For instance, it can effectively help prevent reforms it doesn’t
like by severely limiting resources of the CFTC to the point
where it cannot implement these reforms.

Staff morale is apparently at an all time low and there are
increasing concerns that the CFTC will not be able to attract the
brightest talent needed to effectively regulate the markets.

Speaking at the SEFCON IV conference last month, Rick
Shilts, former director of the CFTC Division of Market
Oversight, weighed in on the debate.

“The most important thing right now is staffing and my
experience is that the new chairman and the Commission as a 
whole have to think carefully about what its mission is and what
it can accomplish.

“The Commission either gets additional funding to do all its
functions, but if not, there has to be some sort of reconsideration
about what can actually be done with the level of staffing that it
has in terms of carrying out its mission. I just don’t think that it
can be done at its current staffing level,” he said.

Misleading Figures from Gensler?

Not everyone agrees that the CFTC is critically underfunded
though. In June 2012 Republican Congressman Jack Kingston
issued a letter to Gensler questioning some of the facts and
statistics behind the CFTC’s requests for more funding.

“CFTC funding has increased 85%, and staffing 53% since the
financial crisis of 2008. The Commission has received funding
increases in 2001 and 2012 when most agencies have been cut
over this period,” he said in the letter.

Kingston also argued that the claim by Gensler that the CFTC
needed greater resources to regulate the larger swaps market is
misleading. He said that Dodd-Frank was about reducing
systemic risk and that both the Bank for International
Settlements and the Office of the Comptroller of the Currency
agree that it is not notional value – which is the $400 trillion
figure that Gensler cites – but gross value which denotes the
amount of financial risk.

Back in 2012 Kingston put the gross value of the swaps market
at $20 trillion.

“Further undercutting the agency’s budget request, the number
of registered entities that the CFTC regulates has only grown by a
marginal 5% over the past decade and under Dodd-Frank that
number will only increase by an additional 0.3%,” he added.

Keeping Pace with Technology

Another key thrust in Kingston’s argument was that the CFTC
has the resources it needs, but is not utilising them effectively,
relying on a plethora of staff rather than implementing new
technology.

“It is unacceptable that the CFTC still receives and enters over
5,000 paper forms by hand each quarter. The marketplace trades
almost 80% electronically compared to 10% in the early 1990s.
Yet your budget requests over a 33% increase in staff. It’s time to
bring the CFTC into the 21st century and use technology more
effectively to complete the mission,” he concluded.

In April, when the CFTC submitted its budget request for 2014,
fellow Republican Scott O’Malia issued a statement of dissent
that echoed Kingston’s comments about the need for the
Commission to use technology to make it more efficient.

“Given the vast deficit spending challenges this country is
facing, I do not believe it is fiscally prudent for the Commission
to make broad unsubstantiated appeals for massive budget
increases without specifically identifying its mission needs and
priorities,” he said.

“The Commission frequently highlights the precipitous rise in
trading volume over the past decade as a justification for the
massive staff increase. It bears noting, however, that the vast
increase in trading was facilitated by computer-based trading. If
the Commission is going to keep pace with growth and 
technological innovation in these markets, it must make
automated surveillance the foundation of its oversight and
compliance program,” he added.

Gap at the Top

Whether or not the CFTC is inadequately funded, the fact is
that when the Made Available to Trade (MAT) rules come into
action it increasingly looks like it will be significantly
understaffed.

Gensler is stepping down as chairman and as a commissioner at
the end of the year, Chilton has already announced his decision to
leave the CFTC and Jill Sommers left in July.

Sommers’ proposed replacement, Christopher Giancarlo, still
has yet to be approved by the Senate and Timothy Massad, the
nominated candidate to succeed Gensler, is unlikely to be
confirmed in the position until sometime in the first quarter of
2014.

This has been confirmed in a speech in which Senate
Agriculture Chairman Debbie Stabenow said that she does not
expect her committee to vote on the nominees until next year.

This could create a leadership vacuum at the CFTC and with
only two of the regular five commissioner spots filled also
potentially paralyse it from making decisions. Given the
increasingly divisive nature of US politics there is legitimate
concern in the market that Republican Scott O’Malia and
Democrat Mark Wetjen would be unable to pass a vote together.

In P&L’s report last month, it was noted that speculation was
mounting that Chilton, who has not specified an exact date for
leaving the Commission, could be asked to stay on as chairman in
the interim until Massad is sworn in.

This would enable the Democrats to retain a majority at the
CFTC and enable them to have an experienced commissioner at
the helm when the important MAT rules kick in. In contrast,
Wetjen has only been at the CFTC since 2011.

Since we reported this though, the Senate Democrats changed
the rules in government so that Federal judicial nominees and
executive-office appointments can advance to confirmation votes
by a simple majority of senators, rather than the 60-vote
supermajority traditionally required.

This may help to expedite Massad’s move to take over from
Gensler although the CFTC declined to comment on this.

Challenges for the New Chairman

Regardless of when he takes over, the CFTC’s new chairman
will have a lot of challenges facing him next year.

At a recent panel discussion in New York, Michael Philipp,
partner at Morgan, Lewis & Bockius, highlighted the need for the 
new chairman to slow the pace of regulation.


“In my opinion, less is more. The new chairman is following a 
person who is a profoundly strong personality and I think there’s
probably going to be a lot of bridge building with the other
commissioners, with staff and with market users.

“My advice would be, take a deep breath, put a moratorium on
any new rules for the next year. People are exhausted, completely
exhausted, from implementing the rules we have now. The
framework is there, and maybe it’s time to re-build the trust both
ways between both the industry and the Commission,” he said.

The main focus for the new chairman next year will inevitably
be the development of SEFs as a new trading venue for the
market. Currently there remain numerous long-term concerns
about the rules and regulatory framework of these platforms that
the chairman will need to address. The MAT rules being
introduced in February will be foremost amongst these.

The SEF rules state that a contract can be made available to
trade if there is enough liquidity on it. But the CFTC has not
defined what constitutes ‘sufficient liquidity’ with regards to the
MAT rules and it has been suggested that as a result this figure is
effectively arbitrary.

Additionally, the rules state that there must be sufficient
liquidity in that contract, but don’t specify that the trading venue
itself needs to have a certain volume of that contract trading
there. This could in theory lead to SEFs with no volumes in a
given contract having the power to force it onto SEF platforms.

Finally, given the changing nature of markets, there needs to be
a mechanism in place to take a contract off SEF if it becomes less
liquid. At the moment there is no such provision in the rules.
Once a contract goes on SEF, it stays on SEF.

Shilts noted another challenge with regards to implementing
the MAT rules.

“Something to point out is that what the Commission
ultimately did in adopting the made available to trade rules was
to tie the trade execution mandate to the self-certification
divisions. But the self-certification divisions are such that the
only way that the Commission can determine when something is
filed, that it should not be implemented is if they can find that it
violates the Act….which I personally think it would be very
difficult to do,” he said.

Extraterritoriality Remains Problematic

Also a key issue that the new chairman will have to confront is
the continued confusion over the extraterritorial reach of various
regulatory rules, both those in the US and abroad. Despite the
CFTC guidance issued recently [see related story], the issue for
SEFs is far from settled and the fact that the implementation
timetable is so far behind for similar rules in Europe further
complicates the notion of substituted compliance.

“As much as we’re wrestling with jurisdictional issues in the
US, the same thing is going on around the world. These platforms
are no longer broker platforms, they’re more exchange-like, and
foreign regulators need to get their heads around this and decide
whether they’re going to allow a US SEF to have direct reach and
access to their jurisdiction,” said Phillip.

Core principles Three and Four for SEFs and DCMs could also
prove to be a thorny issue in that they relate to how swaps are
tied to third party indexes. SEFs and DCMs that want to list a
product must certify that it isn’t susceptible to manipulation but if
the Commission finds that Libor is susceptible to manipulation
then it raises questions regarding the sanctity of many of the
contracts that are based on Libor.

“Another area that’s going to have to be addressed is this
whole issue about reporting. There’s a number of inconsistencies
and ambiguities in various reporting requirements and the new 
chairman will have to focus on and reconsider those rules and
come up with an approach that’s consistent will all the no action
and guidance and everything else that’s been issued,” commented
Shilts.

Getting to Grips with the Rulebooks

Under the new chairman, the CFTC will have to go through the
SEF rulebooks in more thorough detail. The CFTC said that it
was taking a “light touch” approach to examining the rulebooks
put forward by SEF operators, which is understandable given that
some of the rulebooks number over 1,500 pages and the
Commission had only a month to go through them all.

But despite this, a number of SEF applicants tell Profit & Loss
that they were surprised at the level of detail in the regulator’s
questions and responses to their rulebooks.

“What this shows is that the Commission has been reading
very carefully around certain parts of the rulebooks, focusing
in on the areas that they are most concerned around such as
market access,” says one, adding that it will be important for
the CFTC to examine the rulebooks fully as this is likely to
become an area where SEFs compete for business by having
less restrictive rules.

Futurisation is an issue that has gone quiet in recent months,
but is expected to rear its head again in 2014. Gensler has said
that it is important that the CFTC does not allow for the
possibility of arbitrage between the swaps market that now has a
block rule and the futures market that does not have a formal
block rule.

He has also said that he hopes that the CFTC staff’s
recommendation to publish a futures block rule for public
comment will be on the agenda for the CFTC’s next open
meeting in December. The reality is though that ensuring this
happens will be the responsibility of the next chairman after
Gensler departs.

Hoping for the Best

The CFTC currently finds itself in a difficult position. It is
clear that the Commission does not currently have the resources
immediately available to effectively police the markets it is
tasked with regulating. Whether it could achieve this by
restructuring how it uses its current funding is an important
debate but does not lessen the immediate concern of how market
participants are supposed to trust this regulatory body to protect
them.

That the CFTC could be entering a momentous point in its
history with no chairman and a severe shortage of commissioners
is also worrying. In this instance they are at the mercy of a
political system that has repeatedly demonstrated an inability to
function efficiently.

With the staff and funds available to them, the CFTC has
brought a huge amount of regulatory reform to the market.
Although there is still a case for arguing that in many instances it
opted for speed rather than market readiness, or even suitability,
the Commission’s achievements in recent years have still been
impressive.

The introduction of SEFs represents a massive change for
market participants and a fundamental change to the
infrastructure of a large part of the financial industry in the US.
But the real test for SEFs and SEF users will only begin when
mandatory trading starts on these platforms.

The CFTC and its new chairman still face a major challenge in
effectively implementing the swathe of regulations introduced
over the past few years. Market participants will be fervently
hoping that they are up to it.
 

Paul Gogliormella

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