Interview with CFTC commissioner Scott O’Malia
When Scott O’Malia approved the final swap execution facility (SEF) rules in August 2013, he did so “reluctantly”. His fears were realized when the regime quickly wrought international havoc. In one of his last interviews before leaving the US Commodity Futures Trading Commission (CFTC), he relives the ordeal of bringing these rules to market and highlights many of the challenges still to come.
|Scott O’Malia resigned as commissioner shortly after Tim Massad was named the new CFTC chairman
Are you happy with how the introduction of the SEF regulations has gone so far?
I am very optimistic about swap execution facilities (SEFs). We were able to create an environment that was flexible, that would give everybody the opportunity to find the best way to transact their products and recognize the differences between the swaps and futures markets.
There are large notional size trades, but relatively few of them. So we’ve shown that people can transact through an electronic platform so we get the transparency that suits the market and our regulatory purpose. Now we are trying to figure out the best way to really move this forward. In credit default swaps you’ve got tremendous uptake on screen, but these are more standard products of course. Dollar denominated interest rate swaps are seeing more volume than non-dollar-denominated. Our challenge is to bring more liquidity to the market and more buy-side participation. Poor buy-side participation is eminently fixable. Any issues they have regarding SEF access, rule-book issues, how many SEFs they want to access, what products are being traded, where the liquidity is in these markets – those are the issues we want to attack.
What about broadening the range of products available on SEFs?
We need to consider newer products, such as packaged trades. We have more and more of these going on-screen: let’s see if that helps increase participation.
We’ve spelled out a schedule for new products so people have some certainty. It’s important to phase these things according to the complexity and different features of each product.
For example, if the CFTC determines that non-deliverable forwards (NDF) are suitable for clearing, the next step will be to determine the process for making them available to trade. When it comes to NDFs, I’ve heard concerns about integration, physical connection, transaction integration, clearing and exchange trading intermediation and so on. This is not the futures market. We need to understand if there are complications around the role of prime brokers, for example. But as I understand it the NDF proposal is complete from a staff level and it is ready to go to the CFTC fairly soon.
How aware are you of the widespread confusion in the market when it comes to the SEF rules?
I am very sympathetic to the marketplace and their level of confusion. We have gone through a three-year rule-making process in which we’ve done 68 final rules. We have rushed through these rules at record pace. I’ve never seen any other federal agency move this many rules this quickly. And as a result we’ve made some mistakes.
Our challenges manifest themselves in the data. We’ve had well over 190 staff no-action letters [statements overriding or changing specific parts of the final rules]. We’ve issued temporary relief, permanent relief and every variety thereof, all trying to accommodate the rules. I’m supportive of the no-action relief obviously because we have to offset the rush that we did the rules in and the complications that we’ve created as a result.
My frustration is when you look at the entire way we’ve gone about this. Going so quickly we haven’t asked the right questions. We didn’t expect many of these outcomes and as a result we’re actually backtracking through the no-action relief to try to accommodate technological policy changes that the market is not ready for.
What are you doing to address the issue?
Early on I have been consistently asking for a schedule, what rules we are going to do and when, so people can get their minds around the rule order and the phase-in of the implementation dates.
The market needs to know when they need to have connections, relationships and new paperwork in place to make sure they are able to trade and clear all of these products as expected. And report data too, which is important.
We also need to consult the market and ask what is possible. The schedule is a problem and it’s been a consistent problem for the past three years.
What sort of response do you get from the market when you ask questions?
The market has had a very steep learning curve. Early on there was a little bit of denial about the expectation of how far we would get and how quickly we would get there, but everybody now completely understands what the rule set looks like.
They are anticipating and helping us understand how the infrastructure, the SEFs, the clearing houses and the data reporting will function and does function and what can be done in what period of time. That’s very positive.
What happened to make market consultation ineffective before the rules were released?
People got confused by the lack of specificity in our questions. We weren’t able to pull the right information out as a result and the industry was left guessing what we wanted. So there has been miscommunication and false expectations about what these rules were going to be.
Footnote 88 had wide implications. Were the effects intended?
This is where our cross-border rules overreached. We were trying to guess at some of these things and what the ramifications would be. When we read the statute we knew we were well beyond our ability to enforce it. The statute essentially says we can apply our rules extraterritorially to the extent it has a direct and significant impact on our economy.
So you have to ask yourself, what is a direct and significant impact? We never received a satisfactory answer as to how a US person involved in exchange trading outside the US would bring risk to our shores, especially if the trade is cleared.
We just applied the rules broadly and as a result we over-reached. We hurt relationships internationally by expecting to apply our rules in foreign jurisdictions.
Instead we should work with colleagues internationally to make sure we have the comparable rules that we can all rely on.
Share the data and have the confidence that each other’s clearing houses are robust and completely in line with international standards.
Then with execution we can work out deals to make sure we have that comparability so you don’t create an arbitrage opportunity that would excuse people to trade somewhere else and undermine our rules. But at the same time we don’t police the world, so we have to do this in a cooperative fashion.
Do you remember how long you had to read over the rules before they became final?
We negotiated them for over a year. But footnote 88 came in at the very last minute. It was not in the draft proposal that the market saw. It came into the final draft; the market didn’t see this thing coming.
Europe didn’t have any reason to fear a SEF rule that was to be applied domestically but then all of a sudden it applied everywhere. And you begin to understand, this is crazy. Traders either a lawyer or some expert here, and all of a sudden it’s a US trade. It doesn’t make sense.
There is a lot of energy spent trying to understand and comply with the rules when, had we made them with a more international mindset, we could have saved everybody a lot of time and energy.
Turning to international cooperation, is enough discussion happening between regulatory bodies around the world?
From the beginning we’ve had good relationships and good intentions among all the regulatory entities. There are some differences in the rule sets and there are certainly timing differences, which bring certain challenges.
Asia is not as keen on exchange trading and we have some clearing and trading timetable differences with Europe.
Data is a great test case. Everybody fundamentally agrees on the objective and we are all in a process of implementing swap data repositories.
Now we have to solve the really difficult challenge of harmonizing the data. We need to unify, as regulators, that form and format the data should come in, so we can begin to share it and do broader market analysis.
We need agreements to be able to share the data. Because as appropriate from time to time we will need to share information about certain market participants. Or simply compare notes about where there is risk build-up.
We’ve made some headway. We have the facilities in place and we have reporting. The US has had reporting for over a year, Europe wasn’t far behind, but we need to take the next steps and we need to do so immediately. This is a difficult situation to manage. Data is complex and it requires very specific outcomes and inputs and we need to make sure that we understand what those are so we get good quality data.
Right now I would characterize our data quality as poor. There are inconsistencies coming in in terms of how people report and we have four different data architectures that make our job more complex.
What about when it comes to clearing?
We have clearing houses internationally; we know the standards and we understand what the risk management and oversight responsibilities look like. We’ve been doing it for years. It’s important we get international recognition sooner rather than later for one another’s jurisdictions because we’ve all agreed to the Principles for Financial Market Infrastructure.
If we don’t recognize global clearing structures we will fracture liquidity and that could be intractable for a while, which wouldn’t be good for anybody.
I’ve sent a letter to commissioner [Michel] Barnier [European commissioner for internal market and services] making sure we stay focused on these issues and I know they are supportive of these goals. But at the same time we actually have to recognize one another’s jurisdiction and the entities within it.
We are never going to get to a rule-by-rule analysis. It’s an outcomes-based objective; we have to be flexible to some extent so we can continue to recognize one another’s rules even though they don’t exactly match up.
If we try to make them exactly match up we will not succeed. There has to be a dialogue which is a little bit more aggressive in terms of getting to outcomes by the end of the year to achieve them.
That’s the set timeframe?
My understanding is that December 15 is a hard deadline for European clearing houses to comply [with European regulations] and the market needs that certainty. They need to know the schedule and which clearing houses Europeans will be able to transact with.
They need to be able to make the decisions and, if it comes with conditions, what they are. And how difficult they will be to comply within the timeframe.
Do you get a good response when you engage in conversations with your regulatory counterparts around the world?
Absolutely. The US in my opinion had a broad overreach of our cross-border rules and that hurt negotiations going forward. It damaged the relationships in some respects.
We are doing a good job of healing those, but we have to demonstrate that by action not just by words. The easiest and best first step would be on data. Let’s get to a recognition on data harmonization.
We’ve taken some difficult steps and not necessarily successful ones on trading. We have the most time on trading; Europe’s trading mandate isn’t until 2016. We now know what their rules, by and large, look like for multilateral trading facilities [the European equivalent of SEFs]. Having discussions now about timing and structural differences between the regimes will bring about better regulatory harmony when the trading mandate in Europe occurs.
We’ve sent enough letters back and forth. Now it’s time to sit down, put our lists on the table and work out how to solve our differences.
Asia seems a long way behind in terms of adopting similar rules. Does that worry you?
I’m not so worried about it because speaking with the regulators throughout Asia, they are committed to this effort. Liquidity in those markets is less and the size of the markets is smaller but I don’t have a sense that they are any less committed to making the necessary reforms. We’re going to have to adjust for time but I don’t sense any lower dedication to the end goals.
What about the idea of a universal rule book for SEFs? Could that work?
No, it’s not possible. This is a principles-based system of outcomes, we are never going to be identical. It’s about accepting the differences and how you are going to solve those.
There are questions about the consistency of data being reported in the SEF market. Do you regret not being prescriptive enough in the rules?
With regard to data you have to be very specific about what you want. We have questioned the market about how to improve our data rules. We need to eliminate the inconsistencies between the various rules to improve data quality and reporting.
We don’t want a rule set where there are various possible outcomes. To provide that certainty will improve the quality of the data and allow us to get what we want out of it.
We went into this asking for everything and not knowing how we would use it or for what purpose. I’ve challenged our staff and the CFTC to think about our priorities in data and technology. Now that we see how big a challenge the data is, we are not going to be able to do everything immediately.
What’s your top priority?
I would put risk management at the top of the list. Understanding bilateral risk management or knowing in which asset class we are seeing a big build-up of risk. The London Whale was a good reminder that these things can happen.
We need to have very clear insight into what’s in the clearing house and what’s outside it and know where risk is building.
It’s a very exciting opportunity; we now have all of this data for the first time. We are looking at how to use it to best effect.
You are forward-thinking when it comes to the use of technology. What is your focus?
Data integration is key. You can’t develop the full picture without pulling all the pieces together.
We’re looking at what it means to have complete surveillance of our markets and how to do comparative analysis between financial products. You have to always be thinking about cross-market trades as well. Working with Finra [the US Financial Industry Regulatory Authority] and the SEC, we need to think about what the next generation of data surveillance looks like.
I’ve been advocating for a strategic plan largely because we need to put on paper our priorities based on our mission and needs. We need to understand what we need in terms of hardware, software and personnel expertise.
We need more data scientists – people who can work with the data effectively, who can programme and develop automated surveillance tools. The massive amount of data that we take in is not something we can throw people at; this has to be an automated process.
After all, you are taking on an automated market.
Exactly. They are trading in a 21st-century way, we are surveilling it in – in my opinion – a very 20th-century way. And that’s just not going to be a successful endeavour in the long term. We need to adjust to the realities of the way the market trades.
We need to bring in order data, something I’ve been asking for and something we’ve provided absolutely zero funding for this year. In automated trade tools, the behaviour and how they trade is in the order data, not necessarily in the transaction data, which is almost stale.
Expanding the types of data we collect will be a learning experience; it’s not something we’ll be able to quickly intake. It’s a massive amount of data, physically. And then to do the analysis, it’s a huge task. But we need experience with that now, so we can be effective in the future.
I’d like to see a bottom-up approach, have the divisions in this building tell us what they believe their priorities should be and then the CFTC can take all the different priorities and knit it together for a full strategic plan. It has to be a one-year and a five-year vision, because this isn’t going to be done overnight. Waiting for this strategic plan is painful and it’s long overdue.
Statutorily we were required to implement a strategic plan one year after the president’s inauguration. We’re well past that date.
What’s causing the delay?
A lack of focus on the specifics. We haven’t focused intensely enough on our priorities and the specific technology and mission functions that we want to achieve. Those are hard decisions to make but there hasn’t been enough attention paid to it and therefore we don’t have any results to show for it. I keep talking about it, raising the pressure and the issue to hopefully create some sort of catalyst in order to get this done.
Do you have a technology team, with data analysts already?
We do, but we don’t have nearly enough. We have different skill sets, some are very good with programming, some with market surveillance, but there is a lot more that needs to be done. It will be dictated of course by the mission we take on. If we are going to expand, for example, our risk analysis, that’s a different skill set we need.
Do you have enough staff with the right market experience to oversee this complex market?
As a result of the rule-making we have really enhanced our market knowledge. This is a market that was outside of our jurisdiction, so there shouldn’t have been an expectation that we knew everything about it. But it is now completely within our jurisdiction and we are building a lot of knowledge and experience.
Our learning curve has been steep but we have tackled it very well. I am impressed with the enormous amount of hard work, time and energy that has gone into this. The staff have learned fast and tried to write rules that accommodate the nuances and unique characteristics of the swaps market.
By and large we got them right, but we made some errors. Now we are in the implementation-correction phase. If we stopped doing the corrections and said “we got it right” that’s when we’d have problems. We are willing to consider changes and that is healthy and appropriate.
What about start-up SEFs struggling with poor volumes and slow uptake? Do you expect to see consolidation?
I appreciate that the willingness to invest in these and try new technologies and innovations takes great commercial spirit. And I know that of the 20-plus SEFs that have come in for registration not all will survive.
But I like the different ideas that people are coming up with and the different products coming out. Innovation is going to be a great thing for this market and it will create new opportunities.
I can’t predict where this will end up, but we are looking at ways to get more trading done on-SEF and allowing people to transact in the way they want to. SEFs are going to continue to evolve and I don’t want us to insist on a single solution; we need to learn from the equities market in terms of fragmentation and what can happen there. This is a new market and we need to stay flexible and think innovatively, just like the market participants are.
What has been the biggest challenge in your term?
It’s difficult when you are presented with what is deemed a consensus document led by the chairman and supported by the staff and told: “Here it is, take it or leave it”. The hard work has been to try to forecast what could and might go wrong and to do my own independent research and analysis into how the market might not function as well as expected under this rule.
That requires a lot more work on our side. My staff have had to work very hard to think critically and anticipate something other than what is being sold to us.
Are you likely to seek another term?
[With a wry smile] I do love this job. I’ve had a lot of experience on Capitol Hill, developing rules and statutes and I thought that was a terrific job. But to have the opportunity to be on the receiving end of the statute and be asked to get the details right is different.
And the details clearly matter, so to take it to the next level in terms of policy analysis is fascinating to me. I’ve enjoyed all of my policy jobs here in Washington but this one is special. The stakes are very high and the outcomes are important.
[Since talking to Euromoney, O’Malia has formally resigned from his post at the CFTC. He will take up the position of chief executive of the International Swaps and Derivatives Association on August 18.]
Euromoney Research Group report into the SEF market
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