On December 9, 2016, Commodity Futures Trading Commission (“CFTC”) Commissioner J. Christopher Giancarlo delivered the keynote address at the International Swaps and Derivatives Association Trade Execution Legal Forum. His address included a strong rebuke of the CFTC’s swaps trading regime, stating that the “time has come for the CFTC to revisit its flawed swaps trading rules to better align them to market dynamics, allow U.S. swap intermediaries to fairly compete in world markets and reverse the tide of global market fragmentation.” More generally Commissioner Giancarlo urged financial regulators, and in particular the CFTC, to adopt a “forward-looking agenda” in response to emerging challenges in financial markets. Commissioner Giancarlo focused on three particular challenges facing financial regulators: (1) technological disruption; (2) the changing nature of market liquidity; and (3) global fragmentation.
The first area addressed by Commissioner Giancarlo was the challenge from “digital technologies that are rapidly changing the very nature of human identity, work, leisure and society.” Commissioner Giancarlo considered the implications of automated trading, distributed ledger technology, and digital data analysis.
- Automated Trading: Commissioner Giancarlo’s remarks on automated trading focused on his criticism of the CFTC’s proposed Regulation Automated Trading (“Reg. AT”), which was first proposed in November 2015, and which it supplemented in November 2016 over Commissioner Giancarlo’s dissent. Commissioner Giancarlo stated that the provision in Reg. AT allowing the CFTC to obtain source code without a subpoena “remains a non-starter,” and further criticized Reg. AT for imposing prescriptive requirements that ignore current industry best practices.
- Distributed Ledger Technology: In order to realize the potential benefits of this technology, Commissioner Giancarlo urged financial regulators to adopt a “do no harm” approach. He suggested that regulators adopt a posture of learning and guidance that will give the industry breathing room to spur innovation while allowing regulators to fully understand the technology and to develop rules and regulations that appropriately address its risks and benefits.
- Digital Data Analysis: According to Commissioner Giancarlo, the failure to obtain visibility into the counterparty credit risk of financial institutions is one of the most disappointing failures of the post-financial crisis reforms. He urged regulators to leverage the resources of the financial sector to obtain better visibility into the financial data necessary to fully identify and assess the counterparty credit risk of large financial institutions.
Commissioner Giancarlo argued that, as a result of prudential capital requirements, liquidity provision has shifted from large financial institutions, who traditionally drew from inventories of financial instruments to provide liquidity, to proprietary traders who source liquidity from the market and whose goal is to carry as little overnight inventory as possible. The result has been an increase in “flash crashes” – numbering twelve since passage of Dodd-Frank – as a result of the “more flighty” and “more shock prone” nature of this new structure of trading liquidity. In imposing the capital requirements that have led to this result, according to Commissioner Giancarlo, global regulators failed to consider whether the capital these requirements caused banks to take out of the global financial system was calibrated to the amount needed to be kept in the system to support its health and durability.
Global Market Fragmentation
Finally, Commissioner Giancarlo addressed the fragmentation of global financial markets. In particular, he cited the CFTC’s swaps trading rules as a significant contributor to this fragmentation. Reiterating his longstanding arguments about the flaws in the CFTC’s rules, he argues that these flaws are such that global financial institutions will not do business with any entity that has the “scarlet letter” of “U.S. person.” According to Commissioner Giancarlo, the result has been the fragmentation of financial markets into smaller, disconnected, and more fragile markets, which in turn poses a risk to the global financial system.