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Ivy Schmerken
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CFTC Commissioner: Time to Define "Swap Dealer"

With derivatives regulations still uncertain, Commissioner Scott O'Malia wants more transparency in the final rule-making process.

Operating under a cloud of uncertainty, dealers and end users of OTC derivatives will soon get some clarity on the final regulations –or at least the anti-manipulation and Large Trader Reporting Rule.

According to a speech by CFTC Commissioner Scott O’ Malia, delivered this morning at a public hearing in Washington, D.C., the regulatory body will be voting on the first major tranche of regulations to be finalized under the Dodd-Frank Act, Title VII which impacts derivatives.

But O’Malia sounds frustrated in that he asked the Commission to consider posting drafts of the final regulations on its website seven days before the public hearing to push for greater transparency.

From O’Malia’s Speech:

“I have not yet received an answer regarding whether the Commission I have not yet received an answer regarding whether the Commission will adopt this proposal. Such transparency is valuable because it is likely to lead to more informed Commission decisions as the public receives one last chance to identify unintended consequences.

In general, the industry has described the regulation as vague. Now the Commission has the opportunity to define terms and clarify the rules so that the industry can prepare to invest in systems and comply with the regulations.

O’Malia is urging the commission to give the industry more “clarity” on the regulations so they can “readily identify their legal obligations and determine when (and with what resources) they need to begin complying with such obligations.”

O’Malia said he’s concerned that the Commission has not provided “adequate clarity on its new anti-manipulation rule and that vagueness on how the Commission will interpret and enforce the rule could add confusion to the markets. Also, O’Malia notes that the concept and case law for identifying insider trading and misappropriation was developed for securities markets under the Securities Act of 1934, so the wholesale adoption of this standard and body of law "runs the risk of disregarding the unique qualities of the futures and derivatives markets," he cautioned.

Clearly, O’Malia is also motivating the Commission’s enforcement staff to define what he calls the “new genre of manipulation.” Under Dodd-Frank the commission will have the authority to pursue cases of intentional conduct that were meant to deceive or defraud market participants without the heavy burden of proving that the conduct resulted in an artificial price, according to O’Malia’s speech.

O’Malia supports the Large Trader Reporting Rule – this was originally proposed by the SEC and CFTC to track the activities of high frequency traders who trade large volumes for the day. The lack of market-wide surveillance and data aggregation across asset classes was one reason why it was hard for the SEC to analyze the causes of the May 6 Flash Crash.

Changes have been made to the rule so that the CFTC can retain its surveillance goals without imposing extraneous costs on end users, said O’Malia.

But there is still a major issue with the final regulations, and that is, that the CFTC has still not defined the terms “swap dealers” vs. “end users.”

Briefly stated, the problem is: how can the Commission move forward on a final regulation implicating “swap dealers,” when the Commission has not determined if the term captures end-users? I recognize that the Commission will obtain the lion’s share of data from financial swap dealers. My concern is with those end-users that may be characterized as non-financial swap dealers. Even though the Commission is voting on Large Trader Reporting today, the Commission cannot determine the full benefits and costs of this regulation until the Commission defines “swap dealer” and “swap.”

As I have stated previously, end-users did not cause the 2008 financial crisis. Every dollar of cost that the Commission imposes on end-users may translate into increases in energy or food costs or squeeze farmers and other industrial producers who are unable to pass on these increased costs.

For example, many end-users rely on the use of trade options in their normal course of business, and will not know if the Commission will regulate those options as “swaps.”

The uncertainty surrounding the various definitions of “trade option”, “swap dealer” and “swaps” could lead end users to divert their resources to developing reporting technology, and away from their activity in energy and agricultural business, he said. Interestingly, the Commission has addressed the uncertainty over definitions by not requiring end users to comply with the LTRP for an extra six months.

With the CFTC expected to finalize the rules in September or October, it seems like it’s time to iron out these definitions. I am puzzled how there can be a swap execution facility or SEF without defining the term "swap" and "swap dealer"? O’Malia also asks the Commission to post a schedule of its final regulations that are under consideration and a proposed plan for implementing over 50 such regulations. The public would have the opportunity to comment.

It’s time that we end the rulemaking mystery, and pull back the curtains so the market has the opportunity to review the implementation plan and provide comment on its feasibility.

End-users are caught in the regulatory crosshairs and they have no idea if they are going to be considered swap dealers. And what about the end users of credit default swaps and interest-rate swaps, which is a much larger group. O’ Malia wrapped up his speech by encouraging the Commission to provide an implementation plan with some idea of when they should expect the Commission to resolve these definitional matters.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio
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