By Dr. Steve Suppan, Institute for Agriculture and Trade Policy
If the financial markets were a global plumbing system, inaccurate or incomplete financial reporting would be leaks in the system. A leak here or there wouldn’t disrupt the public’s understanding of the financial risks of their investments and the solvency of the major market players. But in 2008, the lack of any data reporting system for a class of unregulated financial investment products not traded on regulated exchanges was a major factor in a global financial industry crisis. Better Markets in 2018 estimated the cost of the crisis to the U.S. Main Street economy alone to be “$20+ trillion and counting.”
Title VII of the Dodd Frank Wall Street Reform and Consumer Financial Protection Act of 2010 (Dodd Frank) required U.S. financial regulatory agencies to regulate these off-exchange products called “swaps” and those who trade swaps. Swaps dealers, such as JP Morgan and Goldman Sachs, create and market purportedly customized contracts to manage price risks in agricultural, energy, base and precious metal commodities, as well as financial commodities such as interest rates and foreign exchange rates. Dodd Frank required the Commodity Futures Trading Commission (CFTC) to develop rules for swaps trade data reporting and record keeping requirements in Swaps Data Repositories (SDRs).
Regulators’ monitoring of the data helps them determine whether market participants are aggregating risky contracts that could bankrupt them and lead to a larger version of the $29.2 trillion of Federal Reserve Bank System emergency loans that rescued insolvent Wall Street and other global banks from 2007 to 2010. Regulatory actions to prevent default cascades throughout the industry and into non-financial firms should follow those determinations. Default cascades and extreme price volatility can be accelerated by Automated Trading Systems (ATS), an increasingly common form of trading enabled by computer algorithms.
In ATS mediated trading, one computer algorithm (a numerically expressed set of trading instructions) responding to one or more other algorithms can trigger price mini-crashes if the algorithms cannot process the information that is driving the pattern of trading. In 2016, the CFTC reported that ATS algorithms traded about 48 percent of agricultural contracts, a 10 percent increase over 2014. At that pace of acceleration, at least 60 percent of current agricultural contracts could now be traded that way. (IATP commented on an ATS rule proposed in 2015 but currently shelved.)
ATS and human mediated trades on regulated exchanges are reported in near real time to the CFTC. However, the trading of swaps and reporting of swaps trading data remain to be regulated. The first of three planned CFTC rules to govern swaps trading and trade data reporting was proposed in May. IATP responded to that proposal on October 28. Because the proposed rules are interconnected, the CFTC said it would take comments on all three rules and then issue an aggregate swaps trading rule in 2020 or 2021.
IATP’s comment focused on six topic areas of the proposed rule: the impact on commodity market integrity of inaccurate and incomplete data reporting; definitions; proposed data verification procedures and requirements; record keeping requirements; SDR monitoring, screening and analyzing swap data upon Commission request; and duties of the Chief Compliance Officer (CCO). Throughout the comment letter, we responded to financial industry claims that the data reporting and record keeping requirements were too costly, technologically complex, legally burdensome and “unnecessary.”
IATP urged the CFTC to consider not just what had been reported about inaccurate swaps data, but also the impact of incomplete swaps reporting on market participants, regulators and the public whose goods and services financial reporting affects. In explaining the proposed rule, one of the studies cited by the CFTC staff, concerned agricultural swaps, which IATP once characterized as “a tiny boat in the vast financial data sea.” Paul E. Peterson wrote that of about 40,000 transactions he reviewed in Bank of International Settlements (BIS) data, some omitted the quantity of the agricultural commodity traded, while other transaction data lacked the price. These omissions made it impossible to calculate the value of those agricultural swaps and misrepresented the utility of using agricultural swaps to manage price risks that supposedly could not be managed on regulated exchanges.
Agricultural swaps are the smallest asset class reported to the BIS, so the data omissions could be considered quantitatively insignificant relative to omissions in reporting much larger transactions of swaps trading in interest rates. However, these agriculture swaps reporting omissions are operationally very significant. A BIS study suggested that if swaps dealers, who trade in all asset classes, neglect to report foreign exchange or interest rate swaps data comprehensively and accurately, trillions of dollars of corporate and government debt could not only be “parked” off the balance sheet, but also not be reported to regulators and interested investors as debt repackaged into tradeable assets. Regulators, investors and the public would be in the dark about the extent of financial risk in the incompletely reported trades, as most were in 2007-2008.
IATP raised concerns that the proposed rule definition for “as soon as technologically practicable” regarding the installation and operation of automated data reporting and record keeping systems required more detail to ensure compliance. We argued that the CFTC had to make clear that any swaps market dealer or participant who could afford the expense of acquiring, modifying and maintaining ATS for commercial use must be required to do so for regulatory use, including swaps reporting and recordkeeping. Otherwise the industry would continue to claim that the regulatory costs were not “technologically practicable” yet and hence “unduly burdensome.” We already have good estimates of the economic carnage triggered by an unregulated and unreported swaps market.
The swaps industry, as represented by the International Swaps and Derivatives Association (ISDA), recognizes that the industry must develop consistent swaps data standards for commercial use. ISDA Chief Executive Officer and former CFTC Commissioner Scott O’Malia congratulated ISDA members on progress made on developing these standards for eventual incorporation into a fully automated “smart contract” governing trade in all asset classes.
However, the swaps industry is critical of the data verification rules proposed by the CFTC, arguing that it is legally and technically impossible for Swap Data Repositories (SDRs) to verify the accuracy of the data reported to them by all market participants. Instead, they suggest, the CFTC should continue to allow the SDRs to rely on the “trusted sources exception” of accepting as accurate and complete swaps data from the SDR trusted sources (swaps market participants whose trading history and practices are well known to the SDRs), without SDR verification and obligation to verify.
IATP found the CFTC proposed rules to be necessary and feasible for the swaps industry to implement in concert with ISDA proposed swaps data standardization. Likewise, IATP supported the proposed rule’s record keeping requirements to enable the CFTC to access SDR records in near real time to analyze causes of extreme price volatility and other market events.
The CFTC asked what other data monitoring, screening and surveillance tasks that the SDRs could perform to assist the CFTC, other than the list of tasks proposed in the rule. IATP urged the CFTC to require that swaps market participants report the financial risks related to climate change of their swaps trading, just as central banks were requiring their member banks to report climate related financial risk and investors are demanding that companies report their climate related financial risks to the public. IATP suggested that the SDR climate financial risk data would be useful to the CFTC’s Market Risk Advisory Committee subcommittee on climate related financial risk, to which IATP responded in a CFTC request for information.
Last, but not least, the proposed rule would weaken the explicit language of the Commodity Exchange Act (CEA) requirements concerning the duties of the CCO. CFTC Commissioner Rostin Behnam’s statement about the rule’s release for comment warned that the CCO’s duty to “resolve conflicts of interest” between the commercial and regulatory issues of swaps markets could not be changed by regulatory language modifying those duties.
For example, the proposed language would require the CCO to “resolve conflicts of interest” only if they posed “material risk,” i.e., affected a firm’s financial well-being. The CCO would be vulnerable to being overruled or undermined by the CEO who would determine whether a conflict of interest presented “material risk” or not. The proposed rule would also allow the CEO to fire the CCO without any review by the firm’s Board of Directors, that alone is presently authorized to dismiss the CCO. (Industry lobbyists succeeded in amending the language of the CEA to weaken the autonomy of the CCO in a House of Representatives bill (Section 111) to reauthorize the CFTC, introduced on October 29 and passed by the House agriculture committee on October 30.)
Compliance dies by a thousand little cuts to the rules, such as the cuts proposed by industry lobbyists. If the 2007-2008 swaps market crisis should have taught us anything, it is that strong compliance, not regulatory evasion, is crucial to well-functioning financial markets that serve the needs of non-financial corporations, not for-profit cooperatives and other market participants. However, it appears that the largest swaps dealers and market participants don’t want to learn that lesson and are relying on another public bailout if their firms and markets go bust.