United States: CFTC Chair Massad Defends Dodd-Frank Derivatives Regulations

CFTC Chair Timothy Massad emphasized the dangers of repealing Dodd-Frank, defended the derivatives regulations implemented under it, and discussed the future of the derivatives markets in the political and international arenas.

Speaking at the Economic Club of New York, Chair Massad addressed the impending transfer of power in the United States, and the next Administration's anticipated repeal or dismantling of the Dodd-Frank Act. He warned that "eliminating essential derivatives reforms would be a big step backward," and argued that regulators should continue to make improvements to derivatives markets reforms – particularly to those that concern automated trading and cybersecurity – instead of "refight[ing] the last war."

Chair Massad asserted that UK voters' decision to exit the European Union was an effective test for derivatives reforms. He noted that no clearing member defaulted, even when the volatility of Brexit resulted in larger margin calls. That fact, he argued, affirms the resiliency of clearinghouses "in the face of stressful conditions." He explained that the results of the CFTC's internal stress-testing of clearinghouses – which "assumed price shocks several times larger than what happened after Brexit" – also "support the decision to require central clearing of certain standardized products."

Reflecting on the future of Brexit, Chair Massad stated that the UK now will need to obtain equivalence for its clearinghouses and trading platforms. He discussed some of the challenges of that process and posed questions that will need to be answered, including whether Europe will apply the same equivalence framework to the UK as it did to the U.S. and other third countries.

Chair Massad stated that eliminating the Dodd-Frank derivatives reforms would be a "big step backward" in the international coordination of global regulation. Those who voted for President-elect Trump because of his promises to working-class Americans "will have been sold a bill of goods if wholesale repeal of Dodd-Frank is made out to be a critical part of the solution to concerns about economic stagnation or lack of opportunity," he said.

Commentary / Steven Lofchie

With a change in administration comes an opportunity to reexamine the statute and financial regulation generally. Dodd-Frank is an ill-conceived statute that confuses quantities of regulation for quality. It is unfortunate, but understandable, that the outgoing regulators who implemented the statute continue to support it rather than address its deficiencies.

Commentary / Bob Zwirb

Chair Massad suggests that cleared transactions are superior to bilateral ones because, in the case of the latter, "trouble at one institution [can] cascade quickly through the financial system like a waterfall." However, that same risk can occur in cleared markets. As Federal Reserve Bank of New York Senior Vice President Susan McLaughlin points out, if a Central Counterparty ("CCP") "were for some reason unable to perform on the defaulting member's payment obligations in a timely manner . . . its surviving members would face liquidity shortfalls that would quickly trigger a cascade of failures on their obligations to their counterparties beyond the CCP, transmitting liquidity risk more broadly to a wider set of market participants." Statement of Susan McLaughlin, Fed. Reserve Bank of N.Y., CFTC Market Risk Advisory Committee Meeting, Apr. 2, 2015 (emphasis added).

Similarly, Chair Massad defends Dodd-Frank's clearing mandate by referencing Brexit's impact on clearing activity where large margin calls were met without default last June. But economist Craig Pirrong argues that in reality, the market dodged a bullet – "a known event and a known risk" for which the banks had planned – and might not be so lucky in the future if a larger event takes the market by surprise: "Much of the additional margin [called for in the wake of Brexit] was to top up initial margin, meaning that the cash was sucked into the CCPs and kept there, rather than paid out to the net gainers, where it could have been recirculated. . . . [In addition,] each CCP acted independently and called margin to protect its own interests. With multiple CCPs, there is a non-cooperative game between them. Each has an incentive to demand margin to protect itself, and to demand it before other CCPs do. The equilibrium in this game is inefficient because there is an externality between CCPs, and between CCPs and those who must meet the calls. This is ironic, because one of the alleged justifications for clearing mandates was the externalities present in the OTC derivatives markets. This is another example of how problems have been transformed, rather than truly banished." Streetwise Professor, "A Brexit Horror Story That Demonstrates the Dangers of Clearing" (Oct. 31, 2016) (emphasis added).

During the Vietnam War, soldiers popularized an infamous saying: "We had to destroy a village in order to save it." Here, by contrast, regulators' obsession with mandated clearing could mean that in a future crisis, efforts to save the "village" (i.e. CCPs) may destroy the "countryside" (i.e. the broader market).

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