While the sentencing of the former CEO of Peregrine, Russell Wassendorf Sr. to 50 years in prison, highlighted the importance and challenges of CFTC's role in protecting customer assets in futures markets, the CFTC’s role in oversight of the new swaps market has also been the subject of much critical analysis by market participants. How effectively it can address both issues will be critical in determining its future success. Last week we looked at the protection of customer assets, this week we look at the migration of swaps to more transparent market structures and the importance of the CFTC’s role in supporting that.
Opposition to Dodd-Frank continues almost unabated. CFTC has been under fire, for example, for failing to assess adequately the costs of its implementation, though recently US District Judge, Beryl Howell recently came to its aid. The Judge argued that the CFTC had demonstrated the benefits of a transparent derivatives market by linking the financial crisis to its opacity. In fact, parallels can be drawn to the 1930's. A somewhat similar situation prevailed at that time when, after the Wall Street Crash of 1929, plans were made for legislative reform of the stock market. Most notably the Securities Exchange Act of 1934 increased requirements for transparency.
Such changes came under fire from critics who argued that while the Crash had driven investors out of the market, the tougher securities’ registration rules recently imposed would help to keep them out. Others, however, argued that the nation was experiencing a "capital strike" by industrialists hoping to force a rollback of the new legislation by refusing to market securities.
As a sop to the critics, FDR appointed Joseph Kennedy as the first commissioner of the Securities and Exchange Commission (SEC) which was established under the new legislation in 1934. The SEC now was facing the tough job of overseeing the introduction of new regulation while encouraging investors back into the market. Kennedy approached the task on two fronts: he worked with industrialists and financiers to develop more streamlined rules, and he exhorted investors, industrialists with capital to return to the market in the national interest.
By the spring of 1935, people argue that Kennedy had succeeded in reviving America's flagging capital markets. Others argue, however, that what brought investors back to the market was the increased transparency and regulatory authority over those, like Kennedy, who had benefitted from markets with few rules. The result of course ultimately was a golden age of public markets, an uninterrupted expansion of participation and market volume, through to today, facilitated not by the exhortations of one man but by the consistent application of rules, regulation and enforcement.
One might well argue that derivative products such as interest rate and credit derivative swaps are at a similar turning point now as equities were back in 1935. While there will be some costs borne by some in the short-term, all will arguably benefit in the long-term from the greater transparency afforded by the planned changes. Over time the trust in fair and efficient market functioning afforded by greater transparency will ensure increased liquidity and market participation.
[HFT Demise as the Precursor to Changes in the Markets Landscape]
One question, however, that has been popularly posed is whether the CFTC has the wherewithal and the leadership in place, like Kennedy in 1934, to oversee such a transition to a transparent market place. It is clear, for example, from the recent MF Global and Peregrine episodes, that the CFTC is challenged even in its ability to execute on its existing responsibilities. There are, however, some lessons to be taken from the experience of 1935 that should provide some crumbs of comfort to such doubters.
First, if one can provide clear, focused and unwavering leadership, great obstacles can be overcome, like for example, the opposition of those entrenched in the old ways of doing things.
Second, if regulators/the CFTC can provide a set of clear rules and apply them consistently to all key players, the winners will be those able to take advantage of the new economic opportunities afforded by the new ways of doing things.
Third, new technologies will be developed to facilitate the new ways of doing things better, faster and with greater transparency which will quickly make the old forms of deal sheets and bi-lateral negotiations seem out-dated and inefficient. This can be seen in the rapid development of technologies from the 30’s to the present day to support faster trade execution and better pricing information. The almost daily announcements of new technology solutions to execute on the new rules for swaps appear to support this argument.
While the derivative products that are subject to the new clearing rules may be more complex than the cash equity products that were regulated in the 30's, the leap forward is not one of the imagination as that one was. Market participants understand how to operate in a transparent marketplace. All that the CFTC has to do is provide unwavering determination, a clear set of rules and a regulatory environment that encourages technological innovation. Easy right?