by Leo Melamed
Seminar on Futures Market Regulation
China Securities Regulatory Commission
Beijing, China, August 5, 2010
recent Wall Street Journal editorial commenting on the U.S.
financial reform legislation was entitled, "The Uncertainty
Principle". This was followed by another editorial entitled, "The
Uncertainty Principle---II". It led me to the idea of adopting
the same theme for the presentation at this conference in Beijing.
With due deference to the WSJ, I have entitled my remarks, "The
Of course the original Uncertainty Principle was discovered
long ago, in 1927, by the physicist, Werner Heisenberg, who won
the Nobel Prize for Physics in 1932. In simple terms he postulated
that the position and velocity of an object cannot both be measured
exactly at the same time. In other words, the act of location
of the particle alters the position of the particle in an unpredictable
way. While this profound scientific truism is not noticeable
for large objects and can be proven only with respect to subatomic
particles, it nevertheless is incontrovertibly true.
By no stretch of the imagination could Professor Heisenberg
have had in mind the recent US financial reform legislation when
he promulgated the Uncertainty rule. Nevertheless, metaphorically
speaking, his Uncertainty Principle is descriptive of the Dodd-Frank
Act. Any legislative Act that is 2,300 pages long and is estimated
to require a minimum of 243 new formal rules to be promulgated
by 11 different federal agencies over the next 6 to 18 months
is on its face a prime example of an uncertainty principle. Indeed,
the WSJ estimated that the regulatory uncertainty created by
the bill will last more than a decade.
The number of pages in US financial legislation may not be indicative
of anything significant. On the other hand, perhaps it is. Courtesy
of Dr. Mark Perry of the University of Michigan, here is a chart
of the growth of US financial regulation as measured solely by
the number of pages involved:
Reserve Act of 1913-----------------------31 pages
The Glass-Steagall Act of 1933-------------------37 pages
Interstate Banking Efficiency Act of 1994--------61 pages
Sarbanes-Oxley Act of 2002-----------------------66 pages
Gramm-Leach Bliley Act of 1999------------------145 pages
Dodd-Frank Act of 2010----------------------------2,319
is not my intention, nor would it be possible, to provide a
comprehensive analysis of the Dodd-Frank legislation at this
conference. The main focus of my remarks will be limited to
the effects of the legislation on OTC derivatives and futures
markets. Still, I feel compelled at least to offer some general
observations about the financial reform legislation which was
hailed as a guarantee to prevent future meltdowns. Toward this
goal put me in the Skeptic column. Not only is the Act mainly
misdirected, to be perfectly blunt---if you substitute the
word "definition" for
location, and the word "application" for velocity---then
just like under the Heisenberg principle, the definition of the
Dodd-Frank legislation will be altered upon its application because
its meaning and enforcement will materially depend on regulatory
interpretation and rules which have yet to be written, and will,
I predict, be changed and rewritten over and over again,
a process which will take many years. For your convenience, courtesy
of Thompson Reuters, I have included a flow chart of the new
regulatory structure resulting from the legislation.
CLICK FOR LARGER IMAGE
The underlying rationale of the legislation seems to have been
that the primary cause of the financial meltdown was insufficient
government regulatory authority. In my opinion, that was not
its primary cause. While some new regulatory authority was certainly
warranted, there was plenty of government authority on the books
that was simply not utilized. Indeed, the government itself was
most often the source of the problem. In no particular order,
the following are some of the main causes that I included:
Unprecedented low interest rates coupled with adjustable rate
A politically motivated obsession to make home ownership available
to low income families, causing a housing bubble
Empowering Fannie Mae and Freddie Mac, two government sponsored
entities, (GSEs), to purchase nearly an unlimited amount of sub-prime
Insufficient bank capital relative to assets resulting in an
the unconscionable leveraging of the debt-to-assets ratios
Inadequate risk-disclosure requirements relating to the sale
of OTC Collateralized Debt Obligations (CDOs) and Structured
Investment Vehicles (SIVs)
Failure of rating agencies to properly disclose the inherent
risks for these instruments
Poor judgment and lax business practices by Investment Banks
and Hedge Funds, allowing risk to become excessively underpriced.
note that most of the items in the above list were either government
sponsored, had government backing, or were under government
control. In my previous analysis, I cautioned that if these fundamental
causes were ignored or misconstrued, it will inevitably lead
to flawed corrective measures. My fears may have been realized.
To quote Economics Nobel Laureate, Gary Becker, "the Bill
adds regulations and rules about many activities that had little
or nothing to do with the crisis." For instance, the SEC
and the Federal Reserve had the authority to increase bank capital
requirements and stop abusive lending practices, but did not
exercise their authority. Additional discretionary power, as
the Bill provides, is just another layer of unnecessary regulatory
authority. As Professor Becker points out the most serious omission
in the legislation is that it does nothing with respect to Fannie
Mae and Freddie Mac who were the most egregious culprits of the
collapse. In 2008---supported by the market's assumption that
their debt was guaranteed by government---they held over half
of all mortgages, and almost all the subprimes. Professor Bob
Shiller of Yale agrees, stating that "The housing bubble
is the core reason for the collapsing house of cards in the financial
market in the US and around the world." Instead, the new
legislation creates a consumer financial protection bureau in
order to protect consumers from fraud. To our knowledge consumer
fraud was not a primary cause-factor of the meltdown. As for
the so-called, Volker Rule, which would have gone a long way
to protect the public from the costs of a future crisis, the
Dodd-Frank Bill adopted only a watered down version. And finally,
the Bill gives inordinate discretion to regulatory agencies to
interpret the legislation, write the specific rules and then
I am far from convinced that the legislation signed by the
President on July 21, 2010 achieves the purposes it set out
to accomplish. While some reforms were necessary, the legislation
was fueled by the misguided belief that the meltdown was primarily
caused by Wall Street. It resulted in a thicket of regulatory
enactments that will prove to be a consequential cost burden
to the US financial-service sector and an impediment to its overall
growth. Much worse, it will deter innovation, the fundamental
strength of a modern financial system. By acting alone, the US
legislative response may have also created unintended consequences---especially
as it relates to other global financial centers---particularly
for emerging Asian economies. In the highly competitive international
environment such as defines today's global trade and commerce,
every unilateral action of one nation has the potential of becoming
an advantageous opportunity for another.
Nevertheless, having worked with the members of Congress on
the legislation throughout this past year, I must recognize that
it represented a Herculean effort. What the Dodd-Frank legislation
does accomplish, which we loudly applaud, is to embrace the futures
market model as the most reliable construct for the trading and
clearing of OTC derivatives. In simple language, the legislation
adopts the core tenets exemplified by the CME Group: price transparency,
liquid markets with low transaction costs, market integrity,
customer protection, and safety and soundness in central counterparty
clearing services. These were the reasons that futures markets
performed admirably during the financial crisis.
The following represent only the salient provisions in the legislation
relating to the operation of clearinghouses and futures exchanges:
Mandated exchange trading and clearing of swaps.
1. The Act
mandates trading of clearable swaps on exchanges or swap execution
facilities and includes limited exemptions from these requirements
for end-users who are hedging narrowly defined commercial risks.
requirements apply across asset classes; however FX swaps can
be exempted from these requirements by the Treasury Department.
We agree that a central counterparty clearing house, with sound
risk management practices, will add a substantial layer of credit
protection to participants in the swap market.
We have not been advocates of mandated clearing or mandated
exchange trading, however, and instead have supported reasonable
incentives that emphasize the value of an independent clearing
Clearing house interoperability.
1. The Act
prohibits mandated linkages for clearing houses, which we believe
will have a positive impact on managing credit risks and reducing
broader industry systemic risks.
2. As markets
become increasingly interconnected, CME Group believes that
central counterparties must carefully manage and not be forced
to assume the significant counterparty credit risks of other
In other words, the Act prohibits mandated linkages among clearing
houses in order to preclude a default at one clearing house from
dragging down all the others. This represented a major legislative
victory for our markets.
Open access to clearing.
The Act specifies that open access provisions for clearing apply
only to swaps, and not to futures or options on futures.
We are fully supportive of open access for clearing of swaps
regardless of where the transaction was executed (e.g. DCMs,
SEFs or the bi-lateral market).
We agree that the wide choice of platforms for executing swaps
should permit users to choose the clearing house in which they
have the most confidence as an effective and efficient risk manager
and in which they are best able to manage their portfolios of
We also agree that the end user, rather than the swap dealer
should be the party who has the ability to choose the appropriate
Mandate to list a swap for clearing.
Designated Clearing Organizations (DCOs) are granted discretion
in determining whether to list a swap subject to regulatory oversight.
The language grants the CFTC more latitude than we feel may
be appropriate to direct a clearing house to clear specific or
classes of swap contracts.
DCO should maintain frontline discretion for determining whether
to list a swap for clearing.
1. The bill
gives the CFTC the authority to set limits for physical commodities
(other than excluded commodities) for the spot month contract,
each other contract and all contracts combined.
2. The bill
tempers the command to set such limits with a statement that
the limits should be set, "as appropriate," and
a list of factors that should be taken into account when setting
3. The CFTC
is directed to establish limits on those swaps that are economically
equivalent to those contracts traded on a DCM and these limits
must be developed concurrently and established simultaneously
with limits placed on a DCM.
regard to Foreign Boards of Trade (FBOTs), the CFTC is also
directed to strive to ensure that trading on FBOTs in the same
commodity be subject to comparable limits and that any limits
to be imposed by the Commission will not cause price discovery
in the commodity to shift to trading on the FBOT.
5. The bill
also includes a direction to the CFTC to redefine a hedge that
may be excluded from position limits.
6. The CFTC
is directed to set aggregate limits across related markets.
We believe that exchanges, rather than the CFTC, should set
position limits based on their liquidity and open interest.
We also strongly believe that in order for the limits to be
effective, they must be imposed equally and simultaneously on
OTC markets and similar products traded on FBOTs.
Segregation of funds and bankruptcy treatment of cleared swaps.
language permits segregation of swap customer funds, provides
bankruptcy protection to collateral of swaps cleared by an
FCM through a DCO.
We agree that this approach will provide bankruptcy protection
and collateral management benefits to our customers.
Swap desk spin-off provision.
will be able to retain their divisions that trade "less
risky" derivatives, including those based on interest rates,
foreign exchange, gold or silver, investment-grade swaps, and
hedging for the banks' own risk.
2. However, derivatives based on commodities, energy, other
metals, agriculture, and non-investment grade credit-default
swaps, will have to be segregated in a separately-capitalized
bank affiliate unconnected to the bank federally insured deposits.
of bank trading activity (The Volcker Rule).
A modified Volcker Rule passed which will require banks to face
stricter limits on trading and investing, but allow them to make
small investments in private equity and hedge funds.
Under the new rule, up to 3 percent of a bank's Tier 1 capital
could be invested in such funds, and a bank's investment in any
one fund could not exceed 3 percent of the fund's total ownership
will also give regulators less leeway in implementing it and
require non-bank firms to hold more capital and would bar banks
from doing "proprietary trading" for their
own accounts when such trading is unrelated to the needs of their
A new interagency
Financial Stability Oversight Council, also proposed as part
of the overall legislation, would study the Volcker rule and
regulators would have nine months after that to implement it.
house and swap execution facility ownership.
provision requires (rather than permits) the CFTC and SEC to
adopt rules to mitigate potential conflicts of interest.
2. The legislation
is clear that the methods used to achieve this goal may include
numerical limits on the control of, or the voting rights with
respect to, these entities.
This allows a five-year phase-in period for the new requirement
for larger financial institutions and exempts those with
less than $15 billion in assets from the mandate.
Consumer Financial Protection Bureau.
There will be a single director-led Consumer Financial Protection
Bureau housed in the Fed, rather than acting as a freestanding
Hedge fund management registration requirements.
Tougher SEC registration standards will be imposed upon hedge
funds investment advisors who manage over $150 million and a
provision to ensure that the new registration requirements do
not absolve these advisers of existing registration requirements
under the CEA.
* * *
I am very pleased to report that the above provisions pertaining
to OTC derivatives and futures markets are quite clear and
are favorable to our market arena and specifically to the CME
Group. In my opinion the Act will create a continuous flow
of new business and opportunities for futures markets. That
is of course very good news for our market sector. However,
I cannot help but remember that futures markets are but one
segment of the overall US financial system. And we are inexorably
linked. Thus I fear that the Uncertainty Principle---III, in
the words of Professor Alan Meltzer of Carnegie Mellon University, "is
the enemy of investment and economic growth."
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