Interview with Eric Pan, Director, Office of International Affairs, U.S. Commodity Futures Trading Commission (CFTC)
“We do not wish to be collateral damage in the Brexit negotiations”
Eric Pan represents the US derivatives authority – the U.S. Commodity Futures Trading Commission or CFTC - in international regulatory matters. In the interview with Boersen-Zeitung, Pan comments on the question of how the European Union intends to regulate the supervision of clearing houses in third countries. Pan is concerned with the proposal of the Committee on Economic and Monetary Affairs (ECON) of the European parliament on central counterparties (CCP) regulation. The proposal would suggest that ESMA will regulate 100% of the US CCP and all of its clearing activities, says Pan. That would go far beyond anything the CFTC has done with respect to a European CCP, he states. Pan is concerned also with the role of the European Central Bank to have separate supervisory powers over the third country central counterparties. He states that a split role for the European Central Bank and the European Securities Markets Authority ESMA would immediately create a difference with the United States. Pan also comments on the introduction of Bitcoin futures and their role in the U.S. market.
Mr Pan, what are the CFTC's main regulatory issues from an international perspective?
A significant focus is on our relations with the European Union and our European counterparts. Europe is by far our most important foreign market. The US market and the European market are the two largest derivatives markets in the world. As a result, we take developments in Europe very seriously, and we want the best possible cooperation with European authorities. Given Brexit and a number of major EU legislative proposals in the area of financial regulation being considered currently in Brussels, possible changes to the regulatory framework in Europe are of course of great interest to us. We want to ensure that these changes do not create regulatory conflict with the United States and disrupt the transatlantic market.
We are also looking at how well the post-global financial crisis reforms, laid out by the G20 Leaders in Pittsburgh in 2009 and later in the Dodd-Frank Act in the United States, have been implemented. The CFTC implemented most of Dodd-Frank about four years ago, and we feel we have accumulated enough experience and data about the new reforms to evaluate their effectiveness and to consider how the reforms should be modified to make them more effective. CFTC Chairman [J. Christopher] Giancarlo recently published a white paper, called Swaps Regulation Version 2.0, analyzing the state of the reforms. This paper, which he co-authored with CFTC Chief Economist Bruce Tuckman, shows how the various major reforms are developing, what is going well and what still needs to be improved. I would like to emphasise that this review is not about a roll-back of reforms. Some think that changes to reforms only serve to weaken them. That's not the intention. The goal is to make the reforms work better, not worse.The review we are doing at the CFTC also matches what is happening internationally. We lead groups in the Financial Stability Board and the International Organization of Securities Commissions (IOSCO) examining how the reforms work worldwide.
Is this also connected with the recent amendment of Dodd-Frank made by the US Congress last month?
No. Last month, Congress amended Dodd-Frank to change the threshold for determining when a bank is considered systemically important, but this change does not directly affect the CFTC and our regulatory program. Dodd-Frank is a very expansive legislation that covers not only derivatives, but also other financial regulatory areas like corporate disclosure, bank regulation and consumer protection. Therefore, there are a lot of parts of Dodd-Frank that do not pertain to the CFTC.
What other priorities do you have?
Our financial markets are increasingly intertwined. According to statistics, over 90% of some types of derivative contracts are cross-border, which means one party is in the United States and the other is outside of the United States. So we are regulating an international market. In order to do this well, we need adequate information about what is happening both inside and outside the United States. This makes good cooperation between us and our friends in Europe and Asia even more critical. We need to ensure we have adequate access to information about market activities, not only in the US, but also abroad.
We are currently doing three things: We are trying to make it easier for foreign authorities to access information about our swaps market. At the end of May, we finalised a rule that removes one of the major legal hurdles encountered by European authorities to accessing information from swaps data repositories in the United States. Secondly, we are leading a large international project to define common data standards. Everyone should speak the same language when it comes to data about what transactions and products are being traded in our markets. Common data standards also will simplify how we exchange information. Thirdly, we work to conclude memoranda of understanding or other agreements with foreign authorities to share and access information. Here we want to ensure that laws, such as the new EU General Data Protection Regulation, do not have unintended consequences and prevent the necessary exchange of data between regulators to ensure we have the information we need to protect the safety and soundness of the international financial market. One of the lessons of the global financial crisis is that regulators need to have visibility into the markets; otherwise they will be poorly positioned to prevent future financial crises and financial fraud. We seek to cooperate with our European colleagues to protect vital access to information about the US-EU markets and market participants.
You also have regulation of cybersecurity and crypto-assets on your agenda. What's going on?
We are very active in trying to understand new technologies and how they affect the markets we regulate. We all have seen the tremendous increase in interest in crypto-assets like Bitcoin. Therefore, we believe we need to respond to such interest by making sure these new products are regulated responsibly to ensure robust protection of investors and careful development of the market. Added to this is cybersecurity, probably the biggest risk for the financial system. Although cybersecurity is not just a financial regulatory issue, financial institutions must have strong cyber security practices. We want to ensure that best practices are applied and that the threat is taken seriously by all firms in our financial system. Recognizing that good cybersecurity is an international challenge, we work closely with the European Central Bank, Bundesanstalt für Finanzdienstleistungsaufsicht and other European authorities in developing and implementing international standards. IOSCO recently established a new task force on cybersecurity, and the CFTC chairs this international task force. One of the goals of the task force is to analyse what jurisdictions around the world do to implement existing cybersecurity standards. IOSCO has a very broad membership with representatives from over 115 different jurisdictions, both large and small. Cyber criminals will attack the weakest link in the chain. An attack may not take place in Frankfurt or New York, for example, but on the other side of the world, which in turn may lead to a sequence of events that may harm Germany and the United States. International regulators working together to ensure tough cybersecurity practices is where we must start.
Last autumn, your authority also allowed crypto-futures contracts to be issued. Why?
Last December, two exchanges in the United States introduced futures contracts in Bitcoin. The CFTC does not approve new futures contracts nor does it endorse any financial products. Rather exchanges are permitted to self-certify new contracts and bring them to market, provided that the new contracts do not violate relevant formal legal requirements. When we learned about the proposed self-certifications, we did speak to the exchanges about having in place additional safeguards, such as higher margin requirements and more extensive reporting requirements. Such additional safeguards are consistent with our desire to allow for the development of new markets while ensuring adequate protection of the financial system.
In the past six months, we believe the introduction of the bitcoin futures products has had a maturing effect on the bitcoin market. The introduction of bitcoin futures has enabled market participants to bring forth downward pressure on the value of bitcoin. Recently, the Federal Reserve Bank of San Francisco published a research note indicating that the introduction of bitcoin futures was responsible for the decline in the price of bitcoin. What we are seeing here is that real market forces are being introduced, which is positive.
There are repeated reports of fraudulent behavior in the crypto market.
In the case of illegal activities such as fraud, we make maximum use of our enforcement power to punish the perpetrators of the fraud. And, we have a strong consumer protection aspect here. We go to great lengths to inform the public about these products to ensure they are aware of the risks associated with the crypto market. We also have Memoranda of Understanding with European authorities to exchange information and provide assistance to each other when we seek to monitor market activity or investigate potential wrongdoing. This goes to the point I made earlier. Financial regulators rely on information to do their jobs. Without the ability to share and access information, we cannot protect investors, we cannot ensure firms are safe, and we cannot protect the financial system. We have to make sure that new data protection laws and other possible legal restrictions to the sharing and access of information does not make this impractical.
If there is a different regulatory treatment of crypto assets worldwide, this carries the risk of regulatory arbitrage.
There are, of course, differences in regulation. However, I would not speak of arbitrage. This would suggest that a jurisdiction deliberately seeks to have weaker regulation to attract business. I do not know of any authority in Europe with which I cooperate, nor in the USA, which wants weak regulation. Differences in regulation are not always bad. We must work within our respective legal frameworks, which leads to differences. But we also believe market activity will not go to the jurisdiction with the weakest regulation but the best regulation. What is important is that regulators talk to each other as the market develops. We learn from Europe, but we also hope that Europe learns from us.
Let us move on to another important subject. You gave input to the European Parliament's draft Economic Committee, Econ, with regard to the reform of the supervision of clearing houses - i.e. CCPs, central counterparties. What do you think of the proposal?
We were invited by ECON to give input on the new legislative proposal. We also have had discussions with the European Commission and members of the Council. The legislative proposal is an example of where Europe is working on a very important issue, and Brexit is a major factor in how the EU approaches the issue. Our main concern with the legislative proposal is how third countries, like the United States, will be treated under the proposal. We recognise that Britain will become a third country after leaving the EU. Concern with Brexit, therefore, drives the EU's thinking on how to much access to give third country firms to the EU and what regulatory requirements will be imposed on such firms. The USA is already a third country. We therefore fear that everything the EU does towards Britain, which may be quite restrictive, will naturally also apply to the United States.
Does this necessarily have to be the case?
We hope not. But there are discussions in Brussels and in the European Supervisory Authorities, like ESMA, to limit the ability of firms in the UK to continue to have access to the EU market after Brexit. All indications we have received so far show that the treatment of the UK will be part of a third country regime that applies to all third countries. Since the US will be impacted by any such change in the treatment of third countries, we do not wish to be collateral damage in the Brexit negotiations. The United States should be treated differently than the UK. We are in a very different position from the United Kingdom. We have had an existing third country relationship with the EU for years, including several equivalence and recognition decisions. We would be very concerned if this existing relationship were to be changed simply because of Brexit.
The draft law states that, depending on the systemic relevance of a CCP, the European Securities Markets Authority ESMA may carry out a review of equivalence and recognition every two or five years. Is this the point of concern for you?
Periodic review is not necessarily a problem. The problem is how this review is carried out. In 2016, we reached an agreement with the European Commission, which was reviewed by the EU Council and the EU Parliament. It provided the framework for how we deal with CCPs between the US and Europe. It took three years to work out this agreement. The discussions were very detailed. It covered all technical aspects of supervision and operational implementation, such as how our CCPs manage risk. We have asked for confirmation that this agreement stay in place after the Brexit.
This agreement contemplates that adjustments will be made to reflect significant changes in market conditions. An objective review, based on data and a focus on an assessment of actual market conditions, must be the basis for any future reviews of equivalence and recognition. That is why we seek today assurances that the terms of the 2016 agreement will continue to be respected. What is not tolerable is if US CCPs face different treatment because of political factors and changes in the European political system resulting from Brexit. If such reviews are conducted without consideration of politics or internal European institutional changes then we are very confident that US CCPs meet all current conditions and do not need to be subject to any further European regulation and supervision.
You didn't get that confirmation?
The ECON amendments have some helpful provisions, but I think the committee could have gone further as none of our concerns have been 100 percent addressed. The current proposal says there is a review, but it does not say how the review is conducted. As stated earlier, we do not want a review to change the existing 2016 agreement because of political factors such as the Brexit or other aspects - for example, because ESMA acquires new competences and suddenly imposes new conditions. The 2016 agreement states that the regulatory treatment of CCPs may evolve as the market activities of the CCPs evolve. As regulators, we must keep an eye on the risks of the CCP. To the extent that CCPs gain or lose business significantly, we have always accepted that we make adjustments to the agreement. In short, change should be based on real economic change, not on political change.
The main aim of the proposal is to ensure that the ECB and European supervision can manage risks to the stability of the Eurosystem. So it's not so much about the US and dollar clearing. Why don't you relax here?
The proposal contemplates dividing CCPs into three categories. Much public attention has been focused on a possible systemically-important Tier 3 CCP located in the United Kingdom because there has been discussion of requiring the relocation of the CCP to Europe. We are primarily concerned about the treatment of Tier 2 CCPs. They are not affected by a possible relocation requirement, but they will be subject to greater director supervision and regulation by ESMA. We believe that it is highly likely the largest US CCPs will be classified as Tier 2 CCPs. Tier 2 focuses on the systemic relevance of the CCP on Europe. The proposal is vague about what that means, and that worries us. We think we have already done this analysis with the Commission in 2016. Redrawing all this and allowing ESMA to work through all this again leads us to believe that we must have the same discussion that we have had for three years and that we must once again prove everything that we actually believed to have been clarified before.
Do you have any other concerns?
The Tier 2 proposal does not say very precisely what ESMA would pay attention to. When the CFTC examines a European CCP, two major product groups in the derivatives market are involved. There are futures, i.e. exchange-traded derivatives (ETD), and swaps. In futures clearing, the CFTC does not regulate foreign CCPs. We only have a direct regulatory interest in foreign CCPs that clear swaps, for example interest rate swaps. However, even in such cases, we only look at swap clearing activity involving a US firm. We do not regulate other swaps clearing, such as transactions between two European firms. Thus, CFTC regulation of European CCPs has been quite limited for years. The proposal, which now goes from ECON to the Council, does not distinguish between futures and swaps, and does not distinguish which counterparties are involved in a transaction. In fact, the proposal suggests that ESMA will regulate 100% of the US CCP and all of its clearing activities. This would go far beyond anything the CFTC has done with respect to a European CCP.We also are concerned with the role of the European Central Bank to have separate supervisory powers over the third country CCP on top of the powers already held by ESMA. We do not believe it is wise to have competing roles for the ECB and ESMA. First, in the United States, CCP supervision is the primary responsibility of the CFTC. Therefore, a split role for the ECB and ESMA would immediately create a difference with the United States. Second, in times of emergency or uncertainty, the worst thing that could happen is if multiple supervisors try to direct the CCP without being coordinated with each other. It becomes a source of delay and uncertainty – ingredients for increasing panic and risk. That is why we prefer to give the home country authority control over the steering wheel and encourage other supervisors to work through the home country authority. We take this view based on decades of practical experience overseeing CCPs.
What is problematic in your view?
We have very large CCPs in the USA, where the vast majority of transactions are only US business. The European interest in this should be small. However, the proposal calls for the entire CCP to be scrutinised, and not just the European business. In our opinion, this goes far beyond what is appropriate and is not consistent with what we do to European CCPs. It seems to make our CCPs vulnerable to stricter supervision by the European authorities. We want to see clearer statements in the proposal about the limits to European regulation of US CCPs to avoid possible confusion. If there is a CCP with a strong exposure in euro or to European counterparties, we do support close cooperation between the CFTC and European supervisory authorities. There is already an example of this cooperation in the College of Supervisors on LCH.
What do you think of the issue of relocation of euro clearing from London to the EU27?
We are concerned about governments forcing markets to relocate. Central clearing should support risk mitigation and not be undermined by increasing costs on clearing members.
Could you live with a relocation if there was a clear decision in the treatment of US-CCP?
We have only heard about the possibility of relocation in connection with the LCH business in the United Kingdom, which is part of the Brexit discussions. We do not want to interfere in discussions between the UK and EU. However, relocation could have unintended consequences and disrupt business, affecting everyone including US companies. We are very concerned about what is the objective of such relocation. It appears it is about control. But what type of control and for what purpose?
The point is that, in the end, EU law applies and there is legal certainty.
We must then understand what is the scenario causing concern in Europe? One scenario that has been cited to us is when LCH increased margin requirements for the clearing of certain European government debt swaps. Is this the scenario that proponents of relocation have in mind? The problem is: would legal control be used to direct the CCP to support government debt instruments or to support the safety and health of the CCP? Regulatory authorities must ensure that CCPs operate safely and that they are able to carry out effectively their critical risk mitigation role in the global financial system. This was a clear objective of the G20 Leaders in 2009. We would not support any steps that would suggest using the supervision of CCPs to achieve unrelated policy objectives. This could lead market participants to no longer have confidence in CCPs because they are concerned that the risk mitigation decisions of the CCP would be undermined by external considerations. That would not be a good result for anyone, especially for the European financial markets.
The interview was conducted by Dietegen Müller.
Eric Pan is Director, Office of International Affairs, U.S. Commodity Futures Trading Commission (CFTC)