\”The mission of US Commodity Futures Trading Commission,\” as its website notes, \”is to foster open, transparent, competitive, and financially sound markets, to avoid systemic risk, and to protect the market users and their funds, consumers, and the public from fraud, manipulation, and abusive practices related to derivatives …\” The CFTC is supposed to operate with five commissioners, but it is currently making do with three. One of them is J. Christopher “Chris” Giancarlo who was nominated by President Obama in 2013 and started his role in 2014. Giancarlo recently participated in the Fidelity Guest Lecture Series on International Finance at Harvard Law School, and in his December 1, 2015, lecture, he expressed his frustration about how the financial regulatory apparatus is still so focused on working through the implementation of the Dodd-Frank law passed five years ago–a law designed to address the problems of the 2007-2009 financial crisis–that too little attention is being given to what are right now the more important challenges of regulatory policy. Giancarlo sets the stage this way:

\”The Dodd-Frank Act was passed over five years ago, but U.S. market participants and Washington financial regulators must still spend much of their professional time arguing over and addressing its myriad mandates and peculiar prescriptions – regulatory edicts ostensibly designed to prevent a recurrence of the last crisis. The same is true for much of the European and Asian discussion around the G-20 regulatory reform efforts initiated in Pittsburgh in 2009 and coordinated by the Financial Stability Board (FSB). The hue and cry of the ongoing financial market reforms under Dodd-Frank and the FSB leaves market regulators and participants with very little available bandwidth to assess and prepare for the next financial crisis – a crisis that will certainly be unlike the last one.

Just as “peacetime generals are always fighting the last war” and “economists fight the last depression,” so too do financial regulators outlaw past market abuses that are not a looming threat to our financial markets and economies. The Dodd-Frank Act and its unceasing implementation are uniquely positioned to ensure U.S. market regulators stay focused on the past.

Allow me to use a simple analogy. U.S. market regulators are riding together in an automobile on a high-speed interstate highway. The Dodd-Frank Act is an oversized rear-view mirror covering almost the entire windshield. That rear-view mirror directs our attention to the enormous amount of rules and requirements generated over the past five years that need to be or reworked to meet Dodd-Frank’s never-ending demands. Meanwhile, financial markets continue to evolve and pass by at remarkable speed. New dangers are coming right at us. As we regulators barrel down the road of 21st century financial markets, we must shed this backwards-looking approach to regulating or we will not be able to see the oncoming traffic and looming dangers ahead.\”

What dangers does Giancarlo believe, looking around around from his perch at the CFTC, should be the main focus of financial regulators right now? Here are his six priorities–and the Dodd-Frank legislation has very little to say about any of them: 
1) Cybersecurity. Both Giancarlo and CFTC chair Timothy Massad are on record as saying that \”cybersecurity is the most important single issue facing our markets today in terms of market integrity and financial stability.\”

2) Disruptive Technology. Regulators need to figure out how to deal with issues like automated electronic trading. Giancarlo writes: \”It is hard to deny that finance is increasingly becoming an industry where machines and humans are swapping their dominant roles – transforming modern finance into what scholar Tom Lin has called `cyborg finance.\’\” Other new technologies include \”distributed open ledger\” systems in which records of financial transactions are held openly by many parties, as in the case of Bitcoin and a number of efforts by private-sector banks. and the development of \”financial cartography,\” by which he means maps of how financial networks interact.

3) Government intervention. Here, Giancarlo is referring to the very large role that the Federal Reserve and other central banks have come to play in financial markets. He writes (footnotes omitted):

\”Since the 2008 financial crisis, the Federal Reserve (Fed) has made itself an increasingly outsized player in the U.S. government debt markets … Through its “quantitative easing” (QE) program, the Fed has purchased an unprecedented 61 percent of all Treasuries issued, peaking at close to 80 percent in 2014. Today, the Fed has become the multi-trillion dollar “Washington Whale.” Its intervention in the Treasury and mortgage-backed security markets misprices the true cost of credit below its natural level and distorts the integrity of prices and exchange rates. The Fed is having an increasingly direct and immediate impact on all other markets, from corporate bonds to equities and foreign exchange rates to developing nations’ sovereign debt. It has reduced the heterogeneity of the investor base, herding it into one-way bets on anticipated changes in Fed policy rather than traditional fundamental credit or value analysis. …. Central banks have replaced major dealers and money center banks as marketplace Leviathans plunging into increasingly shallower pools of trading liquidity. With one flip of their policy tails, these central bank behemoths can whack a whole lot of smaller market participants out of once-liquid markets and leave them stranded.

4) Market illiquidity. Here, the main concern is that in writing rules to limit what banks and financial institutions are allowed to do, we may be contributing inadvertently to market that are less liquid and thus more prone to episodes of high volatility or even manipulation. Giancarlo said (footnotes omitted):

Market participants know that liquidity is the lifeblood of healthy trading markets. In essence, liquidity is the degree to which a financial instrument may be easily bought or sold with minimal price disturbance by ready and willing buyers and sellers. …  

We saw evidence of such pronounced liquidity contraction this past August in enormously volatile equity markets, when major global banks focused on executing trades for their clients rather than for their own account.We saw it in June with sudden spikes in the German Bond market.We saw it a year ago when the market for U.S. Treasury securities, futures and other closely related financial markets experienced an unusually high level of volatility and a very rapid and pronounced round-trip. A few weeks ago, Chairman Massad cited new CFTC research showing that “flash” volatility spikes have become increasingly common, with 35 spike events so far this year in core futures products such as corn, gold, WTI crude oil, E-Mini S&P and Euro FX.

Traditionally, large global money center banks served to reduce such market volatility by buying and selling reserves of securities and other financial instruments to take advantage of short-term anomalies in market prices. Their balance sheets served as market “shock absorbers” in times of market turbulence. … According to one senior banker, “Wall Street’s role as an intermediary and risk taker has shrunk.” This evolution appears to have been underway for some time.

A major catalyst of the reduced bank trading liquidity in financial markets is the new regulatory policies of U.S. and overseas bank prudential regulators imposed in the wake of the financial crisis. … Most of the new regulations have the effect of reducing the ability of medium and large financial institutions to deploy capital in trading markets. Combined, these disparate regulations are already sapping global markets of enormous amounts of trading liquidity. …In trying to stamp out risk, global regulators are instead harming trading liquidity. … We need to understand the full implications of constrained bank capital on market health and resiliency and the ability of financial markets to underpin sorely needed global economic growth. 

5) Market concentration. Giancarlo writes: 

\”A wave of consolidation is taking place across the financial landscape, concentrating the provision of essential market services within fewer and fewer institutions. It is now widely recognized that Dodd-Frank regulations have wiped out small community banks across America’s agriculture landscape. It is less well-acknowledged that large banks are broadly reducing market services, jettisoning less-profitable clients and increasing some fees on others in such critical areas as prime brokerage and administrative services. A similar narrowing of market services is taking place in the swaps market, where rising regulatory costs are driving consolidation of transaction service providers into a few remaining major SEFs [Swap Execution Facilities]. This wave of consolidation is perhaps most glaringly apparent in the case of America’s futures commission merchants (FCMs).\” 

6) De-globalization. Here, the concern is that because of regulatory differences across countries, global pools of capital are being splintered and rearranged to sidestep regulations–a game that often does not end well. Giancarlo writes: 

\”Traditionally, users of swaps products chose to do business with global financial institutions based on factors such as quality of service, product expertise, financial resources and professional relationship. Now, those criteria are secondary to the question of the institution’s regulatory profile. Overseas market participants are avoiding financial firms bearing the scarlet letters of “U.S. person” in certain swaps products to steer clear of the CFTC’s problematic regulations. As a result, non-U.S. market participants’ efforts to escape the CFTC’s flawed swaps trading rules are fragmenting global swaps trading and driving global capital away from U.S. markets. … According to a survey conducted by the International Swaps and Derivatives Association (ISDA), the market for euro interest-rate swaps (IRS) has effectively split. Volumes between European and U.S. dealers have declined 55 percent since the introduction of the U.S. SEF [Swap Exchange Facility] regime. The average cross-border volume of euro IRS transacted between European and U.S. dealers as a percentage of total euro IRS volume was twenty-five percent before the CFTC put its SEF regime in place and has fallen to just ten percent since.

Fragmentation has exacerbated the already inherent challenge in swaps trading – adequate liquidity – and is increasing market fragility as a result. Fragmentation has led to smaller, disconnected liquidity pools and less efficient and more volatile pricing. Divided markets are more brittle, with shallower liquidity, posing a risk of failure in times of economic stress or crisis. Fragmentation has increased firms’ operational risks as they structure themselves to avoid U.S. rules and manage multiple liquidity pools in different jurisdictions …\”  

I\’m not sure that Giancarlo\’s six priorities are the right ones. Some seem to me more important than others, and in particular, I don\’t know much detail about the regulation of the swaps market. But I find it easy to believe that while politicians and regulators are refighting the battles of 2008–and in particular, how to reduce the risk of future bailouts by the US Treasury or the Federal Reserve–we are giving insufficient thought to other issues of financial regulation that should at least be on the radar screen in 2016.

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