Michael Brochstein/Sipa USA via AP Images
Rostin Behnam, chairman of the Commodity Futures Trading Commission, speaks at a hearing of the Senate Health, Education, Labor and Pensions Committee at the U.S. Capitol, March 8, 2023.
President Biden’s appointed chair of the Commodity Futures Trading Commission, Rostin Behnam, has taken up a new piece of financial deregulation first crafted under the Trump administration with the backing of Wall Street. The proposed rule would roll back Dodd-Frank protections for swap trades, a major class of derivatives that led directly to the 2008 financial crisis, by relaxing margin requirements for certain categories of investment funds.
There’s growing pushback on Capitol Hill to the proposed rule from Biden’s Democratic allies. Several members of the Senate Agriculture Committee, which oversees the CFTC, sent a letter today to Behnam urging him to drop the rule.
“The Proposed Rule would be a step in the wrong direction and undermine the goals of Dodd-Frank,” the letter from Sens. John Fetterman (D-PA), Sherrod Brown (D-OH), and Tina Smith (D-MN) reads. In October, Sen. Elizabeth Warren (D-MA) also sent a letter to the chair echoing similar concerns about the rule’s potential to create gaps in the regulatory framework put in place to safeguard the financial system after 2008.
Swaps are financial contracts where one party takes on the risk of an interest rate on a loan or a commodity price in exchange for a fixed payment from a counterparty. One side gets reliability about the payments on its balance sheet, the other a chance for a profit if the derivative accrues value beyond the set payment amount. Swaps are commonly used by insurance firms and other large financial institutions including hedge funds. Four large banks registered as swap dealers facilitate almost 90 percent of this derivatives market.
Any changes to rules governing swaps are bound to raise alarms, given that swap trades for adjustable-rate subprime mortgages were one of the main financial instruments that led to the collapse of the financial system in 2008. AIG in particular collapsed under the weight of its uncleared swap deals, which it couldn’t meet payments for once the run on the market was triggered.
The proposal, first announced at the end of July, was approved by the commission in a 3-1 vote with Behnam joining the two Republican commissioners to vote in favor of the rule, against the strident opposition of Democratic commissioner Christy Goldsmith Romero. The other Biden-appointed Democratic commissioner, Kristin Johnson, voted to concur with the majority, a procedural move that stopped short of voting in the affirmative.
“I am concerned that this change could produce unacceptable levels of risk, possibly even systemic risk and harm to financial stability,” wrote Goldsmith Romero in her dissent.
The rule was first drawn up at the CFTC in 2020 under President Trump’s acting chair Heath Tarbert. The idea was first recommended by the CFTC’s Global Markets Advisory Committee, which is made up mostly of industry partners, including JPMorgan Chase as well as numerous swap-trading firms that stand to benefit from the rule. Usually, the CFTC conducts an independent report based on this committee’s recommendations, given the financial conflicts of interest among the advisers. But an independent report was not carried out for this rule; only the GMAC report is cited.
“It is unclear why the CFTC is only now, three years later, considering moving forward with the Proposed Rule,” the letter from the Agriculture Committee members reads. All three signers of the letter also serve on the Senate Banking Committee; Brown serves as that committee’s chair.
Swap trades for adjustable-rate subprime mortgages were one of the main financial instruments that led to the collapse of the financial system in 2008.
The rule permits some swap trades to circumvent margin requirements and also expands the scope of financial assets that could be put down as collateral to meet these requirements, to include riskier securities.
Increased margin standards were one of the primary guardrails implemented by Dodd-Frank. Per the policy’s design, they’re a tool to protect against the buildup of risk in derivatives markets by forcing dealers to put down enough collateral to offset a portion of potential losses should they fail to make payments to the initial loan provider in the swap trade.
The CFTC’s new rule creates carve-outs in these margin requirements for two categories of investive vehicles: seeded funds that receive startup capital from banks or venture capital in exchange for equity stake, and money market funds, which are pillars of the less-regulated shadow banking system that hold mainly short-term securities and are prone to panic runs.
One critical measure of the rule revokes the classification of seeded funds as margin affiliates of their sponsored capital entities, which puts most of the funds under the $50 million threshold triggering margin requirements. It means that swap deals with seeded funds can circumvent margin requirements in nearly all cases.
Furthermore, all swap traders could put down as collateral certain assets held with money market funds, which were previously restricted from the eligible criteria for posting margin.
Both the Agriculture Committee Democrats’ letter and Commissioner Goldsmith Romero’s dissent argue that these changes to regulatory structure for swaps create loopholes that pose significant market risks.
They warn that money market funds should not be used as collateral since these funds are not held to the same risk, liquidity, and capital restrictions as traditional banks, which make them more susceptible to volatility. During the pandemic, stresses on money market funds led to widespread withdrawals by investors and ultimately forced the Federal Reserve to intervene with a taxpayer bailout. Numerous financial groups have pushed for more stringent oversight of the shadow banking system, given the buildup of unstable assets.
Exemptions for seed funds could steer more swap trades in their direction to avoid posting margins. This could put stress on the market and spread out to larger financial institutions that hold equity stakes in these companies.
Better Markets, a financial policy organization that represents the public interest on the CFTC’s advisory committees, shares their assessment. In a public comment submitted for the proposed rule, Cantrell Dumas, Better Markets director of derivatives policy, opposed the rule, explaining that chipping away at the Dodd-Frank regulatory structure may not be felt immediately but could have long-term consequences. He sees it as part of an industry effort to gut Dodd-Frank that has been an ongoing battle since the law’s adoption.
“This rule is like a slow death by a thousand paper cuts, or a game of Jenga, where you pull out one piece and the whole financial structure is shakier,” said Dumas.
In particular, Dumas disputes the commission’s assumption in this rule that posting collateral is some kind of penalty. Rather, it’s a protection to ensure all parties are less exposed to harms.
Both Dumas and lawmakers believe the CFTC’s rule would also conflict with existing banking regulations at other federal agencies tasked with governing derivatives. The CFTC claims it’s merely bringing its rules in line with global regulations, but that comes at the cost of undermining stronger domestic regulations.
“It’s hard to see the rationale for this rule and it’s even more bewildering why a Democratic chair appointed by Biden is pushing for a Republican-led proposal. We need stronger regulatory protections, not weaker ones,” said a Democratic congressional aide.
The rule is just the latest action by the CFTC that has come under question. Chair Behnam has been more favorable to the cryptocurrency industry’s pitch that their tokens are financial assets, and therefore regulated by the CFTC, rather than securities. The latter designation would bring crypto under the jurisdiction of the Securities and Exchange Commission, which has more robust regulatory powers.
Behnam met with Sam Bankman-Fried ten times before the collapse of his crypto exchange FTX last year. A month before the platform imploded, Behnam endorsed FTX’s preferred regulatory proposal, calling it “another phase in the evolution of market structure, innovation, and disruption.” Bankman-Fried was convicted of fraud earlier this month.
Recently, Behnam did help bring billion-dollar penalties against the Chinese crypto exchange Binance for misconduct. But his previous advocacy for crypto has raised scrutiny from lawmakers. The new CFTC rule only adds to the perception on Capitol Hill that the CFTC under his chairmanship is aiding industry patterns at the cost of financial stability.
This story has been updated to clarify CFTC Commissioner Kristin Johnson’s vote on the swaps rule.
