February 4, 2016
Thank you for the kind introduction and good afternoon everyone. It is a pleasure to be here at the George Washington University Law School.
I am honored to give the 2016 Manuel F. Cohen Lecture today as a memorial to Manny Cohen, who was a former Chairman of the Securities and Exchange Commission (SEC), a legal scholar and a teacher here at GW for almost two decades. During his tenure as Chair of the SEC, the concept of the economic theory of regulation emerged. I have long been a student of law, economics and finance. It has shaped my approach as a securities and corporate lawyer for 33 years and my current role as a Commissioner. So, I feel especially at home so to speak, in delivering today’s lecture at the Center for Law, Economics and Finance. Let me first note that the views expressed today are my own, and do not reflect those of my fellow Commissioners or Commission staff.
Before I get to my main topic, I should answer the question that is probably on the minds of many of you: What is the Commodity Futures Trading Commission or CFTC? I’m happy to answer that question, and not at all surprised by it. People often think they are hearing SEC or FTC. For an agency that has such a significant impact on our financial markets, we are relatively not well known when compared to other financial agencies.
The CFTC was established in 1974 to oversee the commodity futures markets. The agency was created to address manipulation, and other types of fraud, in these markets. We were a sleepy little agency back then, at least compared to today. But after the 2008 financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act expanded the Commission’s oversight to cover the $400 trillion swaps market as well, which is about twelve times the size of the futures market.1
The swaps market is vast and incredibly diverse. It includes derivatives contracts that range from plain vanilla interest rate swaps to multi-legged instruments involving equities, options, currencies, and just about any financial instrument under the sun. The Commission oversees the bulk of these swaps including interest rate swaps, commodity swaps, and credit default swaps, which played a major role in the 2008 crisis itself.
Our mission, as aptly described on our website, 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 ….”2 So as you can see, we are a very important agency in the effort to stabilize our financial markets. That fact might not be obvious given our relatively small budget – but more on that later.
Now I’d like to talk about the focus of this symposium which is to answer a question that is of utmost importance to the American people: as far as the derivatives markets are concerned, are we safer today than we were before the 2008 crisis? It’s a fair question. After all, the purpose of the Dodd-Frank Wall Street Reform and Consumer Protection Act3 was to make the economy safer by reforming Wall Street and protecting consumers. Has Wall Street been reformed? Are consumers better protected? I will answer those two questions in my remarks today.
Are consumers better protected?
I’ll start with the second question first: are consumers better protected? The answer is yes, but not as protected as they expected to be after the post-crisis reforms.
Let’s go back to the 2008 crisis for a moment. There is no doubt that the uncollateralized risk hiding in dark derivatives markets greatly amplified the damage caused by the crisis. These hidden costs fell on the economy like an avalanche out of nowhere. We weren’t ready. We weren’t prepared, because we had no idea what was lurking in that darkness.
Right after the crisis, world leaders met at the 2009 Pittsburgh Summit and agreed on how to improve the derivatives markets to avoid another such catastrophe. That it was the corner stone of the G-20 Accord. They identified four ways to improve the derivatives markets - requiring clearing, and execution, of standardized swaps, reporting of all swaps, and “higher capital” for uncleared swaps.4 Our track record in meeting these four goals has been mixed.
Regarding clearing, which is basically when a third party acts as an intermediary to reconcile orders between two parties in a trade, the goal was to bring standardized derivatives onto clearinghouses. The reason for encouraging the use of clearinghouses is that they are able to appropriately manage collateral requirements, while also providing regulators with clear, timely visibility into these markets. Clearing thus shines much needed light on this dark sector of the market. We have had considerable success in this area. Through our rulemakings and through voluntary action by market participants, widely used interest rate and credit default instruments, and other instruments, have been brought onto clearing. This is a success story.
The gains that we have made are at risk, however, of being undermined by the application of a capital charge to the segregated customer funds that have been set aside to secure cleared products. This will discourage clearing, due to this increased cost. While I understand that capital plays an important role in financial stability, applying a capital penalty on clearing is counterproductive, and risks driving many of our now, highly transparent transactions back into the darkness. We need to address this. It is clearly an unintended consequence when two regulations, both of which are meant to buttress our financial system, clash. I am hopeful that ongoing discussions with our prudential regulators will address this unfortunate outcome. We also need to stay vigilant about ensuring that our clearinghouses are engaging in risk management effectively – an issue that the Advisory Committee that I sponsor, the Market Risk Advisory Committee, has considered, and for which a subcommittee has proposed recommendations.5
Regarding execution, the goal was to bring standardized derivatives products onto trading platforms, thereby providing price efficiency and transparency. We have had success here as well. We established, and very recently registered, several swap execution facilities or SEFs, which trade these products through a variety of methods. I am hopeful that the SEFs will continue to improve their technology and oversight to provide execution to more and more derivatives products.
We need to refine SEFs further, however. First, we need a better governance solution than we have now. Currently, all 18 SEFs are each self-regulatory organizations (SROs) – with different rules for market participants. And as many of the SEFs are just building liquidity, they may be reluctant to aggressively discipline their members. I thus strongly advocate that, whether through statutory changes and/or rulemaking, we should consider establishing one self-regulatory organization for all of the SEFs, such as the National Futures Association. That way this one SRO can: (1) provide one consistent set of rules to all market participants; (2) be an impartial umpire – unswayed by competitive concerns; and (3) be a one-stop-shop for our agency to get cross-market information about the conduct of key market players. I think that this would greatly improve our ability to oversee these markets, and I think many of the SEFs would welcome this too. With one SRO after all, SEFs could focus on their core business of providing forums for the trading of swap. And the SRO could then focus on the job of ensuring that our laws and regulations are followed.
I have also endorsed in the past,6 and continue to support, an end to the practice of post-trade name give-up on SEFs. For those of you who do not know, name give-up is when, after anonymously executing a derivatives trade, the SEF reveals the identity of the counterparties to each other. Sounds strange doesn’t it in our modern day cleared market? Post-trade name give-up is a relic of the past, originating in bilateral markets for uncleared swaps, where it was used to manage counterparty credit risk. When the products are cleared, however, as many are today, the need for name give-up disappears, and its continued practice inhibits the use of SEFs by non-dealer customers.
Regarding reporting, the G-20 goal was to require that all swaps be reported so that the public and regulators could see every swap trade that occurs – true transparency. Good news here as well. Under our current rules, all swaps transactions, whether cleared or uncleared, must be reported to a trade repository. This information is then aggregated and sorted, and provided to the Commission so that we can have transparency into the markets under our purview. We are still refining this data however. Our rulemaking did not provide an accompanying data specification document to clearly outline each data field. But our staff is working diligently to address this area. I recently visited a “war room” of our staff beginning the work of creating a data spec by prioritizing which data elements are essential. As an outgrowth of this effort, our staff recently issued a request for comment on 120 data elements.7 I could not be more pleased with this effort of our staff, and I hope to see those efforts continue.
Regarding uncleared swaps, the goal was to require higher capital requirements for uncleared swaps, because the G-20 leaders believed uncleared swaps presented greater risk to the market. We proposed capital requirements for swap dealers in 2011. Those rules need to be re-proposed and finalized.
We have recently finalized, however, the highly-related margin rules for uncleared swaps – a rulemaking that was intended to ensure that there is proper collateral for these transactions. Unfortunately, I had to dissent from that rulemaking. My reason for this was simple. As I noted in my dissenting opinion, our exemption of inter-affiliate trades, which involve trades within a large bank between one affiliate and another, is a big black hole that we have left unfilled.8 And while I am glad that we have some requirement for uncleared margin on trades between different entities, it does not make up for such a gaping regulatory hole on interaffiliate trades. After all, as I also said in my dissenting statement, interaffiliate trades may comprise half of this entire market when it comes to uncleared swaps. I say that again for emphasis – interaffiliate trades may be half of this market. I hope that future Commission action will address this error, possibly in our re-proposed capital rule.
So our track record for meeting the four G-20 goals for derivatives, clearing, and execution, of standardized swaps, reporting of all swaps, and higher capital for uncleared swaps is mixed. At the same time, there are a number of risks that were not contemplated in the Pittsburgh G-20 Accord that we face today – namely cybersecurity and improperly supervised high-frequency trading.
In regard to cybersecurity, the problem is clear – our firms are facing an unrelenting onslaught of attacks from hackers with a number of motives ranging from petty fraud to international cyberwarfare. In December, the Commission released two rules on this subject which I was proud to support. These rules will require trading platforms, clearinghouses, and trade repositories to test their cybersecurity measures.9 Further, for entities that have a significant role in our markets such as clearinghouses, the proposals require heightened measures such as minimum frequency requirements for conducting certain testing, and the use of independent contractors.10 These are much needed rules and I hope we can finalize them quickly. Clearly, however, this is only a first step since all our registrants – not just trading platforms, clearinghouses, and trade repositories – need to have clear cybersecurity measures in place.
High-frequency trading has also considerably changed how the trading of futures works, and we, as regulators, need to be on guard about risks that this new technology may also bring. I have spoken about HFT before and made some recommendations about policies to address some of these concerns.11 Since then I voted yes on a rule proposal that includes many of these requirements.12 Some of these requirements could be real game-changers for these markets.
One requirement is that firms need to put in place sufficient risk controls, including redundant notifications if something goes wrong and efficient communication channels between compliance staff and coding staff. Another requirement is exchanges must disclose the proportion of their orders that are self-trades, and stop market makers from receiving incentives for self-trades.13 Investors need to know whether self-trading accounts for a high percentage of trades, so they can appropriately adjust their trading strategies—or switch to a different exchange altogether. I look forward to reviewing comments about this rulemaking and finalizing it.
So, in answer to the question, are consumers better protected, they are – but there is much more that needs to be done. We need to: (1) continue to support clearing by addressing the leverage ratio issue; (2) support the transparent trading of swaps on exchanges by establishing one SEF SRO and ending name-give-up; (3) continue the work begun by our staff to refine reported data; (4) ensure that there are appropriate risk mitigation requirements for uncleared swaps; (5) finalize our current cybersecurity rules, and expand the requirements to other market participants; and (6) finalize our automated trading rules to address the risks raised by HFT.
Is Wall Street Reformed?
Now I’ll return to the first question: is Wall Street reformed? The short answer is no. I walked into this job concerned that Wall Street would be looking at our penalties for malfeasance as the cost of doing business, as opposed to a real culture change, and today, I still have that concern. In order to really reform Wall Street – we need to address two areas – enforcement and conduct rules.
We need to make statutory changes, so that bad actors know that we are serious about enforcement. To that end, our enforcement division needs many more, and more powerful, weapons in its arsenal. What do those include? First, we need higher enforcement penalties. For instance, currently, if someone manipulates the market, and their customers lose a lot of money, but the manipulator doesn’t any profit, the most we could penalize the manipulator would be $1 million.14 As I told a Subcommittee of the House Agriculture Committee when I testified before them in April, that should definitely change.15 To make the market understand that we mean business, we need to raise these thresholds.
Second, we need privilege protection when cooperating with other agencies – a benefit that the SEC currently has.16 Today, while pursuing civil charges, the Commission sometimes finds it necessary to help the Department of Justice (DOJ) or foreign regulators pursue parallel investigations into criminal charges. In doing so, there are certain situations where sharing work product with the DOJ actually means that the documents lose their privilege protection and the defendants can gain access to them through the discovery process. This unnecessarily impedes our ability to pursue these cases and should be ended.
And last and most importantly, the Commission desperately needs more financial resources. Our enforcement staff is working hard to bring cases that impact the entire derivatives market. Like an ant, the Commission’s enforcement staff carries out mammoth tasks despite its small size. But if our staff had more people, better software, more administrative support, etc. we could do a better job policing this vast and systemically significant market. Two-hundred and fifty million dollars for an agency that oversees a $400 trillion swaps market does not add up. We may be saving money now, but what will it cost us when the next crisis hits?
In order to reform Wall Street, we also have to deal with conduct. First, we need to insist on having governance rules for the derivatives markets. Real change starts at the top – a culture of compliance that is supported by the Board and senior management. In 2010 and 2011, the Commission proposed rules on governance for our clearinghouses and trading platforms. 17 These rules have never been finalized. At this point, they likely should be re-proposed. In reviewing these rules, there are a number of elements that I think are very good, including the requirement to:
1. establish a Board committee that would report to the Board, called a Regulatory Oversight Committee to monitor and oversee the regulatory program of the entity, and supervise its Chief Compliance Officer;
2. submit an annual report for the Commission and the Board, assessing the entity’s self-regulatory program;
3. report to the Commission if the Board rejects any recommendation by the Regulatory Oversight Committee; and
4. ensure that the Board is composed of qualified, diverse, and independent directors who represent a diversity of viewpoints.18
These are just a few of the good, thoughtful, common sense suggestions in these proposals. At this point, what was one of the first rules we proposed, is now one of the last rules to be finalized. And this subject is essential to financial reform. We cannot hold the market to standards that we have not defined for them. As I have noted on a number of occasions,19 the time has come to finalize this rule, this year. I will continue to advocate for finalizing a strong governance rule.
In regard to conduct, I would also like to say a few words about a report issued last year by the Financial Conduct Authority, HM Treasury and The Bank of England in the U.K. called the Fair and Effective Markets Review, which proposed changes to the fixed income, currencies and commodities markets.20 In this report the U.K. regulators make several worthwhile suggestions. One suggestion is that regulators across the globe should develop common standards for conduct.21 I think this is a sensible proposal – the definition of conduct does not change from jurisdiction to jurisdiction. We can develop common standards of what honest, transparent business dealing-making looks like. Of course, these standards would have to be no less rigorous than the conduct rules that exist today for U.S. firms – we do not want to move backwards.
Another excellent recommendation from this publication is that regulators should mandate the kind of information that must appear in references to avoid the recycling of bad actors from one jurisdiction to another or one asset class to another, or as the UK regulators call it, the “rolling bad apple” problem.22 I call it the “whack-a-mole” problem. It is all too easy today for a bad actor in the credit default swap space, who is dismissed, to pick up and move to fixed income, or head over to the U.K., and continue working. We need to develop means to prevent that – standard reference requirements would be one way to do so. Having a global database of the disciplinary history of financial professionals, across jurisdictions, would be another way. We need to explore these options.
In conclusion, in regard to market risk in the derivatives markets, we have made strides. We are, without question, better protected today than we were prior to 2008. We have reporting where there was none, we have execution platforms where there were none, we have a lot more derivatives clearing than there was before. But we have so much more to do in order to give the American people the economy that they deserve – in order to “protect consumers” and “reform Wall Street.” We need to bolster clearing, execution, reporting and risk mitigation of uncleared products. We also need robust rules on cybersecurity and high-frequency trading. And lastly, we need enforcement tools, as well as conduct standards, that will really ignite culture change on Wall Street and across finance. I will be working, and I hope you will join me in the effort, to accomplish these goals. Thank you.
1 See “Mission & Responsibilities,” available at http://www.cftc.gov/About/MissionResponsibilities/index.htm
3 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111–203, 124 Stat. 1376 (2010) (Dodd-(Frank Act).
4 See Leaders’ Statement, Pittsburgh Summit, September 24-25, 2009, available at https://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.
5 See “Market Risk Advisory Committee,” available at http://www.cftc.gov/About/CFTCCommittees/MarketRiskAdvisoryCommittee/index.htm.
6 See “Statement of U.S. Commodity Futures Trading Commissioner Sharon Bowen Regarding Trading Practices on SEFs,” CFTC (Apr. 23, 2015), available at www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement042315.
7 See “Draft Technical Specifications for Certain Swap Data Elements, A Request for Comment by Staff of the U.S. Commodity Futures Trading Commission,” (Dec. 22, 2015), available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/specificationsswapdata122215.pdf.
8 See “Dissenting Statement of Commissioner Sharon Y. Bowen Regarding Final Rule on Margin for Uncleared Swaps,” (Dec. 15, 2015), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement121615a.
9 See “Concurring Statement of Commissioner Sharon Y. Bowen Regarding Notice of Proposed Rulemaking on System Safeguards Testing Requirements,” (Dec. 16, 2015), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement121615b.
10 See more information about the proposed rules at “CFTC to Hold an Open Commission Meeting on December 16th to Consider Final and Proposed Rules,” available at http://www.cftc.gov/PressRoom/Events/opaevent_cftcstaff121615.
11 See “Keynote Address by Commissioner Sharon Y. Bowen before ISDA North America Conference,” (Sep. 17, 2015), available at www.cftc.gov/PressRoom/SpeechesTestimony/opabowen-6.
12 See “Concurring Statement of Commissioner Sharon Y. Bowen Regarding Open Meeting on Regulation Automated Trading (“Regulation AT”),” (Nov. 24, 2015), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement112415.
13 See “Keynote Address by Commissioner Sharon Y. Bowen before ISDA North America Conference,” (Sep. 17, 2015), available at www.cftc.gov/PressRoom/SpeechesTestimony/opabowen-6.
14 See 7 USC § 9(10).
15 See Testimony of Commissioner Sharon Y. Bowen before the U.S. House Committee on Agriculture Subcommittee on Commodity Exchanges, Energy, and Credit, “(Apr. 14, 2015), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opabowen-3.
16 See Dodd-Frank Actc, 15 U.S.C. § 78x(f).
17 For a copy of the rules and summaries, see “Governance & Conflicts of Interest,” available at http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_9_DCOGovernance/index.htm
19 See “Commissioner Bowen’s Speech before the Managed Funds Association, 2015 Compliance Conference,”
(May 5, 2015), available at www.cftc.gov/PressRoom/SpeechesTestimony/opabowen-4; Keynote Speech of CFTC Commissioner Sharon Y. Bowen before the Quadrilateral Meeting at the European Central Bank, (Jun. 24, 2015), available at www.cftc.gov/PressRoom/SpeechesTestimony/opabowen-5.
20 See “Fair and Effective Markets Review, Final Report,” (June 2015), available at http://www.bankofengland.co.uk/markets/Documents/femrjun15.pdf.
Last Updated: February 4, 2016