June 7, 2012
Good afternoon, Rich, thank you for that kind introduction and for inviting me to speak about the Commodity Futures Trading Commission’s (CFTC) efforts to implement swaps market reforms.
The CFTC is working to complete commonsense rules of the road to promote swaps market transparency and help protect taxpayers from again standing behind financial institutions.
Swaps, now comprising a $700 trillion notional global market, were developed to help manage and lower risk for commercial companies. But as highlighted in 2008, they also concentrate and heighten risk in financial institutions. The 2008 crisis led to eight million jobs lost, millions of families losing their homes, and thousands of businesses shuttering.
Congress responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which brings transparency and competition to the swaps market and lowers its risk to the rest of the economy.
The CFTC has completed 33 reforms with less than 20 to go. Nearly four years after the crisis and two years after Dodd-Frank became law, it’s critical that we finish these reforms to protect the public and promote healthier markets.
Crucial among these swaps market reforms is public market transparency, which helps shift information and access from dealers to the broader market. Whether it’s non-financial end users, pension funds, mutual funds, community banks or insurance companies, they all benefit from the lower costs and greater pricing information of a more transparent, accessible and competitive swaps market.
Further, transparency lowers the risk of the swaps market.
First, it does so by allowing the public and users of swaps to see the pricing and volume of transactions, as well as many bids and offers, in real time.
Second, it does so by giving both dealers and end users the ability to look to markets to value positions, allowing for better supervision of and accounting for risk.
And third, it does so by providing greater liquidity. This is particularly important when positions need to be unwound, either by a clearinghouse or a dealer facing a loss or default.
Among the transparency reforms we’ve completed are those related to swap data repositories (SDRs), real-time reporting and designated contract markets (DCMs).
SDRs will receive data on all swaps transactions. Four parties thus far have sent us applications to become SDRs.
Swaps transaction data will be reported in real time to the public and to regulators starting this summer. This will begin with interest rate and credit default swaps (CDS) followed by similar reporting on other swaps later this year.
Last month, we finished guidance and acceptable practices for DCMs, which will be able to list and trade swaps.
We're hoping to complete rules for the block rule and swap execution facilities (SEFs) later this summer. It's important to fulfill Dodd-Frank reforms that bring pre-trade transparency to the swaps marketplace.
Swaps market reform also benefits markets by increasing the use of central clearing, which promotes the financial integrity of markets and lowers the risks of the highly interconnected financial system.
Clearing exists in the swaps market, but on a voluntary, dealer-to-dealer basis. With reform, clearing will expand to include transactions between dealers and financial entities.
The CFTC has made significant progress on clearing. We have completed rules establishing derivatives clearing organization risk management requirements, the bulk of which went into effect last month.
The remainder will become effective in November, including important customer protection enhancements requiring clearinghouses to collect margin on a gross basis and the so-called “LSOC rule” (legal segregation with operational comingling) for swaps.
To further promote market democratization, we finished a rule on client clearing documentation, which limits the ability of futures commission merchants and swap dealers to restrict customers and counterparties from accessing other market participants. The related “straight-through processing” rule further gives market participants the benefit of prompt clearing.
CFTC staff is preparing recommendations for the Commission and for public comment on clearing requirement determinations. The first determinations will be put out for public comment this summer and hopefully completed this fall. They are likely to begin with standard interest rate swaps, as well as a number of CDS indices.
Staff is recommending that we propose a requirement for fixed-to-floating interest rate swaps, basis swaps, forward rate agreements, and overnight index swaps in four currencies: U.S. dollars, Euros, British pounds and Japanese yen.
For CDS indices, the requirement likely will cover certain North American investment grade and high yield CDX indices, as well as certain European iTraxx, high volatility, and crossover iTraxx indices.
The CFTC has worked with market participants on phased implementation and will soon consider a final rule on the implementation phasing of the clearing requirement. Staff recommendations for this rule and the end-user exception are with commissioners.
For market participants trying to plan for the first clearing determinations, though I don’t have a specific date, if we’re able to put a proposal out next month, the determinations could be as early as October.
Swaps market reform also means ensuring that swap dealers are specifically regulated for swaps activity. Leading up to the crisis, it was claimed that dealers were already regulated as banks.
The 2008 crisis revealed the inadequacy of relying on this claim. While banks were regulated for safety and soundness, there was no comprehensive regulation of their swap dealing activity. Similarly, bank affiliates dealing in swaps, and subsidiaries of insurance and investment bank holding companies dealing in swaps, were not subject to specific regulation of swap dealing activity. AIG’s downfall was a clear example of what happens with such limited oversight.
The Commission has made real progress on reforms to regulate swap dealers. We have finished sales practice rules requiring them to interact fairly with customers, provide balanced communications and disclose conflicts of interest.
Our internal business conduct rules require swap dealers to establish risk management policies, as well as put in place firewalls between a dealer’s trading, and clearing and research operations.
We completed dealer registration rules, as well as a joint rule with the Securities and Exchange Commission (SEC) further defining the terms “swap dealer” and “securities-based swap dealer.”
Dealers will be required to provisionally register after we finalize the second definition rule with the SEC, the further definition of “swap” and “securities-based swap.”
A staff document on this further definition rule is before Commissioners at both agencies. It is my recommendation that we consider it expeditiously.
Cross-Border Application of Swaps Market Reform
Before concluding, I want to address two areas that if not handled appropriately could significantly undercut Dodd-Frank swaps market reforms.
First, is how these reforms are to be applied across borders and second is the CFTC’s funding.
Recent events at JPMorgan Chase are a stark reminder of how swaps traded overseas can quickly reverberate with losses coming back into the United States.
We've seen this movie before. Financial institutions set up hundreds, if not thousands of legal entities around the globe. During a default or crisis, risk inevitably comes crashing back onto our shores.
We all remember AIG, Lehman Brothers, Citigroup, Bear Stearns and Long-Term Capital Management.
AIG’s subsidiary, AIG Financial Products, brought down the company and nearly toppled the U.S. economy. How was it organized? It was run out of London as a branch of a French-registered bank, though technically was organized in the US.
We all know what happened when Lehman Brothers collapsed. Among Lehman Brothers’ complex web of affiliates was Lehman Brothers International (Europe) in London. When Lehman failed, this London affiliate, with more than 130,000 outstanding swaps contracts, failed as well. Who stood behind these swaps contracts? The U.S. mother ship, Lehman Brothers Holdings, had guaranteed many of them.
Citigroup is yet another example. It set up numerous structured investment vehicles (SIVs) to move positions off their balance sheet for accounting purposes, as well as to lower their regulatory capital requirements. Yet, Citigroup had guaranteed the funding of these SIVs through a mechanism called a liquidity put. We all know how this ended up. When the SIVs were about to fail, Citigroup in the US assumed the huge debt, and taxpayers later bore the brunt with two multi-billion dollar infusions. Oh, how was it organized? These SIVs were launched out of London and incorporated in the Cayman Islands.
Bear Stearns – same story – its two sinking hedge funds it bailed out in 2007 were incorporated in the Cayman Islands. Yet again, the public assumed part of the burden when Bear Stearns itself collapsed nine months later.
And the same goes with Long-Term Capital Management. When this hedge fund failed in 1998, its swaps book totaled in excess of $1.2 trillion notional, the vast majority of which were booked in its affiliated partnership… in the Cayman Islands.
There are many in the industry who want us to ignore these experiences.
They might tell you that swap trades booked in London branches shouldn't be brought under Dodd-Frank reform.
They might tell you that their affiliates guaranteed by their mother ship shouldn't come under Dodd-Frank reform.
They might tell you that their affiliates acting as conduits for swaps activity back here shouldn't be brought under Dodd-Frank reform.
If we follow their comments, the result would be that American jobs and markets would move offshore but the risk would still be very much part of the activities of these U.S. financial institutions. Particularly in times of crisis, the risks would come back to affect our economy.
I believe that swaps market reform should cover transactions not only with persons or entities operating in the U.S., but also with their overseas branches. In the midst of a default or a crisis, there is no satisfactory way to really separate the risk of a bank and its branches. Likewise, I believe this must include transactions with overseas affiliates that are guaranteed by a U.S. entity, as well as the overseas affiliates operating as conduits for a U.S. entity’s swaps activity.
Commissioners are reviewing the staff’s recommendation on the cross-border application of swaps market reforms.
The other threat to swaps market reform is an effort to underfund the CFTC. Just yesterday, a House subcommittee passed an appropriations bill that cuts our funding.
The result of this bill is to effectively put the interests of Wall Street ahead of those of the American public by significantly underfunding the agency Congress tasked to oversee derivatives – the same complex financial instruments that helped contribute to the most significant economic downturn since the Great Depression.
The CFTC’s hardworking staff is just 10 percent more in numbers than at our peak in the 1990s, yet Congress has now directed the agency to oversee the swaps market that is eight times larger than the futures market.
Picture the NFL expanding eightfold to play more than 100 football games in a weekend, leaving just one referee per game, and, in some cases, no referee. Imagine the mayhem on the field, the resulting injuries to players, and the loss of confidence fans would have in the integrity of the game.
We would not want similar mayhem and loss of confidence in markets so critical to farmers, ranchers and end users that may result from this bill’s significant underfunding of the CFTC.
Last Updated: June 7, 2012