October 30, 2012
Good afternoon, Howard, I appreciate that kind introduction, and thank you and the Ontario Securities Commission (OSC) for the invitation to speak. Hurricane Sandy has hit the U.S. East Coast, preventing me from flying to Canada. I’m glad that you could arrange for me to speak to you from a distance.
This week’s weather disaster makes me think of the 2008 financial disaster.
Canada successfully weathered the 2008 storm, as it looks like you will avoid the worst of Sandy.
As we rebuild from this natural disaster, we’ll be examining ways to better protect the public from and be prepared for the next storm.
After 2008, we had to rebuild from a financial disaster. Though it was a manmade disaster rather than natural, similarly, we had to examine ways to better protect the public.
In so doing, it’s appropriate to take things back to basics.
The role of finance and financial markets is to allocate and price the savings and investments of the public and help businesses grow and manage their risks.
It is to allow the public unfettered access to markets and information, and establish prices transparently and free of fraud and manipulation.
In sum, it’s about ensuring that finance serves the rest of the economy.
As the financial system failed in 2008, the swaps market, which was basically not regulated in the U.S., Canada, Europe or Japan, failed to meet these objectives.
The swaps marketplace operated without the basic transparency and common-sense reforms that Americans have benefitted from since the 1930s. In the aftermath of an even bigger storm, the Great Depression, President Roosevelt and Congress put in place securities and futures markets reforms.
Those historic reforms established a foundation of transparency, competition and market integrity for the futures and securities markets. This democratization of U.S financial markets has led to many decades of economic growth and innovation.
The 2008 financial disaster caused great damage. Just like Hurricane Sandy, it affected millions of bystanders far and wide. Eight million American jobs were lost. Families across Europe still struggle with the ongoing debt crisis.
In 2009, a new international consensus was formed when the G-20 leaders, including the U.S. and Canada, met in Pittsburgh. For the swaps market to serve the rest of the economy, transparency, oversight and competition must be brought to the market.
Over the last three years, each of the major market jurisdictions has been coordinating on implementing reforms to achieve these goals. While we’re bound to have some differences, as we have different cultures and political systems, we’ve made significant progress on a coordinated approach to legislation and now to implementation of reform.
In this historic effort, the Commodity Futures Trading Commission (CFTC) has enjoyed a very close working relationship with authorities in Canada. We’ve worked constructively bilaterally, as well as through international forums such as the International Organization of Securities Commissions (IOSCO), where the OSC is a fellow co-chair of the OTC Derivatives Task Force.
In May, Howard and the OSC hosted the CFTC, along with other international regulators, for an international discussion on reform, and next week the CFTC and Securities and Exchange Commission (SEC) are hosting another such dialogue.
In addition, Mark Carney, as chairman of the Financial Stability Board, has been a great partner on reform.
The New Era of Swaps Market Reform
In 2010, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
As of October 12, the new era of swaps market reform began. For the first time, regulators and the public are beginning to benefit from market transparency. Swap dealers will come under comprehensive oversight, and central clearing will soon lower risk and help level the playing field.
Canada also has taken significant steps to implement reform, including the introduction of legislation on clearing and reporting of swaps. The OSC and other provincial regulators are currently working to draft rules.
I’d like to focus on the three principal areas of reform: the clearing requirement, transparency initiatives and swap dealer registration. I then will turn to international coordination on benchmark interest rates.
The Clearing Requirement
Clearinghouses have lowered risk for the public and fostered competition in the futures markets since the late 19th century.
Central clearing equalizes access to the market and democratizes it by eliminating the need for market participants to individually determine counterparty credit risk, as now the clearinghouse stands between buyers and sellers.
In July, we embarked on the last step toward clearing of standardized swaps when we sought public input on the first set of swaps that will be required to be cleared. They begin with standard interest rate swaps in U.S. dollars, euros, British pounds and Japanese yen, as well as a number of credit default swap (CDS) indices, including North American and European corporate names.
Canadian dollar interest rate swaps were not included in this initial set, though we will continue to consider, in consultation with regulators here in Canada, possibly including them at an appropriate time in the future.
The U.S. transparency reforms of the 1930s have increased liquidity and competition in the securities and futures markets for decades. Such transparency – both pre- and post-trade – levels the playing field by giving all market participants access to critical pricing and transaction information.
As of October 12, bright lights began to shine on the swaps market when cleared interest rate and CDS transactions began to be reported to swap data repositories.
By the New Year, the public will benefit from real-time reporting for these transactions, as well as for uncleared swap transactions entered into by swap dealers.
We’ve consulted widely with market participants, the SEC and international regulators regarding how best to finalize rules to promote pre-trade transparency through the use of trading platforms called swap execution facilities.
The current Canadian authority and the European and Japanese transparency legislative proposals – when fully implemented – will further align international reform efforts promoting transparency to the public.
Swap Dealer Oversight
Comprehensive oversight of swap dealers will promote transparency and lower their risk to the rest of the economy.
The process of registration has begun, and we anticipate many dealers will do so by January 1.
This will include a number of international financial institutions, possibly including some in Canada, that enter into more than a de minimis amount of swap dealing with U.S. persons.
In enacting financial reform, the U.S. Congress had the basic lessons of modern finance and the 2008 crisis in mind. They provided that when financial institutions or others operating outside the U.S. transmit risks directly into the U.S. through swap activities with U.S. persons, our laws provide for the regulation of such activities in the same manner as swap activities within the U.S.
During a default or crisis, risk knows no geographic border. If a run starts on one part of a modern financial institution, almost regardless of where it is around the globe, it invariably means a funding and liquidity crisis rapidly spreads to the entire consolidated entity.
Then finance, rather than serving the rest of the economy, can threaten the rest of the economy.
This was true with the overseas affiliates and operations of AIG, Lehman Brothers, Citigroup and Bear Stearns.
AIG Financial Products’ swaps business was basically run out of Mayfair in London. It nearly brought down the U.S. economy.
A decade earlier, it was true, as well, with the collapse of the hedge fund Long-Term Capital Management. It was run out of Connecticut, but its swaps were booked in its Cayman Islands affiliate.
To give financial institutions and market participants operating outside the U.S. guidance on the cross-border application of Dodd-Frank, the CFTC in June sought public consultation on an interpretation of these provisions.
This guidance says that Dodd-Frank swaps market reform covers transactions with overseas branches, overseas affiliates guaranteed by U.S. entities, and overseas affiliates operating as conduits for U.S. entities’ swaps activity. Failing to do so would otherwise mean that U.S. financial institutions might simply move their swaps activity offshore, but, particularly in times of crisis, that risk would still come crashing back to our economy.
In addition, the CFTC proposed an approach to phased compliance for foreign swap dealers.
Such phased compliance would allow time for appropriate implementation of substituted compliance, or allowing market participants to comply with Dodd-Frank through comparable and comprehensive foreign regulatory requirements.
The CFTC has a consistent record of relying on comparable home country regulation where appropriate.
We rely on Canadian authorities with regard to futures regulation in a number of instances, as they are comparable to CFTC requirements. We also are working on a regulatory memorandum of understanding with the OSC.
In consultation with the international regulatory community, the CFTC will move shortly to finalize the cross-border and phased-compliance releases.
The CFTC also is collaborating on a global approach to margin requirements for uncleared swaps through the Basel Committee on Banking Supervision and IOSCO.
I would anticipate the CFTC, in coordination with domestic prudential regulators, would take up the final rules on margin early next year, so as to benefit from this international work.
Benchmark Interest Rates
Before I close, I’d like to turn to what may be one of the most critical challenges in the upcoming year. Benchmark interest rates, such as the London Interbank Offered Rate (LIBOR), are a key component of our financial markets, and they must work for the rest of the economy. To do so, they must be honest and reliable.
LIBOR is the reference rate for nearly half of U.S. adjustable-rate mortgages; for about 70 percent of the U.S. futures market; and for a majority of our swaps market.
There are four broad questions that market participants and international regulators are focusing on with regard to benchmark rates.
First, what are the best practices to ensure for a reliable benchmark? I believe for a benchmark rate for any commodity or swap to be reliable and have integrity, it’s best to be anchored in real, observable transactions. It’s only through real transactions entered into at arm’s length between buyers and sellers that we can be confident that prices are discovered and set accurately.
When market participants submit for a benchmark rate that lacks observable underlying transactions, even if operating in good faith, they may stray from what real transactions would reflect. When a benchmark is separated from real transactions, it is more vulnerable to misconduct.
The underlying market for interbank transactions in London, however, has largely diminished. Some say that it has basically disappeared.
Second, in light of these best practices, how do the current survey benchmark rates measure up in comparison? Among other important questions, do they have sufficient numbers of underlying transactions to ensure their reliability and honesty?
The UK Financial Services Authority (FSA) addressed this point, in part, in its recent plan recommending reducing 150 benchmark rates to just 20, eliminating five of the currencies, including eliminating Canadian dollar LIBOR, and 11 of the maturities for the remaining currencies.
Third, what alternatives might there be for interest rate benchmarks? Possibilities include the overnight index swaps rate or benchmark rates based on actual short-term financings between banks and other financial institutions.
Lastly, how do we ensure for a smooth transition from benchmark rates that may have become obsolete or if markets move to an alternative rate? If Canadian dollar LIBOR were to be eliminated, as the FSA plan recommended, a transition would be necessary.
There have been circumstances in the past, albeit in smaller markets, such as the gasoline market, when a benchmark has become obsolete and a transition was put in place.
Several international organizations will be recommending approaches to next steps. The IOSCO task force will be seeking public input on possible mechanisms and protocols that would best ensure for a smooth transition when needed.
I hope that these public discussions and efforts lead to benchmark rates that best serve the rest of the economy as honest and reliable reflections of the underlying markets to which they refer.
Bringing it back to basics again, the role of finance is to serve the rest of the economy.
With Hurricane Sandy’s landfall this week, the U.S. will be working to rebuild from this natural disaster.
Swaps market reform is about rebuilding from a different type of disaster, the manmade financial disaster of 2008.
It’s about ensuring the public benefits from the lessons learned: transparency, oversight and competition must be brought to the swaps market.
We continue to make significant progress with the OSC and other authorities here in Canada, as well as globally, on bringing this reform to the swaps market.
Thank you again for inviting me, and I’m just sorry that I wasn’t able to be there in person.
Last Updated: October 29, 2012