March 4, 2013
Good morning. Thank you, Rich, for that kind introduction. I also want to thank Sally Miller and the Institute of International Bankers (IIB) for the invitation to speak at your annual Washington conference.
As I did with you last year, I’d like to speak about matters on the Commodity Futures Trading Commission’s (CFTC) agenda that I believe will be of importance to your members.
First, I’m going to talk about the issues surrounding the London Interbank Offered Rate (LIBOR) and other similar rates. Second, I’m going to talk about the continued implementation of common-sense rules of the road for the swaps market.
LIBOR: Unstable and Unsustainable
As to the issue of LIBOR and similar benchmarks, I believe that continuing to reference such rates diminishes market integrity and is unsustainable in the long run.
Let’s look at what we’ve learned to date.
Foremost, the interbank, unsecured market to which LIBOR and other such rates reference has changed dramatically. Some say that it is has become essentially nonexistent. In 2008, Mervyn King, the governor of the Bank of England, said of LIBOR: “It is, in many ways, the rate at which banks do not lend to each other.” He went on further to say: “[I]t is not a rate at which anyone is actually borrowing.”
There has been a significant structural shift in how financial market participants finance their balance sheets and trading positions. There is an increasing shift from borrowing unsecured (without posting collateral) toward borrowings that are secured by posting collateral. In particular, this shift has occurred within the funding markets between banks.
The London interbank, unsecured market used to be where banks funded themselves at a wholesale rate. But the 2008 financial crisis and subsequent events have shattered this model.
The European debt crisis that began in 2010 and the downgrading of large banks’ credit ratings have exacerbated the hesitancy of banks to lend unsecured to one another.
Other factors have played a role in this structural shift. Central banks are providing significant funding directly to banks. Banks are more closely managing demands on their balance sheets. And looking forward, recent changes to Basel capital rules will take root and will move banks even further from interbank lending.
The Basel III capital rules now include an asset correlation factor, which requires additional capital when a bank is exposed to another bank. This was included to reduce financial system interconnectedness.
Furthermore, the rules introduce a liquidity coverage ratio (LCR). For the first time, banks will have to hold a sufficient amount of high quality liquid assets to cover their projected net outflows over 30 days.
At an International Organization of Securities Commission (IOSCO) roundtable on financial market benchmarks held in London last week, one major bank indicated that the LCR rule alone would make it prohibitively expensive for banks to lend to each other in the interbank market for tenors greater than 30 days. Thus, this banker posited that it is unlikely that banks will return to the days when they would lend to each other for three months, six months or a year.
We also have learned that LIBOR – central to borrowing, lending and hedging in our economy – has been readily and pervasively rigged.
Barclays, UBS and RBS were fined $2.5 billion for manipulative conduct by the CFTC, the UK Financial Services Authority (FSA) and the Justice Department. At each bank, the misconduct spanned many years; took place in offices in several cities around the globe; included numerous people – sometimes dozens, and even included senior management; and involved multiple benchmark rates and currencies. In each case, there was evidence of collusion.
In the UBS and RBS cases, one or more inter-dealer brokers painted false pictures to influence submissions of other banks, i.e., to spread the falsehoods more widely. Barclays and UBS also were reporting falsely low borrowing rates in an effort to protect their reputation.
These findings are shocking, though the lack of an interbank market made the system more vulnerable to such misconduct.
In addition, we have seen a significant amount of publicly available market data that raises questions about the integrity of LIBOR today.
A comparison of LIBOR submissions to the volatilities of other short-term rates reflects that LIBOR is remarkably much more stable than any comparable rate. For instance, how is it that in 2012 – if we look at the 252 submission days for three-month U.S. dollar LIBOR – the banks didn’t change their rate 85 percent of the time?
Why is it that some banks didn’t change their submissions for three-month U.S. Dollar LIBOR for upwards of 115 straight trading days? This means, in effect, that one bank represented that the market for its funding was completely stable for 115 straight trading days or more than five months.
When comparing LIBOR submissions to the same banks’ credit default swaps spreads or to the broader markets’ currency forward rates, why is there a continuing disconnect between LIBOR and what those other market rates tell us?
Nassim Nicholas Taleb, whom you may know as the bestselling author of The Black Swan, has written a recent book called Antifragile: Things that Gain from Disorder.
He notes that systems that are not readily able to evolve and adapt are fragile. Such systems succumb to stress, tension and change.
One of his key points is that propping up a fragile system in the interest of maintaining a sense of stability only creates more instability in the end. One can buy an artificial sense of calm for a while, but when that calm cracks, the resulting turmoil is invariably greater.
I think that the financial system’s reliance on interest rate benchmarks, such as LIBOR and Euribor, is particularly fragile.
These benchmarks basically haven’t adapted to the significant changes in the market. Thus, the challenge we face is how does the financial system adapt to this significant shift?
At the London roundtable, a man named David Clark approached me to discuss a bit of the history of LIBOR in which he had personally been involved. As a young banker in 1970, he worked on a floating rate note deal for ENEL issued by Bankers Trust that used a reference rate called LIBOR.
A lot has changed since 1970 – Nixon was President, we were in the midst of the Vietnam War, the Beatles released their final album Let It Be, and I was a kid wearing bell-bottoms.
Sixteen years later, the British Bankers Association (BBA) began publishing LIBOR as we know it today. A lot has changed since 1986 – Reagan was President, we were in the midst of the Cold War, and I was dating the wonderful woman I would marry, Francesca.
And now, I have three wonderful daughters, but unfortunately, we lost Francesca. In life, one must adapt to change.
Yet LIBOR – embedded in the wiring of our financial system – largely remains the same.
This is why international regulators and market participants have begun to discuss transition. The CFTC and the FSA are co-chairing the IOSCO Task Force on financial market benchmarks.
One of the key questions in the consultation with the public is how do we address transition when a benchmark is no longer tied to sufficient transactions and may have become unreliable or obsolete?
Without transactions, the situation is similar to trying to buy a house, when your realtor can’t give you comparable transaction prices in the neighborhood – because no houses were sold in the neighborhood in years.
Given what we know now, it’s critical that we move to a more robust framework for financial benchmarks, particularly those for short-term, variable interest rates.
A reference rate has to be based on facts, not fiction.
I recognize that moving on from LIBOR may be challenging. Today, LIBOR is the reference rate for 70 percent of the U.S. futures market, most of the swaps market and nearly half of U.S. adjustable rate mortgages.
But as the author Nassim Taleb might suggest, it would be best not to fall prey to accepting that LIBOR or any benchmark is “too big to replace.”
Further Implementation of Swaps Market Reform
This conference is occurring at an historic time in the markets. The CFTC now oversees the derivatives marketplace – not only futures that we have overseen for decades, but also swaps. Our agency has completed 80 percent of the Dodd-Frank swaps market rules.
And the marketplace is increasingly shifting to implementation of these common-sense rules of the road.
For the first time, the public is benefiting from seeing the price and volume of each swap transaction. This information is available free of charge on a website, like a modern-day tickertape.
For the first time, the public will benefit from the greater access to the swaps market and the risk reduction that comes from centralized clearing.
For the first time, the public is benefiting from oversight of swap dealers. So far, 73 swap dealers have registered and must adhere to sales practice and business conduct standards to help lower risk to the overall economy. In addition, two major swap participants have registered. Of these 75 entities, 30 are non-U.S. entities.
In 2013, we still need to finish rules and guidance in two key areas.
First, is completing pre-trade transparency reforms. These reforms will allow buyers and sellers to meet and compete in the marketplace, just as they do in the securities and futures marketplaces. It’s a priority to complete the swap execution facility and block rules.
Secondly, is ensuring the cross-border application of swaps market reform appropriately covers the risk of U.S. affiliates operating offshore. In enacting financial reform, Congress recognized a basic lesson of modern finance and the 2008 crisis: during a default, risk knows no geographic border.
Risk from our housing and financial crisis contributed to economic downturns around the globe. If a run starts in one part of a modern financial institution, whether it's here or offshore, the risk comes back to our shores. It was true with AIG, which ran most of its swaps business out of the London neighborhood Mayfair. It was also true at Lehman Brothers, Citigroup, Bear Stearns and Long-Term Capital Management.
Last year’s events of JPMorgan Chase, where it executed swaps through its London branch, were a stark reminder of how when risk is booked offshore, any losses are absorbed back here at home.
Failing to incorporate this basic lesson into the CFTC’s oversight of the swaps market would fall short of the goals of Dodd-Frank reform. It would leave the public at risk.
More specifically, we have to complete the guidance that Dodd-Frank reform applies to transactions entered into by branches of U.S. institutions offshore, between guaranteed affiliates offshore, and for hedge funds that are incorporated offshore but operate in the U.S. Otherwise, American jobs and markets may move offshore, but, particularly in times of crisis, risk would come crashing back to our economy.
Last July, the Commission proposed guidance addressing market participants’ obligations under the Dodd-Frank Act (and Commission regulations) with respect to their cross-border activities. The Commission also proposed granting time-limited relief until this July for non-U.S. swap dealers (and foreign branches of U.S. swap dealers) from certain Dodd-Frank swap requirements.
The proposed guidance includes a commitment to permitting foreign firms and, in certain circumstances, overseas branches and guaranteed affiliates of U.S. swap dealers, to meet Dodd-Frank requirements through compliance with comparable and comprehensive foreign rules. We call this substituted compliance.
In December, the Commission finalized the time-limited relief. In July, when the relief expires, various Dodd-Frank requirements will apply to non-U.S. swap dealers. Overseas banks who wish to look to substituted compliance to fulfill Dodd-Frank requirements are encouraged to engage now with the CFTC, as well as their home country regulators.
The final order, as an interim step, took a narrower, more territorial-based approach to the definition of “U.S. person.”
The Commission is seeking yet additional public comment on the “U.S. person” definition, as well as the aggregation requirements with respect to the de minimis calculation for swap dealer registration and the treatment of a “foreign branch.”
Further, we must ensure that collective investment vehicles – including hedge funds, that either are managed (or otherwise have their principal place of business) in the U.S. or are directly or indirectly majority owned by U.S. persons – are not able to avoid clearing or any other Dodd-Frank requirement simply due to how they are organized.
If we don’t ensure for this, the P.O boxes may be offshore, but the risk will flow back here.
Once again, I want to thank the IIB and its members for inviting me to speak today on derivatives markets reform. I’m glad if we have a few minutes for questions.
Last Updated: March 4, 2013