April 10, 2013
Good afternoon, thank you David for that kind introduction. I’d also like to thank the Chamber of Commerce for inviting me to speak at your annual Capital Markets Summit. I’m honored to be joining this summit for the fourth year in a row.
Your conference is about managing risk in a global economy so I want to start by addressing what may be one of the most significant risks you’re facing in the capital markets.
That is the risk to market integrity of the continued use of LIBOR, Euribor and similar benchmark interest rates.
Interest rate benchmarks – central to borrowing, lending and hedging in our economy – are of critical importance to members of the Chamber.
LIBOR, as you may know, purports to represent the rate at which unsecured borrowing occurs between large banks. The insufficient number of transactions in this market, though, undermines market integrity.
Given their fundamental role in the capital markets and our economy, benchmark rates must be based on facts, not fiction.
Prices and rates formed by the competitive forces of supply and demand in a robust, transparent marketplace are the best guarantee of a reliable price or rate. Yet hundreds of trillions of dollars of financial instruments and contracts rely upon a benchmark referencing a market where essentially no borrowing occurs.
Banks simply are not lending to each other as they once did. 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.”
This is a result of many factors: the 2008 crisis, the continuing European debt crisis, the downgrading of large banks’ credit ratings, as well as central banks providing significant funding directly to banks. Recent changes to Basel capital rules, including the new liquidity coverage ratio, suggest that banks may not return to interbank lending on an unsecured basis.
The shift away from banks funding each other in the unsecured market (without posting collateral) has led to a scarcity or outright absence of actual transactions underpinning LIBOR and other benchmark rates.
This situation – having benchmark rates that are not anchored in actual transactions – undermines market integrity and leaves the financial system with benchmarks that are prone to misconduct.
Indeed, as law enforcement actions brought by the Commodity Futures Trading Commission (CFTC), the U.K. Financial Conduct Authority and the U.S. Justice Department have shown, LIBOR and other benchmark rates have been readily and pervasively rigged.
These cases resulted in Barclays, UBS and RBS paying fines of approximately $2.5 billion for manipulative conduct relating to these rates. At each bank, the misconduct spanned many years.
At each bank it took place in offices in several cities around the globe.
At each bank it included numerous people – sometimes dozens, among them senior management.
Each case involved multiple benchmark rates and currencies. In one case, there were over 2,000 instances of misconduct over a six-year period.
And 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 reputations.
Beyond these cases, there is a significant amount of publicly available market data that further calls the integrity of LIBOR into question.
A comparison of LIBOR submissions to the volatilities of other short-term rates reflects that LIBOR is curiously 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?
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?
Whether we consider the broad structural shift away from unsecured, interbank lending; the recent enforcement actions; or questions about market data, confidence in the continued use of LIBOR and other similar interest rate benchmarks is undermined.
For capital and risk to be efficiently allocated within the economy – which is of vital importance to Chamber members – interest rate benchmarks should reflect actual price discovery anchored in observable transactions.
While ongoing international efforts targeting benchmarks, which I am pleased to be a part of, will focus on governance principles for benchmarks, these efforts cannot address a central vulnerability of LIBOR: the lack of transactions in the underlying market.
The time has come for U.S. regulators to work with our counterparts abroad, along with market participants, such as the people in this room, to promptly identify alternative benchmarks that are anchored in observable transactions and determine how to transition to such alternatives. The transition must be as smooth and orderly as possible, but given the vulnerabilities in the system, I believe that a transition is warranted.
The market has some experience with benchmark transitions, albeit for smaller contracts. When the euro was created, a number of interest rate benchmarks were discontinued. How many of you remember PIBOR, RIBOR, MIBOR and FIBOR? Transitions have also occurred for energy and shipping rate benchmarks.
I recognize that moving on from LIBOR and Euribor may be challenging. But continuing to support LIBOR and Euribor in the name of stability may have the opposite effect. Using benchmarks that threaten market integrity may create more instability in the long run.
The status quo leaves your members at risk that benchmarks that were rigged in the past may be exposed to rigging again in the future.
That risk is neither good for the capital markets nor for our economy.
Swaps Market Reform
Now, let me turn to swaps market reform.
Your members benefit from transparent and efficient derivatives markets. Both futures and swaps markets provide the opportunity to hedge a risk by locking in a future price or rate. Managing the price risk of energy or agriculture or the rate risk of interest rates or foreign currency allows your members to focus on what they do best – innovating and producing goods and services for the economy.
The derivatives markets work best for farmers, ranchers, producers and commercial companies when they are transparent; competitive; and free of fraud, manipulation and other abuses. The implementation of the common-sense reforms in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) brings these benefits to the once opaque and unregulated swaps market.
Transparency lowers costs for businesses and consumers, as it shifts information from dealers to the broader public. Post-trade transparency has come to the marketplace. The price and volume of transactions is available to the public on a website, like a modern-day ticker tape.
Seventy-five swap dealers and two major swaps participants are now provisionally registered. With this new oversight, they are subject to standards for sales practices, recordkeeping and business conduct to help lower risk to the economy and protect the public from fraud and manipulation.
As of last month, the public is benefiting from the greater access to the swaps market and risk reduction that comes with central clearing. Swap dealers and the largest hedge funds began clearing the vast majority of interest rate and credit default index swaps. Compliance will continue to be phased in throughout this year.
Swaps Reforms Benefit End-users
Each component of swaps market reform has been done with an eye toward ensuring they work for end-users, America’s job providers. It’s the end-users in the non-financial side of our economy that provide 94 percent of private sector jobs.
Congress provided in the Dodd-Frank Act that end-users should be able to choose whether or not to clear swaps that hedge or mitigate commercial risks. Last summer, the Commission finalized rules to implement this exception, including for small financial institutions.
As the Chamber calls for in your Financial Regulatory Reform 2013 Report Card, the Commission’s proposed rule on margin provides that end-users will not have to post margin for uncleared swaps. We also continue to advocate with global regulators for an approach consistent with that of the CFTC.
Non-financial companies, other than those genuinely making markets in swaps, will not have to register as swap dealers.
Further, the CFTC has ensured that when end-users are required to report their transactions, they are given more time to do so than other market participants.
Exceptions for Inter-affiliate swaps
Also of importance to your members, last week the CFTC finalized a rule to exempt swaps between certain affiliated entities within a corporate group from the clearing requirement.
In addition, CFTC staff issued a letter last week exempting swaps between affiliated counterparties that are not swap dealers or major swap participants from certain swap reporting requirements. This “no-action” letter extends to swaps between almost all non-financial affiliates.
We’ve received many comments and had many meetings with non-financial end-users that about required clearing if they use a treasury affiliate when entering into their market facing swaps. Though I don’t have any announcements today, let me assure you that the staff and Commission are taking a close look at how to appropriately address these issues in the context of the Dodd-Frank Act.
Further Implementation of Swaps Market Reform
Looking forward, it’s a priority that the Commission finishes rules to promote pre-trade transparency, including those for swap execution facilities (SEFs) and the block rule for swaps.
Pre-trade transparency will allow buyers and sellers to meet and compete in the marketplace, just as they do in the securities and futures marketplaces. Market participants will be able to view the prices of available bids and offers prior to making their decision on a transaction.
End-users will get to see the pricing and volume of swap transactions on these platforms, but get to choose whether or not to use them. Furthermore, companies will continue to be able to rely on customized transactions to meet their particular needs, as well as to enter into large block trades.
Looking forward, it’s also a priority that the Commission ensures the cross-border application of swaps market reform appropriately covers the risk of U.S. affiliates operating offshore. During a default, risk knows no geographic border.
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. That 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.
Thus, as the CFTC completes the cross-border guidance, I believe it’s critical that Dodd-Frank swaps 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. Where there are comparable and comprehensive home country rules abroad, we can look to substituted compliance, but the transactions would still be covered.
If we fail to provide common-sense oversight to offshore affiliates of U.S. entities, American jobs and markets may move offshore, but, particularly in times of crisis, risk would come crashing back to our economy and could affect your businesses all over again. As I’m standing here speaking with the American Chamber of Commerce, which has the words “JOBS” in giant letters on the front of your building, I would imagine we would agree that this would not be a good result for the American public.
Ensuring we get the cross-border application of swaps reforms right is critical to protecting you members from the risk of another foreign-affiliate failure.
I was flattered to see that this year, the CFTC got a slightly better grade in your annual report card than last year – you moved us up to a C+ from a C.
I also noticed that derivatives reform was graded higher than all the other issues you covered, except “Preserving the Integrity of Accounting and Auditing.”
More seriously, I was pleased to see that we agree on your overall statement on derivatives reform: moving the vast majority of swaps into central clearing and onto transparent exchanges increases transparency and lowers risk.
As I’ve said in past speeches to you, why aren’t we more aligned? We both want more transparency, openness and competition in these markets, which lowers costs for companies and their customers.
And we cannot forget the real scorecard for so many Americans that resulted in eight million jobs lost.
Last Updated: April 10, 2013