June 6, 2013
Thank you, Rich, for that kind introduction. I’m honored to be here for the fourth year at your Global Exchange and Brokerage Conference.
A lot has happened since we were together last year. And I’m not just talking about my hometown Ravens winning the Super Bowl.
Swaps market reform is becoming a reality.
We can’t forget why this reform matters.
In 2008, the financial system failed and the financial regulatory system failed as well. Middle class Americans paid for this crisis with their jobs, their pensions and their homes. We lost eight million jobs and thousands of businesses shuttered.
The unregulated swaps market was one of the central causes of the crisis. Furthermore, it was financial institutions operating complicated swaps businesses in offshore entities that nearly toppled the U.S. economy.
Five years later, market participants are coming into compliance with the common-sense reforms that Congress laid out to promote transparency and protect the public.
The large, international banks, though, have asked the Commodity Futures Trading Commission (CFTC) to finalize guidance on the cross-border application of reform.
Congress was clear in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) that swaps reform does apply to activities outside our borders with “a direct and significant connection with activities in, or effect on, commerce of the United States.”
Congress did this knowing that risk knows no geographic border. Risk from our housing and financial crisis contributed to economic downturns around the globe. Risk also comes crashing back to our shores from overseas when a run starts in any part of a modern, global financial institution.
This reality has played out time and again -- before, during and since 2008.
Let me lay out what is at stake. The CFTC has completed fully 90 percent of the rules to bring transparency and oversight to the swaps market.
No longer will this market be closed and dark.
As a result of reforms completed last month, swap execution facilities (SEFs) will begin operating on August 5. This means all market participants, not just dealers, will have the ability to compete in the marketplace. Everyone will benefit from the ability to make bids and offers to the rest of the market in an order book, or simply just seeing quotes before making a decision on a transaction.
As a result of the block rule for swaps, starting July 30, half of the swaps market (by volume) will be reported to the public without delay – or as Congress mandated “as soon as technologically practicable” – making real-time reporting a reality.
Furthermore, by October 2, each swap trading platform will have to register, thus finally closing what had been known as the “Enron Loophole.” It had allowed for unregulated trading of swaps on trading platforms.
Lastly, by the end of this year, Dodd-Frank’s trade execution requirement comes to life. It is likely that SEFs will make available for trading a significant part of the interest rate and credit derivative index swaps markets.
When light shines on a market, the economy and the public both benefit.
Broad market participation in central clearing is also becoming a reality. Clearing lowers the risk of the swaps market to the economy. Equally important, it significantly broadens access to the market – particularly when coupled with the reforms requiring that transactions be processed straight through to the clearinghouse.
Swap dealers and the largest hedge funds began clearing the vast majority of their interest rate and credit default index swap transactions in March. The next critical phase is Monday, June 10, when most other financial entities will be required to clear.
Swap Dealer Oversight
For the first time, swap dealers are now subject to oversight for their swap dealing activity.
Seventy-eight swaps dealers and two major swap participants are now provisionally registered.
With this new oversight, they are responsible for sales practice, recordkeeping, and business conduct standards to help lower risk to the economy and protect the public from fraud and manipulation.
Cross-border Application of Swaps Reform
All of these common-sense reforms Congress mandated, however, could be undone if the overseas guaranteed affiliates and branches of U.S. persons are allowed to operate outside of these important requirements.
The nature of modern finance is that financial institutions commonly set up hundreds, if not thousands, of “legal entities” around the globe with a multitude of affiliate relationships.
When a run starts on any overseas affiliate or branch of a modern financial institution, risk comes crashing back to our shores.
Lest we forget AIG that nearly brought down the U.S. economy. Its affiliate, AIG Financial Products, was run out of the London neighborhood Mayfair as a branch of a French-registered bank. Contributing to this overseas operation’s ability to take on outsized risk was a guarantee from the U.S. parent.
Lehman Brothers had 3,300 legal entities here and abroad when it failed. The London affiliate had more than 130,000 outstanding swaps contracts, many of them guaranteed by Lehman Brothers Holdings back in the United States.
Citigroup set up numerous structured investment vehicles to move positions off its balance sheet. Citigroup had guaranteed the funding of these SIVs through a mechanism called a liquidity put. When the SIVs were about to fail, Citigroup here in the U.S. assumed the huge debt, which taxpayers later bore the brunt of with two multi-billion dollar bailouts.
And from where were the SIVs launched? London. And incorporated? The Cayman Islands.
Bear Stearns is another example from the 2008 crisis. Bear Stearns’ two sinking hedge funds it bailed out in 2007 were incorporated in the Cayman Islands. The public assumed part of the burden nine months later when Bear Stearns collapsed.
A decade earlier, the same was true for Long-Term Capital Management. The Connecticut hedge fund had a $1.2 trillion swaps book that sent it into a downward spiral, threatening the stability of the U.S. economy. At the time, I was working at the U.S. Department of the Treasury and had to break the news to the Treasury Secretary that the hedge fund’s swaps were booked in a Cayman Islands affiliate that wasn’t much more than a P.O. Box.
Just last year, we had another stark reminder that swaps booked offshore can send risk straight back to the United States. JPMorgan Chase suffered a multi-billion dollar trading loss from credit default swaps executed in its U.K. branch by a trader known as the “London Whale.”
Each of these examples clearly had “a direct and significant connection with activities in, or effect on, commerce of the United States.”
Congress knew this painful history when it crafted the cross-border provisions of swaps market reform. As market participants asked the CFTC to provide interpretive guidance on Congress’ words, we too must keep this painful history in mind.
The CFTC last June approved proposed interpretive guidance. At that time, the Commission also proposed a one-year transition period phasing in requirements for foreign swap dealers and foreign branches of U.S. swap dealers. In December, the Commission finalized this transition period, which runs until July 12.
The Commission now is considering the staff’s recommendation on final guidance for the market. We have benefitted from significant public input, as well as collaboration with regulators here and abroad.
To ensure that we don’t undermine the critical Dodd-Frank swaps market reforms, the final guidance needs to include some essential elements:
• First, Dodd-Frank requirements must cover swaps between non-U.S. swaps dealers and guaranteed affiliates of U.S. persons, as well as swaps between two guaranteed affiliates that are not swap dealers. Compliance with transaction requirements for these trades could come under comparable and comprehensive rules abroad, where they exist – or what we call “substituted compliance.”
As if the history of AIG, Lehman Brothers, Citigroup and their guaranteed affiliates aren’t enough to guide us regarding the dangers of leaving guaranteed affiliates out of reform, it’s also clear that if allowed, financial institutions would just skirt common-sense requirements by setting up affiliates in the Cayman Islands or some other offshore location.
• Second, the definition of U.S. person in the final guidance must include offshore hedge funds and collective investment vehicles that are majority-owned by U.S. persons or that have their principal place of business in the United States.
If we don’t address this, the P.O Boxes may be offshore in places like the Cayman Islands, but the risk will flow back here – just as it did with Long-Term Capital Management and Bear Stearns.
• Third, under the proposed guidance, foreign branches – like JPMorgan’s U.K. branch – of U.S. swap dealers possibly may comply with Dodd-Frank through substituted compliance. The final guidance, however, must ensure that the definition of a foreign branch is bona fide and that the swap is actually entered into by that branch. This is to ensure financial institutions don’t attempt to sidestep full compliance with reform through substituted compliance, which may not be identical to Dodd-Frank.
• And fourth, swap dealers – foreign or U.S. – transacting with U.S. persons in New York, New Jersey or anywhere else within the United States are to comply with Dodd-Frank swaps market reform. In fact, this has been the case since December 31, 2012, when swap dealers began registering.
We are committed to working through any instances where the CFTC is made aware of a conflict between U.S. law and that of another jurisdiction.
But there is no question that the words in the Dodd-Frank Act – “direct and significant connection with activities in, or effect on, commerce of the United States” – cover trades with people here in the United States.
Further, if trades with U.S. persons were allowed to come under substituted compliance, we may be giving an advantage to overseas swap dealers over those located right here in New York.
Some large financial institutions with swap businesses that dwarf those of the 2008 crisis dispute these goals because they contend it could be costly or hinder their competitiveness.
But we’ve heard this before. It’s easy for financial institutions to avoid reforms by setting up shop in an offshore locale, even if it’s not much more than a tropical island P.O. Box.
They’ll take the American jobs overseas but may operate their swaps business without adequate transparency, risk management and the other common-sense requirements in Dodd-Frank.
It is rational for financial institutions to try and engineer around our regulations. Our job, however, is to protect the American public.
We meet today on June 6, the day that American and allied forces stormed the beaches of Normandy.
My dad was serving in the Pacific then, and I think of him today.
After the war, he took his $300 mustering out pay and started what became the family business. And he knew that if he didn’t make payroll, nobody was going to bail him out.
I’m sure if he were alive he would say it shouldn’t be any different for banks and other large financial institutions. That’s what Congress said, as well, in passing Dodd-Frank.
Companies, large and small, should be free to innovate, to grow, and, yes, to fail without taxpayer support.
Swaps market reform is a key component in ensuring that firms are not too interconnected, too complex or too in the shadows of the market to fail.
If the offshore operations of financial institutions are allowed a free pass from reform, though, we will not fulfill Congress’ intent to end “too big to fail.”
At some point in the future, someone will be calling the U.S. Treasury Secretary with bad news: a U.S. financial institution is failing under the weight of its overseas swaps business. And what else might he or she say? The public was on the losing end of the deal, in part, because the CFTC back in 2013 knowingly left offshore operations out of common-sense reform.
Last Updated: July 10, 2013