October 11, 2013
I want to thank the Americans for Financial Reform and Georgetown Law Center for this invitation. We’re in the midst of a government shutdown so I’m going to give a presentation from some notes, not the usual prepared text speech.
Five years ago, the U.S. economy was in free fall.
Five years ago the swaps market was at the center of this crisis. It cost middle class Americans – and hardworking people around the globe – their jobs, their pensions and their homes.
President Obama and Congress came together and they responded with historic reforms to bring the swaps market into the light through transparency and oversight.
And now, with the Commodity Futures Trading Commission’s (CFTC) near completion of these reforms, a true paradigm shift has resulted.
A paradigm shift to a transparent, regulated marketplace that benefits investors, consumers and businesses in this country and around the globe.
The CFTC, through 61 final rules, orders, and guidances, has brought traffic lights, stop signs, and speed limits to this once dark and unregulated market.
Through these reforms, we have stood up an entire comprehensive regime covering:
These completed reforms have resulted from an active public debate –
I thought I would review where we stand today in this critical reform in the context of a dozen debates that have gone on around this reform.
The first three debates relate to the scope of reform.
First, which products should be covered?
Congress and the Administration chose not to limit regulatory reform only to those products or entities that received the most attention during the financial crisis, which were credit derivatives. The comprehensive regulatory framework now covers the full suite of swaps products. This includes interest rate swaps, currency swaps, commodity swaps, equity swaps, credit default swaps – the center of the crisis – as well as derivative products that may be developed in the future.
Credit default swaps may have been the leading culprit in the crisis, but omitting the markets for interest rate, currency swaps and commodity swaps would have left, the market still opaque and inefficient. And we needed to shine the same light and lower risk in all of the OTC derivatives markets, not just credit derivatives.
Now there was some debate about foreign currency forwards and swaps. Though they are exempted from clearing and the trade execution mandate, Congress and the CFTC worked to ensure that they have to be reported into trade repositories, and also that they come under business conduct standards. We’ve worked closely with the foreign currency community, and they have changed their back office documentation as of June of this year.
Second, which participants should be covered through reforms?
Congress and our rules ended up with a three-tiered system of participant reforms: swap dealers at the center; then financial institutions; and finally, non-financial institutions, or so-called end-users.
It is only with comprehensive regulation of the dealers at the center of this market that we can really oversee and regulate the entire derivatives markets. This was one of the key reforms that we laid out with Secretary Geithner and Mary Schapiro during the presidential transition five years ago. Subsequently, we worked with then Chairman Harkin of the Senate Agriculture Committee and others to ensure that there would be oversight of the dealers themselves.
Through regulating the dealers, we ensure that reform applies to both standardized and customized products.
You might remember the debate. Would there be an allowance for a bilateral or customized swap, ensuring the economy could get the benefit of all these hedging products? The answer was yes. Customized products would continue, but we would need to oversee the dealers that are offering those swaps.
By giving the CFTC clear authority to set business conduct standards, swap dealers and their nearly 10,000 counterparties around the globe have changed their swap documentation, lowering risk.
Today, we have 86 registered swap dealers and two major swap participants. This group includes the world’s 16 largest financial institutions in the global swaps market or what’s called the G16. It also includes a number of energy swap dealers.
The second group of market participants was financial institutions. There was a debate four years ago as to whether financial institutions were to be covered by reform. Our thinking was that if we didn’t include hedge funds, insurance companies, mortgage companies and the like, we would leave a significant part of the interconnected financial system outside of reform. Though not required to register as dealers, they came under two of the very critical reforms – the required clearing and the required trade execution. Congress did that, and we’ve executed on that plan.
The third group of market participants is the non-financial participants – the so-called “end-users.” It’s really the end-users, the non-financial side of our economy, that provide 94 percent of private-sector jobs in America. They only make up a small, single-digit percent of the swaps market. End-users were exempted from clearing and many other rules. For instance, the Commission’s proposed rule on margin provides that end-users do not have to post margin. They do have some responsibilities for recordkeeping and reporting.
Third, what would be the cross-border scope of reform?
Would reform just be territorial, such that only that which happened within the borders of the United States were covered? Or would it extend further?
Congress recognized that risk knows no geographic border. Look at AIG – it nearly brought down the economy – its operations were in London. It was actually registered as a French bank with a branch in London.
AIG wasn’t the only one. Lehman Brothers, Citigroup, Bear Stearns – Bear Stearns hedge funds, by the way, were incorporated in the Cayman Islands, as well as Citigroup’s off-balance-sheet Structured Investment Vehicles (SIVs). Ten years earlier, there was Long-Term Capital Management, a hedge fund operated out of Connecticut. You would have thought, as I did on a certain Sunday in September of 1998 when I visited it, that it was a U.S. person, even though it was booking its $1.2 trillion derivatives book in its Cayman Island affiliate.
Congress knew that the nature of modern finance is that financial institutions commonly set up hundreds, even thousands of institutions around the globe. When Lehman Brothers went down, it had 3,300 legal entities. When a run starts at any part of an overseas affiliate or branch in modern financial institution days, risk knows no geographic boundary. It comes right back here, just as our housing risk went offshore to other countries.
What Congress made clear in reform was that the far-flung operations of U.S. enterprises are to be covered. Congress said this in key words. We really need to thank Chairman Frank because he reached out to our agency and asked how to deal with what he called “risk importation?”
Our remarkable staff at the CFTC worked with his staff on the key words in the statute that say if it has “a direct and significant connection with activities in or effect on Commerce of the United States” it’s covered by reform. We were not going to just take a territorial approach. That’s really because Chairman Frank had the vision and foresight, asked for advice, got advice, and included, in a bipartisan way at the time, these key words in the statute.
The CFTC, coordinating closely with global regulators, completed cross-border guidance in July. Swaps market reform would cover transactions between non-U.S. dealers and guaranteed affiliates of U.S. persons. Why guaranteed affiliates? Because their risk can come right back here. Reforms also cover swaps entered into between two guaranteed affiliates or with the offshore branches of U.S. banks. Another more recent lesson comes from the events surrounding JPMorgan Chase’s Chief Investment Office, which booked their credit index swap trades through their London branch, which was fully part of the bank.
After allowing time for market participants to phase in compliance, this week, much of our cross-border guidance became effective. Yesterday, the final U.S. person guidance became effective. Based on that, hedge funds and other funds whose principal place of business is in the U.S. or majority owned by U.S. persons will clear and come into many other reforms.
Hedge funds like Long-Term Capital Management today would now clear standardized swaps. So no longer would a P.O. Box in the Cayman Islands or another nice vacation holiday spot be good enough to get out of reform.
Further, yesterday foreign branches of U.S. persons, that means branches of big U.S. banks, and guaranteed affiliates of U.S. financial institutions now have to comply with the clearing requirement.
Now, let me turn to the big decisions on substance.
Let me start with transparency.
Key to promoting efficiency in markets is transparency and access. Adam Smith in the Wealth of Nations wrote about this over 200 years ago. He contended that if the price of information is lowered or you make information free, in promoting such transparency, the economy benefits. Similarly, if access to the market is free, everybody gets to compete.
Transparency and access was not the swaps market as we knew it in 2008. It was opaque. Most people in the market couldn’t see the pricing, and access was really dominated by large dealers with trillion dollar plus balance sheets.
In bringing forward reform, there was a debate about whether transparency to regulators was enough or if we also needed public market transparency. Congress and the Administration determined that regulatory transparency wasn’t enough. We have put in place swap data repositories (SDRs) to provide transparency to regulators, and as of two weeks ago, there was $400 trillion notional of swaps in the data repositories (market facing and single counted swaps).
But that’s not enough. Adam Smith was about promoting transparency to the public, and that’s what Congress believed as well.
First, Congress responded that we need post-trade transparency. As of December 31 of this past year, we started putting it in place, and as of September 30, the last compliance date, the public and end-users can see the price and volume of each transaction as it occurs on a website, like a modern-day ticker tape.
Due to an amendment sponsored by Sen. Jack Reed during the conference, this post-trade transparency covers not only those transactions on an exchange or on a registered platform, it covers the entire marketplace – including customized swaps and off-exchange swaps.
Also Congress adopted an initiative to make sure there is transparency before the transaction. This covers the portion of the market for swap dealers and financial institutions trading swaps that are required to be cleared and made available for trading on a platform.
Starting this past week, on October 2, the public began to benefit as swap trading platforms, called swap execution facilities (SEFs), came under common-sense rules of the road. SEFs will require that the dealers and non-dealers alike are able to get impartial access -- another part of Adam Smith’s writings from 200 years ago.
Seventeen SEFS are currently registered and operating. It is truly a paradigm shift. It’s still early, but just to give you a few numbers, the first day there was about 1,200 trades on this collection of SEFS. Two or three days ago, it was 1,800 trades.
We do understand that there are going to be issues that arise. Just as we have for other reforms, we are going to try to work with market participants to smooth the transition. But let there not be any doubt – over time, market participants will benefit from enhanced pre-trade transparency because it brings competition into the marketplace.
A fifth key decision was regarding requiring central clearing.
Clearing has existed since the 1890s. It lowers risk to the market. The debate was not whether there was going to be clearing. It was who was going to be covered by it. Where Congress came out is that financial actors would be covered as well as the dealers.
The dealers in 2009 came together, and it’s been well reported, and said they could live with clearing, but they were contending it should be mandated only for between dealers. That was because they wanted to lower their risk between themselves. Congress responded and said no, it needs to cover 90-plus percent of the market. It has to cover financial enterprises as well to lower the risk of that interconnected market.
This month, with the completion of phased implementation, mandatory clearing of interest rate and credit index swaps is a reality for dealers, hedge funds, and other financial institutions. And with yesterday’s phase-in, it’s now also a reality for these P.O. Box hedge funds as well, and for the branches and guaranteed affiliates around the globe. In mid-September, 72 percent of new interest rate swaps were being cleared.
In the data repositories, there are currently $330 trillion of interest rate swaps, and $182 trillion, or 54 percent, were cleared.
The sixth key debate was regarding access.
Back to Adam Smith’s writings, how do you make a market competitive? You make information free, and you make access free. Congress got this right. It required, and the CFTC has followed, impartial access to trading venues. As these 17 SEFs have gone live, we are looking at each of their rulebooks to ensure they really provide impartial access -- that it’s not just a dealer-dominated platform, but other financial institutions and market participants can have access and compete in the marketplace.
When we come out of the shutdown, we’ll be calling up a few of these platforms and saying “I don’t think that’s consistent with the spirit of what Congress put in place.” Impartial access really means that the non-dealers as well as the dealers, the non-clearing members as well as the clearing members, have access. All of these parties can make bids and offers on a central-limit order book. All can respond as well as request quotes in an RFQ system. There’s not supposed to be two rooms in a swap execution facility, one for the insiders and one for the less dealer-oriented group.
Open access to clearing was a key piece that Congress included in reform as well. That means that the clearinghouses have to take swaps trades even if it’s not from their sister or affiliated trading platform. Of the 17 registered SEFs, only one of them is affiliated directly with a clearinghouse, and the other 16 are not. They all actually do have access to the main clearinghouses. This is significant.
We also put in place something called straight-through processing. It’s highly technical, but it was significantly debated. What it comes down to is – will there be real-time processing of a trade to a clearinghouse. Why is it critical? Because it creates great access when everybody knows that if they intend to clear a trade, they don’t have to worry about their counterparty’s credit risk. In the 1980s and 1990s and into the next decade, swaps became centered and concentrated with the bank sector because the banks are in the business of extending credit, and they have very large balance sheets. To bring access to everybody else, you need this highly technical, specialized thing called straight-through processing or real-time processing.
With regard to SEFs, we put out guidance on September 26 to ensure that straight-through processing is a reality, that it’s not just something in the CFTC rulebooks. That’s what we do, every step of the way. We’re trying to ensure that the vision of Congress, the vision of the Administration happens.
A seventh key decision related to intermediaries.
Were we going to register them or not? Registration or licensing means if you go on the roads, you have passed some test. You also are consenting in various states to the jurisdiction or the authority of the police. Registration is a critical part of reform – for dealers as well as to many others. I see Pat McCarty back there who worked for Sen. Blanche Lincoln. He ensured the word “swap” was put into each and every statutory definition for intermediaries – commodity pool operators, futures commission merchants, introducing brokers, every spot. The registration regime had to include swaps, not just futures.
An eighth key decision was on customer protection. This was not so much a decision Congress had – that was straightforward at the time. But after Dodd-Frank passed, we had to go back and ask -- what do we do to better protect customers? There were a lot of debates. We decided to reverse the loosening made in 2003-2005 on the investment of customer funds, in Rule 1.25. We required clearinghouses to move to something called gross margining -- they can no longer net two customers’ positions against each other. But there’s more that we need to do on customer protection when you look at the events in the last two years and the failings of a couple of big firms in that area.
A ninth key decision that Congress made was repealing what was called the “Enron loophole.”
You might remember that a law passed in 2000, the Commodity Futures Modernization Act, which included provisions that various trading platforms didn’t have to register with the CFTC. They didn’t have to have that driver’s license to be a trading platform. These platforms, whether they were for energy, foreign currency or interest rates, they didn’t have any oversight at all. Congress debated it, and it was a long debate. It reached its crescendo in the summer of 2008. There was a farm bill that passed that year that moved to close the “Enron loophole” that was partially successful. I’d even note that in June of 2008, then Senator Obama put out a release calling for fully closing the “Enron loophole.”
Why do I focus on this? Because it spilled over into the debate about SEFs. A footnote in the SEF rule, Footnote 88, has gotten much attention, both by the media and market participants. This Footnote 88 is just confirming what Congress did -- Congress closed the “Enron loophole.” I don’t see what the discussion is here. We put a footnote in confirming that Congress had closed this loophole. What it means is that all the platforms as of October 2 needed to register.
Now there are some questions that have come up about jurisdiction. What will trigger this registration? Which platforms will trigger it? I think that if anybody is asking the question, they may want to read the guidance we did on cross-border in July.
My own conservative advice is that if a multilateral trading platform itself is a U.S. person, they probably ought to register. If a platform itself is operating in New York or Chicago or elsewhere in the U.S., you’ve got to think that you’ve got a connection to activities or commerce in the U.S.
I would also say that if you permit U.S. persons or persons located in the U.S. – you’ve got a lot of folks located in New York or Connecticut or Chicago that are using your platform – you’d think that the platform has a direct and significant connection to the activities in the U.S., whether you’ve given direct or indirect access. My conservative advice would be that you would want to register.
I recognize that this approach would trigger some SEF registrations for foreign-based platforms that are already registered with their home country. We’ve had one such platform actually reach out to us from Australia. It’s going to register with us, and we’re working with the Australian home country regulators. We’re prepared to figure out where we might defer to those home country regulators. But the registration itself is important so that we have some oversight, some licensing if I can use that analogy.
We also along the way registered many commodity pools that had previously not registered with the CFTC because of exemptions from 2003. The repeal of these exemptions was actually the case that went to the DC Circuit.
A tenth key decision was on enforcement tools.
Prior to Dodd-Frank, our enforcement authority was more narrow. In particular, our anti-manipulation rules required us to prove that someone intentionally created an artificial price. Dodd-Frank filled gaps in our authority. As a result of Senator Cantwell’s amendment and our new rules, we have broad powers to prohibit reckless, fraud-based and other manipulative conduct. We also can use this new broad provision against any deceptive conduct in connection with futures and swaps. These authorities bring us in line with some similar authorities the SEC has had for years, as well as the Federal Energy Regulatory Commission. These authorities expand our arsenal of enforcement tools and strengthen the Commission’s ability to effectively deal with threats to market integrity. We will use these tools to be a more effective cop on the beat to promote market integrity and protect market participants.
An eleventh decision was about compliance dates, phased compliance.
We as an agency were given by Congress one year to get everything done. We didn’t quite make that. We basically did it in three years – these 61 completed rules, orders and guidances. Congress also gave us another authority. They said nothing we put in place could be effective shorter than, I think it is 60 days after we have a completed rule. We chose to use the congressional authority to give more time. Sometimes we’d give a year. Sometimes we’d only give the two months. But we also sought public input on phased compliance to lower the costs of this change but also to make it work.
Phased compliance started with the anti-manipulation rules that went into effect in 2011. The next piece was that swap data repositories had to register with us. The big compliance date was one year ago, October 12 of 2012, when the whole reform went live, the definitions were in place. Dealers then registered in December. We started with 66. We have had 20 more -- 86 dealers have registered. Clearing was phased through this whole year. Real-time reporting was phased through this whole year. Now swap execution facilities are in place. We very much believe phased compliance smoothes this through because it is a monumental change.
Lastly, decision twelve, which was not directly in Dodd-Frank. A number of years ago, we decided to focus on reforms on the benchmarks that underlie the vast majority of the swaps market.
There are interest rate benchmarks called LIBOR, Euribor and others, if I can just call them the “ibors,” that are critical reference rates for our markets. In the U.S., LIBOR is the reference rate for 70 percent of the futures market and more than half of the swaps market. Thus, it is the most significant reference rate for the swaps market, which we’ve brought under reform.
A benchmark that is an underlying reference to a market, like these interest rate benchmarks, can only have market integrity if it is based on fact, not fiction. Unfortunately, what we have found with regard to LIBOR and Euribor is the underlying market, the so-called interbank market for unsecured lending between banks, has essentially dried up and no longer exists. Why is that? Well why does a bank really want to lend to another bank with an open line of credit, like a credit card loan? They only want to lend to each other like an auto loan or a mortgage. They want collateral to back that loan up. That market has shifted dramatically over the last ten or so years.
We’ve brought four big enforcement cases with regard to this, along with the Justice Department and international regulators. We’ve worked with international standard setters called International Organization of Securities Commissions to put in place a new paradigm for how benchmarks should be based on observable transactions – they need to be anchored in observable transactions. There needs to be a there, there. These benchmarks need better governance to ensure against conflicts of interest.
The Financial Stability Oversight Council, a reform out of Dodd-Frank, has spoken to need for benchmark reform and recommended that U.S. regulators work with foreign regulators and international bodies and market participants to really address two questions:
It’s not going to be without challenges. These are the underlying benchmarks of $300 trillion plus in derivatives. But we have the ingenuity and the human spirit that we can make change. We cannot leave the system so frail that it has an underlying benchmark that is essentially fiction, not fact.
Those are the 12 big decisions that we’ve made along the way.
The government shutdown and resources are a challenge. Looking forward, our greatest challenge at the agency is not the shutdown. We’ll get through that. It is surreal having only 30 or so people at the agency, but we’ll get through the shutdown. We are a skeletal crew right now and at best we have a cursory oversight of the markets. Though we are dark, we have brought additional lightness to the markets with these new swap execution facilities and the cross-border guidance going into effect yesterday.
Looking past the shutdown, we’re only an agency of about 680 people. Far too small to oversee the markets that we’ve been tasked with from Congress. I think that’s a significant challenge for reform going forward.
I think the other significant challenge going forward is that as market participants look to maximize their revenues and customer support, as they should, they, at times, may look to arbitrage our rules versus other rules around the globe, or just arbitrage our rules against our rules, if they can.
I think that we’re in very firm setting on clearing, on data reporting, on real-time reporting, on some of the business conduct areas, reforms that all have been implemented. Right now, with this week’s implementation of cross-border and last week’s standing up of SEFs and, there’s bound to be challenges with regard to these reforms and we’ll get through them as they arise.
Lastly, just as Congress came together on new reforms in 2010, our regulations will need to evolve. They will need to evolve to stay abreast of market participants’ practice. We are hopeful that we got things right, but I think we always need to stay open that there may be things down the road that need to change.
Thank you. I’m pleased to take questions.
Last Updated: October 22, 2013