March 16, 2010
Good morning Chairwoman Bowles and members of the Economic and Monetary Affairs Committee. I thank you for inviting me to speak today on regulatory reform of over-the-counter (OTC) derivatives, or swaps. I would also like to introduce my two daughters, Lee and Isabel, who are here with me today, enjoying their Spring break from school.
The 2008 financial crisis was global in nature. The financial system failed the test. The financial regulatory system failed the test. So many people in Europe and in the United States who never had any connection to derivatives or exotic financial contracts had their lives hurt by the risks taken by financial actors.
OTC derivatives were at the center of the 2008 financial crisis. They added leverage to the financial system with more risk being backed up by less capital. U.S. taxpayers bailed out AIG with $180 billion when that company’s ineffectively regulated $2 trillion derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system. As we later learned, much of the bailout money flowed through AIG to U.S. and European banks. These events demonstrate how over-the-counter derivatives – initially developed to help manage and lower risk – can actually concentrate and heighten risk in the economy and to the public.
As capital and risk know no geographical boundaries, the nature of today’s marketplace demands a coordinated, international approach. We’re going to need to work closely together to reform and repair the regulatory system.
CFTC’s Regulatory Regime
Before I discuss much-needed reforms, I will take a moment to explain the market regulatory system in the U.S. In the midst of the last great financial crisis in the 1930s, President Franklin Roosevelt and the U.S. Congress established two market regulators: the Securities and Exchange Commission (SEC) to oversee the securities markets and the predecessor to the Commodity Futures Trading Commission (CFTC) to oversee the on-exchange derivatives markets, or what we refer to as the futures marketplace in the U.S. The CFTC is an independent regulator, and it is in the capacity as CFTC Chairman that I speak with you today.
The CFTC’s mission is to promote fair and orderly trading, free from fraud, manipulation and other abuses. The CFTC oversees clearinghouses to lower risk in the marketplace. We regulate critical market participants and have wide-ranging transparency efforts that provide the public much information about commodity futures markets and trading. The agency also has broad surveillance and enforcement powers.
Innovations in the derivatives marketplace in the 1980s led to transactions that were arranged off-exchange – so-called “over-the counter derivatives” – and thus out of sight of market participants, regulators and the public. Nearly 30 years later, though regulation has been much-debated, this market still is unregulated in Asia, Europe and the United States. At nearly $600 trillion notional amount – nearly $12 for every dollar in goods and services sold around the globe – it is now time to bring regulation to this marketplace similar to what we have in the securities and on-exchange derivatives – or futures – markets. Our goal should be to lower risk and promote transparency in these markets.
Regulatory reform must be comprehensive and international. At the conclusion of the G-20 summit held in Pittsburgh last year, G-20 Leaders concurred that “[a]ll standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” It is now our challenge, working across borders, to achieve that goal.
A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, including interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future. Effective reform of the marketplace requires three critical components:
First, we must explicitly regulate derivatives dealers. In so doing, we can set higher capital requirements as well as specific margin requirements for tailored and other bilateral transactions. Without being brought to central clearing, these so-called “bespoke” transactions leave financial institutions with greater risk, leave the system more interconnected and justify higher requirements. Capital requirements are essential so that dealers – rather than the taxpayers – are on the hook for the risk they undertake in the derivatives markets.
Dealers also should be required to meet robust standards to protect market integrity as well as to help bring standardization to documentation, netting and other non-economic terms of derivatives contracts. Lastly, dealer regulation should include stringent record-keeping requirements. Dealers should be required to post all bilateral uncleared transactions to trade repositories and information on all cleared transactions to clearinghouses so that regulators have access to information on all of the transactions – both uncleared and cleared. Regulators must have access to information on all OTC trades to properly asses risk and police these markets. As we move forward to establish such trade repositories in both the U.S. and in Europe, we should create a common reporting framework so that appropriate information can be shared among international regulators.
Second, to promote transparency of OTC derivatives markets to the public, standard over-the-counter derivatives should be traded on exchanges or other regulated trading platforms. I understand that in Europe, you are taking up the clearing issues now, capital issues this summer and plan to address the transparency requirement later in the year when you take up possible reforms to MiFID. Let me, if I might, however, say a few words at this time on the importance of bringing transparency to the OTC market. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies using derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, banks and the U.S. government had no price reference for particular assets – assets that we began to call “toxic.” Regulators also should be able to aggregate position information across trading platform and set position limits in the OTC derivatives marketplace as we have had authority to do so in the futures markets. Position limit authority enables regulators to ensure against excessive concentration in the marketplace.
Bringing transparency to the regulators through recordkeeping and reporting is essential, but it is not enough. We also must bring real-time transparency to the public through exchanges and other regulated trading venues. Financial reform will be incomplete if we do not achieve public market transparency.
Third, to further lower risk to the economy, standard over-the-counter derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Clearinghouses in the futures markets have been around since the late-19th Century and have functioned both in clear skies and during stormy times – through the Great Depression, numerous bank failures, two world wars and the 2008 financial crisis – to lower risk to the economy. While U.S. taxpayers were not required to cover market exposures on any cleared futures transactions, they had to bail out AIG and others in part to cover uncollateralized and uncleared derivatives contracts.
We should avoid mandating specific geographic locations for clearinghouses. Mandating a location for clearing may decrease efficiency – such as in capital allocation – and may increase risk. Allowing market participants to choose between robustly supervised clearinghouses allows participants to most efficiently participate in central clearing. To address legitimate supervisory interests, we can develop an appropriate and cooperative supervisory process for central counterparties. As part of this, we are committed to sharing appropriate information with foreign regulators, regardless of the location of the central counterparty, to best reduce risk.
Credit Default Swaps
Regulating derivatives dealers and requiring transparent trading and central clearing of standardized derivatives would greatly reduce risk and increase transparency in the entire OTC derivatives marketplace. Additional reforms, however, should be considered to address the unique characteristics of credit default swaps (CDS).
First, capital requirements should take into account the unique risks that CDS pose. Sellers of CDS take on the risk of default of the underlying entity. A seller of CDS could one month collect its regular premium with little expectation of default and in the next month be on the hook for billions if the underlying company goes bankrupt. CDS contracts can quickly turn from consistent revenue generators to ruinous losses for the seller of protection. Thus, regulation should account for this “jump to default” exposure by requiring sufficient capital and reserves to cover the CDS in the event of a credit event. With similarities in some regards that CDS have to selling insurance, regulators could look to lessons in setting capital and reserve requirements for insurance companies faced with similar risks. Also, bank capital regulation should be modified to more stringently control when CDS can be used as a credit risk mitigant.
Second, market regulators should have clear authority to police the CDS market for manipulation and other abuses. In the U.S., market regulators have this authority in the regulated securities and on-exchange derivatives markets. Regulators should have the same general anti-fraud and anti-manipulation rulemaking authority with respect to CDS as they have with regard to all securities, securities derivatives and futures, including equity securities, debt, securities options and single-stock futures. Market regulators also should have the authority to aggregate and limit positions with respect to an underlying entity across markets, including CDS, equity securities, securities options, debt and single stock futures.
Regulatory reform will only be as effective as it is comprehensive. We should bring as many contracts into centralized clearing and transparent trading venues as possible. Many corporations and financial firms are calling for exemptions from clearing for transactions with so-called corporate “end-users.” If reform includes exemptions for this large class of customer transactions, we will leave dealers interconnected with significant risk on their books – risk that, as we witnessed in 2008, can reverberate throughout the entire financial system if a bank fails.
If reform ultimately includes exemptions for customer transactions, those exemptions should not apply when dealers are trading with financial end-users. Data collected by the Bank for International Settlements indicates that while only 9 percent of the interest rate swap market is comprised of transactions between dealers and their commercial customers, 57 percent of the market consists of transactions between dealers and their financial customers. Though I do not support exemptions from clearing and trading for standardized contracts, if reform includes exemptions for customer transactions, it would be best to limit them to the 9 percent of the market involving commercial customer transactions. It is critical that we directly address with mandatory clearing the 57 percent of the market that so interconnects the dealers with the rest of the financial system. Furthermore, given the unique nature of credit default swaps, and that more than 95 percent are traded between financial institutions, there should be no end-user exemptions for those contracts.
Derivatives and Fiscal Situations
Before I close, I would like to briefly address the news stories regarding derivatives and fiscal situations. Of course, there are many things unrelated to derivatives that are affecting fiscal situations, debt and the Euro. Still, I understand from press reports that countries may have entered into derivatives transactions, which, being structured as off-market transactions, may have masked an underlying lending arrangement. It has been reported that Greece several years ago entered into a derivatives contract with net exposure of $1 billion. With reform, the dealer of such an off-market standardized derivative could be required to bring the contract to central clearing. Thus, the dealer’s counterparty would be required to post $1 billion in collateral on the day of the transaction, cancelling out the embedded loan and discouraging the counterparty from entering into such a transaction in the first place. If such a transaction were deemed to be a customized transaction and outside of central clearing, reform should allow regulators to set capital, margin and business conduct standards as appropriate for this off-market transaction. These events are reminders of the pressing need for comprehensive regulation of the over- the-counter derivatives market.
We must now bring comprehensive reform to the over-the-counter derivatives market. Effective reform cannot be accomplished by any nation alone. It will require a comprehensive, international response. With the significant majority of the worldwide OTC derivatives market being conducted in the U.S. and Europe, the effectiveness of reform depends on our ability to cooperate and find general consensus on this much needed regulation. If we fail, we will leave the global economy and the global citizenry at risk.
Thank you for inviting me to be with you today. I look forward to answering any questions that you may have.
Last Updated: January 24, 2011