May 18, 2010
Good morning. I thank the Association for Financial Professionals for inviting me to speak this morning on financial regulatory reform and, in particular, the efforts to bring comprehensive regulatory reform to the over-the-counter derivatives marketplace. This marketplace was at the center of the 2008 financial crisis. It is essential that we work to lower risk and increase transparency in the OTC marketplace to protect the American public and lower the risk of a future taxpayer-funded bailout.
Reform of the over-the-counter derivatives marketplace is important to all of the corporations you represent, as well as to your employees and your customers. Regulatory reform will lower risk that a bank’s failure could have significant implications for you, and it will help you to secure better pricing on derivatives as you hedge your commercial risk. This morning I will address the key components of reform and their importance to your respective industries.
Derivatives have been around for a long time. In fact, they have traded since the Civil War, when grain merchants came together to hedge the risk of changes in the price corn, wheat and other grains on a central exchange. These derivatives are called futures. Many of you may already use the futures marketplace to hedge your business risk.
Nearly 60 years and a financial crisis – the Great Depression – after they first traded, Congress brought Federal regulation to the futures markets. It wasn’t until the 1930s that the Commodity Exchange Act, which created the Commodity Futures Trading Commission’s (CFTC) predecessor, became law.
Futures markets facilitate the price discovery process and make it easier to hedge commercial risk.
From the 1930s until the 1980s, all stocks, bonds and derivatives were subject to comprehensive oversight by federal regulators. Things began to change in 1981 with the first over-the-counter derivative transaction. Instead of trading through exchanges and being cleared through clearinghouses, over-the-counter derivatives are generally transacted bilaterally and are not subject to regulation.
Over-the-counter derivatives were at the center of the 2008 financial crisis. Taxpayers bailed out AIG with $180 billion when that company’s ineffectively regulated $2 trillion derivatives portfolio nearly brought down the financial system.
Essential Components of Reform
As of today, the U.S. House of Representatives, the U.S. Senate Banking Committee and the U.S. Senate Agriculture Committee have each passed regulatory reform legislation that addresses the over-the-counter derivatives markets. The two Senate committees also have produced a strong joint substitute amendment that takes some of the strongest provisions from each committee’s bill. It is essential that any reform that passes accomplishes three goals.
First, it must comprehensively regulate any entity that deals derivatives.
Second, we must bring standardized over-the-counter derivatives onto transparent and regulated exchanges or similar trading venues to lower risk and improve pricing in the marketplace.
Third, to further lower risk, we must bring standardized over-the-counter derivatives into central clearinghouses. Clearinghouses in the futures markets have been around since the late-19th century and have functioned both in clear skies and during stormy times to lower risk to the American public.
Regulating the Dealers
Financial reform must bring comprehensive regulation to derivatives dealers. By fully regulating the dealers, we can ensure that every derivatives transaction is regulated.
Dealers should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail, as the public was forced to do with AIG. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.
Regulating derivatives dealers will directly benefit each of the treasurers in this room. I do not know for sure, but I doubt many of you represent swap dealers. Instead, I imagine most of you would be commercial end-users of derivatives.
Bringing comprehensive regulation to derivatives dealers will lower risk to each of your businesses, your customers and your employees. Dealers will be subject to strict capital and margin requirements to protect you in the case of their failure. They will have business conduct standards to ensure that their customers are protected from fraud, manipulation and other abuses. The dealers – and not their corporate customers – will be subject to recordkeeping and reporting requirements so that regulators can best police the marketplace.
Enhancing Transparency in the Marketplace
Regulating the dealers is essential, but it is not enough. We also must bring sunshine to the currently dark over-the-counter derivatives markets.
To bring market transparency to the regulators, Congress should enact robust recordkeeping and reporting requirements for all derivatives transactions. This would include on-exchange transactions and bilateral transactions.
Bringing transparency to the regulators, however, is not enough.
We must also bring transparency to the public. Right now, when Wall Street banks enter into derivatives transactions with their customers, they know how much their last customer paid for the same deal, but that information is not made publicly available. They benefit from internalizing this information.
The buyer and seller never meet in a transparent market, and Wall Street profits from wider spreads between the bids and the offers. This is in stark contrast with the regulated futures and securities markets, where the public can see the price of the last transaction traded on a regulated exchange as well as the latest bids and offers. Can you imagine doing a buy-back of your company’s stock without the benefit of seeing where a transparent marketplace prices that stock?
In addition to improving pricing, bringing transparency to over-the-counter derivatives is critical to lowering risk in the marketplace. We all recall the inability of the Federal Government and Wall Street to price assets during the 2008 crisis – assets that we began to call “toxic.” It is essential that reform enables better pricing of those assets.
To best promote public market transparency, regulation should require that standardized over-the-counter derivatives trade on regulated exchanges or similar trading venues.
The more transparent a marketplace, the more liquid it is and the more competitive it is. Transparent trading venues would enable all market participants – from the oil producer to the retailer importing products to the corporate treasurer – to lower the cost of hedging their risk. This also would lower costs to their customers and lower risk to their enterprises.
You will be able to see transactions on a real time basis, including prices, volume and other key descriptive terms. Transparency narrows bid-ask spreads and benefits the users of derivatives contracts. That may be why some of the major Wall Street firms have been opposed to transparency. They have estimated that if the derivatives reform becomes law, they could lose billions in revenue. That is billions that their customers could save by getting better pricing on each of their derivatives transactions. In fact, the only ones who benefit from a lack of transparency in the marketplace are the Wall Street banks.
Exchanges and other regulated trading venues also would lower risk in the system by enabling clearinghouses to get reliable pricing information and determine the liquidity of particular contracts. This is essential for clearinghouses to adequately manage their risk and thus lower risk to the economy and the public.
To further lower risk in the over-the-counter derivatives marketplace, standardized derivatives should be cleared through central clearinghouses.
Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. When you enter into futures contracts on cotton, your contracts are centrally cleared to lower risk your risk.
In the over-the-counter marketplace, transactions stay on the books of the derivatives dealers for many years. This enables dealers to become dangerously interconnected with each of its counterparties as we saw with AIG. Clearinghouses move the risk off of the books of the dealers and into robustly regulated central counterparties.
There are going to be many customized or tailored risks that corporations will wish to hedge. To the extent that those customized derivatives are not accepted for clearing, corporations and municipalities will be able to hedge their risk without clearing those contracts.
It is essential, though, that we move as many standard over-the-counter derivatives transactions into central clearing as possible. There should be no exemption from clearing when a contract is transacted between two financial entities. That would leave interconnectedness in the financial system and make future bailouts ever more compelling.
The Wall Street reform bill now being considered by the Senate does include exemptions for non-financial end-users that use derivatives to hedge commercial risk. For most of you in this room, you would be able to choose whether or not to clear your contracts. For those of you who represent financial companies, your companies would be required to clear your standard transactions that are accepted for clearing. Your corporations would get the benefit of lower risk that clearing affords.
Centralized clearing of over-the-count derivatives will make the entire financial system safer. If a dealer and a hedge fund have to clear their transactions, then your corporation’s risk will be lower when you enter into a transaction with the same dealer.
In 2008, the financial system failed, and the financial regulatory system failed. The results have been calamitous. While the stock market has rebounded and many Wall Street banks have paid back their TARP money, the American public is still largely unprotected from the risks associated with the over-the-counter derivatives marketplace. Financial reform will be incomplete if it does not bring robust, comprehensive regulation to this market.
Financial reform will have real, tangible benefits for corporate treasurers. You will benefit from better pricing and lower risk in the system. This can benefit your corporation’s bottom line while mitigating the implications that your bank’s failure can have on your business.
Thank you, and I’d be happy to take your questions.
Last Updated: January 19, 2011