June 3, 2010
Good morning. I thank Sandler O’Neill for inviting me to speak at this conference and Rich Repetto for that very kind introduction.
Today’s conference falls at a critical moment in the nation’s financial history. In the next weeks, House and Senate conferees will meet in an effort to produce final legislation that will bring great reform to our financial regulatory system. Only once before in our history has Congress considered such comprehensive financial reform – in the midst of the Great Depression.
At that time, President Franklin Roosevelt signed legislation to bring regulation to the futures and securities markets. Futures and securities were regulated to protect the investing public against fraud and manipulation. Exchanges were regulated to ensure they were transparent, fair and orderly. Roosevelt and Congress at that time recognized that transparency, a key to market-based reform, was critical to ensuring that a market functions well.
Companies that need to raise or borrow capital, for example, can see and rely upon where other companies have priced their securities. The public can see the last transactions in futures or securities as they consider their investment decisions. Hedgers and speculators can see where futures trade in a marketplace to get the best pricing. All market participants and the public benefited from the great reforms of the 1930s that regulated securities and futures.
The legislation before Congress today would bring similar reforms to the over-the-counter derivatives marketplace. As we saw in 2008, an opaque derivatives market, concentrated with a small number of financial institutions, contributed to a financial system brought to the brink of collapse.
Both the House and Senate Wall Street reform bills include robust recordkeeping and reporting requirements for all derivatives transactions. This would include on-exchange transactions and bilateral transactions so that regulators can police markets for fraud, manipulation and other abuses.
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 centralized market. The lack of transparency enables Wall Street to profit from wider spreads between bids and offers. This is in stark contrast to 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.
We now must bring a similar level of transparency – and benefit to the public – that exists in the futures and securities markets to the over-the-counter derivatives markets. The more transparent a marketplace, the more liquid it is and the more competitive it is and the lower the costs for hedgers, borrowers and, ultimately, their customers.
To address the lack of transparency in the over-the-counter marketplace, the House and Senate each passed bills that require standardized products to trade on regulated exchanges or similar trading vehicles, called swap execution facilities. These facilities allow buyers and sellers to meet in an open, centralized marketplace. By moving derivatives transactions from a dealer-dominated market – where Wall Street has a significant information advantage – to a centralized market, businesses, investors and consumers will benefit.
Further, the transparency brought about from exchanges and swap execution facilities is essential to lowering risk in the financial system. 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.” Transparent, centralized trading of these products will bring price discovery and lower the risk they create in stormy economic times.
It is essential that the conference report that comes out of the House and Senate conference protect the robust transparent trading requirements in both bills. Every exemption, exception or loophole could weaken the legislation, leave risk in the system and strengthen Wall Street’s information advantage.
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 a trading requirement. They have estimated that if the derivatives reform becomes law, they could lose billions in revenue – billions that their customers could save by getting better pricing on their derivatives transactions.
Exchanges and swap execution facilities 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.
Real time post-trade reporting of transactions is an essential element of a transparent marketplace. The Senate bill includes a provision that requires real time public reporting for all derivatives that would be accepted for clearing, even if it falls under the end-user exemption. The Senate bill also requires data to be reported as soon as technologically practicable after the transaction is executed. An effective conference committee report should include these provisions.
In addition to trading venues, the second critical piece of regulated futures and securities markets is central clearing. We should learn from and borrow from that system to lower risk to the American public in the over-the-counter derivatives marketplace.
Over-the-counter derivatives, after all, were at the center of the 2008 financial crisis. Taxpayers were forced to bail out AIG with $180 billion, for example, when that company’s ineffectively regulated $2 trillion derivatives portfolio nearly brought down the financial system.
As such, 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.
In the over-the-counter marketplace, transactions stay on the books of the derivatives dealers often for many years. This enables dealers to become dangerously interconnected with each of their counterparties as we saw with AIG. Clearinghouses move the risk off of the books of the dealers and into robustly regulated central counterparties.
The goal of reform should be to move as many standard over-the-counter derivatives transactions into central clearing as possible. Though both the House and Senate bills include exemptions from clearing when banks are transacting with their end-user customers, we should ensure that this exemption is not so broad that it includes transactions between two financial entities. That would leave interconnectedness in the financial system and make future bailouts ever more compelling.
Data collected by the Bank for International Settlements indicates that transactions between derivatives dealers and their commercial customers comprise only a small percentage of the derivatives market in notional value. For example, in the largest over-the-counter derivatives class – interest rate swaps – transactions with non-financial entities comprise only 9 percent of the market. Transactions between two dealers comprise 34 percent of this market, and transactions between dealers and other financial entities, such as hedge funds or insurance companies, comprise 57 percent.
Source: Bank for International Settlements, June 2010 (Data as of December 2009)
The Senate Wall Street reform bill explicitly provides that financial entities’ standard derivatives must be brought to clearinghouses. Though the bill does include exemptions for non-financial end-users that use derivatives to hedge commercial risk, the exemption is narrow and explicit. Language in the House bill may be read to provide for a more liberal exemption for entities using derivatives to hedge commercial, balance sheet or operational risk, which could leave a larger class of transactions out of a clearing requirement – including those between two financial entities.
But as long as financial entities remain interconnected through their derivatives, one entity's failure could mean a run on another financial entity and a difficult decision for a future Treasury secretary. Every exemption for financial companies creates a link in the chain between a dealer's failure and a taxpayer bailout. Every slice of the financial system that we cut out through an exemption could allow one bank's failure to spread like fire throughout the economy. It is essential that financial reform does not allow loopholes that leave interconnectedness in the system. Such exemptions will only come back to haunt us in the future.
Effective reform must ensure that over-the-counter derivatives clearinghouses be regulated to protect against conflicts of interest, have open non-discriminatory access for all of the regulated trading venues and have open membership.
Clearinghouse governance should be open to both dealers and non-dealers. Open governance would ensure that clearinghouses are not governed by parties that might have a conflict of interest or financial stake in particular transactions. Both the Senate bill and House bill include strong provisions that establish mechanisms to limit the control of clearinghouses by swap dealers. This is important to address conflicts of interest.
Swaps clearinghouses should have open access, where they would be required to take on trades from any regulated exchange or swap execution facility. Clearinghouses should not be allowed to discriminate between or amongst the trades coming from one regulated trading venue or another.
Lastly, clearinghouses should have open membership. Assuming a party meets the rigorous risk-management, operational and financial requirements of a clearinghouse, it should be permitted to become a direct member of that clearinghouse.
In 2008, the financial system failed, and the financial regulatory system failed. The results have been calamitous. While 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.
Thank you, and I’d be happy to take questions from the audience.
Last Updated: January 18, 2011