November 9, 2010
Good evening. I thank the National Economists Club for inviting me to speak at your annual dinner. I also thank Eric Robins for that kind introduction.
Today I’m going to speak about the new protections that the Dodd-Frank Wall Street Reform and Consumer Protection Act brings to the swaps marketplace – or what also has been referred to as over-the-counter derivatives. Before I begin, I’d like to thank my fellow Commissioners at the Commodity Futures Trading Commission (CFTC) for their thoughtful work on the Dodd-Frank Act.
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.
It was not until the 1920s that Congress brought Federal regulation to the futures markets. Later in 1936, Congress passed the Commodity Exchange Act, which created the CFTC’s predecessor and subjected all of the derivatives of the time to comprehensive oversight by federal regulators. Things began to change in 1981 with the first swap transaction. Instead of trading through exchanges and being cleared through clearinghouses, swaps were generally transacted bilaterally outside the scope of futures regulation.
Unregulated swaps were at the center of the 2008 financial crisis. Taxpayers bailed out AIG with $180 billion, for example, when that company’s ineffectively regulated $2 trillion derivatives portfolio nearly brought down the financial system.
In bringing oversight to the swaps market, Congress built upon strengths from the futures marketplace. The Dodd-Frank Act brings new reforms to the swaps markets that will increase transparency and lower risk.
Promoting Transparency in the Swaps Markets
Economists and policymakers have for decades recognized that market transparency benefits the public. This is true both for transparency to regulators as well as transparency to the public.
To increase transparency of the swaps markets to regulators, the Dodd-Frank Act establishes a new registration category called swap data repositories. The bill requires registrants – including swap dealers, major swap participants, swap execution facilities and designated contract markets – to have robust recordkeeping and reporting, including an audit trail, for swaps. The statute requires that entities report all trading and position data to swap data repositories – both for bilateral swaps and for those traded on trading platforms.
At the CFTC, we anticipate writing rules to require swap data repositories to perform their core function of collecting and maintaining swaps data and making it directly and electronically available to regulators. We also anticipate rules governing how data must be maintained by registrants and sent to the data repositories. This added transparency in the swaps markets will enable the CFTC to police the markets for fraud, manipulation and other abuses. Information in the swap data repositories also will be available to the SEC and the banking regulators, as well as to international regulators.
It is not enough, however, simply to promote transparency to the regulators. The Dodd-Frank Act also makes the swaps marketplace transparent to the public. The more transparent a marketplace is, the more liquid it is for standardized instruments, the more competitive it is and the lower the costs for hedgers, borrowers and, ultimately, their customers. Transparency in the securities markets allows companies that need to raise or borrow capital to see and rely upon where other companies have priced their securities. Transparency in the futures markets allows hedgers and speculators to see where futures trade in a marketplace to get the best pricing. The Dodd-Frank Act brings similar transparency to the swaps markets.
The bill promotes pre-trade transparency in the swaps markets by requiring standardized swaps – other than block trades – to be traded on regulated exchanges or other trading facilities, called swap execution facilities. These facilities allow buyers and sellers to meet in an open, centralized marketplace, where prices are made publicly available, particularly as the statute requires these trading facilities “to provide market participants with impartial access to the market.”
Congress also has been very specific that market participants and end-users will benefit from post-trade transparency through real time reporting. Such post-trade transparency must be achieved “as soon as technologically practicable” after a swap is executed to enhance price discovery. This requirement applies to both cleared and bilateral swaps. Just as in the futures marketplace, block trades for swaps will be reported with some delay. I don’t know where the proposed rule will come out, but I might note that in the futures market the delay is currently five minutes.
Lowering Risk in the Swaps Markets
Beyond the transparency initiatives, to help lower risk to the financial system and the economy, the Dodd-Frank Act has three critical features.
1. Mandatory clearing of standardized swaps;
2. Regulating swap dealers through business conduct and documentation standards; and
3. Regulating swap dealers for capital and margin.
The Dodd-Frank Act includes a requirement that standardized swaps be centrally cleared. Clearinghouses have effectively reduced risk since they were first developed in the futures markets in the 1890s. Those clearinghouses 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 American public. Over this same time, we have watched repeated cycles in the financial sector where numerous banks and financial institutions have failed, causing great stress to the economy and the public.
Currently, swaps stay on the books of the dealers that arrange them, often for many years after they are executed. Like AIG, these dealers traditionally engage in many other businesses, such as lending, underwriting, asset management, securities trading and deposit-taking. These dealers often are part of institutions that are both “too big to fail” and “too interconnected to fail.” This interconnectedness heightens the risk that a dealer’s failure will reverberate throughout the economy as a whole. Uncleared derivatives allow the failure of one institution to potentially cascade, like dominoes, throughout the financial system and ultimately crash down on the public.
The Dodd-Frank Act’s clearing requirement will reduce risk in the swaps markets. Clearinghouses act as middlemen between two parties to a transaction and take on the risk that either party might fail to meets its obligations under the contract. They require derivatives dealers to post collateral so that if one party fails, its failure does not harm its counterparties and reverberate throughout the financial system.
Roughly 90 percent of swap transactions are between two financial entities, such as banks, hedge funds, finance companies, pension plans and insurance companies. The Dodd-Frank Act requires that these transactions between two financial entities be subject to the clearing requirement. That is because interconnectedness among financial entities allows one entity's failure to cause a run on another financial entity, spreading risk quickly throughout the economy. We know from AIG that future bailouts will be ever more tempting if we allow financial entities to remain interconnected through their swaps books.
The Dodd-Frank Act does, however, include an appropriate exception from clearing for transactions that are between dealers and non-financial end-users that use the swap to hedge or mitigate commercial risk. Transactions between non-financial entities and financial entities do not present the same risk in the midst of a crisis as those solely among financial. The risk of a crisis spreading throughout the financial system is greater the more interconnected financial companies are to each other.
Capital and Margin Requirements
To further lower risk brought about by swaps. the Dodd-Frank Act authorizes regulators to establish capital and margin requirements for all swap dealers. One of the lessons from the financial crisis was that banks were insufficiently prepared for the losses they could take if they were on the losing end of a derivatives transaction. The Federal Reserve and other prudential regulators are to adopt rules for bank swap dealers, and the SEC and the CFTC are to do so for nonbanks. The Act also says that, “to offset the greater risk to the swap dealer… and the financial system from the use of swaps that are not cleared,” regulators shall “help ensure the safety and soundness of the swap dealer” and set capital and margin requirements that are “appropriate for the risk associated with the non-cleared swaps.”
Requiring banks to have sufficient capital to cover their derivatives transactions should prevent dealers from externalizing their losses to the American public in a taxpayer-funded bailout. Margin, or collateral, functions as a cushion to protect a bank’s counterparties in the event that the bank cannot fulfill their end of the derivative transaction. Imposing prudent and conservative capital and margin requirements on all derivatives dealers will help prevent similar risks to the public that AIG created.
Business Conduct Standards
Lastly, the Dodd-Frank Act requires swap dealers to meet robust business conduct and documentation standards to lower risk from swaps transactions. Such business conduct and documentation standards include:
• Diligent supervision of a dealer’s swap business;
• Rules relating “to timely and accurate confirmation, processing, netting, documentation, and valuation of all swaps;”
• And establishing firewalls to ensure a separation between the research arm, the trading arm and the clearing activities of a swap dealer.
The Commission will consider several proposed rules relating to business conduct standards at a public meeting tomorrow. These standards for “back office” functions will help reduce risks because they require senior management of swap dealers to have in place policies to oversee the risks of their swaps desks and to have the proper and timely documentation to ensure that senior management and regulators know what those risks are.
Implementing the Dodd-Frank Act
Before I take questions, I will briefly discuss the efforts the CFTC has underway to implement the Dodd-Frank Act. The Act requires the CFTC and the SEC to write rules generally by July 15, 2011. For those of you keeping track, we have 249 days left.
Two principles are guiding us throughout the rule-writing process. First is the statute itself. We intend to comply fully with the statute’s provisions and Congressional intent to lower risk and bring transparency to these markets.
Second, we are consulting heavily with both other regulators and the broader public. We are working very closely with the SEC, the Federal Reserve, other prudential regulators in the U.S. and international regulators.
We also are soliciting broad public input into the rules. Many individuals have asked for meetings with either our staff or Commissioners to discuss swaps regulation. As of this morning, we have had at least 350 such meetings. Just as we believe in bringing transparency to the swaps markets, we also have added additional transparency to our rule-writing efforts. We are posting on our website a list of all of our meetings, as well as the participants, issues discussed and all materials given to us.
We are in the process of publishing proposed rules, using regular public Commission meetings for this purpose. So far, we have had three public meetings and published 11 proposed rules, two final rules and three advanced notices of proposed rulemaking. Our next public meeting is tomorrow, and we have another scheduled for November 19.
The CFTC faces challenges in the months ahead, but we are prepared and geared up to meet those challenges. I look forward to continued dialogue with market participants and the public as we work to implement the Wall Street reform bill.
Thank you, and I’d be happy to take questions from the audience.
Last Updated: January 18, 2011