November 11, 2010
Good morning. I thank the Practising Law Institute for inviting me to speak today.
Today I will update you on the Commodity Futures Trading Commission’s (CFTC) efforts to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act with regard to regulation of the swaps marketplace. Before I begin, I’d like to thank the staff and 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.
Though there were many causes of the 2008 financial crisis, unregulated swaps played a central role. 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 regulation to the swaps markets that will increase transparency and lower risk.
There are three critical reforms of the derivatives markets included in the Dodd-Frank Act. First, the bill requires swap dealers to come under comprehensive regulation. Second, the bill moves the bulk of the swaps marketplace onto transparent trading facilities – either exchanges or swap execution facilities. Third, the bill requires clearing of standardized swaps by regulated clearinghouses to lower risk in the marketplace.
Implementing the Dodd-Frank Act
The Dodd-Frank Act is very detailed, addressing all of the key policy issues regarding regulation of the swaps marketplace. To implement these regulations, it requires the CFTC and the Securities and Exchange Commission (SEC) to write rules generally within 360 days. For those of you keeping track, we have 247 days left. We have organized our effort around 30 teams who have been actively at work.
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 and international regulators.
We also are soliciting broad public input into the rules. This began the day the President signed the Dodd-Frank Act when we listed the 30 rule-writing teams and set up mailboxes for the public to submit their views directly. We want to engage the public as broadly as possible throughout the rule-writing process.
In addition to setting up mailboxes for the public to comment, we also have organized public roundtables to hear on particular subjects. Additionally, many individuals have asked for meetings with the CFTC to discuss swaps regulation. As of yesterday, we have had more than 365 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 now 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 four public meetings and published 18 proposed rules, two final rules and three advanced notices of proposed rulemaking, including seven proposals at a public meeting yesterday. Our next meeting is scheduled for November 19.
I will now address four broad areas as we bring regulation to the swaps marketplace.
Regulating the Dealers
The first is regulating swap dealers. It is anticipated that as many as 200 entities will register with the CFTC as swap dealers. The Dodd-Frank Act builds upon the CFTC’s current oversight of intermediaries in the futures marketplace. We currently regulate futures commission merchants (FCMs), commodity pool operators (CPOs), commodity trading advisors (CTAs) and introducing brokers (IBs). The new statute adds comprehensive oversight over swap dealers and major swap participants, including capital and margin requirements, business conduct standards and recordkeeping and reporting requirements. The statute also broadens the definitions of FCMs, CPOs, CTAs and IBs to include their swaps activity in addition to their futures activity.
Just yesterday, the Commission voted to propose rules regarding registration requirements, risk management practices, firewalls and chief compliance officers for swap dealers. We have another team working with the SEC on defining key terms, such as “swap dealer” and “major swap participant.” We anticipate taking up these definitions in early December. We also have teams working on sales practices and other external business conduct standards, capital and margin requirements, recordkeeping and reporting requirements, documentation standards and rules for segregating customer funds. We will take up a proposal regarding bankruptcy protections and segregation of customer funds for non-cleared swaps at next week’s public Commission meeting.
Transparent Trading Requirement
In addition to regulating swap dealers, the Dodd-Frank Act brings transparency to the swaps marketplace by requiring standardized swaps to trade on exchanges or swap execution facilities (SEFs). We have five teams focused on writing rules related to trading. We anticipate that as many as 40 entities could register with the CFTC as SEFs.
Some have asked: what is a swap execution facility? The statutes says that it is “a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants.” These facilities allow buyers and sellers to meet in an open, centralized marketplace, particularly as the statute requires these trading facilities “to provide market participants with impartial access to the market.”
This is a real change in the swaps marketplace. Congress mandated that if a swap both is clearable and it is “made available for trading” on a SEF or an exchange, then there is a mandate that it be traded on such a facility. The statute says that one of the goals of swap execution facilities is “to promote pre-trade transparency in the swaps market,” though it appropriately authorizes the CFTC to write rules to facilitate block trades.
Congress also has been very specific that market participants and end-users will benefit from real time reporting and that such post-trade transparency must be achieved “as soon as technologically practicable” after a swap is executed. This is mandated for both SEF-traded swaps as well as so-called “bilateral” swaps.
The Commission yesterday proposed a rule regarding registration of foreign boards of trade (FBOTs) that wish to make their markets available to U.S. participants. The proposal also provides that FBOTs subject to comparable, comprehensive supervision and regulation in their home country and that meet conditions outlined in the proposal would be allowed to make available swaps contracts through direct access to U.S. market participants. We also have published a proposed rule regarding governance of exchanges and SEFs. We anticipate considering a proposed rulemaking regarding real time reporting at next week’s public meeting. We also plan to consider exchange and SEF rules in December.
To further lower risk in the system, the Dodd-Frank Act requires that standardized swaps be cleared through central clearinghouses. Clearinghouses have effectively reduced risk since they were first developed in the futures markets in the 1890s. They 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. Derivatives clearinghouses 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 American public.
The Commission has proposed several rules relating to clearinghouses, including rules related to clearinghouse governance, financial resource requirements for clearing organizations, a rule on reviewing clearinghouse rules and the process for reviewing which swaps should be subject to the Dodd-Frank Act’s clearing requirement.
In addition to those rules, the Commission will consider rules regarding clearinghouse risk management standards, the commercial end-user exception from clearing, segregation of customer funds, participant eligibility and compliance with other core principals included in the Dodd-Frank Act.
Furthermore, for the first time, some derivatives clearinghouses may be designated systemically important by the Financial Security Oversight Council. For those clearinghouses, the Commission will consider enhanced rules for financial resources, risk management and other prudential standards. In this regard, we are consulting very closely with the Federal Reserve and international regulators. We recognize the need for very robust risk management standards, particularly as more swaps are moved into central clearinghouses.
Moreover, the Dodd-Frank Act for the first time sets up 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 Commission has adopted a rule that requires swap participants to preserve pre-enactment swap transaction data and report it to a registered swap data repository, once it is established, or to the CFTC. Since swap data repositories have not yet been established, the rule directs swap participants to save their data so that they can report it in the future, after the Commission has promulgated reporting requirements and after swap data repositories are registered.
We also will consider two proposed rules relating to data at our next public meeting. The first would establish rules for swap data repositories, including how they must maintain data and make it directly and electronically available to regulators. The second proposed rule will outline what data must be kept by regulated swap entities – such as swap dealers, major swap participants, SEFs, exchanges and clearing organizations. This rule proposal also will include what of that data must be made available to and maintained by data repositories.
The CFTC is working diligently to complete rule-writing to implement the Dodd-Frank Act by the statutory deadline next July. Thank you, and I’d be happy to take questions.
Last Updated: January 18, 2011