January 14, 2011
Good morning. I thank Ed Labaton for that kind introduction as well as George Washington Law School and the Center for Law, Economics, & Finance for inviting me to speak. I also want to wish everyone a happy new year.
The 2008 financial crisis left us with many lessons and many challenges to tackle. As the head of the Commodity Futures Trading Commission, I swim in the derivatives lane. In July of last year, Congress passed – and the President signed – the Dodd-Frank Wall Street Reform and Consumer Protection Act to, among other things, bring the unregulated over-the-counter derivatives markets under comprehensive regulation. Those derivatives, also known as “swaps,” were not the only cause of the 2008 financial crisis, but they played a significant role.
Markets work best when they are transparent, open and competitive. The American public has benefited from these attributes in the futures and securities markets since the great regulatory reforms of the 1930s. In enacting reforms after this generation’s financial crisis, Congress directed the CFTC and the Securities and Exchange Commission to bring similar features to the swaps markets. We are in the midst of the rule-writing process to fulfill Congress’s direction.
History of Derivatives
Derivatives are contracts used by corporations, municipalities, nonprofit organizations and others to protect themselves from the risk of a future change in market prices. Every consumer is touched by corporations that use derivatives. Some of these corporations hedge interest rate risks; some purchase products from a supplier who hedged a currency rate risk. If you flew to visit your family over the holidays, the airline may have hedged its risk that the price of jet fuel would increase. Local fuel companies use derivatives to lock in the price of winter heating oil for their customers.
Many derivatives, called futures, are currently regulated by the CFTC. Futures are standardized, liquid derivative contracts that have traded on exchanges since the 1860s. They are used to hedge many different types of risks. Initially, futures products covered agricultural commodities, such as corn and wheat. They allowed farmers, for example, to both hedge a future price risk and get the benefit of transparent pricing established through a national market rather than just with a local dealer.
Futures markets were first regulated in the 1920s. Over the next sixty years, futures trading expanded to cover energy products and financial products, and Congress ensured that all of these products were traded on central markets and covered by regulation. This allowed for transparency and competition in the marketplace that continues to benefit American businesses and consumers.
Things started to change in 1981 with the first derivative transaction that took place outside of a centralized exchange. The early stage of this new unregulated “over-the-counter” swaps market was highly tailored to meet hedgers’ specific needs. Contracts were negotiated between a dealer and a corporation seeking to hedge a risk.
In the last three decades, the over-the-counter derivatives marketplace has grown up. From total notional amounts of less than $1 trillion in the 1980s, the notional value of this market has ballooned to approximately $300 trillion in the United States – that’s $20 of swaps for every dollar in the American economy. The contracts have become much more standardized, and rapid advances in technology – particularly in the last ten years – facilitate more efficient trading. While so much of this marketplace has changed significantly, it remains dominated by a small number of dealers and pricing and transaction data is not made generally available to the public.
When a corporation or another end-user wants to hedge a risk through derivatives, they typically go to their bank and get a price quote. When they enter into transactions, they do not benefit from centralized pricing on an exchange. The price or quote they receive is not discovered on transparent trading venues, such as exchanges. Corporations and hedgers are largely unaware of whether the prices they’re getting are the best available.
The Dodd-Frank Act includes essential reforms that bring sunshine to the opaque swaps markets. Economists and policymakers have for decades recognized that market transparency benefits 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.
There are two types of transparency that Congress sought to bring to the swaps markets. The first is transparency to the regulators, which will include swap data repositories that will provide data to regulators in real time. The second type of transparency is to the public, which I will focus on today.
Bringing public transparency to the swaps markets shifts the information advantage from derivative dealers to the broader market. This not only benefits end-users, but increases competition in the markets by lowering the barriers to entry for additional market makers and liquidity providers. A greater number of market makers also lowers risk to the system and provides greater liquidity.
There are three phases that a swap transaction goes through that will be more transparent under the Dodd-Frank Act. The first occurs before the transaction takes place by moving standardized swap transactions onto exchanges or swap execution facilities. The second is immediately after the transaction occurs, when pricing data must be made public. The third is during the life of the swap contract. Whereas in the cash market, a product is sold for a certain price and the transaction ends, a swap transaction can have a life of many years. The Dodd-Frank Act requires that swaps be marked to market every day of their lifetime and that such valuations be shared with market participants.
I’m sure everyone here is familiar with exchanges that trade securities or futures. This is where investors and hedgers and speculators can meet in a transparent, open and competitive central market. The Dodd-Frank Act enables futures exchanges to also offer swaps for trading and, in addition, establishes a new category of trading platforms called swap execution facilities (SEFs) than can only trade swaps.
Exchanges and swap execution facilities provide the marketplace with pre-trade transparency. The Dodd-Frank Act requires standardized swaps – other than block trades – to be traded on these venues. Exchanges and SEFs allow buyers and sellers to meet in an open, centralized marketplace, where prices are made publicly available. The CFTC’s proposed rules provide flexibility to market participants whereby they can make requests for quotes; make indicative quotes; and make firm bids and offers to other market participants.
Real Time Reporting
Congress also has been very specific that market participants and end-users should benefit from real time reporting. Such post-trade transparency must be achieved “as soon as technologically practicable” after a swap is executed, which will enhance price discovery. This requirement applies to both cleared and uncleared swaps. Just as in the futures marketplace, block trades for swaps will be reported with some delay.
In addition to promoting transparency for swaps immediately after the transactions, the Dodd-Frank Act brings sunshine to swaps over the duration of the contracts. One of the key chapters from the 2008 financial crisis was when large financial players, including AIG, had valuation disputes. The Dodd-Frank Act directly addresses many of these issues by requiring daily valuation of swaps. For cleared swaps, clearinghouses have to publicly say where they are marking their positions. For uncleared swaps, swap dealers and major swap participants have the obligation to provide the mid-market pricing of outstanding swaps to their counterparties on a daily basis. Furthermore, when swap dealers and major swap participants are valuing the swaps, our proposed rulemaking requires those entities to use as objective data as possible, such as settlement prices as reported by clearinghouses.
In addition to transparency requirements on individual swap transactions, the Dodd-Frank Act requires additional transparency on the market in aggregate. Both trading venues and clearinghouses will have to provide aggregate trading data to the public on a daily basis. Trading venues will be required to make aggregate data available on trading volume, open interest and pricing. Clearinghouses will be required to make aggregate data available on daily trading volume, open interest and mark-to-market settlement prices. The CFTC also is required to publish a regular report on trading and clearing by swap categories. The Dodd-Frank Act requires that data to be released at least every six months, but we hope to release data more frequently than that. We are looking to promote the transparency of the swaps market in ways similar to what we have done for many years through aggregate reporting of futures trading data.
A significant benefit that transparency brings to the marketplace is increased competition. But transparency is not enough. The Dodd-Frank Act also has essential provisions to promote competition through access in the marketplace. Competition is essential to well-functioning markets. In passing the Dodd-Frank Act, Congress decided that there should be open access to the swaps markets in a number of key ways.
Impartial Access to SEFs
In establishing SEFs, Congress required that trading platforms give multiple market participants the ability to execute an order with multiple participants. SEFs also must give all potential traders the ability to participate, particularly as the statute requires these trading facilities “to provide market participants with impartial access to the market.” The CFTC’s proposed SEF rules require SEFs to allow market participants to leave executable bids or offers that can be seen by the entire marketplace. That means that any market participant – a bank or a nonbank – can choose if they want to take on risk and buy a swap. This brings competition to the marketplace that improves pricing and lowers risk.
Open Access to Clearinghouses
In addition to opening access to trading facilities, the Dodd-Frank Act requires open access to clearinghouses. Clearinghouses act as middlemen between two parties to a swap transaction after the trade is arranged. 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.
The CFTC recently proposed rules on clearinghouse participant eligibility requirements to promote fair and open access to clearing. Importantly, the proposal addresses rules of how a futures commission merchant can become a member of a swaps clearinghouse. The proposal promotes more inclusiveness while allowing the clearinghouses to scale a member’s participation and risk based upon its capital. This improves competition that will benefit end-users of swaps, while protecting clearinghouses’ ability manage risk.
Non-Discriminatory Open Access to Clearinghouses
Congress also passed an important provision to promote competition amongst trading platforms. The Dodd-Frank Act requires clearinghouses to provide non-discriminatory open access to trading facilities. This means that clearinghouses will have to accept equivalent swaps for clearing regardless of where the transaction was executed. This includes both swaps that are executed bilaterally and those on unaffiliated trading platforms. We’ve incorporated this requirement into proposed rulemakings. It will promote competition in and amongst trading platforms. This is not required in the futures world.
In conclusion, the American public benefits most when markets are transparent, open and competitive. The U.S. swaps market today does not have these features. Rather, it has been opaque and concentrated amongst a small group of dealers. It was the intent of Congress in passing the Dodd-Frank Act to bring diversity and sunshine to the market. It is our mission at the CFTC to fulfill Congress’s mandate.
Thank you for inviting me to speak today.
Last Updated: January 18, 2011