March 22, 2011
Good afternoon Chairwoman Bowles and members of the Economic and Monetary Affairs Committee. I thank you for inviting me to speak today on regulatory reform of over-the-counter (OTC) derivatives, or swaps. I am honored that this is the second time that you have asked me to appear before you, but as it goes, it is once again when my daughters are home on spring break. As I did last year, I would like to introduce my two daughters, Lee and Isabel.
It has now been more than two years since the financial crisis, when both the financial system and the financial regulatory system failed. So many people in Europe and in the United States who never had any connection to derivatives or exotic financial contracts had their lives hurt by the risks taken by financial actors. But still, the effects of that crisis remain. Throughout the U.S. and Europe, we still have high unemployment, homes that are worth less than their mortgages and pension funds that still have not regained the value they had before the crisis. We still have significant uncertainty in the financial system.
Though there were many causes to the crisis in 2008, it is clear that swaps played a central role. They added leverage to the financial system with more risk being backed up by less capital. U.S. taxpayers bailed out AIG with $180 billion when that company’s ineffectively regulated $2 trillion swaps portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system. These events demonstrate how swaps – initially developed to help manage and lower risk – can actually concentrate and heighten risk in the economy and to the public. Reform is needed now as much as it was in the immediate aftermath of the financial crisis.
Markets work best when they are transparent, open and competitive. The American public has benefited from these attributes in the securities markets and in the regulated, on-exchange derivatives markets, or what we Americans call the futures markets, since the great regulatory reforms of the 1930s.
The U.S. Congress responded to this generation’s financial crisis by enacting the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act, for the first time, brings oversight to the heretofore unregulated over-the-counter derivatives markets, or what we call the swaps markets. The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) in the U.S. are working to implement these reforms.
Today, I will discuss what we are doing in the United States to increase transparency and lower risk in the swaps marketplace. I also will address these efforts in the context of the proposals you currently are considering in Europe.
With regard to swaps, the Dodd-Frank Act includes three critical components:
Like the U.S. law, the European Commission’s swaps proposal released last year covers the entire swaps marketplace – both bilateral and cleared – and the entire product suite, including interest rate swaps, currency swaps, commodity swaps, equity swaps and credit default swaps. Furthermore, it is essential that reform covers all swaps transactions, regardless of where they are transacted.
Regulating the Dealers
The Dodd-Frank Act includes comprehensive regulation of swap dealers. Though the E.C.’s proposal is organized differently, it includes many of the same critical components for the regulation of dealers, including capital and margin, risk mitigation techniques and reporting.
One of the lessons from the financial crisis was that dealers were insufficiently prepared for the losses they could take if they were on the losing end of swaps transactions. This was most obvious when AIG was failing. Capital requirements, usually computed quarterly, help protect the public by lowering the risk of a dealer’s failure. Margin requirements, usually paid daily, help protect dealers and their counterparties in volatile markets or if either of them defaults. Both are important tools to lower risk in the swaps markets. The Dodd-Frank Act authorized bank regulators, the CFTC and the SEC to set both capital and margin “to offset the greater risk to the swap dealer or major swap participant and the financial system arising from the use of swaps that are not cleared.” Recognizing that swaps transactions involving non-financial end-users to not pose the same risk as transactions between two financial entities, Congress excepted these transactions from mandatory clearing, and, thus, the CFTC does not intend to impose margin requirements with regard to these transactions.
The Dodd-Frank Act also explicitly authorizes regulators to write business conduct standards to lower risk and promote market integrity. The E.C. proposal addresses similar protections though risk mitigation techniques, such as documentation, confirmation and portfolio reconciliation. These are important features to lower risk. Further, the Dodd-Frank Act provides regulators with authority to write business conduct rules to protect against fraud, manipulation and other abuses.
Lowering Risk through Central Clearing
Another area where the Dodd-Frank Act and the E.C.’s proposal are similar is requiring clearing of standardized swaps – those that Americans call “clearable” and that Europeans often call “eligible.” The U.S. Congress determined that swaps that are clearable should be subject to mandatory clearing regardless of whether they are traded on an exchange, on a swap execution facility or otherwise.
Central clearing has been a feature of the U.S. futures markets since the late-19th century. 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 economy. We recognize the need for very robust risk management standards, particularly as more swaps are moved into central clearinghouses. We have incorporated the newest draft Committee on Payment and Settlement Systems (CPSS)-International Organization of Securities Commissions (IOSCO) standards for central counterparties into our proposed rules. We also are working to include in our proposals the clearing standards included in the E.C. proposal.
The Dodd-Frank Act requires that clearinghouses have nondiscriminatory open access for swaps. They will be required to clear trades from any regulated exchange or swap execution facility. They will not be allowed to discriminate between or amongst the trades coming from one trading venue or another. The Act also requires clearinghouses to provide open access to clearing members. These access provisions will promote competition amongst trading venues as well as allowing the greatest choice among market participants and end-users.
In both the Dodd-Frank Act and the E.C.’s proposal, financial entities, such as swap dealers, hedge funds and insurance companies, will be required to use clearinghouses when entering into standardized swap transactions with other financial entities. Non-financial end-users that are using swaps to hedge or mitigate commercial risk, however, will be able to choose whether or not to bring their swaps to clearinghouses.
In the U.S., Congress determined that the end-user exception should be limited to non-financial entities. Expanding the exception to include financial end-users, such as hedge funds, insurance companies or pension funds, would leave significant risk and interconnectedness in the financial system. If pension funds or other financial entities, for example, do not benefit from central clearing, they will remain interconnected with their swap dealers. This increases the risk that the dealer’s failure could spread to the pension funds or other financial entities. Central clearing lowers that interconnectedness and lowers the risk that taxpayers might be called upon to bail out a dealer if it should fail.
The third critical reform that the Dodd-Frank Act brings to the swaps market is transparency. This includes transparency both to the regulators and to the public. The Act includes robust recordkeeping and reporting requirements for all swaps transactions. It is important that all swaps – both on-exchange and off – be reported to data repositories so that regulators can have a window into the risks posed in the system and can police the markets for fraud, manipulation and other abuses.
The U.S. statute says that information in swap data repositories that we regulate should be available to foreign regulators. It will be incumbent as we finalize rules that we ensure such global access. We look forward as well to working with our international counterparts on arrangements to ensure that necessary data in swap data repositories be available to foreign regulators.
Though transparency to regulators is essential, we also must bring transparency to the public. The Dodd-Frank Act requires that all swaps transactions – both cleared and bilateral – be publicly reported post-trade. Furthermore, the Act requires all swaps that can be cleared and are made available for trading to be traded on a transparent trading platform. I understand that in Europe, you plan to address the public transparency requirements later when you take up possible reforms to the Markets in Financial Instruments Directive (MiFID).
At the conclusion of the 2009 G-20 summit held in Pittsburgh, G-20 Leaders concurred that “[a]ll standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.” Last month, the IOSCO issued a report on trading that further clarifies the G-20 Leaders’ mandate to trade standardized swaps on electronic trading platforms, including eight characteristics of such platforms. Many of the IOSCO members participating indicated a belief that added benefits are achieved through multi-dealer trading platforms. The IOSCO report concluded that beyond the added benefits of pre-trade transparency, trading helps mitigate systemic risk and protect against market abuse.
The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies using derivatives to hedge risk. Transparency to the public brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, banks and the U.S. government had no price reference for particular assets – assets that we began to call “toxic.” To address this, it is essential that reform includes a strong requirement that standardized swaps be traded on exchanges or similar swap execution facilities.
Physical Commodity Markets
Rising prices for basic commodities – including in both agricultural and energy markets – highlight the importance of having effective market oversight that ensures integrity and transparency. Though the CFTC is not a price-setting agency, we have a number of tools to help ensure market integrity and protect against fraud and manipulation. This includes position limits, anti-manipulation authorities, large trader reporting and pre-trade risk safeguards. As it relates to anti-manipulation, we have authorities to pursue both manipulation and attempted manipulation. I understand you are taking that up in the Market Abuse Directive. We strongly support providing regulators the power to deter and prosecute attempts to manipulate the market.
Let me take a moment to discuss position limits. In the U.S., regulators have had the authority to set position limits in the futures markets since 1936 to protect against the burdens of excessive speculation, including those caused by large concentrated positions. Hedgers and speculators both play a role in the marketplace. For instance, when a farmer wishes to lock in a price for their corn or wheat at harvest time, they might sell a futures contract in a marketplace where a speculator provides the other side of that transaction. Similarly, companies hedging energy prices, interest rate movements or currency movements enter into transactions in which speculators may take the other side.
In setting position limits, the CFTC has sought to ensure that the markets were made up of a broad group of market participants with a diversity of views. At the core of our obligations is promoting market integrity, which the agency has historically interpreted to include ensuring markets do not become too concentrated. The Dodd-Frank Act extended our traditional authorities to set position limits on futures to now include the authority to set aggregate limits across all markets and trading platforms on all derivatives that perform or affect a significant price discovery function with respect to regulated markets that the CFTC oversees.
The CFTC now is working to implement the reforms of the Dodd-Frank Act. We are engaged in a process of broad public consultation and outreach. Based upon the input that we received from the public and our fellow regulators, we have proposed more than 40 rules and made them available for public comment. We have come to a natural pause, as we are hearing from the public on those proposals. We will begin considering final rules only after staff can analyze comments, after the Commissioners are able to provide feedback to staff, and after the Commission can receive feedback from fellow regulators both in the U.S. and abroad. We envision finalizing rules beginning in the spring and running though the fall.
Congress gave the CFTC flexibility as to setting implementation or effective dates of the rules to implement the Dodd-Frank Act. For example, even if we finish finalizing rules in a particular order, that doesn’t mean that the rules will be required to become effective in that order. Implementation dates may be conditioned upon other rules being finalized.
Furthermore, we are looking at phasing implementation dates based upon a number of considerations, possibly including asset class, type of market participant and whether the requirement would apply to market platforms, like clearinghouses, or to specific transactions, such as real time reporting. We are considering whether a rule might become effective for one asset class or one group of market participants before it is effective for other assets or other groups of market participants. We are looking to phase in implementation, considering the whole mosaic of rules. We look forward to hearing from market participants and regulators, both in the U.S. and abroad, regarding the phasing of implementation.
Regardless of the eventual effective dates of the swaps rules, to provide regulatory certainty to the market, rules relating to mandatory clearing, real time reporting, the trading requirement, margin and business conduct standards will apply only prospectively to those transactions that are executed after the rules go into effect.
Broad International Coordination
As we work to bring oversight to the swaps market, the CFTC is consulting heavily with counterparts in Europe and elsewhere to harmonize our approach to swaps oversight. We are sharing many of our memos, term sheets and draft work product with the European Commission, the European Central Bank, the new European Securities and Markets Authority and other regulators in Europe and elsewhere.
In the U.S., we stand ready to work with our international counterparts on memoranda of understanding to cover both information sharing and supervisory matters. In particular, the Dodd-Frank Act gave both the CFTC and SEC authority to enter into such information sharing arrangements. A coordinated approach is necessary to overseeing a global marketplace.
Today’s meeting of the ECON Committee is an important part of our ongoing work to harmonize swaps oversight. Through this consultation, we are working to bring consistency to regulation of the swaps markets.
I again thank you again for inviting me to address you. Though two years have passed, we cannot forget that the 2008 financial crisis was very real. We must continue to work together to bring oversight to the swaps market to help reduce the chance of the next crisis. Effective reform cannot be accomplished by one nation alone. It will require a comprehensive, international response. With the significant majority of the worldwide swaps market located in the U.S. and Europe, the effectiveness of reform depends on our ability to cooperate and find general consensus on this much needed regulation. I look forward to answering any questions that you may have.
Last Updated: March 22, 2011