April 13, 2011
Good afternoon. I thank the Levy Economics Institute and Bard College for inviting me to speak today. When first contacted by Bard College to speak at this event, I thought it might have something to do with my daughter Lee, who is a freshman at their beautiful campus in Annandale-on-Hudson. I was glad that everything was fine with Lee and that it wasn’t yet another call to say I had been late on getting the tuition check in. Far better and an honor to boot, the call was to invite me to speak with you today about the important topic of “Financial Reform and the Real Economy.”
As Chairman of the Commodity Futures Trading Commission, I swim in the derivatives lane. Thus, I’m going to spend my time with you this afternoon discussing how regulatory reform of certain derivatives, called swaps, will bring tangible benefits to the real economy. Derivatives markets and effective oversight of those markets matter to corporations, farmers, homeowners and small businesses. The recent increases in commodity prices highlight the need for effective oversight that promotes fair and orderly derivatives markets. Before I get into detail on financial reform, I will provide some background on the role that derivatives play in the economy and some history of their regulation. I also will briefly discuss the 2008 financial crisis before returning to how reform relates to the real economy.
The Role of Derivatives in the Economy
Each part of our nation’s economy relies on a well-functioning derivatives marketplace. It is essential so that producers, merchants and other end-users can manage their risks. It allows those companies to lock in prices for the future. These markets have been around since the time of the Civil War. Initially, there were futures on agricultural commodities, such as wheat, corn and cotton. They allowed farmers to get price certainty on their crops before harvest time. They also allowed farmers and producers to get the benefit of prices on a central market rather than just relying on the local merchants.
The markets have grown to include contracts on energy and metals commodities, such as crude oil, heating oil, gasoline, gold and silver, and contracts on financial products, such as interest rates, stock indexes and foreign currency. These markets benefit tens of thousands of end-users, including farmers, ranchers, oil producers, corporations, municipalities, pension funds and anybody else who wants to hedge a risk and get the benefits of transparent pricing in competitive markets. The price certainty that derivatives markets provide allows companies to better make essential business decisions and investments.
Every consumer is touched by corporations that use derivatives. You likely bought something recently from a corporation that hedged an interest rate risk or a currency risk. The airline that you use the next time you take a trip most likely hedged its risk that the price of jet fuel would increase.
Changes in the Derivatives Markets
These early derivatives, called futures, are currently regulated by the CFTC. After much debate, futures markets first came under regulation in the 1920s – more than sixty years after the first contracts were traded – and have been comprehensively regulated since.
Things started to change in 1981 when a new derivatives product appeared, which was transacted off-exchange. These derivatives, called swaps, were unregulated and remained so until the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act last summer.
In the meantime, the swaps marketplace has grown up and played a significant role in the financial crisis of 2008. From total notional amounts of less than $1 trillion in the 1980s, the notional value of this market has ballooned to about $300 trillion in the United States – that’s approximately $20 of swaps for every dollar in the U.S. economy.
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 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. Still, the effects of that crisis remain. We still have high unemployment, homes that are worth less than their mortgages and pension funds that 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, 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, which was 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.
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. The Dodd-Frank Act brings similar features to the swaps market for the first time.
Promoting Transparency in the Swaps Markets
The Dodd-Frank Act includes essential reforms to bring sunshine to the opaque swaps markets. The real economy benefits from such transparency. Economists and policymakers for decades have 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.
The Dodd-Frank Act helps end-users of swaps by bringing transparency in each of the three phases of a transaction. First, it brings transparency to before the transaction is completed, which we call pre-trade transparency. This is done by requiring standardized swaps – those that are cleared and made available for trading – to be traded on exchanges or swap execution facilities (SEFs). SEFs are a new type of swaps trading platform created by the Dodd-Frank Act.
Exchanges and SEFs will allow investors, hedgers and speculators to meet in a transparent, open and competitive central market. This will benefit end-users by providing better pricing on derivatives transactions.
Second, the Dodd-Frank Act brings real-time transparency to the pricing immediately after a swaps transaction takes place. This post-trade transparency provides all end-users and market participants with important pricing information as they consider their investments and whether to lower their risk through a similar transaction.
Third, the Dodd-Frank Act brings transparency to swaps over the lifetime of the contracts. End-users and the public will benefit from knowing the valuations of outstanding swaps on a daily basis. If the contract is cleared, the clearinghouse will be required to publicly disclose the pricing of the swap. If the contract is bilateral, swap dealers will be required to share mid-market pricing with their counterparties. This daily valuation will help prevent similar scenarios to 2008 when we were unable to price “toxic assets.”
Additionally, the Dodd-Frank Act brings transparency of the swaps markets to regulators. The Act includes robust recordkeeping and reporting requirements for all swaps transactions 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.
Lowering Risk in the Swaps Markets
In addition to promoting transparency, the Dodd-Frank Act lowers the risk that the swap market poses to the American public in two key ways: requiring central clearing and bringing oversight to swap dealers.
Currently, swap transactions stay on the books of the dealers that arrange them, often for many years after they are executed. Like AIG did, these dealers 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 swaps 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 addresses this interconnectedness by requiring that standardized swaps transactions between financial entities be brought to clearinghouses. Central clearing has been a feature of the U.S. futures markets since the late-19th century. Clearinghouses act as middlemen between two parties to a derivatives transaction after the trade is arranged. They protect the real economy from the failure of a swap dealer. They require dealers to post collateral so that if one party fails, its failure does not harm its counterparties and reverberate throughout the financial system. They 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.
Regulating the Dealers
Leading up to the financial crisis, it was assumed that the banks that deal in swaps were already regulated and thus did not need to be explicitly regulated for their swaps transactions. The financial crisis demonstrated that this was a flawed assumption. While banks and securities firms were regulated by their prudential regulators, their affiliates that traded swaps often were left ineffectively regulated – that was the case for Lehman Brothers and AIG. Even when swaps were traded inside a regulated bank, the banks were not regulated explicitly for their derivatives trading.
The Dodd-Frank Act addresses this by requiring comprehensive oversight of swap dealers. The Act includes capital requirements to reduce the risk of a swap dealer’s failure. It also includes margin – or collateral – requirements to help prevent one financial entity’s failure from spreading to other financial entities and the broader economy. The Act also authorizes regulators to write business conduct standards, including documentation, confirmation and portfolio reconciliation requirements. Each of these is an important tool to lower risk that the swap markets pose to the real economy.
Further, the Dodd-Frank Act provides regulators with authority to write business conduct rules and set position limits to promote market integrity and protect against fraud, manipulation and other abuses. This helps ensure that the users of derivatives get the benefit of transparent, open and competitive markets.
Financial markets are complex, global and interconnected. They perform essential functions for American businesses, their customers and the real economy. The derivatives markets allow producers, merchants, corporations, municipalities, nonprofit organizations, pension funds and other end-users to lower their risk by locking in prices and rates in the future. This helps promote a vibrant economy.
But we also must remember that the financial crisis was real, and the effects remain in our economy. It is essential that we have comprehensive oversight of these markets to protect and benefit both end-users of derivatives and the broader American public. The Dodd-Frank Act was essential in bringing this oversight, but reform will only be effective once rules are completed and regulators have additional resources aligned with their expanded missions.
I thank you for inviting me to speak with you today.
Last Updated: April 13, 2011