May 11, 2011
Good morning. I thank the World Bank and the International Finance Corporation for inviting me to speak today at the 13th annual Global Private Equity Conference. I also thank Roger Leeds for that introduction.
As managers of private equity funds, you are part of an industry with up to $3 trillion in assets under management. Your investors and you benefit from markets that are transparent, open and competitive. All of your funds benefit from the great advances that were put in place to regulate our markets in the 1930s when President Franklin Roosevelt, working with Congress after an earlier crisis, brought that transparency, openness and competitiveness to the securities and commodity futures markets.
But a new world of financial products developed in the 1980s that remains largely unregulated to this day, called swaps.
At the Commodity Futures Trading Commission (CFTC), we are actively at work implementing the Dodd-Frank Wall Street Reform and Consumer Protect Act to bring oversight to the swaps markets. In doing so, we have had hundreds of meetings with outside groups to hear directly from the public on how best to write new swaps rules, and we post details of the meetings to our website.
If you scroll through that list of meetings, you’d be hard pressed to find more than a handful of meetings with private equity funds. You’d find a lot more meetings with banks, hedge funds, asset managers, commercial end-users and other market participants.
So let me ask for a show of hands: how many of you use derivatives at your fund level – not at your portfolio companies, but your fund itself?
That’s what I thought. So you might be asking yourself, “Why is Gensler here talking to us? He’s a derivatives guy.”
Now let me ask for a show of hands if your fund invests in a company that uses derivatives. As I expected, many more hands went up.
I think that’s probably why the IFC invited me to be with you today.
In any event, even if your funds don’t invest in companies that use derivatives, you’ve got me for the next 20 minutes anyway. So let me tell you a little bit about what we’re doing and why it brings meaningful benefits to the economy and to the companies in which you invest.
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. Based on your earlier show of hands, it is likely that your portfolios of companies include at least some companies that use those derivatives markets to hedge their risk. The price certainty that these markets provide allows companies to better make essential business decisions and investments.
Changes in the Derivatives Markets
These early derivatives, called futures, are currently regulated by the CFTC, after first coming under regulation in the 1920s.
In 1981, a new derivatives product appeared, which was transacted off-exchange. These derivatives, called swaps, were unregulated and largely will remain so until we complete implementation of the Dodd-Frank Act, which became law last summer.
Since the 1980s, the swaps marketplace has evolved significantly. It also played a significant role in the 2008 financial crisis. 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. Still, the effects of that crisis remain. I suspect few of your portfolio companies made their budgets in 2009, and many may still be below the growth for which you had planned.
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.
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.
Promoting Transparency in the Swaps Markets
The Dodd-Frank Act includes essential reforms to bring sunshine to the opaque swaps markets. 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. This transparency would benefit the companies that comprise your investment portfolios.
The Dodd-Frank Act brings transparency in each of the three phases of a transaction. First, it brings transparency to the time immediately before the transaction is completed, which we call pre-trade transparency. This is done by requiring standardized swaps – those that are cleared, made available for trading and not blocks – to be traded on exchanges or swap execution facilities (SEFs), which 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 similar transactions.
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.
Transparency in all three phases 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 through swap data repositories. 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.
The Dodd-Frank Act requires that standardized swap transactions between financial entities be brought to clearinghouses.
Currently, however, 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.
Furthermore, these dealers are interconnected with other financial entities through their swaps transactions. 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.
Clearinghouses, as mandated by the Dodd-Frank Act, 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.
Clearinghouses act as middlemen between two parties to a derivatives transaction after the trade is arranged. They protect the financial system and the broader economy from the failure of a swap dealer.
Regulating the Dealers
The financial crisis demonstrated the risk to the public of ineffectively regulated swap dealers. 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 economy, including the companies in which your funds invest.
The swaps market performs essential functions for businesses, their customers and the real economy both in the U.S. and abroad.
Well-functioning markets, however, require comprehensive oversight to protect and benefit both end-users of derivatives and the broader public. All of the companies in which your funds invest – those that use derivative and even those that don’t – will benefit from the greater transparency and lower risk that reform will bring. The Dodd-Frank Act was essential in bringing this oversight, but reform will only be effective once rules are completed.
I thank you for inviting me to speak with you today.
Last Updated: May 11, 2011