June 2, 2011
Good afternoon. I thank the National Association of Corporate Treasurers and Tom Deas for inviting me to speak today. Both the Commodity Futures Trading Commission (CFTC) and I have benefited from your thoughtful input and constant attention to important issues with regard to the swaps marketplace during the legislative process and the rule-writing process to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The Dodd-Frank Act brings essential reform to the swaps markets that will benefit the American public and each of you in your roles as corporate treasurers.
Though I am speaking to you in my formal capacity as Chairman of a market regulatory agency, I also was once co-head of finance at a major firm. Like many of you, I helped oversee how a corporation funded itself, managed its risk and met its budget.
As the CFTC has been working to implement the Dodd-Frank Act, I also have had the opportunity to meet with numerous corporate end-users to discuss their perspectives on the derivatives marketplace.
A lot has changed in the 13 years since I last had a role similar to yours – and most of you are treasurers for non-financial organizations – but I think we share a view that the financial system needs to work for both corporate America and the economy as a whole. I think we also can agree that, in 2008, the financial system did not work for corporate America or the economy as a whole.
Derivatives in the 2008 Financial Crisis
The financial crisis was very real. I am sure that most of your organizations did not make budget in 2009 – or at least not your original budget. Many of you probably had trouble making budgets in 2010.
The effects of the crisis remain. We still have high unemployment, millions of 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 economy.
One reason we had the 2008 financial crisis was because we did not have the right financial regulations in place. The financial system and the financial regulatory system failed. They failed the American public and they failed American businesses. When AIG and Lehman Brothers failed, you paid the price. As Americans are still struggling, still out of work and still very careful with their spending, your businesses are directly affected.
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. They contributed, particularly through credit default swaps, to the bubble in the housing market. They contributed to a financial system where institutions were thought to be not only too big to fail, but too interconnected to fail. 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.
A key piece of the derivatives reforms of the Dodd-Frank Act is to lower the risks to the overall economy that are posed by the swaps marketplace. As we were so surely reminded in 2008, your health – the health of corporate America – as well as the economic health of the country, is put at risk when the financial system falters. Therefore, though much of the Dodd-Frank Act was directed to the financial sector, its reforms are critical to the health of the overall economy and the health of your own prospects.
One of the challenges that the Dodd-Frank Act addresses is that, like so many other industries, the financial industry has gotten very concentrated around a small number of very large firms.
Adding to the challenge is the perverse outcome of the financial crisis, which may be that many people in the markets have come to believe that this handful of large financial firms will – if in trouble – have the backing of the taxpayers. As it is unlikely that we could ever ensure that no financial institution will fail – because surely, some will in the future – we must do our utmost to ensure that when those challenges arise, the taxpayers are not forced to stand behind those institutions and that these institutions are free to fail.
The Dodd-Frank Act addresses this in many ways beyond derivatives, but the derivatives piece is a critical component. The derivatives reforms lower risk throughout the economy by heightening market transparency and directly regulating dealers for their swaps activity.
In addition, it directly lowers interconnectedness in the swaps markets by requiring those standardized swaps that are entered into and amongst financial institutions to be brought to central clearing. Each of these reforms is critical to lowering the risk that the financial system and, in particular, the failure of a large financial institution, poses to all of your corporations and the economy as a whole.
Promoting Transparent, Open and Competitive Markets
A further benefit that reform will bring to the economy and you in your roles as corporate treasurers is making the swaps marketplace more transparent, open and competitive. This reform will bring real, tangible benefits to the corporations that you represent.
Each part of our nation’s economy relies on a well-functioning derivatives marketplace. The derivatives markets are used to hedge risk and discover prices. They initially emerged around the time of the Civil War as tools to allow producers and merchants to be certain of the prices of commodities that they planned to use or sell in the future.
Not many of you are active in the agriculture derivatives markets, but that is where the markets first emerged. Initially, there were derivatives on agricultural commodities, such as wheat, corn and cotton. These early derivatives, called futures, are currently regulated by the CFTC. After much debate, futures markets first came under regulation in the 1920s and 1930s and have been comprehensively regulated since.
The derivatives markets have grown from those agricultural futures through the 20th and 21st centuries to include swaps. I am sure that most of you in this room have used swaps to hedge risks in your business. Maybe you have hedged an interest rate risk or a currency risk. A commodity price risk or credit risk. The swaps markets provide corporations with a means of locking in rates or prices in one part of their business so that they can focus on what they are best at – whether it be producing goods or providing services.
Such price certainty allows companies to better make essential business decisions and investments. Thus, it is critical that market participants have confidence in the integrity of these price discovery markets.
While the derivatives market has changed significantly since swaps were first transacted in the 1980s, the constant is that the financial community maintains information advantages over their nonfinancial counterparties. When a Wall Street bank enters into a bilateral derivative transaction with one of the corporations represented in this room, for example, the bank knows how much its last customer paid for similar transactions. That information, however, is not generally made available to other customers or the public. The bank benefits from internalizing this information.
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 is called pre-trade transparency. This is done by requiring standardized swaps – those that are cleared, made available for trading and not blocks – between or amongst financial entities 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. Even if you, as corporate treasurers of nonfinancial entities, decide not to use exchanges or SEFs for your swaps transactions – because the Dodd-Frank Act says that you are not required to do so – you still will benefit from the transparent pricing and liquidity that such trading venues provide.
The Dodd-Frank Act mandates that all market participants have the ability to utilize SEFs and derivatives exchanges if they choose to do so. The statute requires these trading facilities “to provide market participants with impartial access to the market.” The CFTC’s proposed 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 – a corporation or a financial institution – can choose if they want to hedge a risk and enter into a swap. This brings competition to the marketplace that improves pricing and lowers risk.
Corporate treasurers will benefit from markets that have competition. When you use the swaps markets, you are paying for a service to reduce your risk. You want a lot of people competing for that business. You want them to compete in a transparent marketplace where you will benefit from better pricing.
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.
The CFTC’s proposed real-time reporting rules include provisions to protect the confidentiality of market participants. The rules also provide for a time delay for large swap transactions – or block trades.
Third, the Dodd-Frank Act brings transparency to swaps over the lifetime of the contracts. 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. Thus, you as corporate treasurers and the broader public will benefit from knowing the valuations of outstanding swaps on a daily basis.
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.
Commercial End-User Exceptions
So far I have discussed what the Dodd-Frank Act will do to benefit corporate treasurers and the economy as a whole. Before I close, I will take a moment to address what the Act does not require.
First, the Act does not require non-financial end-users that are using swaps to hedge or mitigate commercial risk to bring their swaps into central clearing. The Act leaves that decision up to the individual end-users.
Second, there was a related question about whether corporate end-users would be required to post margin for their uncleared swaps. The CFTC has published proposed rules that do not require such margin.
Third, the Dodd-Frank Act maintains your ability to enter into bilateral swap contracts with swap dealers. You will still be able to hedge your company’s particularized risk, whatever it may be, through customized transactions.
In conclusion, the Dodd-Frank Act reforms are important to the economy and to each of the corporations you represent. Only with these reforms can we hope to lower the risk that taxpayers and your corporations would bear the costs if a large financial institution failed in the future.
Only with reform can the public get the benefit of transparent, open and competitive markets. That transparency, openness and competitiveness will directly benefit your corporations because they will lower your costs over time. These reforms will reduce risk in the swaps market similar to that which contributed to AIG’s failure and the 2008 financial crisis.
Last Updated: June 2, 2011