October 3, 2011
Good morning. I thank the Wholesale Markets Brokers’ Association for inviting me to speak today at your second Swap Execution Facility Conference. I also thank Shawn Bernardo for that kind introduction.
I’d like to start by taking a moment to talk about what we’ve been up to at the Commodity Futures Trading Commission (CFTC) since I spoke with you at your inaugural conference last year.
Since then, the CFTC has substantially completed the proposal phase of the rule-writing process required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. We held 19 public meetings to issue more than 50 proposed rules – on issues including transparency, clearing and regulating swap dealers.
The CFTC has benefited from significant public input throughout this process. We have received more than 25,000 comment letters. CFTC staff and Commissioners have met more than 1,000 times with members of the public to discuss the rules. We have conducted 14 public roundtables on Dodd-Frank.
This summer, the agency turned the corner and began finalizing rules to make the swaps marketplace more open and transparent for participants and safer for taxpayers. To date, we have finalized 15 rules, and we have a full schedule of public meetings this fall and into next year.
The Financial Crisis
It is important to remember why these rules are so critical. Three years ago, our economy fell into a downward spiral when one large financial institution after another teetered on the brink of failure, threatening our financial system and the jobs and retirement savings of the American public.
We’re still feeling the aftershocks of the financial crisis. More than eight million jobs were lost, and the unemployment rate remains stubbornly high. Millions of Americans lost their homes. Millions more live in homes that are worth less than their mortgages. And millions of Americans continue struggling each day to make ends meet.
While the crisis had many causes, it is evident that unregulated derivatives, called swaps, played a central role. Developed in the 1980s, swaps, along with the regulated futures market, help producers, merchants and other companies lower their risk by locking in the price of a commodity, interest rate, currency or other financial index. Our nation’s economy relies on a well-functioning derivatives market – an essential piece of a healthy financial system.
But over the last thirty years, the unregulated swaps market grew by orders of magnitude in size and complexity. It is now seven times the size of the futures market. During its growth, the market lacked the transparency of the futures or securities markets, and risk was able to accumulate. Swaps, which were developed to mitigate and spread risk, actually added leverage to the financial system – with more risk backed by less capital.
Swaps also contributed significantly to the interconnectedness between banks, investment banks, hedge funds and other financial entities. Large financial institutions once regarded as too big to fail were now also regarded as too interconnected to fail. When AIG, Bear Stearns and others collapsed, taxpayers had to pick up the bill to prevent the economy from diving deeper into a depression. The financial system failed. The financial regulatory system failed as well.
The current debt crisis in Europe is but a stark reminder of why completing financial reform is so necessary for the U.S. economy and to protect taxpayers. The U.S. financial system is interconnected with banks in Europe, in significant part through the swaps market. Moreover, as we were so reminded during the 2008 financial crisis, it is precisely during times of heightened market uncertainty that transparent pricing of risk is essential. While European leaders are working to avert a deepening crisis with the tools they have at their disposal, it is critical that we implement the Dodd-Frank Act to protect the American public.
Now you’re here to talk about swap execution facilities (SEFs). SEFs are critical to bringing transparency to the opaque swaps market. The more transparent a marketplace is, the more liquid it is and the more competitive it is. When markets are open and transparent, price competition is facilitated and costs are lowered for companies and the people who buy their products. In addition, transparent markets are safer and sounder for all participants.
While the derivatives market has changed significantly since swaps were first transacted in the 1980s, a constant is that the financial community maintains information advantages over many of their counterparties. When a Wall Street bank enters into a bilateral derivative transaction with a corporation, the bank knows how much its other customers are willing to pay for similar transactions. That information, however, is not generally made available to the public. The bank benefits from internalizing this information.
The Dodd-Frank Act includes essential reforms to bring needed transparency to the swaps markets.
Importantly, it brings transparency to the time immediately before the transaction is completed – or so-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 SEFs.
Swap Execution Facilities
Exchanges and SEFs will allow investors, hedgers and speculators to meet in an open and competitive central market. Even market participants who are exempted from the mandatory trading requirements will benefit from the transparent pricing and liquidity that trading venues provide.
The Dodd-Frank Act mandates that SEFs “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 enter into a swap against a resting bid or offer. This brings competition to the marketplace that improves pricing and lowers risk.
In January, the CFTC published proposed rules for the registration and operation of SEFs providing a 60-day comment period, and we reopened the comment period again for an additional 30 days through June 3. We received more than 100 comments and took many meetings with market participants. We also held a staff roundtable jointly with the Securities and Exchange Commission (SEC) to hear directly from the public.
While we’re making progress toward finalizing rules, there are other rules that we will likely take up before we consider finalizing the SEF rules. These include joint rules with the SEC on product and entity definitions. We also are working to finalize critical rules related to clearinghouses this fall and rules on straight-through trade processing and client clearing after the first of the year. We are hopeful that we’ll be able to consider the SEF rules in the first quarter of 2012.
Working with the SEC
The CFTC is working very closely with the SEC on each of our rules. In working with the SEC to harmonize rules, we’re also mindful of some traditional differences between the futures and securities markets. Many of the swaps contracts that will trade on SEFs are very similar to futures that trade on designated contract markets (DCMs). Swaps and futures markets intertwine in a larger price discovery market, with contracts often priced off each other or used to hedge one another. Interest rate swaps and Eurodollar futures, for instance, are but two parts of a larger interest rate derivatives market. Thus, we are conscious that any differences between the SEF rules and existing regulations for DCMs do not undermine the transparent futures market. The SEC has similar considerations with regard to market structure for security-based swaps in relation to securities trading.
One area where we have received significant public comment is the request for quote (RFQ) model facilitated by SEFs. You likely are familiar with the comments regarding the minimum number of requesters that are required under the CFTC proposal and the SEC proposal. There also are comments as to how market responses to RFQs interact with any resting bids or offers at a SEF. We’re sorting through both of those questions as we move toward a draft final rule.
We also have heard from the public about the potentially different governance requirements for SEFs and security-based SEFs within the two agencies’ conflict of interest rules. This is another area where we are working closely with the SEC.
Congress provided that if a swap is subject to the clearing mandate and is made available for trading; the swap must trade on a SEF or DCM. Thus, it is relevant to discuss the possible timing and process for clearing mandate determinations.
In July, the CFTC finalized a rule on the process for review of swaps for mandatory clearing. It became effective September 26. Under this congressionally mandated process, the Commission has 90 days to review a clearinghouse’s submission and determine whether the swap is required to be cleared. Though clearinghouses will decide much of the timing, it is likely that they will not begin to file submissions until later this fall or in the winter. If, therefore, clearinghouses were to file submissions towards the end of this year, a clearing mandate would take effect towards the beginning of the 2nd quarter of next year.
Last month the CFTC proposed rules on implementation phasing for compliance with the swap clearing and trading mandates. Market participants would be required to comply with a Commission-issued clearing mandate within three, six or nine months, depending on the swap’s counterparties. This timeline would begin after the effective date of the mandatory clearing determination.
Market participants also would have at least 30 days after a swap is made available for trading on a SEF or DCM to comply with the trading requirement. In the proposed SEF rule, the CFTC sought public comment regarding the meaning of “made available for trading” as well as the SEF’s considerations and process in making swaps available for trading. CFTC staff is looking closely at those comments and considering various recommendations on these questions.
In conclusion, the Dodd-Frank Act reforms are important to the economy and to the public. Only with reform can the public get the benefit of transparent, open and competitive markets. Reform is needed to lower the risk that taxpayers will be called upon again to bear the cost when a large financial institution fails in the future.
It has been just over a year since the Dodd-Frank reforms became law. There are those who might like to roll them back and put us back in the regulatory environment that led to the crisis three years ago. But economists have agreed for decades that transparency in markets actually reduces costs. Furthermore, we’re hearing from a growing number of market participants – including people in this audience - who have said they would like to lower regulatory uncertainty and get going on reform.
The CFTC is working diligently to finalize rules bringing much-needed reform to the swaps market. The agency, however, also must be adequately resourced to ensure the new swaps market rules will be appropriately enforced. Furthermore, without sufficient funding, we will not have the staff to answer the many questions market participants will have about the new rules. Without sufficient funding, we will not have the resources to put enough cops on the beat to protect the public.
Thank you and I’d be happy to take questions.
Last Updated: October 3, 2011