October 13, 2011
Good morning. I thank the London School of Economics for inviting me to speak today. I also thank Professor Ron Anderson for that kind introduction.
I am glad to be here in London to discuss with regulators and market participants derivatives reform as well as issues relating to high-frequency trading. It also is an honor to be able to speak at one of the world’s premier educational institutions. I say this with a bit of pride as LSE also happens to be where my identical twin brother spent his junior year in college.
It has now been three years since the financial crisis. 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.
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 evident that swaps – or what many in Europe may call off-exchange derivatives – played a central role. Swaps added leverage to the financial system with more risk being backed by less capital. They contributed, particularly through credit default swaps, to the bubble in the housing market. They contributed to a system where large financial institutions were thought to be not only too big to fail, but too interconnected to fail. The failure of AIG’s swaps affiliate, AIG Financial Products, which had its major operations in London, was sobering evidence of this interconnectedness. Swaps – developed to help manage and lower risk for end-users – also concentrated and heightened risk in the financial system and to the public.
Markets work best when they are transparent, open and competitive. In America, we have 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 Dodd Frank Act
Last year, the U.S. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, which, for the first time, brings oversight to the heretofore unregulated 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.
The Dodd-Frank Act includes three critical components:
• It brings transparency to the swaps market by requiring real time reporting and requiring standardized swaps to be traded on transparent exchanges or swap execution facilities.
• It requires standardized swaps to be cleared by regulated clearinghouses.
• It brings comprehensive regulation to swap dealers.
Like the European Market Infrastructure Regulation initiative – also known as EMIR – the U.S. law 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.
The Dodd-Frank Act also includes essential reforms to bring needed transparency to the swaps markets.
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 or City of London 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 requires that all swaps transactions – both cleared and bilateral – be publicly reported as soon as technologically practicable after the swap has been executed. 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, the European Commission will address public transparency requirements in the Markets in Financial Instruments Directive (MiFID) reform proposal later this year. It is critical that reform includes a strong requirement that standardized swaps be traded on exchanges or similar swap execution facilities that provide true pre-trade transparency.
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.” Earlier this year, the International Organization of Securities Commissions (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 Dodd Frank Act also 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.
Lowering Risk through Central Clearing
The Dodd-Frank Act also requires clearing of standardized swaps – those that Americans call “clearable” and that Europeans often call “eligible.”
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. Importantly, central clearing protects bank customers from the risk of the bank failing. When customers don’t clear their transactions, they take on the bank’s credit risk. We have seen over many decades, however, that banks do fail. Central clearing protects bank customers by requiring daily valuations and requiring collateral to be posted by both parties so that both the bank and their customers are protected if either fails.
Under the Dodd-Frank Act, all clearable swaps, regardless of whether they are done on an exchange or off an exchange, are subject to the clearing requirement. I know there has been some debate in Europe whether to do something similar to this. I am pleased to see that the latest European Council version of EMIR will require clearing of most clearable swaps, including those traded over-the-counter or on electronic trading platforms. It is critical, though, that those swaps traded on regulated exchanges also are subject to the clearing requirement to bring the benefits of clearing to swaps, regardless of where they are traded – on exchange or off exchange. Creating an environment where all standardized swaps are cleared – whether off-exchange or exchange-traded – will ensure a level playing field and promote consistent and comparable requirements internationally within our derivatives regulations.
Regulating the Dealers
The Dodd-Frank Act includes comprehensive regulation of swap dealers. Though EMIR is organized differently, it is important that it include many of the same critical components for the regulation of dealers, including capital and margin, risk mitigation techniques, better communication and sales practices with counterparties and regulatory reporting.
One of the lessons from the financial crisis was that dealers were insufficiently prepared for the losses they could take if their swaps counterparty were to fail. This was most obvious when AIG was failing. Capital requirements help protect the public by lowering the risk of a dealer’s failure. On the other hand, margin requirements help protect dealers and their customers 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.”
A group of international standard-setting bodies, led by IOSCO and the Basel Committee on Banking Supervision (BCBS), recognizes that international consistency on margin for uncleared trades is essential to protect against regulatory arbitrage. The group is developing standards for margin on uncleared trades for consultation by June 2012.
The Dodd-Frank Act also explicitly authorizes regulators to write business conduct standards to lower risk and promote market integrity, including documentation, confirmation and portfolio reconciliation requirements. Further, the Dodd-Frank Act provides regulators with authority to write business conduct rules to provide material information to customers and to protect against fraud, manipulation and other abuses. It is important that similar authorities also are written into European swaps reform.
We are actively consulting and coordinating with international regulators to promote robust and consistent standards in swaps oversight. As we do with domestic regulators, we are sharing many of our memos, term sheets and draft work product with international regulators.
We also have been meeting regularly with officials in Europe. I have met with Michel Barnier of the European Commission numerous times, acting in partnership to bring much-needed reforms to best protect the public. Since our last meeting in June, we have set up a process with weekly staff calls coordinated between the CFTC, SEC, E.C. and the European Securities and Market Authority.
As part of our implementation efforts, we also will work with our international colleagues on memoranda of understanding for access to information and cooperative oversight. We have a long history of recognizing foreign regulatory regimes. The Dodd-Frank Act gives the CFTC the flexibility to recognize foreign regulatory frameworks that are comprehensive and comparable to U.S. oversight of the swaps markets in certain areas.
We also anticipate seeking public input on the application of Section 722(d) of the Dodd-Frank Act, which says that the law doesn’t apply to activities outside the United States unless those activities have a direct and significant connection with activities in, or effect on, U.S. commerce.
Let me take a moment to mention the CFTC’s status in IOSCO as IOSCO is restructuring over the coming year. There are two categories of membership in IOSCO: Ordinary and Associate. The CFTC is seeking inclusion as an Ordinary member of IOSCO. For IOSCO to be the premier standard-setter for both securities and derivatives, it is critical that the CFTC – which will regulate both the $300 trillion U.S. swaps market as well as the $40 trillion U.S. futures market, in aggregate the largest derivatives markets in the world – have membership status in this body commensurate with our regulatory responsibilities.
Twenty-first century finance knows no true geographic borders. Money and risk can move around the globe with a touch of a button. Moreover, the U.S. and European financial systems are interconnected through many linkages, including, significantly, the swaps market.
The current debt crisis in Europe – one not only of sovereign nations but also of the banks – is but a stark reminder of our interconnectedness. At a time when many market participants are taking a critical look at their exposure to banks, they continue to bear credit exposure to their banks through their uncleared swaps. Central clearing is essential to protect banks customers as much as it is to protect the taxpayers. Moreover, 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, it also is critical that we each implement regulatory reforms in the global swaps market.
As such, 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.
Thank you and I’d be happy to take questions.
Last Updated: October 13, 2011