November 16, 2011
Good morning, I’d like to thank the University of Chicago for inviting me to speak today, and thank you Austan for that kind introduction. Being back here reminds me, Austan, of soon after we first met. You were working out of a cramped office with books and papers piled sky high. Since then, your office moved to a pretty fancy address in Washington. But now that you’re back in Chicago, the real question is, what does your office look like now?
In all seriousness, I met Austan when he was a valued advisor to then senator and candidate Barack Obama. At the time, I was working on Hillary’s campaign. And when his candidate became the Democratic nominee, Austan was exceedingly gracious in welcoming the other candidates’ advisors into the fold. It turns out, we were better teammates than rivals. It’s great to see you back in Chicago, Austan.
Lessons of 2008
Three years ago, the financial system failed, and the financial regulatory system failed as well. We are still feeling the aftershocks of these twin failures.
There are many lessons to be learned from the crisis. Foremost, when financial institutions fail, real people’s lives are affected. 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 to make ends meet.
Second, it is only with the backing of the government and taxpayers that many financial institutions survived the 2008 crisis. We are seeing this situation all over again with the current debt crisis in Europe.
A perverse outcome of these crises may be that people in the markets believe that a handful of large financial firms will – if in trouble – have the backing of taxpayers. We can never ensure that all financial institutions will be safe from failure. Surely, some will fail in the future because that is the nature of markets and risk. When these challenges arise though, it is critical that taxpayers are not forced to pick up the bill – financial institutions must have the freedom to fail.
Third, high levels of debt – and particularly short-term funding at financial institutions – was at the core of the 2008 crisis. When market uncertainty grows, firms quickly find that their challenges in refunding debt, so called problems of “liquidity,” threaten their solvency.
Fourth, the financial system is very interconnected – both here at home and abroad. Sober evidence from 2008 was AIG’s swaps affiliate, AIG Financial Products, which had its major operations in London. When it failed, U.S. taxpayers paid the price. Further evidence is the risk posed to the U.S. economy from the ongoing debt crisis in Europe.
Lastly, while the 2008 crisis had many causes, it is evident that swaps 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 considered not only too big to fail, but too interconnected to fail. Swaps – developed to help manage and lower risk for end-users – also concentrated and heightened risk in the financial system and to the public.
Congress and the President responded to the lessons of the 2008 crisis – they came together to pass the historic Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
The law gave the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) oversight of the $300 trillion swaps market. That’s more than $20 of swaps for every dollar of goods and services produced in the U.S. economy. At such size and complexity, it is essential that these markets work for the benefit of the American public; that they are transparent, open and competitive; and that they do not allow risk to spread through the economy.
To date, the CFTC has finalized 18 rules to make the swaps marketplace more open and transparent and lower risk to taxpayers. We have a full agenda of public meetings in December and into next year. The agency is continuing to concentrate on four areas of reform: promoting transparency, lowering risk through clearinghouses, promoting market integrity and regulating dealers.
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 their customers. Transparency shifts information from derivatives dealers to the public, which helps promote economic activity throughout the entire economy.
To promote transparency, we have completed rules that, for the first time, give regulators and the public specific information on the derivatives market’s scale and risk. These rules will require large traders to give the CFTC data about their swaps activities and establish swap data repositories, which will gather information on all swaps transactions. By contrast, in the fall of 2008, there was no required reporting about swaps trading.
Moving forward, we are working to finish rules relating to the specific data that will have to be reported to regulators. These reforms will provide a window into the risks posed by the system so regulators can effectively police the markets for fraud, manipulation and other abuses.
We are also looking to finalize real-time reporting rules, which will give the public critical information on transactions – similar to what has been working for decades in the securities and futures markets. In addition, we are working on final regulations for trading platforms, such as Designated Contract Markets, Swap Execution Facilities and Foreign Boards of Trade – all of which will help make the swaps market more open and transparent.
Lowering Risk Through Clearing
Another significant reform is lowering risk to the economy by mandating central clearing of standardized swaps. Centralized clearing protects banks and their customers from the risk of a default by one of the parties to a swap. Clearinghouses reduce the interconnectedness between financial entities. They have lowered risk for the public in the futures markets since the late 19th century. Last month, we finalized a rule establishing risk management and other regulatory requirements for derivatives clearing organizations.
The market events of the last three years have underscored the importance of maximizing protection of customer funds. It is critical that the CFTC finish a rule that will enhance customer protections regarding where clearinghouses and futures commission merchants can invest customer funds. I am hoping we can consider it at the Commission’s next public meeting December 5.
We also are looking to finalize a rule on segregation for cleared swaps. Segregation of funds is the core foundation of customer protection.
In addition, after the first of the year, we hope to finish rules that will broaden access to the markets, including client clearing documentation; straight-through processing, or sending transactions immediately to the clearinghouse upon execution; and the exemption for non-financial end users.
To enhance market integrity, we finished a rule giving the Commission more authority to effectively prosecute wrongdoers who recklessly manipulate the markets. This new authority expands the CFTC’s arsenal of enforcement tools so the Commission can be a more effective cop on the beat. And we finalized a rule to reward whistleblowers for their help in catching fraud, manipulation and other misconduct in the financial markets, which will enhance our ability to police the markets.
In addition, we recently completed speculative position limit rules that, for the first time, limit aggregate positions in the futures and economically equivalent swaps market.
To further support market integrity, we are looking to finalize guidance on disruptive trading practices, as well as regulations for trading platforms.
It is also crucial that swap dealers are comprehensively regulated to protect their customers and lower risk to taxpayers.
The CFTC is working closely with the SEC and other regulators to finalize a rule further defining the term swap dealer. We are looking to soon consider final external business conduct rules to establish and enforce robust sales practices in the swaps markets. We also will consider final internal business conduct rules, which will lower the risk that dealers pose to the economy. In addition, we have been working closely with other regulators, both domestic and international, on capital and margin.
As the CFTC finalizes these Dodd-Frank rules, the agency will need additional resources consistent with the CFTC’s significantly expanded mission and scope. The swaps market is seven times the size of the futures market that we currently oversee.
The agency has the necessary funding to complete rules called for in the Dodd-Frank Act. Moving forward though, with seven times the population to police, even greater resources will be needed for the public’s protection. Without sufficient funding for the CFTC, the nation cannot be assured that this agency can oversee the swaps market and enforce rules that promote transparency, lower risk and protect against another crisis.
In conclusion, the current debt crisis in Europe is but a stark reminder for the need to complete financial reform in the United States.
It’s a reminder of the financial system’s interconnectedness.
Furthermore, it is precisely during times of heightened market uncertainty that transparency is even more essential. While European leaders are working to avert a deepening crisis, it is critical that we implement the Dodd-Frank reforms to protect the American public and strengthen our economy.
Now, there are those who might like to roll back some of these reforms and put us back in the regulatory environment that preceded the crisis three years ago. But that regulatory system failed. It didn’t protect the American public. The only thing that bolstered the U.S. economy and saved the financial system was the American taxpayer.
Some have raised cost considerations about our rules. Many of these comments have been very helpful. But far more costly is the fact that the public remains unprotected from the risks of the swaps market.
We must never forget the eight million lost jobs – the majority of which were lost by people who never used derivatives or even know what they are. We must never forget what the nation went through three years ago, and we continue to recover from today. We must never forget the risks are still out there.
Last Updated: November 16, 2011