July 23, 2015
As Prepared for Delivery
Good afternoon. I am delighted to be here today. I thank Diana for that kind introduction. And I want to thank the DC Bar Association for coordinating today’s event.
This week was the fifth anniversary of the Dodd-Frank Act. This legislation brought fundamental – and much needed – reform to the regulation of banking and financial markets, including the derivatives markets. So today I would like to review the progress we have made in implementing the reforms of the derivatives markets. And I will discuss some of the top priorities we have for the months ahead.
The 2008 Global Financial Crisis and the Need for Reform
Many of you are familiar with the derivatives markets. You may have clients that engage in derivatives transactions, you may know something about Title VII and our rules. But most Americans don’t. They don’t participate in the derivatives markets. They don’t buy and sell futures or trade swaps. And so most people don’t realize that these markets affect the prices we all pay for many goods and services – everything from the cost of a new car or a plane ticket, to the price of milk, gasoline, and electricity. They may not realize that in normal times, these markets create substantial benefits for American families, because they enable commercial firms to manage risk, whether it is a farmer worried about the price he will get for his crops or the manufacturer trying to lock in supply costs.
But during the global financial crisis, Americans heard the word “derivatives.” And that wasn’t because of problems in the traditional futures markets – those operated very well. It was because excessive risk in one part of the derivatives markets –over-the-counter swaps – contributed to the intensity of the worst financial crisis since the Great Depression. It is now almost eight years since the onset of the crisis, and we have made a lot of progress in restoring our economic health. But we must not forget the costs of that crisis. Eight million Americans lost their jobs. Millions lost their homes and life savings. Countless retirements and college educations had to be deferred, and businesses shuttered.
There were many causes of that crisis, but risk related to over-the counter swaps meant that trouble at one financial institution could easily infect another. Because the OTC market was unregulated, that risk was opaque. It was difficult to know where risk lay, which entities were exposed, and to what extent. And because these were global markets, risk could be incurred offshore but still threaten financial stability here. Today, it still staggers the imagination to consider that the U.S. government had to commit more than $180 billion to prevent the collapse of just one company, AIG, because its failure due to excessive swap risk, at that time and in those circumstances, would have led to catastrophic consequences.
I spent five years working to get that money back overseeing the TARP program at Treasury. I am pleased that we succeeded – we even recovered a profit on behalf of American taxpayers. But we never should have been in that position, and must not be again.
It was against this backdrop that leaders of the G-20 nations met in Pittsburgh in 2009, and agreed to enact reforms of over-the-counter swaps. They agreed to four basic principles:
The Dodd-Frank Act gave the CFTC primary responsibility to implement and oversee this new framework. And thanks in large part to the hardworking CFTC staff, we have largely implemented this framework. The new framework has brought greater resiliency to our system. We have good measures to guard against excessive risk. We have greater transparency, which is beneficial to regulators and to market participants.
But our work is far from finished. There is much to be done. And that is because our goal must be to implement these reforms in a way that not only achieves the Congressional objectives; we must also create a foundation on which these markets can continue to thrive and serve the businesses that need them. In that way, and only in that way, will our economy be best served.
Implementing Dodd-Frank: Progress to Date
Let’s look at where we are, five years later, in each of the four reform areas. And then I will review some next steps and priorities.
First clearing. Central clearing of transactions has been around for hundreds of years. It is one of the great innovations of the financial system. We have now implemented it for the swaps market. Clearing is now required for most interest rate and credit default swaps. Roughly 75% of outstanding transactions, measured by notional value, are now being cleared, versus only about 16% in December 2007.
But central clearing is not a panacea. It allows us to monitor and mitigate risk, but we must remember that it does not eliminate risk. So as we increase our use of central clearing, we must focus on making sure clearinghouses are strong and resilient. I will return to this issue in a moment.
Oversight of Swap Dealers
With regard to oversight of the largest market participants, we have likewise made important progress. Today, we have a framework in place for registration and regulation of swap dealers – more than 100 are now provisionally registered.
The new framework requires registered swap dealers to comply with strong risk management practices. It requires them to follow basic business conduct practices, such as documentation and confirmation of transactions, as well as dispute resolution processes. And they must make sure their counterparties are eligible to enter into swaps, and make appropriate disclosures to those counterparties about risks and conflicts of interest.
In regard to swaps trading, we have implemented a new framework for trading on regulated platforms. We currently have almost two dozen swap execution facilities or SEFs. According to the International Swaps and Derivatives Association, SEF trading accounted for about half of total volume in 2014, and the percentage is much higher for swaps on CDS indices. Electronic trading of swaps has also increased significantly. Data compiled by Greenwich Associates shows that 60 percent of client trading by notional volume is now electronic, up from nine percent in 2010. We have also seen a significant increase in non-U.S. market participants participating on SEFs for credit indices.
Finally, we have made progress on data reporting. In the fall of 2008, there was virtually no reporting of swap positions or transactions. This meant regulators had little knowledge of what was going on in the market, and market participants lacked the transparency that fosters competition and efficiency. Today we are creating a reporting infrastructure that is fundamentally changing this picture. All swap transactions, whether cleared or uncleared, must be reported to swap data repositories. That means we as regulators can do a better job because we have better information. And market participants have better information as well, which contributes to competition and better pricing. You can now go to public websites and see the price and volume for individual swap transactions. You can go to our website for a Weekly Swaps Report that gives a snapshot of the market. And we will be enhancing this reporting in the future.
Next Steps in the Dodd-Frank Implementation Process
The progress we have made to date is significant. It is a tribute to the dedication and tireless efforts of the CFTC’s staff. Their work has been extraordinary.
But our work is not finished. On the contrary, there remains a good deal of important work to accomplish in all of these areas. We still have some important rules to complete, and we need to make sure this new framework is working well in practice: we must make sure that the derivatives markets are continuing to serve the needs of the businesses that rely on them and that we are achieving the goals of Dodd-Frank in the best way possible. And so we have been, fine tuning and adjusting these rules and we will continue to do so in the days ahead. Finally, writing rules only creates a framework; good implementation is required for success, and that is an ongoing, process. So let me turn to some of the issues in each of these four areas that we will be focusing on in the coming months.
I noted earlier the importance of focusing on the strength and resiliency of clearinghouses. This was critical before, but it is even more so today because of the increased importance we have placed on central clearing. Over the last few years, we have done a major overhaul of our clearinghouse supervisory framework. We have substantially strengthened risk management and increased transparency. We have incorporated international standards into our regulations, strengthened customer protection measures, and enhanced our examination, compliance, and risk surveillance programs.
We are also working on clearinghouse strength and stability with other regulators internationally. The CFTC is helping to lead much of this important work. This includes examining whether we should have standards for clearinghouse stress testing, so that risks across clearinghouses can be compared. We are looking more closely at margin methodologies and the resources available to a clearinghouse in the event of a default, including the capital contributions of CCPs themselves to those resources, or what is often referred to as “skin in the game.” We are also working on recovery and resolution planning at CCPs. Our goal is never to get to a situation where recovery or resolution is necessary. That is why risk management and risk surveillance are so important. But we must nevertheless plan for such contingencies.
Enhancing Oversight: Margin and the Swap Dealer De Minimis Threshold
Let me turn now to oversight of major market participants. Here, we are working to finish one of the most important rules in Dodd-Frank, and it is important not only to oversight of major market players. It is also linked to the resiliency of our clearinghouses. This is the rule on margin for uncleared swaps. This rule plays a key role in the new regulatory framework because uncleared transactions will always be an important part of the market. We do not want to push all transactions into clearinghouses. There will always be some products that are not suitable for clearing because of their illiquidity or other risk characteristics. Clearinghouses will be stronger if we exercise care in what is centrally cleared. And so we will also require swap dealers to post and collect margin from their counterparties on uncleared swaps. This helps reduce the risk of those trades, and thus reduce the risk to our financial system as a whole. I want to highlight that, as with our clearing and trading mandates, our proposed rule on margin for uncleared swaps does not apply to commercial end-user counterparties. We know commercial end-users do not pose the same risk as large financial institutions.
We have been working closely with the banking regulators who are also responsible for developing rules on margin for uncleared swaps, so that our respective rules are as similar as possible. And, we have been working with European and Japanese regulators, who are also currently considering margin rules, to harmonize our rules as much as possible. I am hopeful that they will be similar on many key issues.
Another important issue in the area of swap dealer oversight is the swap dealer de minimis threshold. Under the swap dealer rules adopted in 2012, the threshold for determining who is a swap dealer will decline from $8 billion to $3 billion in December of 2017 unless the Commission takes action. This threshold was set when we had very little information about the market. Today we have much more data. I believe it is vital that our actions be data-driven, and so we have started work on a comprehensive report to analyze this issue, which will look at the consequences of setting the threshold at different levels. We will make a preliminary version available for public comment, and seek comment not only on the methodology and data, but also on the policy questions as to what the threshold should be. I want us to complete this process well in advance of the December 2017 date so that the Commission has some data, analysis, and public input with which to decide what to do.
Let me turn now to swaps trading. A primary purpose of mandating trading on regulated platforms was to provide greater price transparency. This can bring better pricing to market participants and better information to the public at large. In addition, trading on regulated platforms can bring greater integrity to the trading process, as well as facilitate straight-through-processing.
With respect to the trading mandate, our goal is to build a regulatory framework that not only achieves these objectives, but which also creates the foundation for the market to thrive, a foundation which attracts participants to trading on SEFs.
We have taken a number of steps to improve SEF trading over the past several months. This included actions related to the procedures for executing package transactions and block trades and correcting erroneous trades. We have provided more flexibility regarding acceptable modes of execution. We have improved SEF confirmation practices, and clarified SEF capital requirements. We are also reviewing the made available to trade or MAT determination process. The roundtable CFTC staff held last week was very useful as we consider potential next steps. We are also working with our international colleagues to minimize conflicts between our rules.
Let me also take a moment to discuss the general issue of cross-border harmonization. This is an audience of lawyers, so you will appreciate the situation we have. Think for a minute about what areas of financial regulation are completely harmonized across international boundaries. Mergers and acquisitions? No, tender offer rules vary, as do procedures for schemes of arrangement versus mergers. Sales of securities? No, complying with the rules for a public offering in this country does not entitle you to make a public offering abroad. Secured lending? Hardly. The rules on mortgages vary among the fifty states, not just internationally. Indeed, if the rules in these areas were the same, some of you might not have enough to do.
Now, that is not an endorsement of lack of harmonization. The point is, we should keep the issue of cross-border harmonization in perspective. The swaps market became a global market over a period when it was essentially unregulated. Participants were used to engaging in cross-border transactions without worrying about differences in rules. And now we are regulating this market, and regulation must be implemented by nation states. It is to be expected that there are differences. The truth is, there is far more harmonization in the area of derivatives than in many other areas. And let’s be realistic about the goal: we will not eliminate all differences, just as we have not, and will not, eliminate all differences in most other areas of financial regulation. But we should strive to eliminate barriers and minimize the costs of international transactions.
Harmonizing and Standardizing Reporting
Finally, let me talk about where we are in the area of swap data reporting. Creating the system to collect and effectively use data is a massive project, and there is still much to do. It involves many countries, over two dozen trade repositories and thousands of participants. We are currently focused on data harmonization and standardization. To give you just one example, if a swap is executed bilaterally and then centrally cleared, you can have a record in one SDR of the original bilateral swap and records in another SDR of the two clearinghouse swaps that replace it. The first record may not be terminated when the swap is cleared. Reporting fields may vary for the different records. So we are coming out with rule changes soon to fix that. We are working on many other initiatives in this area, including by helping to lead extensive international work in the area of harmonization.
Finally, one of our key priorities has been, as we continue to implement Dodd-Frank, to make sure the markets continue to work well for commercial end-users. The new rules are not meant to burden them. We have taken a number of actions to address end-user concerns – rule adjustments and clarifications addressing trade options and contracts with embedded volumetric optionality, the ability of publicly-owned utilities to use the swap market efficiently, the requirements pertaining to posting of collateral with clearing members; adjusting real-time reporting requirements for certain less liquid, long-dated swaps; and making sure end-users can use the clearing and swap trading exemptions Congress provided when they transact through treasury-affiliates. I expect we will continue fine tuning the framework in the months ahead.
I know there is also concern about liquidity in our financial markets generally and the impact of new regulations on costs, and we will continue to look at these issues. These are complex topics. Liquidity in particular is shaped by many forces including changes to market structure. The decline in clearing members is a long term historical trend – it did not start with the passage of Dodd-Frank – and is similarly influenced by many factors. So it is important that we look at these issues with data and objective analysis.
There are many other critical issues that we are working on – automated trading, cybersecurity, position limits, and continuing to have a robust enforcement program, among others. But in the interest on having time for your questions, let me conclude with just a few general thoughts about the Dodd-Frank reforms.
The G-20 commitments and the Dodd-Frank Act brought fundamental change to the derivatives markets. And as with any fundamental change, there has been – and continues to be – active discussion and debate, about implementation of these changes. That is healthy and useful. Our rules and the framework as a whole are stronger as a result.
But insofar as some raise questions about the fundamental need for reform, I respectfully, but firmly, disagree. We saw first-hand the consequences that the absence of sensible regulation created. And the basic principles reflected in the G-20 commitments and Title VII of Dodd-Frank – central clearing, oversight of dealers, transparent trading, and reporting – are sensible: they help reduce the risks in our financial system and, enhance its resiliency, and they contribute to the transparency and integrity of our markets.
The current reform effort is similar to other waves of reform in the securities and futures markets. In the 1930s, coming out of the Great Depression, we created a framework for securities regulation and trading the fundamental principles of which have remained in place and which proved tremendously successful. Many of its mandates were revolutionary at the time, and sparked concern – such as periodic reporting by public companies. But today, those reforms are about as controversial as seat belts. Indeed, they have been the foundation for the growth of our securities markets.
Likewise in the case of futures, Congress created a framework for the regulation of the industry, which properly balanced allowing innovation with strong oversight. Today, our futures markets are the strongest, largest, and most dynamic in the world – in large part because they have the integrity and transparency that attracts participants.
In the five years since Dodd-Frank was enacted, we have made tremendous progress. There is more to do, but the benefits of reform are beginning to be seen and felt. We are creating a new regulatory framework that can contribute to the resiliency of our financial system and, at the same time, insure that our markets continue to grow and thrive.
Thank you for again for inviting me. I welcome your thoughts and questions.
Last Updated: July 23, 2015