As Prepared for Delivery
Thank you, Stephen for that warm welcome. I am very pleased to be here today. I’m particularly honored to kick off this conference.
I’ve been asked to talk about the “State of the Derivatives Marketplace.”
We recently marked the seventh anniversary of Lehman Brothers’ bankruptcy and the onset of the financial crisis. And it is five years since the enactment of Dodd-Frank. So now is a good point to take stock of where we are.
The financial crisis of 2008 had many causes. While the derivatives markets generally worked well, there was a build-up of excessive risk in certain areas of the over- the-counter (OTC) swaps market. That excessive risk, exemplified by AIG, intensified the damage of the crisis.
The financial sector was hit hard, but American families bore the brunt of the damage. We lost eight million jobs. Millions of homes went into foreclosure. And thousands of small businesses closed.
I was on the front lines – so to speak – of the aftermath and the government’s response. I spent five years at Treasury helping our nation recover from the financial crisis. That included getting back all of the $182 billion dollars the U.S. government committed to prevent the collapse of AIG.
I also had a long career working as a corporate lawyer. That included helping to draft the original ISDA master agreements and advising businesses on derivatives. So I appreciate both the need for reform and the importance of implementing it in a way that ensures that these markets can continue to thrive and contribute to our economic growth.
That work began in 2009, when the G-20 nations came up with a framework to reform OTC derivatives. That framework was later codified in the United States by Dodd-Frank.
As many of you know, the four key components of that reform included: central clearing of standardized swaps, oversight of the largest market participants, transparent trading on regulated platforms and regular reporting.
Today that framework is largely in place. The vast majority of transactions are centrally cleared. Trading on regulated platforms is a reality. Transaction data is being reported and is publicly available. And we have developed a program for the oversight of major market participants.
But there’s more work to be done in all of these areas. And so today, I’d like to tell you a little more about how far we’ve come and what we are working on in the days ahead. In particular, I like to focus my remarks on a number of issues related to clearing.
One of the most important reforms we’ve undertaken was to require that more derivatives transactions be cleared through clearinghouses.
Central clearing is one of the great innovations of the financial system. It enables market participants to reduce exposures through netting, mitigate counterparty credit risk, and mutualize tail risk.
We have now implemented it for the swaps market. Clearing is now mandated for most interest rate and credit default swaps. Today, approximately 75 percent of the swap transactions are being cleared, as compared to only about 15 percent in 2007.
But central clearing is not a panacea. It allows us to monitor and mitigate risk, but it does not eliminate it. So as we increase our use of central clearing, it becomes even more important to focus on making sure clearinghouses are strong and resilient.
Over the last few years, we have done a major overhaul of our clearinghouse oversight. 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.
But there is more to do.
Currently, recovery and resolution planning for clearinghouses are at the top of our agenda. I know they are important topics for many of you.
The Commission is also working on clearinghouse strength and stability with other regulators internationally. I’m pleased that the CFTC is helping to lead much of this important work. It includes taking a close look at margin methodologies and the resources available to a clearinghouse in the event of a default, including “skin in the game.” Also includes recovery and resolution planning.
Let me just add that while we must engage in recovery and resolution planning, our goal is never to get to a situation where either of those is necessary. And that is why risk management is so important in the first place. Sometimes in the current discussions about clearinghouse resiliency, the activities that comprise ongoing risk management don’t get much attention.
But let me spend a moment highlighting some of the things we do or that we require at both the clearinghouse and clearing member level – because these are the everyday activities that fundamentally matter to clearinghouse safety.
For example, we have extensive daily margin and position reporting requirements that enable us to engage in daily risk surveillance. Our program includes daily review of the positions of clearing members and large traders. We engage in analysis of margin models, stress testing of positions, back testing of margin coverage, and in-depth compliance examinations. We require clearinghouses to oversee the risk management policies and practices of their members. And likewise, we require futures commission merchants (FCM), whether clearing members or not, to meet risk management and minimum capital standards. We’ve made public transparency a priority. In fact, our website provides monthly information on the amount of capital and customer funds held by each FCM.
I am a strong supporter of transparency when it comes to clearinghouse risk management. Because clearinghouses mutualize risk, it’s important that clearing members have sufficient knowledge of their risk management practices. This allows them to have meaningful input. And we are working with our international colleagues on standards for stress testing, so that clearinghouse risks can be compared across borders.
In addition, we’re stepping up efforts to protect against cyber threats – as well as technological and operational risk generally. That’s because clearinghouse risk does not come only from credit or market risk. Let me take a minute to expand on this, because it’s a priority for us this fall.
The need to strengthen the security and resilience of our financial markets against cyber-attacks and technological failures is clear. Examples of cyberattacks or significant technological disruptions from inside and outside the financial sector are all too frequent and familiar. And the interconnectedness of our financial institutions and markets means that the failure of one institution can have significant repercussions throughout the system.
So we are addressing this risk in several ways. First, system safeguards are part of the core principles and regulations with which clearinghouses, exchanges and other institutions, must comply. Second, we are focusing on these issues in our examinations – to determine whether an institution is following good practices and paying adequate attention to these risks at the board level and on down.
Third, we are currently working on a proposal to make sure the entities that run the core infrastructure under our jurisdiction –the major clearinghouses as well as exchanges and swap data repositories – are doing adequate evaluation and testing of these risks and their own protections.
We don’t have the resources to do this type of testing ourselves. But these companies do. In fact, many major financial institutions have cyber defense budgets that exceed the entire budget of the CFTC. So we will be proposing a number of principles-based standards on testing, to make sure these companies are following best practices. I expect these proposals to be issued this fall.
Let me turn to two other topics related to clearing that I know are of interest to many of you. The first is the dialogue we are having with European regulators over their recognition of U.S. clearinghouses, or the issue of “equivalence.”
We have had a very constructive dialogue with the European Commission and ESMA and I have a very good relationship with Commissioner Jonathan Hill. I believe there is an ample basis for Europe to declare us equivalent, and I think this should have happened some time ago. But we are continuing to discuss some differences in our regulatory systems and, in particular, differences related to margin methodologies.
I have noted previously that margin methodologies are complex and have many parameters. In addition, they are only one part of overall risk mitigation. And that is why I think we should not focus on one or two particular aspects of margining in this process – but rather look at overall outcomes. I believe that is especially appropriate because our rules are consistent with existing international standards—the PFMIs—and when measured through back testing or in other ways, our margining is just as robust.
Moreover, I think there is a better way to consider whether we need international standards on margining that are more granular than the PFMIs. That is the current CPMI-IOSCO process that is already underway. Both Europe and the U.S. are participants. That group, for example, is reviewing the practices by a number of clearinghouses on more than 100 different areas of margin methodologies.
The EU has already granted equivalence to Australia, Hong Kong, Japan and Singapore. Recently, the European Commission recommended that five additional jurisdictions be deemed equivalent—Canada, Mexico, South Africa, South Korea and Switzerland. Many of these jurisdictions actually follow practices similar to ours. We will continue our dialogue, and I hope that equivalence can be granted soon.
Supplementary Leverage Ratio
I also want to spend a minute discussing the supplementary leverage ratio, or “SLR,” because it also affects clearinghouse resiliency. As many of you know, there has been some discussion of the SLR in recent weeks.
I want to be clear about my views on this issue. I support efforts to ensure that banks have a very strong capital base, including the SLR. I do not believe that derivatives should be exempt from the SLR—or even that exposures arising from cleared derivatives should be exempt. The issue I have raised with respect to the SLR is a very narrow one.
My concern pertains to how we measure that exposure, and in particular, the effect of the collateral collected from a customer for cleared derivative trades that is posted to – and held by – the clearinghouse. There are two aspects of this issue. The first is whether, for the purposes of the SLR, the cash held by the clearinghouse is treated as an asset of the bank – and is counted in the same way as cash that is actually held by the bank—even though that clearinghouse cash cannot be used by the bank.
I believe there may be a solution here, which is that under GAAP, cash will not be treated as an asset of the bank if certain conditions are met, such as the bank agreeing to waive any investment income.
The more significant aspect of this issue is the “off-balance sheet” issue. The question is how do we measure the exposure arising from the clearing member’s guarantee of the customer’s trade? This is not something governed by GAAP.
The issue is this: if the clearinghouse rules are that it must use the collateral first – before seeking recourse against the clearing member – shouldn’t that be taken into account in deciding how to measure the exposure?
The larger issue here is, we have made a decision as a nation to expand the use of central clearing. That requires strong clearinghouses and a robust clearing member industry. Being a clearing firm is already a challenging business.
Many are concerned about the decline in the number of clearing firms. Many are concerned about portability of customers. That is, if one firm should default, will other firms be willing and able to take on additional customers? So I hope we can continue to examine these issues and make sure we achieve both objectives: well-capitalized banks, and a resilient clearing industry.
Oversight of Major Market Players
Now I’d like to turn to the second pillar of reform: oversight of major market players. Here we also have made important progress. We have a framework in place for registration and regulation of swap dealers – more than 100 are now registered. This new framework requires swap dealers to comply with strong risk management practices. It requires them to follow good, basic business conduct practices, such as documentation and confirmation of transactions – as well as dispute resolution processes. Further, they must ensure their counterparties are eligible to enter into swaps. And they must make appropriate disclosures to those counterparties about risks and conflicts of interest.
Margin for Uncleared Swaps
One important issue related to the oversight of major market participants is the rule on margin for uncleared swaps.
This rule plays a key role in the new regulatory framework. We recognize that there will always be a large part of the swaps market that is not centrally cleared. There will always be some products that are not suitable for clearing mandates because of liquidity concerns or other risk characteristics. And clearinghouses will be stronger if we exercise care in what is centrally cleared.
That’s why margin for uncleared swaps is critical. Our proposed rule requires swap dealers to post and collect margin on uncleared swaps with one another – and with certain financial counterparties.
This helps reduce the risk of those trades, and thus reduce the risk to our financial system as a whole. I would also note that our proposed rule exempts commercial end-users from these requirements.
We have been working closely with the banking regulators, who are also responsible for developing rules on margin for uncleared swaps. Our goal is to ensure that our respective rules are similar.
In addition, we have been working with European and Japanese regulators, who are currently considering margin rules, to harmonize as much as possible. I expect our final rule will use the same overall threshold for defining material swaps exposure, and follow the same implementation schedule as Japan and Europe. We are also continuing to work with them on matters such as requirements for margin models, lists of eligible collateral, and collateral haircuts. I expect our final rule to come out before the end of the year.
I also expect that once we finalize the margin rules, we will repropose rules related to capital requirements for swap dealers and major swap participants. As with the margin rules, we’re working with our fellow regulators—in this case the prudential regulators as well as the SEC—to harmonize these standards as much as possible.
Another important pillar of reform is the area of swaps trading. Over the past two years, we have implemented a new framework for trading on regulated platforms. This is bringing greater transparency, better price information and greater integrity to the process.
Currently, we have nearly two dozen swap execution facilities -- or SEFs. According to the International Swaps and Derivatives Association, SEF trading accounted for about half of the total average daily volume of interest rate derivatives in 2014. And according to data by Clarus Financial Technology, for the past few quarters, over 70 percent of U.S. dollar credit default swaps – both cleared and uncleared –have been transacted on SEFs.
So the volume is growing. But there is more to do here also.
We continue to focus on fine tuning our rules to improve SEF trading. Over the past several months, we have taken action to ensure more flexibility regarding acceptable modes of execution. We have improved SEF confirmation practices and confirmation data reporting. We have clarified SEF capital requirements. We provided relief related to executing block trades and correcting erroneous trades. And just last month, we proposed a rule that would clarify certain reporting obligations for cleared swap transactions. I will discuss this in greater detail in a moment.
Last fall, we issued no-action relief to provide market participants additional time to adapt to procedures for executing package transactions. Today, I am announcing my intention to seek a further extension of the relief for remaining packages until late 2016.
And there are a number of areas we’re still looking at, such as the “made available to trade” – or MAT – determination process. This identifies products that must be traded on SEFs. Some market participants have suggested that the Commission play a larger role in this process, and we are considering that.
Finally, we are working with the European Commission, European Securities and Markets Authority and the Financial Conduct Authority so that we first understand each other’s regulations. There are many similarities, particularly in the objectives we seek. And there are also some differences. Sometimes they are more prescriptive than we are, such as in requirements to provide liquidity—and sometimes less prescriptive, such as in execution methods.
Europe’s rules are still evolving, and ours are new. So I am hopeful that as their rules take shape, and as we look for ways to fine tune ours, we can work together to ensure greater harmonization.
Harmonizing and Standardizing Reporting
Finally, let me talk about where we are in the area of data reporting. Though we have made a number of significant changes to the overall regulatory structure, one of the most dramatic shifts from that time is in swap 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 or the exposures of major institutions. And market participants lacked the transparency that fosters competition and efficiency.
But today, all swap transactions, whether cleared or uncleared, must be reported to swap data repositories (SDRs). And the availability of accurate data is allowing the CFTC to move forward with the important work of monitoring the market and understanding potential risks. 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.
But creating the system to collect and effectively use data is a big project, and there is still much to do. I often compare it to a massive infrastructure project. It takes time. We’re learning more about the terrain as we continue to plow ahead. As with any project – we’re dealing with unanticipated roadblocks and challenges. And while we are refining the project as we go, we—and market participants—are also trying to use it while it is being built. Imagine a bridge that is not yet fully built or secure, but people still insist on traveling over it.
Reporting of Cleared Swaps
An important piece of this effort took place just last month – when the Commission unanimously voted to propose changes to the reporting obligations for cleared swap transactions. Here’s an example of a problem: If a swap is transacted on a SEF, it is reported to an SDR. If that “alpha” swap is then cleared, the so-called “beta” and “gamma” swaps that are created as a result are also reported. But those two new swaps might be reported to a different SDR, and there might not be any record of the termination of the original alpha swap.
Our proposal will fix this problem – helping to reduce reporting costs and improve the quality of swap data. It will do so by creating a simple, consistent process for the reporting of cleared swaps. It will eliminate unnecessary reporting requirements. It will help ensure that accurate valuations of swaps are provided on an ongoing basis. And it will improve the Commission’s ability to trace swaps from execution through clearing.
The proposal reflects the helpful feedback we received from our request for comment in 2014. And it is just one of the policy changes we expect to propose. We are continuing to look at how we can improve data reporting and clarify reporting obligations.
Our goal is rules that provide accuracy and complete reporting, while also avoiding excessive burdens and duplication. I hope to have more to say about this later this year.
There are many other critical issues that we are working on, but in the interest on having time for your questions, let me conclude with just a few general thoughts.
The reforms embarked upon following the global financial crisis have enhanced the safety, soundness and resiliency of our markets. While there is more work to do, overall we have made tremendous progress.
As this new framework continues to take shape, I am committed to working with market participants to achieve two important objectives. First, making sure we strengthen our financial system, and in doing so creating a foundation on which our derivatives markets can continue to flourish and contribute to our economy.
Thank you for again for inviting me. I welcome your thoughts and questions.
Last Updated: October 15, 2015