November 12, 2014
As Prepared for Delivery
Introduction and Background
Thank you for inviting me today, and I thank Chris for that kind introduction. I am pleased to have the opportunity to speak with you. I also want to acknowledge the work of the Wholesale Markets Brokers’ Association and its members with respect to the work of the CFTC. I appreciate your input on all of the issues before the Commission and look forward to continuing to work with you.
Today I would like to discuss some of the issues facing the Commission and how I intend to approach them. Let me do so first by telling you what shapes my perspective on the Commission’s responsibilities overall. I spent five years immediately prior to this job helping our nation recover from the worst financial crisis since the Great Depression. At that time, I was overseeing the TARP program at Treasury. That experience makes it easy to remember why we are implementing reforms of the derivatives market in the first place. We must never forget the true cost of the crisis: eight million jobs lost, millions of foreclosed homes, countless retirements and college educations deferred, and businesses shuttered.
My perspective is also shaped by my work as a lawyer in the private sector for 25 years before joining Treasury. I worked with businesses and governments all over the world on all types of transactions. And as a young lawyer, I was part of a small group that drafted the original ISDA master agreements in the late 1980s as well as related documents such as the code of definitions and the user’s guide. I then went on to advise clients periodically on derivatives matters. And so I appreciate the importance of these markets to a wide variety of businesses.
The New Regulatory Framework
In response to the financial crisis, Congress created a regulatory framework for bringing the over-the-counter derivatives market out of the shadows. We have made significant progress over the last 5 years implementing that framework.
The Dodd-Frank Act included four key commitments, which were also agreed to by the leaders of the G-20 nations. Let’s look at where we are on each:
Clearing of standardized transactions. 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.
Increased oversight of major market players. Today, we have 105 swap dealers and 2 major swap participants provisionally registered, and we require them to observe strong risk management practices and business conduct standards.
Regular reporting for increased market transparency. We also have four swap data repositories provisionally registered, collecting and disseminating market data. This is a work in progress, but today we and the public have much more information regarding the swaps marketplace, enabling more competition and better oversight.
And finally, transparent trading of swaps transactions on regulated platforms – the area I want to focus on today.
Before going further, I would like to thank the CFTC’s hardworking professional staff. Their dedication implementing the Dodd-Frank mandates and carrying forward our mission has been extraordinary. We would not be where we are today without their tireless efforts.
Trading of Swaps: Progress to Date, and Work Ahead
We have made much progress in implementing the Dodd-Frank mandate for transparent trading of swaps. There are 22 swap execution facilities temporarily registered with 2 more applications pending. Trading volumes are increasing. Through the summer notional value executed on SEFs was generally in excess of $1.5 trillion weekly.
Recent statistics show a general increase. Based on trading data collected by Clarus Financial, total notional traded volume on SEFs is up 49% in October versus February of this year. To take one specific example, CDS SEF trading activity increased 133% from February 2014 to September 2014. One SEF recently confirmed that it had exceeded 700 buy side firms as participants.
There are ups and downs month to month, but the general trend is good. It indicates that the process of operationalizing the new trading framework is moving forward. This is no small task. Establishing the new platforms, developing the new workflows, creating the administrative infrastructure, and testing and refining to make sure things work smoothly take time, effort, and resources.
The increase in SEF trading means the benefits envisioned in Dodd-Frank are beginning to be realized. 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.
There is, of course, more to do. And as with any new market, there has been – and continues to be – active discussion, and sometimes debate, among market participants on how best to develop these new platforms. The views on what the CFTC should do are quite varied. For example, some say our oversight rules are too demanding and too costly. Others want us to be more specific about what SEF rule books should say, so that no SEF gains an unfair advantage, and participants do not have to spend time worrying about whether differences are significant. Some want us to exercise more control over the process of determining which products are required to be traded on a SEF.
There are many issues, and many different views, including within this very room. So let me outline a few principles that guide my approach to these issues.
First, to state the obvious, our duty is to implement the law. The law created the trading mandate. It prescribed its general terms. It prescribed the core principles that all SEFs must follow, and directed us to write rules to implement the trading mandate and those core principles. Whatever we do must be faithful to the law.
Second, market development takes time. We must remember that the SEF rules are barely a year old. The first made-available-for-trade or MAT determinations are eight months old. It is early. This is a work in progress. Participants are still adapting. Technology is evolving.
Third, markets don’t develop simply as a result of government directives. Markets develop, markets thrive, when private actors find it beneficial to transact. We must create a regulatory framework that not only implements the statutory trading mandate, but that creates conditions in which participants wish to trade on SEFs.
Consider the history of the development of our securities and futures markets in this country. In the 1930s, we created a framework for securities regulation and trading, which proved tremendously successful. Many of its mandates were revolutionary, and at the time, many felt those requirements would be the death knell of capitalism. When the Securities Exchange Act was passed, the President of the New York Stock Exchange said it was “a menace to national recovery.” History has proved otherwise. Today, the public reporting and basic trading requirements of our securities laws are about as controversial as seat belts. Indeed, they have been the foundation for the growth of our securities markets.
The history of the futures market is no different. Congress created a framework for the regulation of the industry, which properly balanced allowing innovation with strong oversight. We have the strongest, largest and most dynamic futures markets in the world – in part because they have the integrity and transparency that attracts participants.
So, my goal is to build a regulatory framework that not only meets the Congressional mandate of bringing this market out of the shadows, but which also creates the foundation for the market to thrive. The regulatory framework must ensure transparency, integrity and oversight, and, at the same time, permit innovation, freedom and competition. In particular, in this day and age, and with these products, we recognize the power of technological development; our rules should encourage it. In short, this should be a situation where, if you build it, they will come.
So let me touch on some of the issues we are looking at in a few areas--general oversight, products, and methods of execution.
In regard to oversight, we want to make sure it is strong oversight because it promotes integrity and therefore confidence by participants. At the same time, we do not want that oversight to burden participants, particularly the users of these markets, unnecessarily. This is consistent with our general regulatory approach in futures. That is, we seek to have strong oversight of futures exchanges to make sure there is not fraud and manipulation in trading, strong oversight of clearinghouses to make sure they have adequate financial and operational resources, and strong oversight of intermediaries like futures commission merchants to make sure customer funds are protected and they monitor risk adequately.
Similarly for swaps, we need to strike the right balance in terms of where burdens and responsibilities fall. Our framework provides strong oversight of SEFs and swap dealers. We should seek to make sure that our rules do not impose unnecessary or duplicative burdens on market participants, particularly the nonfinancial companies who do not generate the types of risks that the reforms were intended to address. The benefits of transparency and integrity in trading should flow to them.
One of my priorities is to fine tune our rules in this regard. We have done this in several areas, particularly to focus on issues of concern to nonfinancial commercial companies that use these markets. So, for example, last week we proposed changes to Rule 1.35 on recordkeeping. This will benefit SEF trading because it applies to SEF participants who are not otherwise registered with us. They will not have to keep texts and we are reducing the burdens with respect to records being searchable.
In response to feedback from WMBAA, and others, we have also sought to be flexible with respect to the oversight we require of SEFs.
Let me turn to a second category: products. Here, packages have been an area of concern. Now, packages might more accurately be thought of as strategies involving multiple products, but whatever name you use, there is no doubt that different types of packages introduce significant complexities as we look to bring them into the SEF and DCM framework. And therefore, basically since the time of the first MAT determinations earlier this year, we have been working with market participants to figure out how to deal with packages in which one leg is a MAT swap. To enable that process, we issued no-action relief earlier this year. For some types of packages, the market has developed technical solutions, and the relief has expired. For others, however, more time is needed.
Consequently, at my direction, the CFTC staff this week have extended previously issued no-action relief so that we continue to work with market participants on phasing in trading for certain types of packages.
We have become more and more granular in breaking out categories and subcategories of packages. We identified one category of packages, where MAT swaps are packaged with agency mortgage-backed securities, as one where the industry was close to ready but just needs a few more months to finish testing the pipes.
For other packages, we will require the MAT component to take place on a SEF or DCM, but we will not require them to be subject to “competitive execution.” This approach will be phased in three months from now, and then, the relief will expire a year afterwards. Here, we believe that moving MAT legs of packages onto a SEF or DCM will result in key benefits. They will be traded on platforms that have the transparency and integrity of regulated markets. The SEFs and DCMs will have the opportunity to innovate or apply their technology to develop appropriate workflows. And we as regulators will have access to data – new data not previously available to us about these transactions – that will help us to assess what should happen when the relief is due to expire.
Phasing of rule implementation and compliance deadlines in this area has been and should be an important part of our approach. Phasing provides market participants the necessary time to develop operational procedures and safeguards, and to transition smoothly to the new framework without creating unnecessary disruption or costs.
Phasing isn’t always appropriate – sometimes it simply allows bad practices to persist – but, as in this case, it can be a very important tool.
Another issue regarding products is the MAT process itself, by which a type of swap can become required to be traded on a SEF or DCM. As you know, the initiative rests with the market; any SEF can propose a MAT determination to the Commission. This is modeled after the process followed for product innovation in other financial markets, including the futures markets. But some have suggested this puts too much in the hands of the market; the CFTC should decide which products, or at least when a product, should be subject to a MAT determination. It is unusual to hear market participants ask a regulator to exercise more authority over the ability of market participants to compete and innovate. While I cannot say today whether we will consider changing the process, I recognize the concern.
Finally, let me note quickly some of the issues on execution methods and market structure. The views in this area are wide-ranging, to say the least.
Some say that for all the talk of a new market framework, not much has changed. Yes, they say, we now have regulated SEFs, required trading and data, but dealer-to-dealer and dealer-to-client trading venues existed previously. How are we in a different or better place today? More should be done, they say.
Others take the view that we should let the market determine best methods of execution and market structure. Bilateral relationships continue to be important for valid business reasons, they say, and, at least today, market makers are still needed.
I expect that we will look at several issues here, including anonymity or name give up. Some have said the practice is discouraging SEF trading, and in particular usage of central limit order books. Post-trade affirmation is another issue where many feel Commission action is needed. Yet another is whether certain execution methods that are not strictly RFQ or CLOB are consistent with the legal requirements, and whether our rules should allow flexibility as long as basic transparency and fairness requirements are met.
We look forward to listening to market participants on these and other issues that may arise.
We will also focus on the cross-border implications of our trading mandate rules. Keep in mind where we are historically. The swaps industry grew to become a global industry without any regulation. Now we are creating a regulatory framework which necessarily must be done through the actions of separate nation states, each of which has their own legal traditions, regulatory philosophies, and political processes. It should not surprise anyone that there are differences in the rules that affect cross-border trading. It should not surprise anyone that traders will seek to do what business they can outside of our rules, when other jurisdictions have not yet implemented, or in some cases, written, their rules. But, like my counterparts in Europe and Asia, I am committed to harmonizing our rules as much as possible. It will, however, take time.
Finally, well-working markets depend on good regulation and oversight, and that requires resources. In my view, our current budget falls short. We are stretched too thin. To take just a few examples:
As I noted earlier, we are not able to process SEF registration applications as quickly as we would like. The same people responsible to review SEF applications have numerous other responsibilities.
The simple fact is that, without additional resources, our markets cannot be as well supervised; participants cannot be as well protected; market transparency and efficiency cannot be as fully achieved.
The United States has the best financial markets in the world. They have been a significant engine of our economic growth and prosperity. Good regulation is necessary to keep them that way. As with any significant reform effort, there will be issues to work through. I look forward to working with you as we move forward.
Thank you again for inviting me today.
Last Updated: November 12, 2014