December 6, 2016
Thank you so much. It is a great honor to be here today.
My focus today is the derivatives markets. Over the last six years, we have made a number of reforms to increase the openness, transparency and competitiveness of these markets—not just here in the U.S. but around the world. And those reforms are working. But with the impending change in our government, there is talk of repealing the Dodd-Frank Act. So I believe we face a choice: we can choose to refight the last war—that is, debate, and perhaps repeal everything we have put in place. Or we can recognize that while we should continue to fine-tune and improve these measures, we also need to focus on the challenges ahead.
I will come back to those new challenges in a moment. But first, let me discuss the state of our derivatives markets today.
Today’s Derivatives Markets
Most Americans do not participate directly in the derivatives markets. Yet these markets profoundly affect the prices we all pay for food, energy, and most other goods and services. They enable farmers to lock in a price for their crops, utility companies and airlines to hedge the costs of fuel, exporters to manage fluctuations in foreign currencies, and businesses of all types to lock-in their borrowing costs. In the simplest terms, derivatives help businesses throughout the U.S. economy manage risk.
In normal times, these markets create substantial, but largely unseen, benefits for American families. But during the 2008 financial crisis, a large, unregulated part of these otherwise strong markets—known as “over-the-counter swaps”—accelerated and intensified the damage like gasoline poured on a fire. In response, the government was forced to take actions that today still stagger the imagination. For example, largely because of excessive swap risk, the government committed $182 billion dollars to prevent the collapse of a single company – AIG – because its failure at that time, in those circumstances, could have caused our economy to fall into another Great Depression. It is hard for most Americans to fathom how this could have happened.
Swaps were just one of many factors that contributed to the crisis. But the structure of certain swaps and the lack of capital and margin standing behind transactions created significant risk in an economic downturn. In addition, the extensive, bilateral transactions between some of the largest banks and other institutions meant that trouble at one institution could cascade quickly through the financial system like a waterfall. And the opaque nature of this market meant that regulators did not know who was at risk.
Before joining the Obama Administration, I had a long career in private law practice, which included a great deal of work on derivatives. I helped draft the original master agreements for swap transactions in the 1980s. At that time, I don’t think anyone foresaw the growth that would occur in these markets. But that growth essentially took place in an unregulated environment worldwide. And this is what led to the unfortunate situation the government faced in September of 2008 with AIG.
In the spring of 2009, President Obama and the other leaders of the G20 nations agreed to some basic reforms of the over-the-counter (OTC) swaps market. They agreed that standardized swaps would be cleared through clearinghouses and traded on regulated platforms; that there would be capital and margining requirements for uncleared contracts; and that all contracts would be reported to trade repositories.
Today, those reforms are in place. Approximately 75 percent of swap transactions are being cleared, as compared to only about 15 percent in 2007. Financial institutions post and collect margin for uncleared swaps. Trading on regulated platforms is taking place, and it is growing. The reporting of swaps puts regulators in a much better position to monitor the market and understand potential risks. And market participants have better information as well, which contributes to greater competition and better pricing.
Brexit: An Important Test for Reform
Although there are disagreements over details, there is a wide consensus that the derivatives reforms we implemented make sense. Some contend nonetheless that the financial reforms enacted since the crisis generally have harmed liquidity and increased volatility, and that we will pay the price in a stressful event. And with respect specifically to the derivatives reforms, some argue we have simply moved risk from banks to clearinghouses, and created new systemic points of failure.
I do not believe this is true. In fact, I believe there is clear evidence the reforms are working, and the swaps market and financial system are stronger and more resilient as a result. There are many ways to see that. One is to consider what happened after the United Kingdom’s vote to leave the European Union–or Brexit. That is, consider Brexit not for its policy implications—I will get to those in a moment—but rather as the most stressful event in the derivatives markets since implementation of these reforms.
So let’s look at what happened on the night of June 23 and June 24, after the vote took place.
Everyone knew the referendum would occur, and we encouraged exchanges, clearinghouses, and other market participants to take precautions in case there was volatility. But the outcome was clearly viewed as a surprise, and one that generated a high degree of anxiety, making it a largely unanticipated and very stressful event. In the aftermath, the British pound experienced price moves larger than we have seen in decades, and trading volume was much larger than normal.
Brexit’s Impact on Clearing Activity
Let’s first look at the impact on clearing activity. It’s important to remember first that clearinghouses mark all products to market every day, and require that participants with market losses post margin every day, sometimes more than once a day. Margin payments must be paid promptly because for every payment made to the clearinghouse, the clearinghouse must make a payment to another participant who has gains. The clearinghouse always has a balanced or “matched” book.
Even though margins were increased in advance of the vote, the volatility resulted in very large margin calls on June 24.
Clearing members paid $27 billion dollars in variation margin across the five largest clearinghouses registered with the CFTC. This was $22 billion dollars greater than the previous 12-month average—over five times larger. The good news is no one missed a payment, no one defaulted.
Supervisory Stress Tests
The results after Brexit confirmed what we recently found in our own internal testing: resilience in the face of stressful conditions. Last month, CFTC staff released a report detailing the results of a series of stress tests we performed on the five largest clearinghouses under our jurisdiction, which are located in the U.S. and the UK. Our tests assessed the impact of stressful market scenarios across these clearinghouses as well as their clearing members, many of whom are affiliates of the world’s largest banks.
We developed a set of 11 extreme but plausible scenarios based on a number of factors, including historical price changes on dates when there was extreme volatility. By comparison, our assumed price shocks were several times larger than what happened after Brexit. We applied these scenarios to actual positions as of a specific date. And we looked at whether the pre-funded resources held by the clearinghouse—in particular, the initial margin and guaranty fund amounts paid by clearing members as well as the clearinghouse’s capital—were sufficient to cover any losses.
The results showed that clearinghouses had ample resources to withstand these extremely stressful market scenarios on the test date. And they further showed that risk was diversified across clearing members —a clearing member that had a loss at one clearinghouse might actually have gains at other clearinghouses. Risk was also diversified across scenarios—that is, clearing members differed greatly as to which scenario produced the worst results.
These findings are good news. They support the decision to require central clearing of certain standardized products. And they show how far we have come—in terms of transparency as well as oversight. The clearinghouse can monitor and mitigate risk because this activity is now centrally cleared. And we are able to engage in regular surveillance and measure the impact of stressful scenarios.
Contrast that with where we were eight years ago, when the over-the-counter swaps market was bilateral and opaque. At the time of AIG’s near collapse, people scrambled to figure out the exposures of one institution to another, and what would happen if one defaulted.
Of course, clearing is no panacea. It does not eliminate risk. We should not require clearing of all swaps. And we must remain vigilant in our oversight. But I do think we have strengthened the system through these reforms.
Brexit’s Impact on Trading Activity
Let me now turn to the impact Brexit had on trading activity. Did liquidity disappear in this stressful situation? No. Market depth was a little less than normal in the initial hours after the vote, perhaps indicating participants were cautious as they eyed the results. But market depth for the British pound/U.S. dollar futures contract and other contracts was good, and remained stable as trading continued into the next day.
We must also recognize that liquidity today has changed. I want to spend a few minutes discussing the issue of liquidity. There is an iconic model of liquidity: traditional dealers who use their balance sheets to make a market for their customers regardless of price. Dealers who will catch the proverbial “falling knife”— that is, they stand ready to buy even if prices are rapidly falling.
That is not how our markets work today. Whether they ever really did is an open question. But to the extent that model is less true today, I do not believe that is solely, or even principally, due to regulation. It reflects instead technological and other changes in market behavior, as well as additional factors.
Automated trading dominates the markets we oversee. In just a few years, we have gone from the controlled chaos of open-outcry pits, to a machine dominated market where now even a millisecond is considered slow. In the time it would take a floor trader to hang up the phone and signal a bid with his hands in the pit, today’s machines can generate around 2,000 orders.
That has changed the composition of trading volume. The number of dealer bids and offers on behalf of customers that remain unchanged in the order book for significant periods of time is relatively small, as compared to orders that are modified or canceled in a microsecond.
Today proprietary trading firms represent 50 to 60 percent of the volume in many key contracts. This amount is often higher in stressful moments. But they represent a far lower percentage of the open interest, often only 5 percent. Open interest is the measure of whether one has a long or short position at the end of the day. And it is open interest that truly measures the ability of derivatives markets to transfer risk. A farmer can only hedge the price of corn over a three or six month period if someone else is willing to take the other side for that same period.
Today much of the trading volume—that is, number and frequency of transactions, not to mention bids and offers--comes from traders who want to be flat at the end of the day. They do not contribute to open interest.
I meet with many traditional users who have concerns about the nature of trading and wonder if they should still participate in these markets. They complain that bids or offers disappear before an order can be placed. They complain that their bids are picked off, or that they cannot execute large orders.
It may just be that large orders must be broken up into a series of smaller ones, and the overall execution price is still lower. It may be that the volume from traders who do not increase open interest still adds to the price discovery process, which is another key function of these markets. It may still contribute to a narrowing of spreads.
But these concerns, which I hear frequently, deserve attention. Another is whether the speed of trading contributes to greater volatility.
If we were to roll back the Dodd-Frank Act, would the nature of liquidity change? I am skeptical that it would. Banks that participate today often use similar algorithmic trading strategies.
So the question is not whether there is liquidity in the markets. There is liquidity, but liquidity is very different today. And we must understand these trading dynamics and consider how well our markets are serving their traditional purposes. We need to make sure that participants, given the speed of modern markets, have implemented controls that mitigate the effects of unanticipated algorithmic behavior on the market and market liquidity as a whole. I will talk more about the market protections we have been working on later in this speech. Businesses of all types still depend on these markets to hedge routine risk and engage in price discovery. Whether it is corn or crude oil, equities or Treasuries, Japanese yen or British pounds—businesses need these markets to function reliably, fairly, and free of manipulation or disruption.
The Road Ahead
At the outset, I mentioned the need to focus on the challenges ahead, and I believe one is the implications of automated trading. But of course, one of the most pressing questions on people’s minds is: what should we expect for the regulation of these markets in light of recent political events?
I do not wish to make any predictions. And frankly, when it comes to Brexit, it’s difficult for anyone to do so, as we do not even know the broad outlines of the future relationship between the U.K. and Europe. But I would make the following observations, first with respect to Brexit and then with respect to our own election.
Regulation in a Post-Brexit World
Under the European regulatory framework today, Brexit will mean that the UK must obtain mutual recognition—or “equivalence”— for its clearinghouses and trading platforms, as must any third country. If it does not, European financial firms will face higher capital charges for transactions cleared in the UK. The CFTC secured this status earlier this year, reaching a landmark agreement with the European Union after long and difficult negotiations.
Even if the UK adopts laws to regulate its markets that are quite similar to European laws today, there could be significant challenges. The first is simply timing: under the law today, the process for deciding whether to grant equivalence would not start until after the UK exits. Therefore, there would need to be a change in the process to avoid a gap between exit and recognition.
A more fundamental question is whether Europe will be willing to apply the same equivalence framework to the UK as it did with the U.S. and other countries, or whether Europe will want greater ongoing oversight of UK clearinghouses and exchanges, given their importance to Europe. The equivalence standard does not easily provide that—it is largely a one-time decision. Moreover, some European leaders have said that the clearing of euro-denominated products should move from London to continental Europe. This demand raises very significant issues.
Prior to Brexit, the European Central Bank sought to move euro-dominated repo clearing, but failed following a lawsuit by the UK. At the time, this action may have been motivated by a desire for greater control over repo clearing in light of linkages to monetary policy. Today, the objectives may be broader.
While requiring that euro-denominated transactions be cleared in the E.U. will provide greater oversight, it will be at the price of disrupting market relationships. It will limit the ability of users to manage euro-denominated transactions with the rest of their portfolios, and effectively raise margin costs. All of that will increase costs for organizations using euro-denominated products, which will potentially reduce the use of such contracts.
In addition, if Europe were to insist that clearing of euro-denominated products cannot occur in London, does that mean such clearing cannot occur anywhere outside of Europe, including in the United States? Could such a demand lead other countries to adopt similar policies regarding clearing of products in their own currencies? And how should the U.S. respond in that event?
The volume of euro-denominated products cleared in the U.S. is quite small. But the volume of dollar denominated derivatives clearing that takes place in London is very large. Indeed, there is more dollar swaps clearing in London than euro swaps clearing.
The CFTC has never insisted that dollar-denominated products be cleared in the U.S. On the contrary, we have not even insisted that dollar-denominated products traded on U.S. exchanges be cleared in the U.S.
Instead, the CFTC requires overseas clearinghouses that do substantial U.S. business to register with us and provide us with access just like any U.S.-based clearinghouse. Today, the principal clearinghouses located in London are registered with us. In the course of the equivalence negotiations, European leaders asked us to eliminate this registration framework because it provides for ongoing oversight, unlike the European equivalence model, but I staunchly defended it.
This framework gives us the ability to oversee what is going on at such foreign clearinghouses. It is because of this oversight that we were able to include these foreign clearinghouses in our recent stress test. No other regulator of clearinghouses is currently able to look across national boundaries like that. Another benefit of this registration framework for the UK is that Brexit is not likely to require significant changes to the U.S.—U.K. regulatory relationship with respect to derivatives clearing.
With freely convertible currencies, I think it is a mistake to restrict where clearing can occur in this way. Markets benefit from large pools of liquidity. Market participants benefit from managing as many of their transactions together as possible. But it can be valuable to have some degree of oversight into offshore clearinghouses. E.U. and U.K. officials will have to decide how to address these issues.
The Future of Reform in the United States
Let me turn to our own election. There is much talk about repealing or dismantling Dodd-Frank. I will not make predictions here either, but I will offer a few thoughts on what I believe is the proper path forward when it comes to the derivatives markets.
As I noted earlier, I believe there’s a wide consensus that the reforms made to bring transparency and oversight to the swaps market made sense, and therefore it would be a mistake to significantly change them.
Of course, this does not mean we cannot have good faith policy differences on how best to implement that framework, nor does it mean we cannot improve upon the existing rules. We surely can—and will. I and my fellow Commissioners, Chris Giancarlo and Sharon Bowen, joined the agency together in June of 2014. The agency already had written most of the rules required by Dodd-Frank. However, there were many criticisms and concerns. There were those who said we hadn’t done enough and those who said we had done too much. We inherited the task of finishing and improving this framework.
We have achieved a lot since then. We addressed many concerns of commercial end-users, to make sure the reforms did not place inappropriate burdens on them. They were, after all, not responsible for the financial crisis. We worked to keep the focus of regulation on those who create the most risk. We have worked to make rules less prescriptive in some areas. We have also worked hard to strengthen relationships with international regulators and harmonize regulations across borders. And we did much of this work on a bipartisan, unanimous basis. Let me thank Commissioners Bowen and Giancarlo for always ensuring a very constructive and cooperative engagement.
There is more that can be done in all these areas. But let me be clear: eliminating essential derivatives reforms would be a big step backward.
As we approach the peaceful transfer of power, we are approaching an important choice. We can choose to refight the last war, as I mentioned at the outset—and debate or even unwind the basic framework that has clearly strengthened our derivatives markets. Or we can choose to recognize that while we should continue to make improvements to these reforms, we should focus on other challenges that require our attention.
Markets constantly evolve. Regulators often have difficulty keeping up. We are often directed to look backward and address the causes of past problems, as with the financial crisis. But current and future challenges may well be different. And regulators should always have a good degree of humility about what we can accomplish.
For example, technological change has brought significant new challenges to our markets. First and foremost is the risk of cyberattack. Cybersecurity has been a priority for us, and we should continue that effort. This is probably the greatest single threat to financial stability today.
Automated trading is another key concern. While this technology brings many benefits, it also brings increased risks of a disruptive event and new forms of improper or abusive behavior. We must focus on the risk of disruption, breakdowns or loss of information that can come with increasing speed and technological complexity generally. We must enhance our ability to understand and analyze activity at the micro-second level, as well as in correlated cash markets. Regulators must cooperate to the extent that trading in different markets is linked. We must also focus on the changing nature of trading and liquidity to make sure our markets still function with integrity and serve the businesses that need them.
The innovations that may be created through financial technology such as blockchain represent another form of change that deserves our attention. We are probably still a ways away from meaningful applications of this technology in our markets. But we must make sure our rules do not stand in the way of its potential.
We also need to continue to work with other regulators from around the world. We cannot have modern, global regulation of markets without extensive international coordination and cooperation. This includes harmonizing rules as much as possible, and working together on oversight. We have made great strides here. This is true not just with Europe and the U.K. We are actively engaged with China, India, Japan, Hong Kong, Australia, Singapore and others on important initiatives, including clearinghouse regulation, automated trading, cybersecurity and surveillance and enforcement matters.
Finally, we must remember that making sure our financial markets work well does not mean we have made sure our economy delivers opportunity for all. The United States has the strongest financial markets in the world, and these have helped to create our strong economy, of course. But the bigger, broader challenges facing our economy, particularly as a result of structural shifts due to decades of globalization and automation, will not be addressed by the debate over how to regulate financial markets. Those who supported President-elect Trump because of his promises to working class voters, many of whom may believe the government has been captured by powerful interests, will have been sold a bill of goods if wholesale repeal of Dodd-Frank is made out to be a critical part of the solution to concerns about economic stagnation or lack of opportunity. By the same token, we cannot claim that Dodd-Frank has solved those voters’ economic struggles.
The path to creating an economy that offers opportunity to all may require action on many fronts—whether it is infrastructure financing, tax reform, job training, and immigration reform. Let us therefore not spend too much time on battles of the past--but rather let us come together and look for the solutions that move our economy and our country forward.
Thank you very much.
Last Updated: December 6, 2016