In September 2008, our economy fell into a downward spiral when one large financial institution after another teetered on the brink of failure, threatening our financial system and the well-being of the American public.
We are still feeling the aftershocks of this financial crisis. More than eight million jobs were lost and the unemployment rate remains stubbornly high. Millions of Americans lost their homes or are now in homes worth less than their mortgages. And millions of Americans continue struggling each day to make ends meet.
While the crisis had many causes, it is evident that unregulated derivatives, called swaps, heightened risk on Wall Street and played a central role in the financial crisis. Developed in the 1980s, swaps, along with the regulated futures market, help producers, merchants, and other companies to lower their risk by locking in the price of a commodity or an interest rate, currency or other financial index. The public buys gasoline and groceries from companies that rely upon futures and swaps to hedge their commodity price risks. The public keeps their savings with banks and pension funds that use swaps to manage their interest rate risks. Our nation's economy relies on a well-functioning derivatives market - an essential piece of a healthy American financial system.
Over the last thirty years, however, the swaps market had remained unregulated and grew in size and complexity that far outstrips the futures market; it is now seven times the size. Swaps added leverage to the financial system - with more risk backed by less capital.
Swaps contributed significantly to the interconnectedness between banks, investment banks, and hedge funds, among other financial entities. Large financial institutions, were regarded not only as too big to fail, but also too interconnected to fail. When AIG, Bear Stearns and others collapsed, taxpayers were made to pick up the bill to prevent the economy from diving deeper into a depression. The financial system failed. Moreover, the regulatory system that was put in place to protect the public failed as well.
Just over a year ago, Congress and the President came together and passed an historic law: the Dodd-Frank Act. For the first time, the CFTC and SEC will have oversight of the swaps and security-based swaps markets.
The Dodd-Frank Act includes many important provisions, but includes two overarching goals of reform: bringing transparency to the swaps market and lowering the risks of this market to the overall economy. Both of these reforms will better protect taxpayers from again bearing the brunt of a financial crisis and will cut costs for businesses and their customers.
The first overarching goal of reform brings critical transparency to the derivatives marketplace. The more transparent a marketplace is the more liquid it is and the more competitive it is. In short, when markets are open and transparent, costs are lower for companies and the people who buy their products. They are safer and more sound.
The Dodd-Frank Act promotes both pre-trade and post-trade transparency. It moves certain standardized swaps transactions to exchanges or swap execution facilities. This will allow buyers and sellers to meet in an open marketplace where prices are publicly available, rather than in the shadows of the financial system. The Dodd-Frank Act also requires the real-time reporting of the price and volume of transactions. Furthermore, it requires that once a swap transaction is arranged, its valuation must be shared on a daily basis with the counterparty. These measures of transparency and openness reduce some of the information advantages that dealers currently have over Main Street.
The second overarching goal of reform is equally as important. The law lowers risk to the overall economy by directly regulating dealers for their swaps activities as well as moving standardized swaps into central clearing. Clearinghouses mitigate the risks that arise from the interconnectedness in the financial system by standing between counterparties and guaranteeing the obligations of the parties in case of default. They have lowered risk for the public in the futures markets since the late-19th Century - through world wars, the Great Depression, and financial crises. It's time to modernize the swaps market and provide the same protections for taxpayers.
This spring, the CFTC largely completed the proposal phase of its rule-writing process. This summer, the agency turned an important corner, as we began finalizing rules to make the swaps marketplace more open and transparent for participants and safer for taxpayers.
Among the regulations we have completed is a rule giving the Commission new authority to effectively prosecute wrongdoers who recklessly manipulate the markets. Also, we will soon begin rewarding whistleblowers for their help in catching fraud, manipulation or other misconduct in the financial markets.
The Commission also finished rules that, for the first time, will give regulators and the public specific information on the derivatives market's scale and risk. These rules require dealers, clearing members and clearinghouses to give the CFTC data about their swaps activities and establish swap data repositories that will receive information on all swaps transactions. By contrast, in the fall of 2008, there was no required reporting about swaps trading: no one knew how big a problem this market posed to the economy because so much of the trading happened in the dark.
Next in queue of the final rules will be the consideration of critical regulations related to speculative position limits, as well as risk management for clearinghouses.
While U.S. regulators work to implement the Dodd-Frank Act here at home, the Commission also is actively consulting and coordinating with international regulators to promote robust and consistent standards in swaps oversight. The Commission also anticipates seeking public input on the application of Section 722(d), which says that the law does not apply to activities outside the United States unless those activities have a direct and significant connection with or effect on U.S. commerce.
Twenty-first century finance, though, knows no true geographic borders as money and risk can move around the globe with a touch of a button. Sober evidence of this can be seen through AIG's swaps affiliate, AIG Financial Products, which had its major operations in London. When it failed, the U.S. economy, and taxpayers shouldered the greatest burden.
Economists have agreed for decades that transparency in markets actually reduces costs and makes markets more efficient. Furthermore, the U.S. financial system remains interconnected through the swaps market here, in Europe and in Asia. Thus, the current debt crisis in Europe is but a stark reminder of why completing financial reform is so necessary for the U.S. economy and to protect taxpayers. Dodd-Frank is about transparency and ensuring the public does not bear the risks of the financial system.
In 2008, if Dodd-Frank had been in place, greater transparency would have allowed regulators to see the simmering problems at large financial institutions, such as AIG. In 2008, our nation had a difficult decision: rescue institutions or risk a depression. At its core, Dodd-Frank lowers the risk that the American people will ever be put in that position again.
At the CFTC, commissioners and staff are working day and night to put up the necessary street lamps to bring the swaps market out of the shadows and the traffic signals to protect the public from another financial crash. Until these reforms are complete, however, the public remains at risk.
The agency is taking on a significantly expanded scope and mission. So far, staff and commissioners have held more than 1,000 meetings with the public, and received over 25,000 comments on its proposed rules. As the Commission continues to finalize rules, market participants will increasingly seek guidance from the CFTC. Without sufficient funding, though, it will not have the resources to be as responsive to the public as it should be.
The agency must be adequately resourced to ensure the new swaps market rules will be strictly enforced - rules that promote transparent markets, lower costs for consumers and protect taxpayers. Without sufficient funding, the Commission will not have the resources to put enough cops on the beat for the public's protection.
The financial crisis prompted multilateral organizations, such as IOSCO, to emphasize the identification of systemic risks as a new principle for its member regulatory agencies. The 2010 financial legislation similarly stressed the need for a more comprehensive approach to the identification of systemic risk through the creation of a new risk council composed of the U.S. financial regulators. The Commission will need to develop internal mechanisms and acquire new competencies and approaches to risk identification to address this new policy objective. Addressing systemic risks will also involve greater international cooperation and the development of new global mechanisms for the ongoing evaluation of, and sharing of concerns regarding, emerging global financial risks. The challenge will be to develop internal, domestic and global mechanisms that can understand, identify and address novel, emerging forms of risk.
The May 2010 "flash crash" has focused attention on the activities of high frequency, algorithmic-driven traders. High frequency trading challenges regulators to understand how this form of trading has transformed markets and poses new questions concerning what constitutes abusive trading practices. As part of addressing this issue, the Commission will continue its participation with the SEC in the Joint Advisory Committee on Emerging Regulatory Issues. Because trading takes place globally, the CFTC expects to cooperate with other international authorities that are examining these issues as well. The Commission also will continue to conduct its own research in this area.
The continued concerns that have been expressed with respect to contract specifications in several agricultural futures contracts raise issues that go to the core of the commodity markets and their continued viability for hedging. The Commission will remain engaged in these critical issues, both through the Commission's Agricultural Advisory Committee and the deployment of staff to analyze these problems on a priority basis.
Global shortages, increasing consumer demands and a variety of fundamental factors that affect and possibly distort supply and demand make it likely that there will be continued periods of price volatility in strategically important energy and agricultural commodities. Most recently these concerns have been expressed by the G20 Group of Financial Ministers, and the Commission expects that these concerns will continue to be expressed in the years ahead.
The Commission has contributed to the U.S. response to these G20 concerns through its co-chairing of an IOSCO Task Force on Commodity Futures Markets. Work within the Task Force helped focus attention on the need for greater transparency in OTC and cash markets as means to match the transparency that already exists in futures markets. The Commission expects to share its expertise concerning techniques used to: identify and make public, through its Commitments of Traders (COT) reports, large concentrations of positions, the use of position limits as a means to address what the CEA terms excessive speculation, and the application of aggressive enforcement programs that target conduct that may involve futures, OTC and cash markets. The continued "linkage" of U.S. and European markets through dually-regulated intermediaries, exchanges, clearing-houses and soon-to-be registered trade repositories will undoubtedly require closer cooperation and coordination with European authorities.