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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.
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.
The swaps market since its inception has remained unregulated. The swaps market has grown in size and complexity that far outstrips the futures market, and is over six times the size of the futures market. 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 limited regulatory system that was put in place to protect the public failed as well.
In 2010, 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.
As of October 12, the new era of swaps market reform began. For the first time, regulators and the public are beginning to benefit from market transparency. Swap dealers will come under comprehensive oversight, and central clearing will soon lower risk and help level the playing. Three principal areas of reform include the clearing requirement, transparency initiatives and swap dealer registration.
Central clearing equalizes access to the market and democratizes it by eliminating the need for market participants to individually determine counterparty credit risk, as now the clearinghouse stands between buyers and sellers. In July 2012 the Commission embarked on the last step toward clearing of standardized swaps when we sought public input on the first set of swaps that will be required to be cleared. They begin with standard interest rate swaps in U.S. dollars, euros, British pounds and Japanese yen, as well as a number of CDS indices, including North American and European corporate names.
As of October 2012, transparency was brought to the swaps market when cleared interest rate and CDS transactions began to be reported to swap data repositories. By 2013, the public will benefit from real time reporting for these transactions, as well as for uncleared swap transactions entered into by swap dealers. Further transparency will result from the use of swap execution facilities.
Comprehensive oversight of swap dealers will promote transparency and lower their risk to the rest of the economy. The process of registration has begun, and the Commission anticipates that many dealers will do so by January 1, 2013.
The development of swaps regulations marks new era for the commission, one that will challenge the Commission to provide effective oversight for the futures and swaps markets.
However, regulation in the United States alone will not be sufficient to protect the financial system. The swaps market is conducted on a global basis. As a result, during a default or crisis, risk knows no geographic border. If a run starts on one part of a modern financial institution, almost regardless of where it is around the globe, it invariably means a funding and liquidity crisis rapidly spreads to the entire consolidated entity. This was illustrated by the activities of the overseas affiliates of AIG, Lehman Brothers, Citigroup and Bear Stearns.
When financial institutions or others operating outside the United States transmit risks directly into the United States through swap activities with U.S. persons, Dodd-Frank Act and Commission regulations provide for the regulation of such activities in the same manner as swap activities within the United States. In the summer of 2012, the Commission proposed guidance interpreting the cross-border application of the Dodd-Frank Act and an approach to phased compliance for foreign swap dealers. In the interim, the CFTC issued time-limited relief to certain foreign legal entities regarding the counting of swaps toward the de minimis swap-dealing threshold.
Given the new era of swaps market reform, it's the natural order of things that market participants have sought further guidance. This regularly occurs as the Commission moves to market implementation from Congressional legislation and agency rulemaking.
Benchmark interest rates, such as LIBOR, are a key component of our financial markets, and they must work for the rest of the economy. To do so, they must be honest and reliable and based on sufficient numbers of transactions. The Commission's settlement with Barclay's Bank reflects that better standards are needed with respect to benchmarks, many of which are referenced in futures and swaps contracts. The Commission is co-chairing an IOSCO Task Force on benchmarks with the U.K. FSA. This project will include a public roundtable and culminate in a report and recommendations in the spring. The IOSCO Task force will be seeking public input on possible mechanisms and protocols that would best ensure for a smooth transition when needed.
As noted above, futures and swaps regulation in the United States alone will not be sufficient to protect the financial system. The Commission's Global Markets Advisory Committee will continue to meet to obtain the views of international regulators, futures and swaps industry professionals and market participants on cross-border issues related to OTC derivatives reform.
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. These issues will continue to be addressed within the Commission's Technology Advisory Committee. In addition, , 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.
To effectively accomplish its mission, the CFTC must adapt to frequent and innovative changes in the derivatives markets, increasing use of technology and growing market complexity. The Commission will extend its data ingestion and analysis framework to manage market data as it evolves with the industry and to make greater use of pre-trade and non-regulatory data. The framework will continue to be leveraged and built upon to provide services that multiply the effectiveness of staff, accomplishing integration between futures and swaps data and increased integration of CFTC systems and processes for monitoring registered entities, market and financial risk, market integrity, trade practice, enforcement, and economic analysis. CFTC will also extend the framework to complement direct access portals being deployed by SDRs in order to integrate swaps and futures data in Commission systems. The CFTC will establish common minimum data standards among the SDRs to ensure data interchange and interoperability. The CFTC will also establish and maintain a unified set of master data and reference data using legal entity identifiers as a linchpin. The Commission will also increase the use of industry and government system-based data services in order to reduce as much as practical the latency between market events and staff ability to analyze correlated data from diverse sources.
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 Committee on Commodity Futures Markets. Work within that Committee led to the development of reports articulating principles for the regulation and oversight of commodity futures markets and principles for oil price reporting agencies. 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.
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