The New Era of Swaps Market Reform - Keynote Address before the George Washington University Center for Law, Economics and Finance Conference
CFTC Chairman Gary Gensler
October 10, 2012
Good afternoon. Dean Berman I appreciate that kind introduction. I thank the George Washington University Center for Law, Economics and Finance for the invitation to speak today. I look forward to talking with you about the importance of this week.
The days of the opaque swaps market are ending. This Friday, October 12, we are shifting to a new era of transparency and commonsense rules of the road for the swaps market.
New Era - Swaps Market Reform Becomes a Reality
During the Great Depression, President Roosevelt and Congress put in place similar rules to bring transparency to the securities and futures markets, and protect investors from fraud, manipulation and other abuses.
These critical reforms of the 1930s are at the foundation of our strong capital markets and many decades of economic growth.
Swaps emerged in the 1980s to provide producers and merchants a means to lock in the price of commodities, interest rates and currency rates. Our economy benefits from a well-functioning swaps market, as it’s essential that companies have the ability to manage their risks.
The swaps marketplace, however, has lacked the necessary transparency to best benefit Main Street businesses and common-sense rules to protect the public.
Further, in 2008, swaps, and in particular credit default swaps, concentrated risk in financial institutions and contributed to the financial crisis, the worst economic crisis Americans have experienced since the Great Depression.
Eight million Americans lost their jobs, millions of families lost their homes, and small businesses across the country folded.
When the financial crisis hit, the swaps market was the largest dark pool in our financial markets. Think about this for a moment. At $300 trillion – or $20 for every $1 of goods and services in our economy – the swaps market lacked any transparency except for that which the financial sector was willing to share.
It lacked the great reforms of the 1930s, such as public reporting of transactions and central exchange trading.
It lacked the time-tested tenants of risk management to protect the public, such as central clearing and dealer regulation.
Congress and President Obama responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and tasked the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) with bringing transparency to and lowering the risk of the swaps market – the same type of public protections that have worked for decades in the securities and futures markets.
To date, the CFTC has completed 39 of these reforms, and substantive swaps market reform is now in sight. The foundation of transparency and lowering the risk of the swaps market has been laid.
The reform structure Congress and the President have built is becoming a reality this week. The new era is beginning.
Bright lights will begin to shine on the swaps market. Transparency lowers costs for investors, consumers and businesses. It increases liquidity, efficiency and competition. And it shifts some of the information advantage from Wall Street banks to businesses across the country that use these markets to lock in a price or rate and hedge a risk.
By the New Year, we will have achieved real-time public reporting and reporting to swap data repositories (SDRs) of interest rate and credit default swap (CDS) indices. Reporting for energy and other physical commodity swaps begins shortly thereafter.
Regulators and the public will have their first full window into the swaps marketplace.
This week, swap dealers begin the process of registering and, for the first time, will come under comprehensive regulation to lower their risk to other market participants and the economy. Once registered, swap dealers will implement crucial back office standards that lower risk and increase efficiency. Swap dealers also will be required to implement sales practices that prohibit fraud, treat costumers fairly, and improve transparency.
The Commission has made significant progress on bringing swaps into central clearing, which will lower the risk of the highly interconnected financial system. For over a century, through good times and bad, central clearing in the futures market has lowered risk to the broader public.
Dodd-Frank financial reform brings this effective model to the swaps market. Clearing is particularly critical given the current economic uncertainty in Europe and recent ratings downgrades of many of the world’s leading banks.
Based on completed rules, clearinghouses are adopting risk management reforms that will be implemented by November 8.
Among these are customer protection enhancements that require clearinghouses to collect margin on a gross basis and the so-called “LSOC rule” (legal segregation with operational comingling) for swaps. This rule prevents clearing organizations from using the collateral attributable to cleared swaps customers who haven't defaulted to cover losses of defaulting customers.
Looking forward, in line with the historic reforms that Congress and the President enacted, we’ll be further enhancing the swaps market reform structure.
First, the initial set of clearing determinations may be finalized as early as next month. This would lead to required clearing by swap dealers and the largest hedge funds as early as February. Compliance would be phased in for other market participants through the summer of 2013.
Second, the CFTC is looking to finalize later this fall a set of rules promoting further transparency for the swaps marketplace. This includes rules on minimum block sizes, as well as for trading platforms called swap execution facilities.
And third, the CFTC is working on final guidance on the cross-border application of Dodd-Frank swaps market reform. This guidance is critical because swaps executed offshore by U.S. financial institutions can send risk straight back to our shores. This happened with the London and Cayman Islands affiliates of AIG, Lehman Brothers, Citigroup, Bear Stearns and Long-Term Capital Management. Earlier this year, it happened again when JPMorgan Chase executed swaps through its London branch.
Details of Implementation
As October 12 means a new era for the swaps marketplace, bringing it more into the public light, the natural order of things is that market participants will seek guidance. As we’ve moved from congressional legislation to agency rulemaking -- and now to market implementation, such questions and requests are a normal part of the process. The fine tuning that results is expected.
We welcome inquiries from market participants. My fellow commissioners and I, along with the CFTC staff, are all committed to sorting through issues as they arise.
Throughout the rule writing and now the implementation process, the CFTC has been working with market participants to provide guidance. For example, we issued a guidebook on the large-trader reporting rule with detailed instructions for submitting reports to the Commission.
The CFTC also has worked to appropriately phase in compliance. We reached out broadly on the topic of appropriate timing for various market participants to comply with reforms. We put out a concepts document guide for commenters, held a two-day public roundtable with the SEC, and proposed rules on implementation phasing. The Commission has included phased compliance schedules within many of our rules, including data, real-time reporting and the recent guidance on cross-border application of swaps market reform.
We continue to want to hear from market participants on any timing or phasing issues that may arise.
Benchmark Interest Rates
Before I close, I’d like to turn to the international work being done on benchmark interest rates, such as LIBOR.
As a market regulator, the CFTC’s mission is to ensure that markets are free of fraud, manipulation, false reporting and other abuses, which is why the CFTC began to investigate Barclays in 2008.
But this is not just about one settlement. It’s about ensuring the public can rely on honest benchmark interest rates. And market data continues to raise questions about the integrity of LIBOR today.
As international market participants and regulatory authorities move toward more reliable and honest benchmark interest rates, I believe it is critical that such rates rely upon observable transactions.
For a benchmark rate for any commodity to be reliable and have integrity, it’s best to be anchored to real, observable transactions.
A rate that relies upon observable transactions is anchored by the reality of that price discovery.
A rate that relies upon observable transactions has a lit path to credibility.
A rate that relies upon observable transactions is less vulnerable to misconduct.
Martin Wheatley and I are co-chairing the International Organization of Securities Commissions task force that will build on the plan he recently published and examine next steps on benchmark interest rates. We had our first meeting in Madrid last week.
Among the critical topics before us are issues market participants might confront when seeking to make a transition to a new or different benchmark and potential mechanisms to overcome those challenges. I look forward to broad global consultation on these critical matters.
In conclusion, this week marks a new era in the swaps marketplace.
The 1930s reforms brought light to the securities and futures markets, helping to promote decades of economic growth and are at the core of our strong capital markets.
The swaps market reforms going into effect this week hold out similar potential. Bright lights of transparency will shine, dealers will come under comprehensive regulation and standardized swaps between financial entities shortly will be centrally cleared. The public will benefit and our markets will be stronger in this new era.
Last Updated: October 10, 2012