Remarks of Chairman Gary Gensler on Over-the-Counter Derivatives Reform to the American Cotton Shippers Association Annual Meeting, Washington, DC

(The meeting was held at the Charleston Place Hotel, 205 Meeting St., Charleston, SC. Chairman Gensler delivered his remarks via telephone from Washington, DC.)

May 14, 2010

Good morning. I thank the American Cotton Shippers Association for inviting me to speak this morning. We have reached a critical moment in our effort to bring comprehensive regulatory reform to the over-the-counter derivatives marketplace. This marketplace was at the center of the 2008 financial crisis. It is essential that we work to lower risk and increase transparency in the OTC marketplace to protect the American public and lower the risk of a future taxpayer-funded bailout.


Now I will take a few minutes to discuss the status of over-the-counter derivatives reform legislation before taking your questions.

As you know, derivatives have been around since the Civil War, when grain merchants came together to hedge the risk of changes in the price corn, wheat and other grains on a central exchange. These derivatives are called futures.

I am sure that many of you use futures to hedge the risk of future changes in the prices of cotton. Nearly 60 years and a financial crisis – the Great Depression – after they first traded, Congress brought Federal regulation to the markets. It wasn’t until the 1930s that the Commodity Exchange Act, which created the CFTC’s predecessor, became law.

Futures markets facilitate the price discovery process and make it easier to hedge commercial risk. Even as our markets have become more diverse and we have seen a large influx of investors seeking exposure to commodities as an asset class, the Commission has remained committed to ensuring markets remain effective hedging tools for commercial users.

To promote transparency in the futures markets, we have improved our Commitment of Traders reports so that the market can see what types of traders are participating most. We also started regularly releasing data on index investment in the commodity markets. These reports provide the public with a window into market structure that we hope helps in making hedging decisions.

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Before I get back to discussing the over-the-counter derivatives marketplace, I will take a moment to discuss the issue of additional cotton delivery points. It is important that the exchanges periodically review contract specifications and make sure that they are keeping up with changing markets. In particular, it is important that exchanges review delivery points so that they best reflect the changing characteristics of the physical marketplace. The IntercontinentalExchange, Inc. (ICE), where the principal cotton futures contracts are traded, is currently reviewing a study on current and potential delivery points for the ICE US Cotton No. 2 futures contract. Recently, the Chicago Board of Trade undertook a similar review with their Soft Red Winter Wheat contract. The CFTC recognizes there have been concerns about delivery points as the demand and production patterns for cotton have changed. We look forward to reviewing the exchange’s recommendations.

Over-the-Counter Derivatives

From the 1930s until the 1980s, all stocks, bonds and derivatives were subject to comprehensive oversight by federal regulators. Cotton futures, for example, were traded on regulated exchanges and policed to ensure fair and orderly trading. Things began to change in 1981 with the first over-the-counter derivative transaction. Instead of trading through exchanges and being cleared through clearinghouses, over-the-counter derivatives are generally transacted bilaterally and are not subject to regulation.

Over-the-counter derivatives were at the center of the 2008 financial crisis. Taxpayers bailed out AIG with $180 billion when that company’s ineffectively regulated $2 trillion derivatives portfolio nearly brought down the financial system.

Essential Components of Reform

As of today, the U.S. House of Representatives, the U.S. Senate Banking Committee and the U.S. Senate Agriculture Committee have each passed regulatory reform legislation that addresses the over-the-counter derivatives markets. The two Senate committees also have produced a strong joint substitute amendment that takes some of the strongest provisions from each committee’s bill. It is essential that any reform that passes accomplishes three goals.

First, it must comprehensively regulate any entity that deals derivatives.

Second, we must bring standardized over-the-counter derivatives onto transparent and regulated exchanges or similar trading venues to lower risk and improve pricing in the marketplace.

Third, to further lower risk, we must bring standardized over-the-counter derivatives into central clearinghouses. Clearinghouses in the futures markets have been around since the late-19th century and have functioned both in clear skies and during stormy times to lower risk to the American public.

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Regulating the Dealers

Financial reform must bring comprehensive regulation to derivatives dealers. By fully regulating the dealers, we can ensure that every derivatives transaction is regulated.

Dealers should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail, as the public was forced to do with AIG. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

Enhancing Transparency in the Marketplace

We also must bring sunshine to the currently dark over-the-counter derivatives markets.

To bring market transparency to the regulators, Congress should enact robust recordkeeping and reporting requirements for all derivatives transactions. This would include on-exchange transactions and bilateral transactions.

Bringing transparency to the regulators, however, is not enough.

We must also bring transparency to the public. Right now, when Wall Street banks enter into derivatives transactions with their customers, they know how much their last customer paid for the same deal, but that information is not made publicly available. They benefit from internalizing this information. The buyer and seller never meet in a transparent market, and Wall Street profits from wider spreads between the bids and the offers. This is in stark contrast with the regulated futures and securities markets, where the public can see the price of the last transaction traded on a regulated exchange as well as the latest bids and offers.

Further, one of the lessons from the 2008 financial crisis was that transparency is critical to lowering risk in the marketplace. We all recall the inability of the Federal Government and Wall Street to price assets during the crisis – assets that we began to call “toxic.” It is essential that reform enables better pricing of those assets.

To best promote public market transparency, regulation should require that standardized over-the-counter derivatives trade on regulated exchanges or similar trading venues.

The more transparent a marketplace, the more liquid it is and the more competitive it is. Transparent trading venues would enable all market participants – from the cotton shipper to the oil producer to the retailer importing products – to lower the cost of hedging their risk. This also would lower costs to their customers and lower risk to their enterprises.

Exchanges and other regulated trading venues also would lower risk in the system by enabling clearinghouses to get reliable pricing information and determine the liquidity of particular contracts. This is essential for clearinghouses to adequately manage their risk and thus lower risk to the economy and the public.

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Centralized Clearing

To further lower risk in the over-the-counter derivatives marketplace, standardized derivatives should be cleared through central clearinghouses.

Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. When you enter into futures contracts on cotton, your contracts are centrally cleared to lower risk your risk.

In the over-the-counter marketplace, transactions stay on the books of the derivatives dealers for many years. This enables dealers to become dangerously interconnected with each of its counterparties as we saw with AIG. Clearinghouses move the risk off of the books of the dealers and into robustly regulated central counterparties.

Some derivatives are highly tailored to meet the particular needs of particular hedgers, and those contracts should not be subject to a clearing requirement. We should, however, ensure that capital and margin requirements account for the additional risk posed by customized bilateral derivatives transactions.

It is essential that we move as many over-the-counter derivatives transactions into central clearing as possible. There should be no exemption from clearing when a contract is transacted between two financial entities. That would leave interconnectedness in the financial system and make future bailouts ever more compelling.

The Wall Street reform bill now being considered by the Senate does include exemptions for non-financial end-users that use derivatives to hedge commercial risk. Cotton shippers, for example, would only have to clear their non-agricultural contracts if they choose to do so. You also will benefit from real time reporting of all clearable trades and significantly better price transparency than what we currently have in the over-the-counter marketplace. Lastly, you would benefit from significantly lower risk as all swap dealers would be regulated and all financial entities would have to clear their swaps.

Agriculture Swaps

Before I close, I will take a moment to discuss agricultural swaps. The financial reform bills currently before Congress are likely to leave in place the existing regulatory regime for agricultural swaps as addressed in Part 35 of the Commission’s regulations. Such current regulations only allow for agricultural swaps if (1) they are negotiated between eligible parties and (2) they are not brought to a clearinghouse. Once financial reform legislation is signed into law, I look forward to the Commission considering rulemaking that would make treatment of agricultural swaps consistent with the treatment of other swaps where appropriate. For instance, in considering revisions to Part 35, we would address whether to generally allow the clearing of agricultural swaps or to continue to make decisions on clearing on a case by case basis as we do today. If financial reform is passed, we will welcome your input during this process.


In 2008, the financial system failed, and the financial regulatory system failed. The results have been calamitous. While the stock market has rebounded and many Wall Street banks have paid back their TARP money, the American public is still largely unprotected from the risks associated with the over-the-counter derivatives marketplace. Financial reform will be incomplete if it does not bring robust, comprehensive regulation to this market.

Thank you, and I’d be happy to take your questions.

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Last Updated: January 19, 2011